Myths about Deferred tax

There are many myths about what deferred tax is. As a result, many companies do not understand what information about deferred tax can tell investors. Thus, companies typically present that information in a technical way that investors find difficult to understand. Consequently, most investors dismiss that information as an uninteresting technicality and they ignore it.

This post examines some of the myths. It also explains why the myths do not describe accurately the information that deferred tax conveys.

The discussion of the final myth explains what this information tells investors.  

Myth 1. Deferred tax is not about future cash flows.

Some people believe that deferred tax liabilities and deferred tax assets will not lead to future cash flows. That belief is incorrect. As IAS 12 Income Taxes explains, recognising deferred tax liabilities and deferred tax assets shows the future tax consequences of:

• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in the company’s statement of financial position; and
• transactions and other events of the current period that are recognised in the company’s financial statements.

Examples 1 and 2 illustrate how recognising a deferred tax liability shows those future tax consequences in 2 cases: accelerated tax depreciation (example 1) and accrual of interest income taxed on a cash basis (example 2).

Example 1. Accelerated tax depreciation

Fact pattern

Company A bought a machine on 1 January 20X1 for £1,200. It depreciates the machine over its useful life of 4 years. But, for tax purposes, the machine is depreciated over only 3 years.

Company B bought an identical machine on 1 January 20X1 for £1,200 and depreciates it over its useful life of 4 years. For tax purposes, company B’s machine is depreciated over 4 years.

The tax rate is 30%.

Applying IAS 12 to this fact pattern

At 31 December 20X3:

• the carrying amount of Company A’s machine is £300 (after cumulative depreciation of £900).
• the machine’s tax base is £0 (after cumulative tax deductions of £1,200). Those deductions have reduced cumulative tax paid by Company A by £360.
• Company A will pay tax of £90 in the future when (as expected) it recovers the machine’s remaining carrying amount of £300. Company A recognises its obligation to pay that tax as a deferred tax liability, and measures it at £90.

At 31 December 20X3, Company B has a machine with a carrying amount of £300. That machine’s tax base is also £300. In the future, when Company B recovers its machine’s remaining carrying amount of £300, tax depreciation of £300 will offset the recovery. Thus, Company B will pay no tax on that recovery of £300.

Company A has a deferred tax liability of £90 and Company B has no deferred tax liability. That difference reflects Company A’s obligation to pay £90 more tax than Company B.

That difference arises partly because Company B has not yet received a tax benefit (deduction of £300 from taxable profit) that Company A has already received. But, as discussed for myth 2, the extra amount of tax Company A must pay in the future does not necessarily equal the tax saved in the past by Company A (in comparison with Company B).

Example 2. Interest income taxed on a cash basis

Fact pattern

At 31 December 20X1, Company C has accrued interest income of £100. The interest will become receivable on 15 January 20X2, together with further interest of £40 that will accrue up to that date. The tax rate is 30%.

Applying IAS 12 to this fact pattern

Company C will pay tax of £30 for 20X2 if, as expected, it recovers the carrying amount of the accrued interest income (£100). Thus, Company C recognises a deferred tax liability, measured at £30.

Company C will also pay tax of £12 on the further interest of £40 that will accrue from 1 January to 15 January 20X2. But the financial statements at 31 December 20X1 do not reflect that further interest. So, at that date Company C does not have a deferred tax liability for the additional £12.  

Deferred tax assets

For simplicity, in the rest of this post, I will mainly mention only deferred tax liabilities. Similar principles apply to deferred tax assets, except that they lead to future cash inflows rather than outflows.

Myth 2. Deferred tax is a deferral of past tax received or paid.

Some people think that recognising deferred tax liabilities (or deferred tax assets) defers the recognition of taxes received (or paid) in the past. That is not correct. A deferred tax liability is an obligation to pay more tax in some future period, because of transactions (or other events) already reflected in the primary financial statements. Examples 3 and 4 illustrate this.

