Creation of Deferred Tax Liabilities and Assets

A deferred tax asset arises whenever a company’s taxable income is greater than its accounting profit. This variance results in an excess amount being paid for income taxes, which the company expects to recover in the course of future operations.

A deferred tax liability, on the other hand, arises whenever a deficit amount is paid for income taxes and the company expects to eliminate this deficit during future operations.

Creation of Deferred Tax Assets and Liabilities and Treatment in Financial Analysis

• Deferred tax assets and liabilities arise whenever the accounting standards and tax authorities recognize the timing of taxes due at different times. They are based on temporary differences which result in a company paying an excess or deficit amount for taxes, which the company expects to recover from future operations. The differences are considered ‘temporary’ since the taxes paid will be recoverable or payable at a future date, and as a result, a deferred tax asset or liability is created.

• Changes in the deferred tax asset or liability amounts reported on the balance sheet reflect the difference between the amounts recognized in the previous and current accounting periods.

• Changes in deferred tax assets and liabilities are added to income tax payable to determine a company’s income tax expense.

• At the end of each financial year, deferred tax assets and liabilities are recalculated. This is done by comparing the tax bases and carrying amounts of the balance sheet items.

• Temporary differences, once identified, should be assessed with a view to establishing if they will cause future economic benefits.

• If it there is no guarantee that future economic benefits will be derived from a temporary difference, a deferred tax asset or liability will not be created. Additionally, if a deferred tax asset or liability resulted in the past, but future economic benefits are not expected to be realized as at the current balance sheet date, then IFRS dictates that an existing deferred tax asset or liability that is related to the item will be reversed. In similar circumstances under US GAAP, a valuation allowance will be established.

Question

Which of the following statements is the least accurate?

1. Deferred tax assets and liabilities are recalculated at the end of each financial year.
2. Deferred tax assets and liabilities are based on permanent differences which result in a company paying an excess or deficit amount for taxes.
3. A deferred tax asset or liability will not be created if there is no guarantee that future economic benefits will be derived from a temporary difference.

Solution

The correct answer is B.

Deferred tax assets and liabilities are based on temporary, not permanent, differences that result in a company paying an excess or deficit amount for taxes.

Options A and C are correct statements.