FinancialReporting
FINANCIAL REPORTING
Deferred tax
Steve Collings unpacks the reasons for deferred tax and how to account for it
Illustration: Mario Wagner
FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with deferred tax in Section 29 Income Tax. Micro-entities preparing financial statements under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime are prohibited from accounting for deferred tax.
Accounting for deferred tax
This article examines some of the technical detail relating to deferred tax. However, I think the first thing to understand is why entities are required to account for deferred tax.
Deferred tax applies the accruals concept. The accruals concept requires the tax effects of a transaction to be reported in the same accounting period as the transaction itself. Hence, an adjustment to the tax charge in the financial statements will be needed. It is this concept that gives rise to deferred tax, and the overall objective is to lessen volatility in the financial statements. This also helps to highlight the future obligations to pay tax that are based on profits that have already been made, which may help the directors of a company to manage their cash flow better and to ensure they have enough funds to pay their tax bills once deferred tax ‘turns into’ current tax.
Consider an entity that includes three months’ worth of accrued pension contributions in its financial statements. Tax legislation in the UK grants tax relief on pension contributions that have been paid over to the pension fund. Tax relief is not available on accrued pension contributions (i.e. those recognised in the financial statements but not yet paid). In the year-end financial statements, the entity must recognise the tax effects of this transaction so as to apply the accruals concept. Hence, it will recognise a deferred tax asset because the tax relief on those accrued pension contributions will be granted in the next tax computation.
The accruals concept requires the tax effects of a transaction to be reported in the same accounting period as the transaction itself.
Software GAAP
You can be forgiven for thinking ‘Software GAAP. What is that?’ This is a non-existent GAAP and I have coined it ‘software GAAP’ to reflect the situation when a preparer places too much reliance on the information produced automatically by accounts production software.
For example, consider the notes to the financial statements. Contemporary accounts production software systems are capable of producing various notes, such as accounting policies that are often driven by entries in the trial balance or chart of accounts. However, the fact that they have been generated by the software does not mean they are necessarily correct.
Accounting policies such as ‘Stock is valued at the lower of cost and estimated selling price less costs to complete and sell’ is invariably the ‘usual’ accounting policy that is produced by the software when a client has stock and work in progress in the balance sheet (statement of financial position). However, one would expect an accounting policy for stock and work in progress to be more concise, particularly where such items are material to the financial statements.
For example, a description of what constitutes ‘cost’ and ‘estimated selling price less costs to complete and sell’ as well as a description of any cost methodologies that have been used by the entity (such as first-in, first-out, or weighted average cost) in valuing closing stock and work in progress.
Accounting policies are often criticised by reviewers for being ‘boilerplate’. A boilerplate accounting policy is one which just regurgitates the content of an accounting standard and adds nothing meaningful to the policy.
Consider the following accounting policy: ‘Turnover is stated net of VAT and trade discounts.’
Turnover is often the largest number in the financial statements. A policy such as this is virtually meaningless. The accounting policy should describe the point at which revenue is recognised (e.g. on dispatch of goods) and should also discuss other revenue-related points such as where revenue is deferred.
The key to high-quality disclosures is to ensure they are entity-specific and concise. Conversely, any irrelevant disclosures should be removed from the financial statements as they do not add anything.
Basic principles of deferred tax
Sunnie Ltd prepares its financial statements to 31 March each year. During the year to 31 March 2024, the company purchased an item of machinery for £1m, which has an expected useful life of four years. Sunnie Ltd claims the Annual Investment Allowance from HMRC that allows 100% tax relief to be granted on this machine in the year of acquisition as it is a qualifying asset.
The draft financial statements for the year ended 31 March 2024 show a profit of £1.2m and forecasts suggest that this level of profit will continue for the foreseeable future as the company has a five-year contract in place meaning income and profitability is relatively static. The company pays tax at 25%.
DEFERRED TAX IS NOT RECOGNISED
> If Sunnie Ltd ignores deferred tax, this is how the profits will look:
> Extracts from Sunnie’s profit and loss accounts for the four years are as shown above
If deferred tax is ignored, the profit and loss accounts suggest a declining performance between 2024 and 2027. This is caused by the timing of the current tax charge on the company’s profits. Due to the purchase of the machine in 2024 and the 100% tax relief available on it, some of the accounting profit is not charged to tax in 2024. This is only a postponement (essentially a cash flow saving in the year of acquisition) until 2025, 2026 and 2027, when taxable profit becomes more than accounting profit.
DEFERRED TAX IS RECOGNISED
> Sunnie calculates deferred tax at a rate of 25% because this is the tax rate that will apply when the timing differences reverse. The deferred tax computation is as follows:
> Extracts from Sunnie’s profit and loss account when deferred tax is recognised are shown above
As you can see from the above, accounting for deferred tax produces a more meaningful performance profit of Sunnie Ltd and smooths out profit and loss volatility due to timing differences.
ASSETS
Deferred tax assets
Care must be taken where deferred tax assets are concerned – particularly those arising from utilised tax losses. FRS 102, para 29.7, is restrictive in its approach to recognising deferred tax assets on the balance sheet. Unrelieved tax losses, which can be offset against future taxable profits, and other deferred tax assets are only recognised to the extent that it is probable (i.e. more likely than not) that they will be recovered against the reversal of deferred tax liabilities or other future taxable profits. The objective of this restriction is to stop reporting entities from disproportionately inflating assets on the balance sheet that may never be recovered.
FRS 102, para 29.7, states that the very existence of unrelieved tax losses is to be taken as strong evidence that there may not be other future taxable profits against which the losses will be relieved. Hence, prior to recognising a deferred tax asset on the balance sheet, the entity must be satisfied that there is evidence that it is capable of recovery.
EXAMPLE
> The table below provides non-comprehensive examples of indicators when an entity may or may not generate future taxable profits to utilise a deferred tax asset:
Rate to be used in calculating deferred tax
FRS 102, para 29.12, requires an entity to measure deferred tax using the tax rates and laws that have been enacted or substantively enacted by the balance sheet date and which are expected to apply to the reversal of the timing difference.
The term ‘substantively enacted’ is a defined term in the Glossary to FRS 102 and means when the remaining stages of the enactment process will no longer affect a tax rate or are unlikely to do so. In England, a tax rate is announced in the Budget and is said to be ‘substantively enacted’ when it reaches the House of Lords. This is because the House of Lords can debate the tax rate, but they cannot change it. A Republic of Ireland tax rate is regarded as being substantively enacted if it is included in a Bill that has been passed by the Dáil.
In practice, this means that a change in tax rate will become effective for the purposes of deferred tax earlier than it becomes effective for tax purposes. For example, when the former chancellor announced an increase to the headline rate of corporation tax in England from 19% to 25% in 2021, the Bill containing this new tax rate reached the House of Lords on 24 May 2021. This is when the tax rate became effective for deferred tax purposes even though the new tax rates did not become effective for tax purposes until 1 April 2023.
The key issue to bear in mind is that when a change in tax rate is on the horizon, it will become effective earlier for financial reporting purposes because of the ‘substantively enacted’ rule.
Conclusion
Deferred tax is a thorny subject for preparers and can be a complex issue. It is important to have a sound understanding of the technical aspects relating to deferred tax because they can have a material impact on the financial statements (particularly nowadays given the headline rate of corporation tax is now 25%).
FINANCIAL REPORTING