(Similarly, a deferred tax asset is a right to pay less tax in some future period, because of such transactions or other events.)

Example 3. Reflecting future tax rates

Fact pattern

As in example 1, Company A bought a machine on 1 January 20X1 for £1,200. It depreciates the machine over its useful life of 4 years. But, for tax purposes, the machine is depreciated over only 3 years. The tax rate was 30% in 20X1-X3. Early in 20X3, the government enacted a tax rate of 40% for 20X4.  

Applying IAS 12 to this fact pattern

At 31 December 20X3, as in Example 1:

• the machine’s carrying amount is £300 (after cumulative depreciation of £900).
• the machine’s tax base is £0 (after cumulative tax deductions of £1,200). Those deductions have reduced cumulative tax paid by £360.

Company A will pay tax of £120 (£300 @40%) in the future when (as expected) it recovers the machine’s remaining carrying amount of £300. Company A recognises its obligation to pay that tax as a deferred tax liability, and measures it at £120. That liability depicts Company A’s obligation to pay more income tax of £120 when it recovers the asset’s carrying amount.

That liability is not a deferral of past tax reductions (of £90) caused by the accelerated tax depreciation.  

Example 4. Future tax: intercompany inventory transfer

Example 4 is another case when a deferred tax liability is measured in a way that shows clearly that it is an obligation to pay more tax in the future, rather than a deferral of tax benefits already received.

Fact pattern

Parent P has inventory that cost £500. On 15 October 20X1, Parent P transferred the inventory to its 100% subsidiary (Subsidiary S) and charged Subsidiary S £700 for the inventory.

At 31 December 20X1, Subsidiary S still holds the inventory. In its consolidated financial statements, Parent P measures the inventory at cost to the group (£500, after eliminating the unrealised intercompany profit of £200). In its separate financial statements, Subsidiary S measures the inventory at cost (to subsidiary S) of £700.

The tax rates are 30% for Parent P and 40% for Subsidiary S.

In 20X1:

• Company C paid income tax of £60 at 30% on the profit (£200) it recognised on selling the inventory to Subsidiary S.    
• Subsidiary S paid no tax relating to the inventory.

When Subsidiary S ultimately sells the inventory, it will deduct the cost (to it) of £700 in determining its taxable profit.

Applying IAS 12 to Subsidiary S’s financial statements

The inventory’s carrying amount in Subsidiary S’s financial statements is £700 (cost to subsidiary S). Recovering that carrying amount would not increase (or decrease) taxable profit, so Subsidiary S has no deferred tax liability (and has no deferred tax asset).

Applying IAS 12 to Parent P’s consolidated financial statements

The inventory’s carrying amount in Parent P’s consolidated financial statements is £500 (cost to the group, after eliminating the unrealised intercompany profit of £200).

On selling the inventory for that consolidated carrying amount of £500 (cost to the group), the recovery of £500 will be more than offset by a deduction of £700 in determining Subsidiary S’s taxable profit.

Thus, recovering the carrying amount of £500 will lead to a net reduction of £200 in Subsidiary S’s taxable profit. That reduction will reduce Subsidiary S’s tax paid by £80 (£200 @ 40%). So, the group recognises a deferred tax asset of £80. This shows that Subsidiary S will pay £80 less tax in the future. It is not a deferral of the tax of £60 already paid by Parent P.

I will say more about deferred tax on intercompany asset transfers in a future post.

Accrual of future taxes, not deferral of past taxes

As examples 3 and 4 show, deferred tax liabilities (and deferred tax assets) are obligations to increase future tax payments (and rights to decrease future tax payments). They are not deferrals of past taxes received (or paid). 

There are 3 reasons why people often think of deferred taxes as deferrals:

• mechanically, the amount of those future increases (or decreases) in future tax payments often equals the amount of some past decrease (or increase) in taxes already paid. But those amounts will differ if, for example tax rates change (as in example 3). The amounts will also differ if the past and future increases and decreases relate to different taxable entities or different tax jurisdictions (as in example 4.)
• until at least the mid 1990s, accounting standards typically used a deferral approach for deferred taxes. Deferral approaches defer taxes already paid or received, they do not measure tax that will be paid in the future.
• the name ‘deferred tax’ dates back to the time when deferral approaches were common. This name gives a misleading impression.  

