Normally the accounting profit before tax figure appearing in the financial

statements of corporate entities differ from the taxable profit showed in

income tax return. Such a difference may be categorized as permanent
difference or temporary difference. Permanent difference arises due
to permanent factors while temporary difference arises due to
temporary factors.

Permanent factors include inadmissible expenditure mentioned in

section 21 of Income Tax Ordinance, 2001, for instance entertainment
expense in excess of limit prescribed in rule 10 of Income Tax Rules, 2002.
Income exempt from tax mentioned in second schedule of Income
Tax Ordinance, 2001, for instance, clause 131 of part I of second schedule
of Income Tax Ordinance, 2001. Nothing can be done about that, and the
increased [due to inadmissible expenditure] or decreased [due to exempt
income] tax charge just has to be accepted. Now we can conclude that if an
expense in the profit and loss account is not allowed for tax
purposes or an income is not recognized for tax purposes,
permanent difference arises.

A temporary difference arises when an expense [temporary factor] is

allowed both tax and accounting purposes, but the timing of the allowance
difference. Temporary factors include deemed income subject to
reversal in subsequent years or treatment difference of depreciation,
amortization etc. for instance, if the depreciation rate is higher for tax
purposes than the depreciation rate in Financial Statement, the tax charge
will be lower in the first year than it would have been if based on accounting
profit, but in subsequent year the tax charge will be higher. In order to fully
understand the situation, let’s consider an example.

Example 1

A Company bought plant and machinery for Rs. 200,000.00. The useful life of
the asset is five years and is to be depreciated on straight-line basis.

For tax purposes, the initial depreciation rate is 50% and 25% in
subsequent years on WDV. The tax relevant tax rate is 43%
throughout the period.

TAX ACCOUNTS
YEA COST / DEP'N
WDV COST / DEP'N WDV DIFFERENC
R OPENING OPENING E
BALANCE BALANCE
1 200,000 180,000 20,000 200,000 40,000 160,000 140,000
2 20,000 5,000 15,000 160,000 40,000 120,000 (35,000)
3 15,000 3,750 11,250 120,000 40,000 80,000 (36,250)
4 11,250 2,813 8,438 80,000 40,000 40,000 (37,188)

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 5 8,438 2,109 6,328 40,000 40,000 - (37,891)

254,688 193,672 600,000 200,000 (6,328)

The WDV of Rs20,000 is the tax base [amount attributed to the asset or
liability for tax purposes] of plant and machinery. While the accounting WDV
of Rs 160,000 is the carrying value of plant and machinery.

From the above chart it is apparent that due to the difference in depreciation
rates, the company’s depreciation expense, for tax purposes, increased by Rs
140,000.00 in year 1. Alternatively, we could also say that the WDV of the
asset has increased by Rs 140,000.00. Hence, we can conclude that the
effect of depreciation or WDV has started reversing from year 2 till year 5
and will continue thereafter till the exhaustion of the cost of asset under
diminishing balance method, that is, year 35.

It is worthwhile here to note that depreciation expense reduces tax

payments. The very impact difference in above referred chart is over
the tax payments and can be analyzed as follows.

TAX ACCOUNTS DIFFERENCE

YEAR DEP'N Reduction DEP'N Reduction
in Tax in Tax
Payment Payment
1 180,000 77,400 40,000 17,200 60,200
2 5,000 2,150 40,000 17,200 (15,050)
3 3,750 1,613 40,000 17,200 (15,588)
4 2,813 1,209 40,000 17,200 (15,991)
5 2,109 907 40,000 17,200 (16,293)

From the above chart it is apparent that due to the difference of

depreciation rates or more appropriately due to difference in tax and
accounting WDV/depreciation expense has resulted in reduced tax
payment of Rs 60,200.00 [deferred tax] (140,000 X 43%) in year 1.
The difference arose during year 1 has start reversing from year 2
till year 35.

Deferred tax can be defined as ‘The estimated future tax

consequences of transactions and events recognized in the financial
statements of the current and previous periods’.

