The tax effect due to the timing differences is termed as deferred tax which literally refers to the taxes postponed. Deferred tax is recognised on all timing differences.
Timing Difference can be categorized into two parts namely:
1) Permanent timing difference
2) Temporary timing Difference
PERMANENT TIMING DIFFERENCE
A permanent difference is the difference between the tax expense and tax payable caused by an item that does not reverse over time.
For example if any expense which is booked in the books of accounts but is not allowable under the Income Tax Act,1961 then this amount of difference will cause an entity to pay more amount of tax as compare to amount of tax which is payable as per books of accounts.
This difference is always be present and cannot be reversed as expense is not allowable under Income Tax.
Entity has to pay taxes as per rules prescribed under Income Tax Act, 1961.
TEMPORATRY TIMING DIFFERENCE
Difference occurs due to transactions that create temporary differences are recognized by both financial accounting and accounting for tax purposes, but are recognized at different times.
For example a timing difference can be a rent income. Accrual accounting will only allow revenue to be recorded when it is earned, but if a company receives an advance payment of rental income, it must report this under taxable income on its tax return. As such, this revenue will be recorded on the tax return but not the book income. This creates a timing difference in this period. At a future period when the rental revenue is finally earned, the company will record that revenue under book income but not on its tax return, thereby reversing and eliminating the initial difference.
DEFERRED TAX LIABILITY OR ASSET
A deferred tax liability or asset is created when there are temporary differences between book tax and actual income tax. There are numerous types of transactions that can create temporary differences between pre-tax book of accounts income and taxable income as per Income Tax Act, 1961 thus creating deferred tax assets or liabilities.
Deferred tax liability occurs when Taxable income books of accounts is more than taxable income as per Income Tax Act, 1961.
As per books of accounts company is liable to pay more tax but as per Income Tax Act company is required to pay tax on Rs. 8500 only. This difference arise as there is an difference in rate of depreciation but this will settle in future times.
Deferred tax asset is created when Profit as per books of account is less than the Taxable income under Income Tax Act, 1961.
Let us say an electrical goods Company has a revenue of Rs 5 lakhs and it has expenses of Rs 3 lakhs, thus a profit of Rs 2 Lakhs. However, the expenses are bifurcated as Rs 2.5 Lakhs for the cost of goods sold, general expenses, etc., and Rs 50,000 for future warranties and returns. The Income tax do not consider future warranties as an expense. It is because this expense has not been incurred but only accounted for. Therefore, the Company cannot deduct such an expense while calculating taxes thus, pay tax on Rs 50,000 as well. Therefore, this amount will be part of the deferred tax assets in the balance sheet.
To summarise, the deferred tax asset or liability can be understood in the following manner.
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