Question

Based on Woolworths, give example of accounting profit, taxable profit, temporary difference, taxable temporary difference, deductible temporary difference, deferred tax assets and deferred tax liability.

Answer 1

Accounting profit is the profits that entity earned during the specific period and reporting on its financial statements based on entity’s accounting policies and in accordance accounting standards or frameworks. The accounting profit of entity might report in different amounts if different accounting standards are used as the principle for reporting financial statements. The most popular accounting standard that use to prepare financial statements are US GAAP and IFRS. Accounting profit and economic profit is different. Accounting profit is used for tax declaration, present in the entity financial statements, stocks exchange requirement, annual board meeting as well as others official use.

For example, if a person invested $100,000 to start a business and earned $120,000 in profit, his accounting profit would be $20,000. Economic profit, however, would add implicit costs, such as the opportunity cost of $50,000, which represents the salary he would have earned if he kept his day job.

Taxable profit is the profit (or loss) upon which income taxes are payable. The composition of taxable profit varies by taxation authority, so it will vary depending upon the rules of the taxation authorities within which an entity is located or does business. For instance, a government may declare that certain qualifying organizations have nonprofit status, so that any of their qualifying earnings are not subject to income tax.

Taxable profit is primarily based on operating earnings,

Temporary Differences

Temporary differences are differences between financial accounting and tax accounting rules that cause the pretax accounting income subject to tax to be higher or lower than the taxable income in current period and lower or higher by an equal amount in future periods.

Temporary differences differ from permanent differences because permanent differences result in irreversible differences between taxable income and accounting income but the temporary differences are expected to reverse in future.

There are two types of temporary differences: taxable temporary differences and deductible temporary differences. Temporary differences have deferred tax implications.

Taxable temporary differences
Taxable temporary differences are timing differences which cause taxable income in current period to be lower than pretax accounting income subject to taxes and hence income tax payable in current period to be lower than the accrual income tax expense. The difference between the income tax payable and the accrual income tax equals the deferred tax liability.

Example and journal entry: deferred tax liability
Let’s consider an example where the pretax accounting income is $40 million, net permanant differences are $1.5 million (i.e. $2 million of exempt income and $0.5 million of non-deductible expense). Assume that included in the accounting income for tax purposes is a depreciation charge of $3 million on straight-line basis while tax rules allow depreciation of $5 million. It means that the taxable income is lower than accounting income for tax purposes by $2 million (=$5 million - $3 million). It is a taxable temporary difference because in future periods tax depreciation will be lower resulting in higher income tax payable. Hence, that increased future tax must be recognized today by recording a deferred tax liability of $800,000. The following journal entry must be passed:

Account	Dr	Cr
Deferred tax expense	800000
Deferred tax payable		800000

Deductible temporary differences
Deductible temporary differences are differences which cause the taxable income and hence income tax payable in current period to be higher than the accrual income tax. They result in deferred tax asset which is expected to be utilized in future periods to plug the difference between the lower taxable income and income tax payable in future periods.

Example and journal entry: deferred tax asset
Let’s assume that the accounting income for tax purpose included taxation of a $5 million rent received in advance half of which relates to the next financial year. This is a deductible temporary difference because it causes the future period income tax payable to be lower than the accrual income tax. A deferred tax asset must be recognized assuming sufficient taxable income will be available in future. It would be recognized using the following journal entry:

Account	Dr	Cr
Deferred tax asset	1000000
Deferred tax expense		1000000

Current tax vs deferred tax
Deferred tax liabilities and assets are just a process through which a chunk of income tax is moved between different times periods.

Let’s reconcile accrual income tax expense with income tax payable:

Taxable income and income tax payable	Calculation	USD in million
Pretax accounting income	EBT	40.00
Less: exempt income (municipal bond interest)	EI	(2.00)
Add: non-deductible expense (fines)	NDE	0.50
Accounting income for tax purposes	EBTT=EBT-EI+NDE	38.50
Corporate tax rate	R	40%
Income tax expense	T=R*EBTT	15.40
Add: unearned revenue recognized for tax purposes	UER	2.5
Less: tax depreciation	TD	(5.00)
Add: accounting depreciation	AD	3.00
Taxable income	TI=EBTT+UER-TD+AD	39.00
Corporate tax rate	R	40%
Income tax payable	ITP=TI×R	15.60
Less: deferred tax expense	DT	(0.20)
Income tax expense on income statement	T=ITP + DT	15.40

During the current financial year, your income statement will show current tax expense of $15.4 million and a net deferred tax expense of -$200,000 and your balance sheet will show a deferred tax asset of $1 million and a deferred tax liability of $800,000.

Deferred tax asset items as well as deferred tax liability items are a prominent aspect of every company’s financial statements. This difference in timings of both, gives rise to certain variance in the company’s accounting. The most generic forms of deferred tax are Deferred Tax Asset and Deferred Tax Liability.

Deferred Tax Asset
Deferred tax assets originate when the amount of tax has either been paid or has been carried forward but it has still not been acknowledged in the statement of income. The actual value of the deferred tax asset is generated by comparing the book income with the taxable income. The biggest benefit of the deferred tax asset is that it causes the company’s tax liability to go down tremendously in the future.

The conditions that cause origin of deferred tax asset are as follows:

The taxing authority takes the expenses into account much before time.
A tax on the revenue earned is levied before time.
There is a difference in tax rules for asset and liabilities.

Deferred Tax Liability
Deferred tax liabilities, on the other hand originate when a company underpays the amount of taxes due, which it would eventually pay in the future. It should be remembered, however, that underpaid does not mean that they have not fulfilled their tax-duties, it’s just that the taxes would be paid on a different timescale. It is a tax to be paid in future. In simple words, deferred tax liabilities are the opposite of deferred tax asset, which occur when the taxable income is lesser as compared to the income mentioned in the income statements of the company.

The conditions that cause origin of deferred tax liability are as follows:

In order to showcase great profits to the shareholders, the companies often push their profits.
When companies keep more than one copies of the financial statement, for their own personal use or for furnishing the same to tax authorities. This is called dual accounting.
Sometimes companies also push the current profits into future, this gives them the opportunity to decrease the tax amount. By doing this instead of paying the saved money as taxes, they use that extra money for making investments.

Example of Deferred Tax Asset and Liability

Balance sheet of the Company
Revenue 1,00,000
Warranty Expenses 2,000
Income that is Taxable 98,000
Payable Taxes (at 30%) 29,400

Statement Presented to the Tax Department
Revenue 1,00,000
Warranty Expenses Nil
Income that is Taxable 1,00,000
Payable Taxes (at 30%) 30,000

Deferred Tax Liability
Let us now discuss the Deferred Tax Liability, for the same ABC Company that produces washing machines. It is assumed by the company that the manufacturing machine that costs around INR 60,000 will work for about 3 years and would pay 30% on the profits earned. It has to be remembered here that when the annual accounting of finances is done, INR 20,000 will be accounted for the coming three years. Therefore, the annual income will decrease INR 20,000 and there will be a tax deduction of INR 9,000, and this originates a tax liability of INR INR 3,000.