As stated earlier, tax saving of Rs 60,200.00 in year 1 is not an actual tax

saving but primarily tax liability is effectively deferred to the extent of useful
life of the asset. Now let’s analyze the concept of difference arose in the

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above referred chart through tax accounting, to the extent of year 5. This can
be illustrated as follows.

TAX ACCOUNTS
YEAR CURRENT TOTAL CURRENT DEFERRED TOTAL
1 - - - 34,200 60,200 94,400
2 4,150 23,285 30,866 34,200 (15,050) 19,150
3 54,863 23,591 31,272 34,200 (15,588) 18,613
4 55,397 23,821 31,576 34,200 (15,991) 18,209
5 55,798 23,993 31,805 34,200 (16,293) 17,907

220,207 94,689 125,518 171,000 (2,721) 168,279

One must not confuse with the negative aggregate balance of Rs 2,721.00,
this will be reversed in 35th year. The most important point is that why
should we recognize deferred tax? It is worthwhile here to note that if an
entity fails to recognize deferred tax, it eventually fails to recognize a liability
or asset, which will ultimately lead to distortion of the post tax profit. Hence,
it can be concluded that it is basically the accrual concept, which requires its
recognition. Failing to recognize deferred tax may lead to over/under
optimistic dividend payment based on inflated or understated profit,
distortion of EPS and PE ratio and above all shareholders will be misled.

There are two main methods of accounting for deferred tax, Deferral method
[the original amount set aside for deferred tax is retained without alteration
for subsequent changes in tax rate] and the liability method [the deferred tax
balance is adjusted as the tax rate change in order to maintain the actual
liability expected to arise].

The liability method is sub-divided into two methods, Income statement

liability method [focuses on difference between taxable profit and accounting
profits timing difference] and balance sheet liability method – IAS 12
preferred [calculation is made by reference to differences between balance
sheet values and tax values of asset and liabilities temporary differences].

It is worthwhile here to note that as per division II of part I of 1st schedule of

Income Tax Ordinance, 2001, the tax rates are continually decreasing till tax
year 2007, that is, 35%. Hence, if an entity adopts the liability method, it
must consider the falling tax rates in advance, that is, during the 1st year of
recognition of deferred tax. Although International Accounting Standard 12 is
silent over the issue of continually reduced tax rates, but in order to
incorporate a transparent, crystal clear and objective recognition of deferred
tax asset or liability, it is of utmost importance.

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Whatsoever the method a corporate entity adopts for deferred tax, still
International Accounting Standard 12 gives a choice in respect of extent of
the provision. The extent of the provision may be nil provision [no provision is
made – flow through method], Full provision – IAS 12 preferred [provision is
made for the tax effect of all temporary differences] and partial provision
[provision is made to the extent that expected liability will actually arise].

The nil provision, or flow through basis ignores the taxation effects of timing
differences completely. Tax is accounted for as it is assessed on the basis
that taxation is an appropriation of profits by the government, and so is not
relevant as a performance indicator. A theoretical justification for this
argument is that the only tax liability that satisfies the statement of
principles’ definition of a liability (an obligation to transfer economic benefits
out of past transactions and events) is current taxation.

The full provision is based on the view that every transaction has a tax
consequence and it is possible to make a reasonable estimate of the future
tax consequences of transactions that have occurred by the balance sheet
date. If this basis of deferred tax accounting is adopted, the computation of
the deferred taxation figures is a relatively straightforward arithmetical
exercise. The approach of International Accounting Standard 12 to tax
accounting under the full provision approach is commonly known as the
valuation adjustment approach. This approach recognizes deferred tax on
all differences between the carrying values of assets and liabilities in the
financial statements and their tax base. An alternative approach to deferred
tax accounting under the full provision basis is the incremental liability
approach. This approach recognizes deferred tax only when it could be
regarded as meeting the definition of an asset or a liability in its own right.

Like the full provision basis the partial provision basis is based on the premise
that the future reversal of a timing difference gives rise to a tax liability (or
asset). However, instead of focusing on the individual components of the tax
computation the partial provision basis analyses the components as a whole
in a single net assessment. To the extent that timing differences are
expected to continue in future (by the existing timing differences being
replaced by future timing differences as they reverse) the tax is viewed as
being deferred permanently. The computation of deferred tax balances under
the partial provision basis is rather more complicated than under the full
provision basis because of the need to use forecasts of future transactions to
estimate the incidence of future timing differences.

