Income Tax Taxation

Deferred Tax Asset or Liability: Know about its Treatment in Books of Accounts

Deferred Tax Asset or Liability is an integral part of the financial statements. Adjustments made in the year-end in the books of accounts affect the income tax amount of the business for that year as well as for the coming years. The word Deferred is originated from the word ‘Deferments’ which means to arrange for something which will happen at a later date. Hence, deferred tax is considered as tax for those items which are accounted for in the Profit & Loss Account but not accounted in taxable income, and which may be accounted for in future taxable income and vice versa. The deferred tax may be a liability or asset depending on the case.

As prescribed in AS 22

What is Deferred Tax (DT)?

The tax effect on timing difference is known as deferred tax, which means taxes which will be settled in a future date. Deferred tax occurs on all timing differences, whether it is permanent or temporary. DT is introduced in accounts to make the difference clear between current tax and future tax.

Deferred taxes are mentioned in the financial statements as deferred tax asset or liability:

S.No	Profit status of Entity	Current and Future state of the entity	Effect
1.	Book profit higher than the taxable value	Payless tax now and more in future	Creates Deferred tax liability
2.	Book profit is less than the Taxable profit	Pay more tax now and less in future	Creates deferred tax asset

The book entries of deferred tax asset or liability are straightforward. We have to create Deferred Tax liability A/c or Deferred Tax Asset A/c by debiting or crediting Profit & Loss A/c respectively.

In case of deferred Tax Liability the journal entry would be:

• Profit & Loss A/C Dr

– To Deferred Tax Liability A/C

If it is a deferred tax asset the journal entry will be:

• Profit & Loss A/C Dr

– To Deferred Tax Liability A/C

When to Create a Deferred Tax Asset or Liability in Books of Accounts?

• If the book profit is more than taxable profit then create a deferred tax liability.
• In case the book profit is less than taxable profit then create a deferred tax asset.
• If there is any loss in the books of accounts, but shows as profit as per income tax create deferred tax asset.
• If there is profit in the books of accounts but loss as per income tax and carry forward of loss is allowed, create a deferred tax liability.
• Deferred Tax Asset and Liability arising on account of timing differences and which are capable of reversal in subsequent periods are recognised using the tax rates and laws that have been enacted or substantively enacted as of the Balance sheet date.
• Deferred Tax Asset (DTA) is not recognised unless there is a virtual certainty that there will be sufficient future taxable income through which the deferred tax asset will be realized.
• DTA are created when it is certain that there will be profit in the future date.
• Direct Tax Liability (DTL) is recognised for temporary differences which will result in a taxable amount in future years. In contrast, DTA is recognised for temporary differences that will result in deductible amounts in future years and also for carryforwards.

What is the Effect of Tax Holiday with Respect to Deferred Tax Asset/ Deferred Tax Liability?

Tax Holiday is a benefit provided by the Government to new undertakings established in a free trade zone, 100% export-oriented undertakings etc., as prescribed in Section 10A,10B of the Income Tax Act, 1961. The Government has introduced this provision to encourage production and consumption of certain items by removing the taxes for a temporary period. DT from the timing difference that reverses during the tax holiday period should not be recognised during the enterprise’s tax holiday period. DT related to the timing difference that reverses after the tax holiday has to be recognised in the year of origination.

What is the Effect on Minimum Alternate Tax (MAT) with respect to Deferred Tax Asset or Liability

MAT is Minimum Alternate Tax which a company is required to pay if its tax payable as per normal provision of the income tax act is less than the tax computed @ 15% of the book profit. Companies having their corporate tax rate cut to 22 per cent without exemptions are not applicable to pay MAT. MAT is charged under section 115JB of the Income Tax Act, 1961. Companies known as ‘zero-tax’ companies show profits as per the Companies Act, 2013 but minimise tax outgo, as they display income that is zero or negative under the provisions of the Income Tax Act.  With MAT, the companies have to pay up a minimum amount of tax to the Government.MAT is calculated in the entities book of profit as under:

In Books of Accounts the profit is increased by the following:

• Income tax paid or provision
• An amount carried to any reserve
• Provisions made for unascertained liabilities
• Deferred tax provision etc

And it is decreased by the following:

• The amount is withdrawn from any reserve or provision
• Depreciation debited to Profit &Loss Account
• Lesser of Loss brought forward or unabsorbed depreciation 
• Deferred tax credited to profit &Loss Account.

There are controversies if deferred tax liability debited to Profit & Loss should be added to the income in books of accounts for the purpose of MAT calculation related to which various judgements have been passed. There have been conflicting judgements in this regard; hence the Government must clarify on this issue.

Disclosures necessary for Deferred Tax Asset or Liability in Profit & Loss Account and Balance Sheet

Profit and Loss Account

• As per AS-22, there is no precise requirement to disclose current tax and deferred tax in the statement of profit and loss.
• Deferred tax assets and liabilities must be disclosed under a separate heading in the balance sheet of the entity, separately from current assets and current liabilities.

Balance Sheet

• Current tax and deferred tax must be disclosed as per Company Law requirements.
• The break-up of deferred tax assets and deferred tax liabilities into major components of the respective balances should be disclosed in the notes to accounts.

How can a Business Calculate Deferred Tax?

The accounting for deferred taxes requires that a business must complete the following steps:

Identify existing temporary differences and carryforwards.

• By using the applicable tax rate, determine the deferred tax liability amount for the temporary taxable differences.
• Determine the deferred tax asset amount for the deductible temporary differences, as well as any operating loss carryforwards, using an applicable tax rate.
• Determine the deferred tax asset amount for any carryforwards involving tax credits.
• Create a valuation allowance for the deferred tax assets if there is more than 50% probability that the company will not realize some portion of these assets. Any changes to this allowance are to be recorded within income from continuing operations on the income statement. The need for a valuation allowance is especially likely if a business has a history of letting various carryforwards expire unused, or it expects to incur losses in the next few years.
• You can also login to https://www.incometaxindia.gov.in/Pages/tools/deferred-tax-calculator.aspx and use the deferred tax calculator provided by the Income Tax Government.

Conclusion

Even after understanding and applying deferred tax assets or liabilities, companies and investors need to analyse and understand the future cash flow effect of it. Future cash flow can be affected by deferred tax asset or liability. If a deferred tax liability is increasing, that means it is a source of cash and vice versa. So, by analysing this deferred tax helps in assessing where the balance is moving forward. It is purely legal for a company to show different accounts for tax purposes and accounting purposes. So, using this deferred tax functionality, a company can pay lesser taxes when it sees the lower profit turnout and can defer the tax payment for the coming years when profit will increase.