‘Deferred’ tax or future tax?

The IASB’s predecessor (IASC) was developing IAS 12 in the mid-1990s. At about the same time, the Canadian Accounting Standards Board was developing a new Canadian Standard along similar lines. The Canadian Board concluded then that ‘future tax’ would be a more informative label than ‘deferred tax’. I agreed with that conclusion then, and still do.

That question of changing the label did come up very briefly in 1995 in IASC’s Steering Committee on Income Taxes and in the Board of IASC. There was no appetite then for changing the name. That is unsurprising: many aspects of the draft Standard were controversial, and changing the name might have seemed unnecessary and provocative. People felt then that the thing we call ‘deferred tax’ was well understood, so there was no need to look for a better name.

The decision to keep the label ‘deferred tax’ seemed sensible at the time, because there were so many other contentious issues in this project. In hindsight, though, sticking to the old name was a mistake. The 27 years since IASC issued IAS 12 have shown that ‘deferred’ tax is understood very poorly, if at all. If we had changed the name then, perhaps understanding might now be better.

Myth 3. Deferred tax is not a liability because it relates to items that will not be taxed until the future.

IAS 12 uses the term ‘current tax’ for tax that tax law treats as arising in the current year. It uses the term ‘deferred tax’ for tax that tax law treats as arising in a future year.

Some people believe that a tax liability cannot exist until the time when tax law treats the tax as having arisen.

That belief is inconsistent with normal accrual accounting. Consider again example 2 (accrued interest income). In that case, Company C has accrued interest income and has a right to receive it (though it cannot exercise that right until the due date). It also has an obligation (liability) to pay tax on interest income (though in that example it cannot be required to pay the tax until it receives the interest).

Some transactions and other events have already been reflected in the financial statements. The financial statements should reflect the tax consequences of those transactions and other events:

• as current tax, if tax law treats them as arising from taxable profit of the current period.
• as ‘deferred’ tax if tax law will treat them as arising from taxable profit of a future period.

Myth 4. Deferred tax is not a liability because there will be no separate tax cash flow.

Most tax systems tax profit as a single net amount; they do not tax each transaction and other events separately. Also, it is not always possible to identify the separate tax effect of each individual transaction or other event. That is because their separate effects may accumulate in complex ways. As a result, some people argue that deferred tax liabilities are not liabilities because companies will not make separate payments for those liabilities.

This argument is not persuasive. Nothing says that there must be a separate future cash flow for each liability. Payments are often made in aggregate. And different liabilities may have joint effects not captured in the separate individual effects.

Deferred tax liabilities lead to increases in future payments. Consider again example 1. Company A’s future tax payments will be £90 higher than they would have been if the asset’s tax base equalled its carrying amount. Company A will pay that £90, even though it will pay it as part of the payment for the entire tax liability, not as a separate payment.

As I have said above, deferred tax liabilities will give rise to increases in future tax payments. Some people suggest that it would be better to incorporate some or all such items in the measurement of the underlying asset or liability, rather than treat them all as (deferred tax) liabilities. I will discuss that suggestion in a future post

Myth 5. Deferred tax is always the tax that would be paid on selling an asset.

Some people believe that a deferred tax liability relating to an asset always reflects the tax that the company will pay if it sells the asset at its carrying amount. They consider this unhelpful and unrealistic if the company expects to recover the asset by using it, rather than by selling it.

The belief that deferred tax always reflects tax that would apply on sale is incorrect. Applying IAS 12, deferred tax is measured on a basis that reflects how the company expects to recover the asset.

