Deferred tax asset is the amounts of income taxes recoverable in future periods in respect of deductible temporary differences, carryforwards of unused tax losses, and carryforwards of unused tax credits. While, deferred tax liability is the amounts of income taxes payable in future periods in respect of taxable temporary differences.

Advertisement

As you may very well know that income tax expense is comprised of two components: current tax expense and deferred tax expense. Either of these can be a benefit (i.e., a credit amount in the statement of comprehensive income), rather than an expense (a debit), depending on whether there is taxable profit or loss for the period.

Although the case for presentation in the financial statements of any amount computed for deferred tax liabilities is clear, it can be argued that deferred tax assets should be included in the statement of financial position only if they are, in fact, very likely to be realized in future periods.

Since realization will almost certainly be dependent on the future profitability of the reporting entity, it may become necessary to ascertain the likelihood that the enterprise will be profitable. Absent convincing evidence of that, the concepts of conservatism and realization would suggest that the asset be treated as a contingent gain, and not accorded recognition until and unless ultimately realized.

Some Important Terms and Definitions of Deferred Tax

  • Accounting profit – Net profit or loss for the reporting period before deducting income tax expense.
  • Tax basis – The amount attributable (explicitly or implicitly) to an asset or liability by the
    taxation authorities in determining taxable profit.
  • Tax credits – Reductions in the tax liability as a result of certain expenditures accorded special treatment under the tax regulations.
  • Tax expense – The aggregate of current tax expense and deferred tax expense for a reporting period.
  • Taxable profit (loss) – The profit (loss) for a taxable period, determined in accordance with the rules established by the pertinent taxing authorities, which determine income taxes payable (recoverable).
  • Current tax expense (benefit) – The amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period.
  • Deductible temporary differences – Temporary differences that result in amounts that are deductible in determining future taxable profit when the carrying amount of the asset or liability is recovered or settled.
  • Deferred tax expense (benefit) – The change during a reporting period in the deferred tax liabilities and deferred tax assets of an entity.
  • Interperiod tax allocation – The process of apportioning income tax expense among reporting periods without regard to the timing of the actual cash payments for taxes. The objective is to reflect fully the tax consequences of all economic events reported in current or prior financial statements and, in particular, to report the expected tax effects of the reversals of temporary differences existing at the reporting date.
  • Operating loss carryback or carryforward – The excess of tax deductions over taxable income. To the extent that this results in a carryforward (to be offset against future periods’ taxable income under local laws), the tax effect thereof is included in the entity’s deferred tax asset, unless this is not expected to be realized.
  • Permanent differences – Differences between accounting profit and taxable profit as a result of the treatment accorded certain transactions by the income tax regulations which differs from the accounting treatment. Permanent differences will not reverse in subsequent periods, and accordingly, do not create a need for deferred tax recognition.
  • Taxable temporary differences – Temporary differences that result in taxable amounts in determining taxable profit of future periods when the carrying amount of the asset or liability is recovered or settled.
  • Temporary differences – The differences between tax and financial reporting bases of assets and liabilities that will result in taxable or deductible amounts in future periods. Temporary differences include “timing differences” under IFRS as well as certain other differences, such as those arising from business combinations.

?

Under IAS 12, deferred tax assets resulting from temporary differences and from tax loss carryforwards are to be given recognition only if realization is deemed to be probable. To operationalize this concept, the standard sets forth several criteria, which variously apply to deferred tax assets arising from temporary differences and from tax loss carryforwards.

The standard establishes that:

  • It is probable that future taxable profit will be available against which a deferred tax asset arising from a deductible temporary difference can be utilized when there are sufficient taxable temporary differences relating to the same taxation authority which will reverse either: (a) In the same period as the reversal of the deductible temporary difference, or (b) In periods into which the deferred tax asset can be carried back or forward;
  • If there are insufficient taxable temporary differences relating to the same taxation authority, it is probable that the enterprise will have taxable profits in the same period as the reversal of the deductible temporary difference or in periods to which the deferred tax can be carried back or forward, or there are tax planning opportunities available to the enterprise that will create taxable profit in appropriate periods.

Thus, there necessarily will be an element of judgment in making an assessment about how probable the realization of the deferred tax asset is, for those circumstances in which there is not an existing balance of deferred tax liability equal to or greater than the amount of the deferred tax asset. If it cannot be concluded that realization is probable, the deferred tax asset is not given recognition!

As a practical matter, there are a number of positive and negative factors which may be evaluated in reaching a conclusion as to amount of the deferred tax asset to be recognized. Positive factors (those suggesting that the full amount of the deferred tax asset associated with the gross temporary difference should be recorded) might include:

  • Evidence of sufficient future taxable income, exclusive of reversing temporary differences and carryforwards, to realize the benefit of the deferred tax asset
  • Evidence of sufficient future taxable income arising from the reversals of existing taxable temporary differences (deferred tax liabilities) to realize the benefit of the tax asset
  • Evidence of sufficient taxable income in prior year(s) available for realization of an operating loss carryback under existing statutory limitations
  • Evidence of the existence of prudent, feasible tax planning strategies under management control which, if implemented, would permit the realization of the tax asset.
  • An excess of appreciated asset values over their tax bases, in an amount sufficient to realize the deferred tax asset. This can be thought of as a subset of the tax strategies idea, since a sale or sale/leaseback of appreciated property is once rather obvious tax planning strategy to salvage a deferred tax benefit which might otherwise expire unused.
  • A strong earnings history exclusive of the loss that created the deferred tax asset. This would, under many circumstances, suggest that future profitability is likely and therefore that realization of deferred tax assets is probable.