Professional accountants must keep an eye over the three dimensional

Income Tax Ordinance, 2001 – Minimum tax, Presumptive tax regime and
normal tax on profit. One may think that Minimum tax needs to be adjusted
in deferred tax provision. It is worthwhile here to note that minimum tax is a
dead tax and have nothing to do with the future adjustment of losses due
unabsorbed depreciation. Although care need to be taken, in subsequent

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years, where the losses are converted into profits after the audit under
Income Tax Ordinance, 2001. This situation may require adjustment of
deferred tax, recognized in earlier years, through International Accounting
Standard 8, before continuing with the current year provision. As far as
presumptive tax regime is concerned, decision of either to make a provision
of deferred tax or not, lies over the conclusion drawn from the future
budgeted activities of the corporate entity. Similarly, a proportionate return
requires careful consideration.

It is worthwhile here to note that under the balance sheet liability method,
deferred tax is calculated by reference to the tax base [amount attributed to
the asset or liability for tax purposes]. The tax base of an asset is the
amount that will be deductible for tax purposes against any future taxable
benefit derived from the asset, hence, where the benefit will not be taxable
[e.g. Income is exempt] the tax base of an asset is equal to the carrying
amount. The tax base of a liability is the carrying amount less any amount
that will not be deductible for tax purposes [e.g. advance revenue on account
of exempt income] in respect of liability in future period.

The problem lies in identifying whether the deferred tax is an asset or

liability, that is, figure of Rs 60,200.00 in the chart. It is worthwhile here to
note that deferred tax liability needs to be recognized for all taxable
temporary difference [where carrying value is greater than tax base or
Carrying value > tax base] while deferred tax asset needs to be
recognized for all deductible temporary difference [where tax base is
greater then carrying value or Tax base >Carrying value]. Care need to
be taken where an item is neither an asset nor a liability, for instance,
research cost.

In our above-referred example the difference arose due to the

difference in tax base and carrying value. The tax base of the asset
is Rs 20,000.00 while the carrying value is Rs 160,000.00. In this
case, the carrying value is greater than the tax base [taxable
temporary difference], hence, it can be effectively concluded that Rs
60,200.00 is a deferred tax liability.

Apart from other issues, creation of deferred tax asset on tax losses is the
most critically appraised hot topic. In order to understand the spirit of the
problem, let’s go through an example.

Example 2

A (Pvt.) Ltd sustained a loss of Rs 100,000.00 in year 1. In order to identify

the reason of sustaining the loss, the auditor has obtained the reason of loss
and budgeted profit and loss account for next five year. The reasons were
found satisfactory and the budgeted data is as follows.

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 Tax year PROFIT/ DEFERRED
LOSS TAX
2003 (100,000) (37,400) 37.4%
2004 20,000 8,200 41%
2005 20,000 7,800 39%
2006 20,000 7,400 37%
2007 20,000 7,000 35%
2008 20,000 7,000 35%

The auditor allowed the creation of deferred tax asset to the extent of Rs
37,400.00. It is worthwhile here to note that a deferred tax does neither
extract cash nor insert cash into the accounts of the company. The amount of
Rs 37,400.00 credited to Profit and loss account will subsequently reverse in
future years and profit and loss account will be debited by Rs 8,200.00, Rs
7,800.00 and so on in subsequent years. This will ultimately save the interest
of shareholder and serve as a deterrent to the intention of the management
to show inflated profit after taxation in subsequent years and deceive
prospective investors. A management may increase the EPS ratio through
creation of deferred tax asset but same EPS ratio will also be kept in line with
normal practice in future years just because of deferred tax. Deferred tax is
normally recognized on all timing differences that have originated but not
reversed by the balance sheet date. However, deferred tax is not recognized
on permanent differences.

The author Mohammed Ashraf, ACCA, APA, AFA, CAT is an international tax
advisor. He can be contacted at mdashraf73@accamail.com.

Article courtesy of Mohammed Ashraf