For instance, in example 1, Company A expects to recover the machine’s carrying amount by selling goods or services it will produce using the machine. Company A uses the tax rate(s) and other aspects of the tax law that would apply to recovering the machine’s carrying amount in that manner; it does not use the tax rate (and other aspects of tax law) that would apply on recovering the carrying amount by selling the machine.    

Myth 6. The amount of deferred tax is unrealistic because companies typically recover more than an asset’s carrying amount.

The measurement of deferred tax reflects the amount of tax that the company would pay (or recover) if the company receives an amount exactly equal to the carrying amount of the underlying asset. For instance, in example 1, the measurement of Company A’s machine is based on recovery of exactly £300.

Some people think this approach is based an expectation that the company will sell its goods or services at no profit and no loss. They say such an expectation would be unrealistic and artificial for profitable companies.

The approach of considering the effect of recovering exactly the carrying amount does not forecast that the company will sell its goods or services at no profit and no loss. The approach rests on 2 pillars:

• IFRS standards apply either an impairment test or a current measurement to most assets. For those assets, the company’s management is implicitly (and perhaps even explicitly) asserting that it expects to recover at least the carrying amount. Accordingly, basing measurement of deferred tax on any lower level of recovery would be redundant (and would lead to a measurement mismatch).
• Accounting for deferred tax focuses on the transactions (and other events) that the primary financial statements already reflect. It aims to recognise the future tax consequences of only those transactions and other events. Basing measurement of deferred tax on an amount above the carrying amount would reflect the future tax consequences of future transactions (and other future events).

Myth 7. Partial provision makes more sense than full provision.

Some people advocate a ‘partial provision’ approach that recognises no deferred tax liability if a company expects that the total carrying amount of deferred tax liabilities will never decrease in the future. Those people view such a balance as a staying permanently so that it will never cause increased tax payments.

That approach is flawed for the following reasons:

• that approach would implicitly (and unjustifiably) offset 2 different items:
  (1) reversing effects of existing deferred tax arising from transactions (and other events) already reflected in the financial statements. In example 1, Company A’s existing deferred tax is its deferred tax liability of £90. That deferred tax balance will reverse (as deferred tax income) when the liability becomes a current tax liability.
  (2) originating effects of future deferred tax that will arise from transactions (and other events) to be reflected in future financial statements. For Company A, that future deferred tax will originate (As deferred tax expense) if and when Company A buys new machines in the future.
• Similar types of ‘permanent’ balance might arise for trade payables. A company might estimate that its business is stable and growing and that the total amount of its trade payables will never decline. Nevertheless, no-one would ever propose that the company should not recognise its already existing trade payables.  
• Suppose a company expects that it will invest a level or expanding amount in plant and equipment in all years for the foreseeable future, and that depreciation of this plant and equipment will be accelerated for tax purposes (as in example 1). Although the company expects that the carrying amount of all its plant and equipment will never decline in the foreseeable future, no one would ever argue that company shouldn’t recognise the plant and equipment.
  Also, it would be inconsistent to recognise the plant and equipment without also recognising the future tax effects flowing from that investment.

Myth 8. Deferred tax is just a book entry with no meaning. It just accumulates and then reverses.

Mechanically, when a company first recognises a deferred tax liability, it also recognises deferred expense. Later, when the company recovers the carrying amount of the underlying asset, it derecognises the deferred tax liability and, at the same time, recognises deferred tax income. Therefore, some argue that accounting for deferred tax is just a series of book entries that inevitably go on to reverse automatically, without depicting any transaction (or other event) occurring in the real world.

That argument is based on an incomplete description of the chain of events. Here is a more complete description:

• a company first recognises a deferred tax liability and at the same time also recognises deferred expense.
• later, the company recovers the carrying amount of the underlying asset. That recovery affects current tax for that period. So, the company recognises both a current tax liability and current tax expense. At the same time, the company derecognises the deferred tax liability and recognises deferred tax income.

