May 38 min read

Deferred Tax Asset & Deferred Tax Liability: A Complete Guide

Updated: May 25

In India, the idea of entities with zero income taxes was popular some decades ago. Based on the accounting profit for that year, these corporations had no liabilities because of various income tax incentives. Consequently, no new "provision of income tax" was made. Previously, profit before taxes and profit after taxes were equal. However, this is an inaccurate representation of the results from an accounting standpoint. Many of these tax benefits were essentially benefits that were expedited.

Under the previous system, companies could claim depreciation in the books of accounts using the straight-line method (SLM), while depreciation was deductible in taxes on a write-down value method (WDV). Everyone is aware that the depreciation charge is higher in the first years under the WDV technique than it is under the SLM approach. In the following years, this led to accounting profits but no taxable earnings. As a result, it causes an annual discrepancy between accounting profits and taxes, which is caused by postponing taxes to later years. The idea of deferred tax assets or liabilities originated from this comprehension and appreciation of the circumstances.

Meaning of Deferred Tax

Any economy's tax system is made up of numerous microunits that work together to form a complex process known as taxation. The total amount of income tax owed to the government is made up of taxes from different people and businesses. Deferred tax refers to a type of corporate tax that is imposed on businesses. It can be either an advance tax that is carried over to the next fiscal year or a tax that is waived due to an advance of an accounting expenditure. Deferred Tax Liabilities and Deferred Tax Assets are the names given to these two types of deferred tax. The table below elucidates both concepts:

Virtual Certainty

Concrete proof of virtual certainty can be found in an entity's projected future earnings, which are prepared based on future restructuring, sales estimation, future capital expenditure, historical experience, etc., and submitted to banks for financing. However, virtual certainty isn't credible if it's only dependent on a legally binding export order that could be revoked at any time. Future projections that are more likely to occur must form the basis of virtual certainty.

Calculation of Deferred Tax

Since deferred tax is simply the difference between gross earnings in a profit and loss account and a tax statement, there are no strict guidelines for calculating it. Below is an example of deferred taxation for your convenience.

Here, the taxable revenues in both circumstances fluctuate by the same amount as the estimated depreciation, which differs by Rs. 20,000. Its tax obligation will therefore be 25% of Rs. 5,00,000 or Rs. 1,25,000. But according to its records, it should have owed Rs. 1,20,000 in taxes. Since an extra Rs. 5,000 is paid in taxes this year, a deferred tax asset is created.

What is a Deferred Tax Asset (DTA)?

When taxes are paid or carried forward but are not yet shown in the income statement, deferred tax assets are created. The gap between the taxable income and the book income is what determines the value of deferred tax assets. If the tax authorities recognises revenue or expenses at a different time than that specified by an accounting standard, for instance, a situation of deferred tax may occur. The company's future tax liability might be drastically reduced by any deferred tax asset. The following are the potential reasons for deferred tax assets:

Even before the need for them to be recognised, the taxing authority considers expenses
Earned revenue is taxed even prior to its proper recognition
There are differences in the tax laws or bases for assets and liabilities

Example of Deferred Tax Asset Calculation

Let us use manufacturer A as an example. According to A's calculations, there is a 5% chance that their product may need to be turned in for warranty repairs. The income statement and the tax authority statement show the following disparity if A's revenue for a financial year is Rs. 10,000,000.

Income Statement of Company:

Revenue	10,00,000
Warranty Expense	50,000
Taxable Income	9,50,000
Taxes Payable (at 30%)	2,85,000

Statement of Tax Authority:

Revenue	10,00,000
Warranty Expense	0
Taxable Income	10,00,000
Taxes Payable (at 30%)	3,00,000

The deferred tax asset in the aforementioned case is the difference between the two taxes payable. In this instance, the deferred tax asset is (Rs. 3,00,000 - Rs. 2,85,000) = Rs. 15,000.

What is a Deferred Tax Liability (DTL)?

The difference between the amount of tax that an organisation can deduct and the amount of tax that is due for accounting purposes is known as deferred tax obligation. A deferred tax liability is an indication that a current transaction may result in a higher income tax bill for the company in the future. The reasons for deferred tax liabilities arising include:

The majority of corporations maintain many versions of their financial statements for their own use in addition to those they provide to the public and tax authorities. This is also due to significant differences between the tax legislation and normal accounting principles in important areas including revenue, expense, and asset depreciation.
To demonstrate maximum earnings to their shareholders, companies typically strive to boost their profits.
In order to lower their tax liability, businesses typically push their current profits into the future. This frees up more funds for investments as opposed to paying the government taxes.

Example of Deferred Tax Liability Calculation

Let's use the same manufacturer, A, as an example. The business estimates that a manufacturing machine worth Rs. 60,000 would last three years and that it will pay a 30% profit-sharing tax. For the following three years, however, conventional financial accounting will account for the depreciation of Rs. 20,000 annually. As a result, income is decreased by Rs. 20,000 and taxes are decreased by Rs. 6,000 annually. Let us assume, however, that tax accounting permits depreciation in the following manner:

Rs. 30,000 in the first year
Rs 20,000 in the second
Rs. 10,000 in the third year

Thus, the corporation receives a tax benefit of Rs. 9000 and can claim Rs. 30,000 in depreciation for the first year. However, doing so results in a tax obligation of: Rs 9,000 – Rs 6,000= Rs. 3,000 (the tax that the business actually paid) - (the tax that it was required to pay under accounting principles).

