Tax authorities treat income, expenses, assets and liabilities differently to the way a business treats them for accounting purposes. The differences in treatment result in the accounting profit being different to the taxable profit, and therefore the accounts tax charge being different to the actual tax charge made by the tax authority. This difference is referred to as deferred tax.
Deferred Tax Calculation
As a simple example, suppose a business has bought a long term asset for 3,000 and decides it has a useful life of 3 years. The depreciation expense each year will be 3,000 / 3 = 1,000.
If the business has profits before depreciation of 6,000, then its accounts profit will be 6,000 – 1,000 = 5,000, and if the tax rate is 25% then the accounts tax charge will be 5,000 x 25% = 1,250.
From the tax authorities point of view, assuming they do not allow depreciation as an expense, but they do allow an 80% of the cost (2,400) allowance in the year of purchase.
The taxable profits will be 6,000 – 3,000 x 80% = 3,600, and the actual tax charge will be 3,600 x 25% = 900, referred to as the current tax.
The difference in the accounts tax and the actual tax charge is the deferred tax of 1,250 – 900 = 350.
This is effectively the tax on the difference in treatment of the asset by the business and by the tax authority. The tax authority gave an allowance of 2,400 on the asset, and the business charged a depreciation expense of 1,000, the difference of 1,400 at the tax rate of 25% is the deferred tax of 350.
The double entry bookkeeping journal to post the deferred tax liability would be as follows:
|Income tax expense||1,250|
Deferred Taxation Accounting Equation
The accounting equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities plus the total equity of the business. This is true at any time and applies to each transaction. For this transaction the accounting equation is shown in the following table.
In this case the balance sheet liabilities (deferred tax liability and current tax payable) have been increased by 350 and 900 respectively. On the other side of the accounting equation the income statement has an income tax expense of 1,250. The expense reduces the net income, retained earnings, and therefore owners equity in the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.