In summary:

• the company initially accrues the tax it will pay in the future (when it ultimately recovers the carrying amount of the underlying asset). It accrues that tax initially as a deferred tax liability.  
• when the company recovers the carrying amount of the underlying asset, the tax has now become current tax. So, the liability changes from being a deferred tax liability to being a current liability.
• at some point, the company pays its current tax liability. This is usually during the current period, or fairly soon after that. The timing depends on the tax system.

Comparison with accounting for trade payables

In most respects, this accounting is largely the same as the accounting for trade payables. In both cases, a company accrues a liability when it comes into existence, recognising an expense at the same time. Later, the company pays the liability, recognising no net expense that time (unless an estimate needs updating). The only difference is:

• for deferred tax, the liability is recognised initially as deferred tax. Later, the liability transfers from deferred tax to current tax. A company records that transfer as current tax expense and deferred tax income, not as a single net amount (normally net zero, unless an estimate needs updating).
• for trade payables, there is no distinction between ‘deferred’ amounts and ‘current’ amounts.

Myth 9. Deferred tax is not a liability because you can avoid paying the tax by selling the asset (or a subsidiary).

When an entity expects to recover the carrying amount of an asset by using it, the measurement of the deferred tax liability reflects recovery by use. Some people argue that a company could avoid paying this tax if it sells the asset first. They argue that paying this tax would be a consequence of a future decision to keep the asset and use it, and that there is no present obligation to pay that tax.

There are 2 situations to consider:

• Selling the asset directly
• Selling a subsidiary containing the asset

Selling the asset directly

If the tax consequences of sale are the same as the tax consequences of recovery by use, selling the asset would not change the amount of tax to be paid. If the 2 sets of tax consequences differ, selling the asset might change the amount of tax that the company is obliged to pay ultimately.

Some people think that the measurement of deferred tax should reflect the manner of recovery that would minimise the tax that will ultimately be paid, rather than reflecting the expected manner of recovery. They say a company has no obligation to use an asset in a manner that would subject the recovery to a higher level of tax—and so has no liability to pay the tax that would result from using the asset in that manner.

Other people think measurement based on the expected manner of recovery produces information more useful to investors. In finalising IAS 12, IASC decided to base the measurement on the expected manner of recovery.

Selling a subsidiary containing the asset

Some argue that a parent could avoid future tax consequences of recovering a subsidiary’s asset because the parent could sell the subsidiary. Therefore, they suggest that a parent has no deferred tax liability for future tax consequences of assets held by a subsidiary.

That argument doesn’t hold water. The subsidiary would still need to pay the tax (for instance, £90 for Company A’s machine in example 1) that will arise as the subsidiary recovers the carrying amount of the machine. And the purchaser would consider the subsidiary’s tax position in deciding how much it is willing to pay. The vendor would end up paying the tax, because the purchaser would offer it a lower price for the subsidiary.

In example 1, if Companies A and B are identical to each other in all other respects, a prospective purchaser would offer £90 more for Company B than it would offer for Company A. That is because Company A will pay £90 more tax than Company B will. Said differently, the purchaser would be acquiring, in addition to the machine and to the other assets and liabilities, a deferred tax liability—which is £90 for Company A but £0 for Company B.

Myth 10. People never consider deferred tax when they price transactions.

Some people think that deferred tax is just an accounting construct. They believe that no-one ever considers deferred tax in setting prices for transactions.

That belief is not true. In the real world, people routinely consider deferred tax when this is necessary to avoid disadvantaging one party to the transaction. The clearest example is for some forms of open-ended mutual fund in which investors enter or exit at a price based on net asset value. If the mutual fund is subject to tax and if capital gains within the fund are taxed only on disposal, the net asset value is usually determined after deducting deferred tax liabilities on unrealised capital gains.

If this were not done:

• investors leaving the fund would not pay their share of the tax on unrealised capital gains. Thus, investors staying in the fund would end up paying that share of the tax.
• investors entering the fund would overpay because they must ultimately pay part of the future tax that will arise from past unrealised gains of existing investors.    

Example 5 illustrates these points.   

