Updated: Jul 5
My name is Steve Chen, a fellow member of ACCA and course director at APC (www.globalapc.com), teaching ACCA online courses to students from all around the world. In this article, I will explain the meaning of deferred taxes in Financial Statements.
I often found accounting students having difficulties understanding the meaning of deferred taxes, although many of them know how to calculate this. Let’s start with the basics.
Deferred tax is the difference between the carrying value of assets or liabilities from an accounting perspective and tax written down value from a tax’s point of view. Let’s say for an item of property, plant, and equipment, the carrying value in accounting is $100 whereas in tax, the tax written down value (tax base) is $80, the difference of $20 is known as taxable temporary difference, ie if the asset is sold in the future, the $20 difference will be realised and should be taxed. We then use the $20 taxable temporary difference and to multiply by the current corporate income tax rate (could be referred to the current tax law or latest tax rate to be substantially enacted, say 10%), the deferred tax liability is $2 ($20 x 10%).
Let me point out a few issues regarding the above calculation. The taxable temporary difference of $20 is where the tax authority allowed the business to provide more depreciation expenses to save them tax, as depreciation expense (known as capital allowance) reduces taxable profits. However, depreciation means total cost of an asset. Because the total cost of an asset remains the same, total depreciation under accounting and tax should also be the same. Therefore, the situation will be reversed in subsequent years, ie more tax depreciation now means less tax depreciation in the future and hence, taxable temporary differences arise.
If you find the above explanation too technical, please do not worry. If you are an investor who reads financial statements of publicly listed companies, you do not need to know these detailed technical dragons. Let me explain the deferred taxes meaning from the investor’s perspective.
Deferred tax liability – if you find this item in the Financial Statements, you can deem the company is growing, ie the asset base increases such as more PP&E are purchased during the year, or liabilities being reduced such as repayment of debts during the year.
This is because an increase in asset value or a decrease in liability value often results in additional recognition of deferred tax liability. Many of my ACCA students in my ACCA lectures found this summary very useful as they will often read disclosure notes about deferred taxes to find out more about what business actually did during the year, ie acquired what assets and repaid what liabilities. Some of my ACCA students are also interested in when businesses repaid those liabilities, do they have further flexibility to arrange additional finance as well.
Deferred tax asset – if you find this term in the Financial Statements, you can deem the company has trading losses, or government is quite generous in offering additional tax credits to the business. You need to read the disclosure notes in the Financial Statements very carefully about this.
I hope this article clarifies the technical issue regarding the understanding of deferred taxes. In addition to providing ACCA lectures online, I also wrote articles in ACCA AB magazine. Besides, I am the author of four accounting books. If you are interested in studying ACCA courses with me, please visit my website http://www.globalapc.com for further information, where you can find many of my ACCA demo video lectures.