A deferred tax liability of Rs. 3,000 has been produced in this scenario. The business will have to make up for this liability in its upcoming tax-related operations.

How to Present DTA and DTL in the Balance Sheet

If an organisation plans to settle such assets and liabilities on a net basis and has a legally enforceable right to set off assets against liabilities representing current tax, it must balance both DTA and DTL amounts.

According to AS-22: Following such a set-off, the DTA (net of the DTL) will be visible on the face of the balance sheet separately following the heading "Investments" or, if applicable, the DTL (net of the DTA) will be visible on the face of the balance sheet separately following the heading "unsecured loans."
According to AS-12: Following this set-off, the DTA (net of the DTL) or DTL (net of the DTA), as applicable, must be declared separately on the face of the balance sheet under the corresponding headings of non-current liabilities and non-current assets.

Effect of DTA and DTL on Minimum Alternate Tax (MAT)

Minimum Alternate Tax, or MAT, is what a business must pay if the tax due under the Income Tax Act's regular provisions is less than the tax calculated at 18.5% of book profit. The Income Tax Act's section 115JB levies MAT, which is computed using the entity's book profit in the manner shown below:

Increasing book profit involves the following:

Paid income taxes or allowances
A sum added to any reserve
Amounts set aside for uncertain liabilities
Deferred tax provisions, etc.

Additionally, the following reduces it:

Amount taken out of any provision or reserve
Except for revaluation depreciation, depreciation is charged to P&L
Lower of the depreciation that was not absorbed or brought forward
P&L, etc., is credited with deferred tax

However, there are disagreements over whether the book income for the MAT calculation should include the deferred tax liability that is credited to the P&L. While the Kolkata Tribunal ruled in favour of Balrampur Chini, the Chennai Tribunal favoured adding back the deferred tax due in the Prime Textiles Ltd case. But the Finance Act of 2008 added a new section to 115JB that specifically addressed the "Amount of Deferred Tax in Profit and Loss A/c." With regard to deferred tax amounts, the following effect shall be given after this amendment:

Add the amount of deferred tax and its provision to the book profit, or
If there is any amount of deferred tax that shows up on the credit side of the profit and loss statement, subtract it from the book profit.

AS22 Guidelines for MAT Credit Treatment as DTA

According to AS 22, deferred tax assets and liabilities do not increase as a result of tax expense alone; rather, they are the result of the difference between book income and taxable income. There is no difference between book income and taxable income as a result of MAT. According to AS 22, it is inappropriate to treat MAT credit as a deferred tax asset.

Effect of DTA and DTL on Tax Holiday

Under sections 10A and 10B of the Income Tax Act of 1961, new undertakings incorporated in free trade zones and undertakings that are 100 percent focused on exports are eligible for the Tax Holiday. The government temporarily waives some taxes in order to promote the manufacture and consumption of specific goods, subject to specified requirements. During the enterprise's tax vacation period, deferred tax (DT) from the timing difference that reverses should not be recognised. DT regarding the timing difference that needs to be acknowledged in the year of origination and then reversed after the tax holiday.

Conclusion

There isn't a clear advantage to delayed taxation in and of itself because it's made possible by the little discrepancy between two assertions. On the other hand, acknowledging these responsibilities enables an organisation to budget for upcoming costs. However, the recognition of deferred tax assets can drastically lower future tax obligations. For the company's shareholders to be aware of all the underlying liabilities (and assets) the firm has at the conclusion of a financial year, deferred tax liabilities and assets must be reported in the company's book. These are beneficial for auditing purposes as well.

FAQ

Q1. What is the difference between DTL and DTA?

Temporary discrepancies, for which a deferred tax asset (DTA) or a deferred tax liability (DTL) must be formed, are variances between book profits and tax profits that can be reversed in later periods. Any discrepancy between tax and book profits that does not get adjusted back in the next period is irreversible.

Q2. How is deferred tax calculated as per the Income Tax Act?

Since deferred tax is simply the difference between gross earnings in a profit and loss account and a tax statement, there are no strict guidelines for calculating it.

Q3. Is deferred tax calculated on loss?

On all time differences, both temporary and permanent, deferred tax is recognised. DTA is only recorded in relation to timing discrepancies pertaining to unabsorbed depreciation or carryforward losses in the event that future virtual certainty exists.

Q4. What is a deferred tax journal entry?

The deferred tax book entries are really straightforward. Profit & Loss A/c must be debited or credited in order to produce Deferred Tax Liability A/c or Deferred Tax Asset A/c. The deferred tax is created at the regular tax rate.

Profit & Loss A/c Dr

To Deferred Tax Liability A/c

Deferred Tax Asset A/c

To Profit & Loss A/c

Q5. How to calculate deferred tax in case of depreciation?

Businesses occasionally record depreciation at a lower rate on their books than when they file their taxes. For instance, a business depreciates assets at a rate of 15% for tax purposes and 12% for bookkeeping. It causes a discrepancy in the total and gives corporations an asset of deferred tax.

Q6. How are DTA and DTL treated in the balance sheet?

In the balance sheet, DTA and DTL should be listed separately from current assets and current liabilities under their own heading. Finally, the DTA/DTL should be examined as of each Balance Sheet Date and recorded in writing to represent the amount that is almost certainly to be achieved.