Deferred Taxes (Deferred Tax – IAS 12): Why Do Accounting Profits Differ from Tax Profits?
Deferred Tax (IAS 12): Why do Accounting Profits Differ from Taxable Profits?
Deferred Tax (IAS 12): Why do accounting profits differ from taxable profits? A simplified guide explaining temporary differences and how to recognize deferred tax assets and liabilities with simplified examples—Digital Salla.
- What is Deferred Tax and why do we need it in financial statements?
- The difference between Temporary Differences and Permanent Differences.
- How to calculate the Tax Base of an asset or liability.
- When to recognize a Deferred Tax Liability (DTL) vs. a Deferred Tax Asset (DTA).
- Practical examples (Depreciation differences, Provisions).
1) The Concept of Deferred Tax
Accounting standards (IFRS/IAS) and Tax Laws often have different rules for recognizing revenue and expenses. Deferred Tax is the “Accounting Bridge” that ensures the tax expense reported in the Income Statement matches the accounting profit of the same period, regardless of when the tax is actually paid to the authority.
2) Temporary vs. Permanent Differences
Not every difference between accounting and tax results in deferred tax. We must distinguish between:
2.1 Temporary Differences
Differences that will reverse in future periods. They arise when an item is recognized for accounting in one year and for tax in another (e.g., different depreciation rates). These create Deferred Tax.
2.2 Permanent Differences
Differences that will never reverse. They arise when an item is recognized by one but never by the other (e.g., non-deductible fines or tax-exempt revenue). These do NOT create Deferred Tax.
3) What is the Tax Base?
To calculate deferred tax, we compare two values: (1) Carrying Amount: The value in the accounting books. (2) Tax Base: The value of an asset or liability for tax purposes (the amount that will be deductible or taxable in the eyes of the authority).
Temporary Difference = Carrying Amount − Tax Base
CIT Computation & Tax Reconciliation - Excel File
4) Deferred Tax Liabilities (DTL): “Pay Later”
A Deferred Tax Liability arises from Taxable Temporary Differences. This happens when you pay less tax today but will have to pay more in the future.
| Scenario | Relationship | Outcome |
|---|---|---|
| Assets | Carrying Amount > Tax Base | Taxable difference → DTL |
| Liabilities | Carrying Amount < Tax Base | Taxable difference → DTL |
5) Deferred Tax Assets (DTA): “Pay Now, Deduct Later”
A Deferred Tax Asset arises from Deductible Temporary Differences. This happens when you pay more tax today but will be allowed to deduct more (and pay less) in the future.
| Scenario | Relationship | Outcome |
|---|---|---|
| Assets | Carrying Amount < Tax Base | Deductible difference → DTA |
| Liabilities | Carrying Amount > Tax Base | Deductible difference → DTA |
6) Practical Examples (Depreciation & Provisions)
Let’s look at the two most common reasons for deferred tax in a Corporate Income Tax environment:
Example A: Depreciation (Asset)
- Accounting: Machine cost 100k, depreciated over 10 years (10k/year). Year 1 Carrying Amount = 90k.
- Tax: Authority allows 25% accelerated depreciation (25k/year). Year 1 Tax Base = 75k.
- Difference: 90k (Book) > 75k (Tax) = 15k taxable difference.
- Result: 15k × Tax Rate (e.g., 20%) = 3k Deferred Tax Liability (DTL).
Example B: Provisions (Liability)
- Accounting: Provision for bad debts recorded (Expense) = 5k. Carrying Amount of Liability = 5k.
- Tax: Provisions are non-deductible until actual write-off. Tax Base = 0.
- Difference: 5k (Book) > 0 (Tax) = 5k deductible difference.
- Result: 5k × Tax Rate (e.g., 20%) = 1k Deferred Tax Asset (DTA).
7) Journal Entries & Financial Statement Impact
Deferred tax is recorded at the end of the reporting period. The entry adjusts the tax expense in the Income Statement and the asset/liability in the Balance Sheet.
Recognizing a DTL (Increase in Tax Expense)
- Dr. Deferred Tax Expense (Income Statement)
- Cr. Deferred Tax Liability (Balance Sheet)
Recognizing a DTA (Decrease in Tax Expense)
- Dr. Deferred Tax Asset (Balance Sheet)
- Cr. Deferred Tax Benefit/Credit (Income Statement)
8) Operational Checklist for CFOs
To ensure IAS 12 compliance and accurate reporting:
Deferred Tax Quality Gate
- Maintain a Tax Base Register for all major assets and liabilities.
- Identify all Temporary Differences (Accruals, Provisions, Depreciations).
- Identify and exclude Permanent Differences from the calculation.
- Validate the recoverability of Deferred Tax Assets (Future Profit Forecast).
- Apply the enacted tax rate (the rate expected to apply when the difference reverses).
Use the CIT reconciliation tool to identify temporary differences automatically: Income Tax (CIT) Calculation and Settlement Template
9) Frequently Asked Questions
What is Deferred Tax?
It is an accounting concept representing the tax consequences of differences between how assets/liabilities are valued for accounting vs. how they are valued for tax.
Does Zakat create deferred tax?
Generally, under most accounting frameworks (like SOCPA/IFRS in Saudi), Zakat is treated as an expense of the period it relates to. Deferred tax usually applies to Income Tax (CIT) where profit-based taxable differences exist.
Is a Deferred Tax Asset a “Refund”?
No. It is a future tax benefit. It means you will pay less tax in the future when the temporary difference (like a provision) becomes an actual deductible expense.
What rate should I use for Deferred Tax?
The tax rate that has been enacted or substantively enacted by the balance sheet date, which is expected to apply when the asset is realized or the liability is settled.
10) Conclusion
Understanding Deferred Tax (IAS 12) is the difference between “Tax Filing” and “Tax Accounting.” By mastering the comparison between Carrying Amounts and Tax Bases, you will provide more transparent financial statements and accurately reflect the company’s future tax obligations and benefits.
Action Step Now (30 minutes)
- List your Top 5 Provisions (e.g., EOSB, Bad Debts, Obsolete Inventory).
- Determine their Tax Base (usually 0 if they are only deductible when paid).
- Calculate the Deductible Temporary Difference and the resulting Deferred Tax Asset.