This answer is not mine, it is of mr. Shyam Sharma copied from all interview.com. It will solve your purpose."Deffered tax liability means currently you are paying less amount of tax as per IT but in future you have to pay more so for this timing difference we have to create a deffered tax liability in our books of accounts accoding to the virtual certainty that in future company will earn sufficient proft to recover it.for deffererd tax liability the entry will be Profit & loss a\c drTo Deffered tax liability"
According to Matching-concept of accounting your expenses should match with your revenue,thats why provision for Prepaid/or Outstanding liability is made in the account books.So that all the expenses and revenue of the relevant financial year are recognised in the same financial year. Similary in the case of Business and profession some incomes and treated in different way e.g, in the case of company some expenses are write in the same year but Under Income Tax they are allowed to be writen of in a period of Five year.or even disalowed in the Income Tax Or in other instance Under Indian Company Act some expenses are allowed on accrued basis but under Income Tax Act these are allowed on payment basis ,(for Example Sec 43B of Income Tax Act)Since different treatment of same item result in different Profit Or Loss for the Fy.So in order to reconcile this different A provision for Tax Liabilty is made so that the Tax Expenses of the same year is recognised in the same year:which is known as Deffered Tax Liability.
Deffred Tax Liability arise when Profit as per Income Tax Act is low where as accounting Profit is more.So in order to neutralise this Deffered Tax Liabilty is provided which is to be adjusted in the forthcoming year/years.
One thing is to be noted that Deferred Tax Liability is Recognised only for Timing Difference and not for Permanent differece.
Timing Difference means treatment of an item based on the different time for example if an item which comes under Sec 43 B is recognised in accounting year itself when it incurred irrespective of payment made but in Income Tax it is recognised only when actual payment is made,which may may be made in the next year.Hence there will arise time difference.
Permanent differene arise which can not be adjusted in any subsequent year.For example if an item is treated as revenue expenditure in Account books but which is compelety disallowed in the Income Tax Act then it is Called Permanent difference.
Hi. As already explained by friends Deferred Tax occurs primarily due to the difference in treatment of expenses and in some cases revenue too as per the accounting rules (Companies Act) and the Tax Code (Income Tax Act). Deferred Taxes lead to the creation of either Deferred Tax Assets (DTA) or Deferred Tax Liabilities (DTL). Both are Balance Sheet items. The difference in treatment can be on account of the value and/or timing of the expense or revenue item. For example depreciation of assets is the most common source of deferred tax liabilities. In a study conducted on the source of deferred tax liabilities, the total DTL arising from depreciation for the BSE-100 companies in March 2005 stood at 43,000 Crores or 95% of the total deferred tax liability accruing from all sources!
In order to encourage investments the tax code is liberal and allows for a higher rate of depreciation versus the accounting rules. For Eg: Buildings can be depreciated at 10% on the written down value (WDV) as per tax rules while accounting permits depreciation of the same building at 1.63% on a straight line basis (SLM). Simply put if tax rules allow the charging of a higher expense then the taxable income calculated as per the tax law would be lower than that calculated as per accounting rules. And therefore the company would actually pay a lower tax in that financial year. It is as if the company was allowed to postpone or "defer" its tax to the future. That is why in such cases a deferred tax liability is created in the company's balance sheet.
This is a real benefit to companies that are able to defer the tax liability into the future. It is offered by the government to encourage investments and avail of faster depreciation rates on assets. In the US this is called the Accelerated Cost Recovery System (ACRS)
Until 2000 companies were not required to dislose sources and details of deferred tax to the public. In 2001 accounting standard 22 (AS-22) was incorporated that requires companies to disclose all taxes that have been deferred.
For anyone interested in the actual application of Deferred Tax can refer to the PDF attachment that explains the mechanics of deferred tax through an example of a simple company.
Comments and criticism are welcome. I can be reached at firstname.lastname@example.org
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