IAS 12 : Deferred Tax – basic idea 1

5 Deferred Tax – basic idea

Deferred tax is an accrual for tax, receipt or payment, created when the economic activity and the tax impact are either in different periods, or do not completely match in amounts or time period.

Accounting for tax is simpler when the transaction is booked for both accounting and tax purposes in the same year. In such a case income tax is recorded and no deferred tax needs to be accrued.

If a transaction takes place in year 1 and tax is paid in year 2, year 1 will show a transaction without a tax charge, and year 2 will show a tax charge without a transaction:

In this example, a financial asset (at fair value through profit and loss) is purchased for 1.000 in Year 1 and revalued at 1.100 at the period end, recording a profit of 100. The financial asset is then sold in Year 2 for 1.100, its revalued amount.

	Year 1	Year 2
Income	100	0
Tax expense @ 24%	0	-24
Net profit	100	-24

The tax expense is a direct result of the income in period 1. Readers of financial statements should be made aware that a tax charge will be levied in the following year.

Deferred tax is used to identify future tax payments generated by transactions in the current year – it is an accrual for tax, and like all accruals, will be reversed when the tax is actually paid.

	Year 1	Year 2
Income	100	0
Tax expense @ 24%	0	-24
Deferred tax @ 24%	-24	24
Net profit	76	0

The deferred tax reverses over time (and will thus disappear).  This provides a more comprehensive picture to readers. Without the deferred tax accrual, profits in Year 1 would be overstated, with the risk that dividends might be higher than the undertaking could afford.

In this case, it creates an accrual of the tax charge in year 1 to link with the timing of the transaction.

It is reversed in year 2 to reflect that tax has been accrued in year 1, even though it was charged in year 2.

On the balance sheet, this deferred tax would be shown as a liability (accrual) at the end of period 1. It will disappear at the end of period 2.

EXAMPLE - tax is paid on receipt of the money in period 1, but only treated as income in period 2.
	Year 1	Year 2
Income	0	100
Tax expense @ 24%	-24	0
Net profit	-24	100
In year 1 there is a tax charge without a transaction. In year 2 there is a transaction without a tax charge. Again, we use deferred tax to link the transaction to the tax charge.
	Year 1	Year 2
Income	0	100
Tax expense @ 24%	-24	0
Deferred tax @ 24%	+24	-24
Net profit	0	76
In this case, deferred tax accrues a tax credit in year 1 to carry forward the tax paid to period 2 to link with the timing of the transaction. The accrual is reversed in year 2. On the balance sheet, this deferred tax would be shown as an asset (or prepayment of tax) at the end of period 1. It will disappear by being reversed at the end of period 2.