Example 5. Mutual fund

Fact pattern

At 7 October 20X1, Mutual fund M has investments with a fair value of £1,000 and a cost of £600 (and an unrealised capital gain of £400). It has no other assets or liabilities (apart from deferred tax). 100 units in the fund are outstanding. Thus, the net asset value of the fund is £10 per unit (before considering deferred tax).

The fund is subject to tax at 30% on realised capital gains.

New investors entering the fund must pay net asset value and investors leaving the fund receive net asset value. At 7 October 20X1, investors holding 30 units leave the fund. At the same date, new investors buy 10 new units in the fund.

Deferred tax and the net asset value

What would happen if the fund issued and repurchased units at the net asset value without considering deferred tax? The fund would pay £300 to the leaving investors and would receive £100 from the new investors. That would leave the fund with assets of £800 and unrealised capital gains still of £400 (assuming the fund does not realise any of the gains before it pays the leaving investors).

When the fund ultimately sells the investments, it will pay tax of £120 (£400 @30%) on the gains that had already accrued before 7 October 20X1. That tax will be borne economically by the 80 remaining investors (70 original and 10 new), at a rate of £1.50 per unit. None of it will be borne by the investors who have already left—even though the unrealised capital gain arose while they were investors. Determining the net asset value without deducting deferred tax would lead to a transfer of value:

• from existing investors to leaving investors; and
• from new investors to existing investors.

Deducting deferred tax in determining the net asset value avoids this problem. The deferred tax liability is £120 (£400@ 30%). The net asset value (after deducting deferred tax) is £880 and the net asset value per unit is £8.80. The leaving investors would receive £264 (30 @£8.80) and the new investors would receive £88 (10 @£8.80). After these transactions, the fund has assets of £824 (cost £424, unrealised gain £400), net assets of £704 and a net asset value of £8.80.

When the fund ultimately sells the investments, it will pay tax of £120 (£400 @30%) on the gains that had already accrued before 7 October 20X1. But now, that tax is borne as follows:

• the holders of the original 70 units bear £1.20 per unit.
• the leaving holders of 30 units paid, in effect, £1.20 per unit into the fund to enable it to pay their share of the tax. They bore their share of the tax because it was already accrued as a deduction in determining the net asset value they received. 
• the holders of the 10 new units bear tax of £1.20 per unit, but they are compensated for this by the reduction of £1.20 per unit in the purchase price they paid. Net of this compensation, they bear none of that tax.

Myth 11. You can’t calculate deferred tax if there is no tax balance sheet.

In describing when deferred tax liabilities are recognised and how they are measured, IAS 12 uses the notion of a tax base. A company recognises a deferred tax liability if an asset’s carrying amount differs from its tax base. Some people suggest that no deferred tax liability can exist if the tax law does not require companies to produce a tax balance sheet in which assets are measured at their tax base.

Although IAS 12 uses the term ‘tax base’ as part of a simple description of how to compute deferred tax in the most straightforward cases, the tax base itself is not a necessary concept.

IAS 12 makes it clear (both in the 2^nd unnumbered paragraph of the Objective section and in paragraph 10) that the fundamental principle underlying the standard is that companies should (with some limited exceptions):

Determining whether those future payments would be larger or smaller does not rely in the slightest on whether the tax law requires a tax balance sheet that measures assets at their tax base.

Myth 12. The only real cash is cash tax

Some people say that the only meaningful tax amount for a period is the amount of ‘cash tax’.

By ‘cash tax’, some people mean the amount of tax paid during that period. It could be valid to look at that number if you are just looking at cash flows, but comparing tax paid with profit before tax does not seem particularly useful. For example, the ratio of tax paid to profit before tax is not meaningful because the numerator (tax paid) is a cash flow but the denominator (profit before tax) is based on accruals.