Although the foregoing may suggest that the reporting entity will be able to realize the benefits of the deductible temporary differences outstanding as of the date of the statement of financial position, certain negative factors should also be considered in determining whether realization of the full amount of the deferred tax benefit is probable under the circumstances. These factors could include:

  • A cumulative recent history of accounting losses. Depending on extent and length of time over which losses were experienced, this could reduce the assessment of likelihood of realization below the important “probable” threshold.
  • A history of operating losses or of tax operating loss or credit carryforwards that have expired unused
  • Losses that are anticipated in the near future years, despite a history of profitable operations

Thus, the process of determining how much of the computed gross deferred tax benefit should be recognized involves the weighing of both positive and negative factors to determine whether, based on the preponderance of available evidence, it is probable that the deferred tax asset will be realized.

IAS 12 notes that a history of unused tax losses should be considered “strong evidence” that future taxable profits might prove elusive. In such cases, it would be expected that primary reliance would be placed on the existence of taxable temporary differences which, upon reversal, would provide taxable income to absorb the deferred tax benefits that are candidates for recognition in the financial statements. Absent those taxable temporary differences, recognition would be much more difficult.

To illustrate this computation in a more specific fact situation, lets construct a light example.

?

Deferred Tax Asset Calculation Example

Assume the following facts:

  • Lie Dharma Corporation reports on a calendar year and adopted revised IAS 12 in 2004.
  • As of the December 31, 2011 statement of financial position, Lie Dharma has taxable temporary differences of $85,000 relating to depreciation, deductible temporary differences of $12,000 relating to deferred compensation arrangements, a net operating loss carryforward (which arose in 2007) of $40,000, and a capital loss carryover of $10,000. Note that capital losses can only be offset against capital gains (not ordinary income), but may be carried forward until used.
  • Lie Dharma’s expected tax rate for future years is 40% for ordinary income, and 25% for net long-term capital gains.

The first steps are to compute the required balances of the deferred tax asset and liability accounts, without consideration of whether the tax asset would be probable of realization.

The computations would proceed as follows:

Deferred tax liability
Taxable temporary difference (depreciation) = $85,000
Effective tax rate                                                  × 40%
Required balance                                            = $34,000

Deferred tax asset
Deductible temporary differences                  = $12,000
Deferred compensation                                  = $40,000
Net operating loss                                          = $52,000
Effective tax rate                                                   × 40%
Required balance (a)                                        = $20,800
Capital loss                                                     = $10,000
Effective tax rate                                                   × 25%
Required balance (b)                                       = $   2,500
Total deferred tax asset
Ordinary (a)                                                    = $20,800
Capital (b)                                                      =     2,500
Total required balance                                   = $23,300

?

The next step would be to consider whether realization of the deferred tax asset is probable. Lie Dharma management must evaluate both positive and negative evidence to determine this matter. Assume now that management identifies the following factors which may be relevant:

  • Before the net operating loss deduction, Lie Dharma reported taxable income of $5,000 in 2011. Management believes that taxable income in future years, apart from NOL deductions, should continue at about the same level experienced in 2011.
  • The taxable temporary differences are not expected to reverse in the foreseeable future.
  • The capital loss arose in connection with a transaction of a type that is unlikely to recur. The company does not generally engage in activities that have the potential to result in capital gains or losses.
  • Management estimates that certain productive assets have a fair value exceeding their respective tax bases by about $30,000. The entire gain, if realized for tax purposes, would be a recapture of depreciation previously taken. Since the current plans call for a substantial upgrading of the company’s plant assets, management feels that it could easily accelerate those actions to realize taxable gains, should it be desirable to do so for tax planning purposes.

Based on the foregoing information, Lie Dharma Corporation management concludes that a $2,500 adjustment to deferred tax assets is required. The reasoning is as follows:

  • There will be some taxable operating income generated in future years ($5,000 annually, based on the earnings experienced in 2011), which will absorb a modest portion of the reversal of the deductible temporary difference ($12,000) and net operating loss carryforward ($40,000) existing at year-end 2011.
  • More important, the feasible tax planning strategy of accelerating the taxable gain relating to appreciated assets ($30,000) would certainly be sufficient, in conjunction with operating income over several years, to permit Lie Dharma to realize the tax benefits of the deductible temporary difference and NOL carryover.
  • However, since capital loss carryovers are only usable to offset future capital gains and Lie Dharma management is unable to project future realization of capital gains, the associated tax benefit accrued ($2,500) will probably not be realized, and thus cannot be recognized.

Based on this analysis, deferred tax benefits in the amount of $20,800 should be recognized.

?

The criterion prescribed by IAS 12 is significantly different than that which is employed under the corresponding US GAAP standard, FAS 109. In conformity with that standard, all deferred tax assets are first recorded, after which a valuation allowance or reserve is established to offset that portion which is not deemed “more likely than not” to be realizable.

The net effect will be generally similar under either approach, but the consensus opinion is that the US GAAP realization threshold, “more likely than not,” represents a somewhat lower boundary than does IAS 12’s “probable.” While the former is acknowledged to imply a probability of just slightly over 50%, the latter is thought to connote a likelihood in the range of at least 75-80%, or possibly higher. Worded yet another way, it would seemingly be more difficult to support the existence of a valid deferred tax asset under IFRS than under US GAAP rules as they now exist.