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In February 2004, Capital Dynamics Sdn Bhd launched icapital education.

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Home > Articles > Deferred Taxation

Deferred Taxation - Part 1


In line with our tradition of not just catching fishes for our subscribers but also teaching them how to fish, i Capital Education is conducting a seminar on 17 Jan 2005 titled “Understanding Financial Statements, Invest Wisely.” The aim of the seminar is to explain the importance of financial statements and the benefits in understanding them. Understanding financial statements can be done at various levels. To take this subject to a deeper level, starting this week, i Capital is featuring a special series on deferred taxation, a topic that has bugged many listed companies.

[1]. Is Tax a Distribution of Earnings or a Business Expense?
Is tax considered a distribution of earnings to government, or is it a form of expense paid by a company? Though this may seem simple, this is one question that has sparked many arguments in the accounting profession. It is also the question that gave birth to the subject of deferred taxation. Those who say tax is a form of distribution to government, just like distribution of dividend to shareholders, argue that [a]. Tax cannot be an expense because there is no exchange of goods involved, and [b]. Paying tax is not a matter of choice. At the other end, those who say that tax is in fact an expense are of the opinion that [a]. As a government does not contribute funds to companies, it cannot be a distribution of income, and [b]. Since a government provides services to a company in the form of providing business platform, tax is an expense paid to the government.

If tax is a form of distribution, then the tax a company needs to pay will only be the tax expense for that financial year. On the other hand, if one were to hold the view that tax is an expense, then tax expenses should be ‘matched’ to its respective financial year, just like other expenses.

[2]. Accounting Profit versus Taxable Profit, Tax Paid versus Tax Expense
Before proceeding further, it is essential to differentiate between accounting profit (or profit before tax) and taxable profit. Accounting profit is the profit for a period before deducting tax expense as reported in the Profit & Loss (P&L) statement whereas taxable profit is the amount that will be taxed for income tax purposes. In certain instances, both accounting profit and taxable profits can be the same, although the chances of this happening are minute. Why are there two profits? The reason behind this is because in Malaysia, the calculation of profit for accounting purposes is based on the Malaysian Accounting Standard Board’s (MASB) rules whereas for tax purposes, it is based on the Inland Revenue Board’s (IRB) rules. Both have different income and expense recognition criteria. For instance, accounting rules recognised income on an accrual basis but tax rules recognise income on a receipt basis. Profit calculated based on the accounting method is called “accounting profit” whereas profit calculated based on tax rules is called “taxable profit”.

Another difference that needs to be clarified is the difference between “tax paid” and “tax expense”. Tax paid is the actual amount of tax that is paid by a company based on the “taxable profit” as calculated according to tax rules. However, tax expense is the total tax attributable to an accounting period, which consists of the tax paid and deferred taxes.

[3]. What is Deferred Tax?
As the trend is towards regarding tax as an expense, deferred taxation was created to “allocate” tax expenses to the respective financial period. In layman’s term, the purpose of deferred tax is to make sure that the tax expenses presented in the financial statements represent the amount attributable to the accounting profit for that particular financial year, regardless of the actual amount of tax paid. Other than that, deferred tax also serves as an estimation of future tax that a company needs to pay based on the current financial standing. The question asked here may be, how can a tax be “deferred” or how can a tax expense for a financial year be different from the tax paid? As stated earlier, because there are differences between the way activities are included in accounting profit and taxable profit, it is possible for a company to incur a tax liability in one financial period and pay the tax liability in a much later period, or vice versa. Example {A} below will highlight this.

Example {A} :
Company ABC (ABC) receives its only income, which is interest income, of RM2,000 for financial year 2004. However, another interest income of RM3,000 for 2004 will only be received in 2005. For financial year 2005, ABC receives 2004’s accrued interest and another RM4,000 interest for that year. Since accounting policy allocates income to the years the income is attributed to, assuming ABC has no other transactions for both years, ABC will record RM5, 000 (RM2,000 + RM3,000) as interest income in fiscal year 2004. Interest income in ABC’s P&L for financial year 2005 would be RM4,000.

However, when tax rules recognise interest income on a cash basis, the taxable profit for 2004 would be RM2,000 and RM7,000 for 2005. Assuming tax rate maintains at 28% for 2004 and 2005, ABC’s tax paid for the financial year 2004 and 2005 would be RM560 and RM1,960, respectively. The summarized Profit and Loss statement for ABC would be as follows:

Table 1 : Summary of ABC’s P&L for 2004 (without deferred tax)

As can be seen, the tax expense shown does not reflect the actual amount of tax attributed for each year. ABC paid less tax relative to its reported profits in 2004 (11.2%) and conversely, paid higher tax compared to its reported profits in 2005 (49%). Therefore, there are 2 direct implications here: [i]. The tax paid in 2004 is less than the actual amount that is attributed to 2004’s income, and [ii]. The estimated tax that is to be paid in 2005 (the RM3, 000 to be received) should be provided in 2004 as a future liability. Therefore, deferred tax accounting serves to answer these two issues.

Since the taxable profit for 2004 is lower than accounting profit by RM3,000, the tax paid for 2004 (RM560) is less than the tax attributable to 2004, which should be RM1,400 (28% X RM5, 000). Based on the matching principle, the current financial year's tax expense must be matched against the current year's financial results. Therefore, an “additional” tax expense of RM840 (RM1,400 – RM560) must be provided for in fiscal year 2004 to “increase” the tax expense to RM1,400. Since this RM840 “additional” tax expense will only be paid in future periods when the interest income is received, it is credited into the Balance Sheet, representing a future tax liability. The journal entry is as follows:

Dr: Tax expense (2004) RM840
Cr: Liability (Balance Sheet) RM840
In 2005, the taxable profit is higher than accounting profit by RM3,000, which is the interest income not recognized by the tax rules in 2004 but when it is actually received in 2005. This translates into tax paid in 2005 being higher than the tax attributable to 2005's results by RM840 (RM3,000 X 28%). To match 2005's tax expense with its results, the tax expense in the P&L is “reduced” by the RM840 tax liability that is already provided in financial year 2004.
Dr: Liability (Balance Sheet) RM840
Cr: Tax expense (2005) RM840
In short, the "additional" tax expense that is created in 2004 is known as "deferred tax". Table 2 below shows the calculation of deferred tax whereas table 3 shows the Deferred Tax Liability account as will appear in the Balance Sheet.

Table 2 : Deferred tax calculation

Table 3 : Deferred tax liability account as in Balance Sheet

The summarized Profit and loss statement for ABC after taking deferred tax into consideration is shown in table 4.

Table 4 : Summary of ABC's P&L (with deferred tax)

Example {A} above provides a basic understanding of the basis for deferred tax. From here, we can make 2 conclusions about deferred tax. [1]. Deferred tax is included in financial statements so that the total tax expense is reflective of the amount of accounting profit recorded for that financial period. [2]. When the amount of tax paid is less than the total tax expenses for the period, a deferred tax liability will be recognised in the Balance Sheet to prepare for future tax obligations. Similarly, when the amount of tax paid is greater than the total tax expense for the period, a deferred tax asset will be recognised in the Balance Sheet. However, in practice, deferred tax involves a number of technical issues, which is sometimes not so straightforward.


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Deferred Taxation (Pt2)>>