A more useful comparison might be between profit before tax and what IAS 12 calls ‘current tax expense’. Current tax is the tax that tax law treats as arising for the current year. That amount will not normally be paid fully in the current year, because the amount cannot be calculated until the current year has finished. In many tax systems, companies must pay advances during the year, with an adjustment after the end of the year once the final amount is known. In some other tax systems, companies pay none of the current tax until the final amount is known after the end of the year.

Even the current tax expense does not give a full picture of the tax consequences of all the transactions (and other events) that have already been reflected in the financial statements:

• current tax expense captures only those tax consequences that tax law treats as affecting taxable profit of the current period.
• sometimes, a company has already recognised in its financial statements the effects of a transaction (or other event), but the tax consequences of that transaction (or other event) will not affect taxable profit until a future period. Those tax consequences will affect current tax expense for that future period. In the meantime, financial statements capture those future tax consequences in deferred tax expense.

It is a good idea to consider both current and future tax consequences of the transactions (and other events) that have already been reflected in the financial statements. To see a full picture of those consequences, it is necessary to look at both current tax expense and deferred tax expense.

Myth 13. Investors can’t use information about deferred tax.

Myth 13 is that information about deferred tax is of no use to users of financial statements (investors). That myth is the most damaging of all. But to  explain why it is a myth, it is necessary to see why myths 1-12 are all myths.

Myth 13 exists because most investors don’t understand what deferred tax is and what the deferred tax numbers tell them. Also, companies generally describe deferred tax very mechanically, focusing on the computation and using accounting jargon. They do not explain how deferred tax depicts future tax cash flows. As a result, many investors ignore information about deferred tax completely.

Consider again example 1, repeated here again as example 6.

Example 6. Accelerated tax depreciation.

Fact pattern

Company A bought a machine on 1 January 20X1 for £1,200. It depreciates the machine over its useful life of 4 years. But, for tax purposes, the machine is depreciated over only 3 years. At 31 December 20X3, the machine’s carrying amount is £300 but its tax base is £0.

Company B also bought a machine on 1 January 20X1 for £1,200 and depreciates it over its useful life of 4 years. For tax purposes, company B’s machine is depreciated over 4 years. At 31 December 20X3, the machine’s carrying amount is £300 and its tax base is also £300.

The tax rate is 30%.

How Companies A and B report this in their financial statements

At 31 December 20X3, Company A reports a deferred tax liability of £90. That is how much extra tax Company A will pay in future periods when it recovers the machine’s carrying amount. Company A needs to tell investors that fact, using clear, plain language.

At 31 December 20X3, Company B reports a deferred tax liability of £0. That is because Company B will pay no extra tax on recovering the carrying amount of its machine. Company B needs to tell investors that fact, using clear, plain language.

Company A will pay £90 more tax than Company B will pay. Investors can see that fact easily from the fact that Company recognises a deferred tax liability of £90 whereas Company B recognises a deferred tax liability of zero. Without looking at the deferred tax information, investors will not see that difference easily and may not see it at all.  

Conclusions

Information about deferred tax can be useful to investors. It tells investors how much tax a company will pay when it recovers the carrying amount of its assets. Unfortunately, most investors do not realise that information about deferred tax tells them this.

Part of the reason why investors do not understand this information is that companies generally provide it in technical accounting jargon in a way that does not make it easy for investors to grasp what this information tells them.

Because there are many myths about what deferred tax information means, people preparing this information often think of it as just a book accounting entry that has little meaning. No doubt this is one of the main reasons why companies generally present this information in a way that does not explain what it means.

IAS 12 is a standard for which the IASB (and IASC before it) have not done enough to explain in simple terms what the resulting information tells users, and to encourage preparers of financial statements to provide the information in a clear, simple and understandable way. In the past, IASB has often taken the view that explanations of this kind belong in educational material outside the standard itself. In this case, and perhaps others, that might not be enough.

I believe the IASB should write standards in a way that shows preparers directly what the resulting information tells users. Putting that material in the standard itself would help preparers produce deferred tax information in a way that meets users’ needs better than we generally see.

The way we account for deferred tax is not perfect. I will discuss some problem areas in future posts.