As stated above, deferred tax liabilities arise on taxable temporary differences (i.e. those temporary differences that result in tax being payable in the future as the temporary difference reverses). So, how does the above example result in tax being payable in the future?
Entities pay income tax on their taxable profits. When determining taxable profits, the tax authorities start by taking the profit before tax (accounting profits) of an entity from their financial statements and then make various adjustments. For example, depreciation is considered a disallowable expense for taxation purposes but instead tax relief on asset expenditure (capital expenditure) is granted in the form of tax depreciation.
Therefore, taxable profits are arrived at by adding back depreciation and deducting tax depreciation from the accounting profits. Entities are then charged tax at the appropriate tax rate on these taxable profits.
In the above example, when the tax depreciation is greater than the depreciation expense in years 1 and 2, the entity has received tax relief early. This is good for cash flow in that it delays (i.e. defers) the payment of tax. However, the difference is only a temporary difference and so the tax will have to be paid in the future. In years 3 and 4, when the tax depreciation for the year is less than the depreciation charged, the entity is being charged additional tax and the temporary difference is reversing. Hence the temporary differences can be said to be taxable temporary differences.
Notice that overall, the accumulated depreciation and accumulated tax depreciation both equal $2,000 – the cost of the asset – so over the four-year period, there is no difference between the taxable profits and the profits per the financial statements. Where local tax legislation requires that tax depreciation is calculated on a reducing (diminishing) balance basis, then the asset may be fully depreciated before the full amount of tax depreciation has been claimed. This does not make a difference to the accounting required for deferred tax.
In this example, at the end of year 1 the entity has a temporary difference of $300, which will result in tax being payable in the future (in years 3 and 4). In accordance with the accruals concept, a liability is therefore recorded equal to the expected tax payable.
Assuming that the tax rate applicable to the company is 25%, the deferred tax liability that will be recognised at the end of year 1 is 25% x $300 = $75. This will be recorded by crediting (increasing) a deferred tax liability in the statement of financial position and debiting (increasing) the income tax expense in the statement of profit or loss.
By the end of year 2, the entity has a taxable temporary difference of $400 (i.e. the $300 bought forward from year 1, plus the additional difference of $100 arising in year 2). A liability is therefore now recorded equal to 25% x $400 = $100. Since there was a liability of $75 recorded at the end of year 1, the double entry that is recorded in year 2 is to credit (increase) the liability and debit (increase) the income tax expense by $25.
At the end of year 3, the entity’s taxable temporary differences have decreased to $260 since the company has now been charged tax on the difference of $140 ($500 depreciation - $360 tax depreciation). In other words, they are now adding back more depreciation in their tax computation than they are able to deduct in tax depreciation. Therefore, in the future, the tax payable will be 25% x $260 = $65. The deferred tax liability now needs to be reduced from $100 to $65 and so is debited (a decrease) by $35. Consequently, there is now a credit (a decrease) to the income tax expense of $35.
At the end of year 4, there are no taxable temporary differences since now the carrying amount of the asset is equal to its tax base. Therefore, the opening liability of $65 needs to be removed by a debit entry (a decrease) and hence there is a credit entry (a decrease) of $65 to the income tax expense. This can all be summarised in the following working: