Deferred Tax Liability A deferred tax liability represents an obligation to pay taxes in the future. These taxes are owed by a company but are not due to be paid until a future date. Companies that incur such an obligation prepare and maintain two financial reports every year: a tax statement and anRead more
Deferred Tax Liability
A deferred tax liability represents an obligation to pay taxes in the future. These taxes are owed by a company but are not due to be paid until a future date.
Companies that incur such an obligation prepare and maintain two financial reports every year: a tax statement and an income statement.
This is because companies maintain their books as per book accounting rules (GAAP/IFRS), but they have to pay taxes according to tax accounting rules, and they each have to follow their own guidelines.
For example, a tax statement follows the cash basis of accounting, and an income statement follows the accrual basis of accounting.
Companies calculate their profit as per the accounting rules as well as tax laws known as accounting income and taxable income, respectively. Some differences arise due to the application of different provisions of law.
These temporary differences are accounted for, recognized, and carried forward in the books of accounts and create deferred tax.
Example
Here is an example of deferred tax liability.
In the given example, tax as per income statement is 70,000, whereas as per tax statement it is 56,000. This temporary difference is termed as deferred tax liability of 14,000.
When accounting income is more than taxable income, it creates Deferred Tax Liability. It will be adjusted in the books of accounts during one or more subsequent year(s).
How Does it Arise?
There are several instances under which a company creates a deferred tax liability. Some other instances are:
Depreciation Methods
- One of the most common reasons for deferred tax liability is when a company uses different depreciation methods in the Income and Tax Statement.
- Assets are depreciated by calculating the straight-line method in the Income Statement, while the written-down value method is used in the Tax Statement.
- Since the straight-line value method produces lower depreciation when compared to the WDV method, accounting income is temporarily higher than taxable income.
- The company recognises deferred tax liability as this difference between accounting income and taxable income.
Treatment of Revenue & Expenses
- Deferred tax liability can also arise when there is a difference in the way revenue and expenses are treated in books of accounts.
- As mentioned earlier, accounting rules follow the accrual basis of accounting while tax laws follow the cash basis of accounting.
- Meaning in the tax statement, income and expenses are recorded when they are received or paid, not when they are incurred or realised.
- This difference in the treatment of revenue and expenses creates deferred tax liability.
Impact on Financial Statements
Recognising deferred tax liability and its subsequent effect on the company’s financial statement is important as it simplifies the process of auditing and analysing financial reports.
Balance Sheet
- Deferred tax liabilities are recorded on the liability side of the balance sheet under non-current liabilities.
Cash Flow Statement
- The deferred tax liability is added back to the net income in calculating cash flow from operating activities to show the actual cash flow.
Definition Net profit is defined as the excess of revenues over expenses during a particular period. For a business i.e. company/firm, it is a liability towards shareholders/promoters/partners/proprietors, etc. as it is their capital that has earned these profits. When the result of this computationRead more
Definition
Net profit is defined as the excess of revenues over expenses during a particular period.
For a business i.e. company/firm, it is a liability towards shareholders/promoters/partners/proprietors, etc. as it is their capital that has earned these profits.
When the result of this computation is negative it is called a net loss.
Net profit may be shown before or after tax.
Formula :
Total Revenues – Expenses
Or
Total Revenues – Total Cost ( Implicit And Explicit Cost )
Liabilities
It means the amount owed (payable) by the business. liability towards the owners ( proprietor or partners ) of the business is termed an internal liability.
On the other hand, liability towards outsiders, i.e., other than owners ( proprietors or partners ) is termed as an external liability. For example – taxes owned, trade payables, etc.
For example creditors, bank overdrafts, etc.
Assets
An asset is a resource owned or controlled by a company and will benefit the business in current and future periods.
In other words, it’s something that a company owns or controls and can use to generate profits today and in the future.
For example – cash, building, etc.
Why debtors are treated as a liability?
Now let me explain to you why net profits are treated as a liability and not as an asset because of the following characteristics :
• Net Profit shows the credit balance of the Profit And Loss Account.
• It is treated directly in the balance sheet by adding or subtracting from the capital.
• Net Profit is a measure of the profitability of the company after taking into consideration all costs incurred during the accounting period.
• Net profit is the last line in an income statement and is the figure that concerns most people who use such a statement.
• Net income is reported on the income statement (profit and loss account) and forms a key indicator of a company’s performance.
Importance Of Net Profit
Now I will let you know the importance of net profit which is as follows :
Owners
Net profit allows owners to calculate the tax to be paid and how much earnings need to be distributed to the business owners.
Investors
Investors need to see net profit as they need to access the risk before investing they basically judge the revenue-generating capacity of a firm based on net profit.
Competitors
For making the comparison competitors tend to look at the net profit of the company to know how are they performing in the industry so that they can build themselves strong.
Creditors
Creditors look at the net profit for the purpose of obtaining business loans or we can say that determines a prospective debtor’s capacity to pay future debts.
Conclusion
Now after the above explanation, we can say that,
Net Profit is shown on the liability side as it belongs to shareholders so the company has to give it to shareholders so we are showing it under the liability side.
Net Profit with respect to the company is a liability as it has to pay it to shareholders.
Net Profit with respect to shareholders is an asset.
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