Financial Reporting: Deferred taxes
By Ben R. Punongbayan
The concept of deferred taxes has been a major part of accounting for income taxes for many years now. It is a simple concept really, but in many cases its application could become complex.
The requirement for deferred tax accounting was brought about by the differences in treatment of certain transactions for accounting purposes and for income tax purposes. As you may know, there are many such differences in the Philippines. A simple and common example is bad debt.
For financial reporting (accounting) purposes, if there are indications that a receivable is uncollectible, a bad debt expense and reduction (allowance) of accounts receivable should be taken up in the books. However, such expense is not yet deductible for tax purposes. It only becomes so when the said receivable is finally written off the books due to it being deemed truly worthless after the company has done the necessary collection efforts required by the Bureau of Internal Revenue (BIR). Note, though, that such a difference is merely a timing issue and, therefore, temporary. For this reason, such differences are called temporary differences in accounting.
To show a simple illustration, assume that a receivable of P1,000 was given a full allowance in Year 1 and was actually written off in full in Year 2. The income statement (without accounting for deferred tax) would look like this:
Year 1 Year 2
Net income before bad debt and
provision for income tax P 10,000 P 10,000
Bad debt expense (1,000) ____-
Net income before tax 9,000 10,000
Income tax expense (actual)
Year 1 – 30% of P10,000 (3,000)
Year 2 – 30% of P9,000 (2,700)
(P10,000 less P1,000 write-off) _______ ______
Net income &nbs
p; P 6,000 P 7,300
Effective tax rate 33% 27%
Clearly, the relationship of the income tax expense to the net income before tax in both years is disproportionate (or, using stronger language, distorted). Considering the many other temporary differences, the overall distortion that these create makes the interpretation of operating results difficult.
This is why deferred tax accounting was required – to remove the distortion. When deferred tax accounting is applied, the bad debt expense when it originates in Year 1 gives rise to an asset (deferred tax asset) and, consequently, to a deferred tax income, computed at the tax rate of 30% applied on the bad debt expense (therefore P300 in the above example). In Year 2, when the receivable is actually written off, and, therefore, the temporary difference reverses, it gives rise to an opposite result: the deferred tax asset is reduced to zero and a deferred tax expense is recognized in Year 2.
Year 1 Year 2
Net income before tax P 9,000 P 10,000
Income tax expense
Actual (as shown above) 3,000 2,700
Deferred tax income/expense (300) 300
[30% of P1,000] P 2,700 P 3,000
Effective tax rate 30% 30%
Clearly, the distortion has been removed and proper matching of tax expense with net
income before tax is achieved.
The foregoing illustration is quite simple and is meant to give you an idea of what is deferred tax and what it achieves. Some of its applications may be complex, especially in cases of business combinations. To achieve accuracy, it is important to diligently monitor temporary differences. For this reason, current accounting standards require that the computation focus on the assets and liabilities that give rise to temporary differences. This means that whenever an asset or liability has a component of temporary differences, its equivalent tax basis must also be determined and monitored. For example, if accounts receivable has an accounting balance of P90,000 and is presented net of allowance for doubtful debt of P10,000, its tax basis is P100,000; the temporary difference is P10,000, which gives rise to a deferred tax asset of P3,000 (30% tax rate x P10,000). Such monitoring discipline must be maintained.
Just like any other assets, deferred tax assets must be evaluated for their realizability. In fact, at the time when an originating deductible temporary difference occurs and gives rise to a deferred tax asset, an evaluation is made before such an asset is recognized.
The test of realizability is linked to the ability of the business entity to generate future taxable profit that is sufficient to cover the temporary differences that gave rise to the deferred tax asset. If no such thing is expected within a reasonable period, the deferred tax asset must not be recognized. In a succeeding period, if the situation changes and sufficient profit is expected in the near future, then the deferred tax asset may and should be recognized. Similarly, the realizability of a previously recognized deferred tax asset should be evaluated at the end of each accounting period and if found to be not realizable, then it should be derecognized.
Accounting for deferred taxes removes the volatility of net income after tax from the effect of temporary differences. As such, a better interpretation of the earnings trend of a business entity could be achieved and forecasting of future earnings becomes less difficult to do.
Of course, it would be simpler if there are only a few temporary differences or none at all. But that requires the cooperation of the BIR. After all, most of the differences relate to timing of recognition, hence such differences will ultimately disappear. But that may be difficult to achieve in the near term. In the meantime, we have to accept the complexity and challenges of deferred tax accounting.
Thank heavens there are accountants around who can help!
This article is the third in Mr. Punongbayan’s monthly series designed to help interested parties, particularly business executives who are involved in preparing financial statements and who use these statements for various purposes, gain a better understanding of the FS. Mr. Punongbayan is the founder of audit, tax and advisory services firm Punongbayan & Araullo, a member firm of Grant Thornton International Ltd.