Deferred Tax - Types, importance & definition

Deferred tax is a vital component in financial accounting and tax planning, often misunderstood by many. Understanding this concept is important for accurate financial reporting and effective tax management.

What is deferred tax?

Deferred tax represents the taxes that are postponed or advanced to future periods due to temporary differences between the accounting income and taxable income. The deferred tax meaning involves recognising these differences, which arise from various factors, including differing treatment of income and expenses under accounting standards and tax laws.

Types of deferred tax

Deferred tax can be classified into two main categories: Deferred tax asset and deferred tax liability.

Deferred tax asset

A deferred tax asset (DTA) arises when the tax payable on the accounting profit is higher than the tax payable as per the income tax return. This scenario occurs due to temporary differences that result in the deferment of tax payments to future periods.

Common instances leading to DTAs include:

• Carry forward of losses: Losses incurred in one financial period that can be used to offset future taxable income.
• Provisions and reserves: Differences in the timing of recognition of expenses and provisions between accounting and tax books.

DTAs are beneficial as they can reduce the taxable income in future periods, thus lowering the tax liability.

Deferred tax liability

A deferred tax liability (DTL) arises when the tax payable on the accounting profit is lower than the tax payable as per the income tax return. This results from temporary differences that defer tax payments to future periods. Typical situations leading to DTLs include:

• Depreciation differences: Variations in the depreciation methods and rates between accounting standards and tax laws.
• Revenue recognition: Differences in the timing of revenue recognition between accounting and tax regulations.

DTL indicate future tax payments due to income recognised in the current period but taxable in future periods.

Recognition and measurement

• Identify temporary differences: Determine the differences between the carrying amounts of assets and liabilities in the financial statements and their tax bases.
• Calculate deferred tax: Apply the tax rates expected to be in effect when the temporary differences reverse.
• Recognise deferred tax in financial statements: Reflect the deferred tax assets and liabilities in the balance sheet, ensuring accurate financial reporting.

Importance of deferred tax

• Accurate financial reporting: Deferred tax ensures that the financial statements present a true and fair view of the company's financial position by accounting for future tax consequences.
• Tax planning: Awareness of deferred tax helps in strategic tax planning, optimising tax liabilities over time.
• Compliance: It ensures compliance with accounting standards and tax laws, avoiding potential legal and financial repercussions.

Also Read: How to open a Current Account in a bank: 3 quick steps

Conclusion

Deferred tax is a complex but essential aspect of financial management, bridging the gap between accounting income and taxable income. By understanding what deferred tax is, its types, and its recognition and measurement, you can ensure accurate financial reporting and strategic tax planning. Incorporating deferred tax into your financial strategy provides a clearer picture of your business's financial health and future tax obligations.

As businesses scale up, smooth financial management is crucial. Current accounts offer benefits such as higher transaction limits, overdraft facilities, and digital banking services, essential for efficient business operations.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.