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6/25/2014 Meaning of Deferred Tax Liability & Asset in Simple Words

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Home> Articles> Accounts > Meaning of Deferred Tax Liability & Asset in Simple Words

Meaning of Deferred Tax Liability &Asset in Simple Words

Vignesh Killu r on 21 March 2012

In Simple words, Deferred Tax Liability is a Provision fo r Future Taxation.

This is in stark Contrast to Provision for Taxation. Provision for Taxation is basically a

provision for Current year Taxation.

Deferred Tax Liability arises due to timing difference in the value of Assets as per Books of

Accounts and as per Income Tax Act .

Also we can say that Deferred Tax Liability/Asset arises due to the difference between Profit

as per Books of Accounts (P&L Account) and profit as per Income Tax Act. (Taxable

Income).

Depreciation is the main reason for difference in the profits as per books of Accounts and

Taxable profits as per Income Tax Act. Both Income Tax Act and Companies Act prescribe

different ratesof Depreciation for different categories of Assets.

Let me illustrate with a simple example. Suppose a Company purchases a Wind Turbine

Generator (Windmill). The Depreciation which can be claimed in the Books of Accounts in as

per Companies Act is let's say 20% (assumed). The Depreciation as per Income Tax Act is80% for Windmill.

Now a Windmill is purchased for Rs. 10,00,00,000/- (10 Crores). The Depreciation Claimed in

the First year is:

Value of Windmill: 10,00,00,000/-

Depreciation as per Books of

Accounts:

10,00,00,000 X

20%= 2,00,00,000/-

Depreciation as per Income Tax

Act:

10,00,00,000 X

80%= 8,00,00,000/-

DIFFERENCE

-6,00,00,000/-

DEFERRED TAX LIABILITY @ 30.9% -1,85,40,000/-

(Deferred Tax Liability is created at the highest Marginal Rate of Tax i.e. 30.9%)

What is the Meaning of Creating this Deferred Tax Liability of Rs. 1,85,40,000/- (One Crore

eighty five lakhs forty thousand)

It simply means that the company will definitely have a tax Liability of that much in the

future years. This is because in the years to come the Depreciation as per Income Tax Act

will be lesser that the Depreciation as per Books of Accounts. Hence in these years the

Company will have to create a Deferred Tax Asset

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For clarity the Following Table is provided. Let's take the figures in Lakhs for Easier

Understanding:

Let Windmill Value be Rs. 100,000/-

Year 1 2 3 4 5* TOTAL

Dep as per IT

Act

(80% OF

WDV)

80,000 16,000 3,200 640 160 100,000

Dep as per

Books

(20% SLM)

20,000 20,000 20,000 20,000 20,000 100,000

DIFFERENCE 60,000 -4,000 -16,800 - 19,360 -19,840 0

DTL/DTA @

30.9%18,540 -1,236 -5,191.20 -5,982.24 -6,130.56 0

Note * In year 5 as per Income tax act let's assume the entire Remaining Balance is written

off

CONCLUSIONS:

1. In Year 1 Deferred Tax Liability amounting to Rs. 18,540/- has to be created. This means

that in Year 1, the company has postponed its tax Liability of Rs. 18,540/- to the Future

years. This Liability will come back to the company one day or the other. (Unless 80 IA is

claimed)

2. In Year 2, as you can clearly see the Depreciation as per Books has gone up. This means

that Depreciation as per IT act will be lesser as a result the profit as per IT Act will be more

and as a result the company has to pay Rs. 1236/- more tax during this year.

3. Thus in the remaining years the company will have Deferred Tax Assets And the Deferred

Tax Liability created in the first year will be reversed in the subsequent 4 years.

4. Thus when the WDV of Assets as per Books and WDV as per IT Act both become ZERO,

there is neither Deferred Tax Liability nor Deferred Tax Asset as there is no timing Difference

Deferred Tax is purely an accounting Concept. AS 22 - "Accounting for Taxes on Income

deals with Deferred Tax.

The following are the Accounting treatment and Tax treatment of Deferred Tax:

ACCOUNTING ENTRIES:

P&L A/c Dr 18,540.00

To Deferred Tax Liability A/c 18,540.00

(Being Deferred Tax Liability created in Year 1 at the Maximum Marginal Rate of Tax)

Deferred Tax is shown under Provisions in Balance Sheet.

Deferred Tax Asset

Dr1,236.00

To P & L A/c 1,236.00

(Being Deferred Tax Liability Reversed in Year 2)

Finally at the end of Year 5 the Balance Sheet will be thus:

PROVISIONS:

Deferred Tax Liability

18,540Rs.Ps

Less: Reversed upto year 4 12409.44

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921

Published inAcc oun ts

Source : Various Text Books on Accounting Standards & Ow n Research

Views : 265879

Other Articles byVig nesh Killur

Soumya Prakash Rath Wrote on 22 June 2014

kehkashan hussain Wrote on 09 June 2014

kishor Wrote on 26 May 2014

Reversed in year 5 6130.56 18,540 0

TAX TREATMENT:

INCOME FROM BUSINESS:

Net Profit as per P&L A/c

XXX

Add: Deferred Tax Liability XXX

Less: Deferred Tax Asset XXX

Note: As Deferred Tax Liability is a Provision, it should be disallowed as an expense. Also

deferred tax asset should be deducted from Income.

As seen from the above, deferred tax liability/asset does not affect tax computation.

PURPOSE: The Purpose of DTA/DTL: More appropriate presentation of financial statements

and to make the various stakeholders aware of the tax situation of the company.

It may be noted that 80-IA (Section 80 IA of IT Act) exemption may be availed for Windmill.

That is if the company starts to claim 80-IA benefit after 5 years (80-IA benefit can be

claimed in any 10 Assessment years out of 15 A.Y's after buying windmill), then there will be

more benefits to the company as the Income in the first 5 years will be low and the company

can claim business loss as there will be huge Depreciation as per IT.

PART II: In the next part, I will explain the how deferred tax should be computed if 80-

IA exemption is availed for Windmill having useful life of more than 5 years. Also I will explain

the other items which cause a difference in profits as per Books and IT Act. Also I will explain

how to deal with brought forward losses.

HOPE IT WAS AN INTERESTING READ.

REGARDS

VIGGI

(I work as an Articled Assistant for a firm in Mangalore and the Information gained was during

the course of my work.)

231 Comments for this Article

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Thank you lot for the said information.

Thanks a lot, it's very useful information.
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