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Practical guide to calculating deferred taxes

16 May 2014

Although it has been more than thirty years that the first International Accounting Standard focusing on deferred taxes (IAS12) was published and most accounting systems are familiar with the concept, Individual financial statements that are prepared pursuant to the Hungarian accounting act are still not permitted to include it. In the course of our audits we often encounter uncertainty when it comes to calculating deferred taxes for the purposes of IFRS financial statements and consolidated data provisions. The purpose of our current newsletter topic is to change this attitude by providing initial help through describing how deferred taxes are generated.

 

To summarise the basics, deferred taxes indicate in the financial statements the future tax impact of the difference between the book value and the tax base (that is, the value accepted in accordance with the company act) of a balance sheet asset or liability, in other words, a future tax advantage or tax payment obligation.

 

If we wish to define the concept of deferred taxes more simply, we may say that in accounting, deferred taxes represent a theoretical receivable or liability that results from the fact that certain types of assets and liabilities must be valuated with the help of different methods pursuant to accounting and tax laws. The tax base modifying items that cause temporary differences and occur "in pairs", that is, one year they increase the tax base while in the years after that they can be expected to be reversed, that is, they may potentially decrease the tax base, are more important for the purposes of calculation.

 

The following table illustrates the mechanism of generating deferred taxes, based on the above:

 

In general, items that modify the corporate income tax base also have an impact on the company's balance sheet, and a related calculation helps us think through the deferred tax impact that needs to be accounted for. The balance sheet of the company prepared pursuant to the tax act can be generated from the balance sheet prepared pursuant to the accounting regulations through the adjustment of the related, cumulated tax base modifying items. In other words, when the tax balance sheet is generated, the net value of each asset and liability, determined in compliance with the tax accept after the impact of cumulated modifying items (of the previous years and of the year concerned), must be considered.

Pursuant to the above-mentioned balance sheet approach, the difference between the balance sheet value of the assets and liabilities listed in the accounting statement (AN) and the balance sheet value calculated pursuant to the tax act (TN) may generate a deferred tax receivable (AN<TN) or liability (AN>TN) as we will see from the concrete examples below.

In relation to the above it is very important to note that although the tax balance sheet includes the impact of all items that modify the tax base, the deferred tax impact can only be calculated in respect of the above-mentioned differences that go in "pairs", generate temporary differences and are reversed in the future. In the case of tax base modifying items that result in definitive differences (for example, adjustments related to costs that are not incurred in the interest of the company, tax penalties or transfer prices), no future tax recovery or any other tax impact is possible; therefore, these items must be excluded from the calculation of combined deferred taxes.

 

In order to make it easier to calculate deferred taxes for the first time, we describe below - although not exhaustively - the typical cases where temporary differences may occur:

 

  • : If there is a difference at the company between the depreciation rates stipulated in the tax law and used in accounting statements, pursuant to the balance sheet approach, the difference between the net value of fixed assets specified in the accounting statement (AN) and the net value calculated at the rates proposed in the tax act (TN) results in a deferred tax receivable (AN<TN) or liability (AN<TN). If assets are depreciated at a faster rate pursuant to the accounting act (AN<TN), it is likely that in the coming years, when calculating the corporate income tax, the increasing item to be enforced with respect to the depreciation that is accounted for pursuant to the accounting principles will be gradually falling compared to the decreasing item of the depreciation specified in the tax act, which justifies accounting for a hidden future (profit) tax receivable in the IFRS statements. The reverse scenario (AN<TN), which results in latent liabilities, can also be deduced from the above.

 

  • Impairment on debtors: The amount of impairment recognised in respect of accounts receivable in a given year, and the difference between the net value of accounts receivable specified in the accounting statements prepared pursuant to the balance sheet principle and the gross value which includes the impairment provides a basis for calculating the deferred tax receivable. In the coming years, the previously recognised impairment (which was taken into account as a tax base increasing item) will be certainly recovered as a tax base decreasing item when tax liabilities are calculated, either because the receivable will be certifiably non-recoverable or, if we are luckier, it is paid. In addition to the above, the corporate tax act permits taking into account as a tax base decreasing item 20% of receivables that have been overdue for more than a year, and this method can also be incorporated into the annual calculation of deferred tax receivables by monitoring the opportunity to decrease the tax base by 20% in the future in respect of receivables that have been completely depreciated in the balance sheet.

 

  • Risk reserves: With respect to the fact that the corporate tax act does not recognise risk reserves in the tax base (it is a tax base increasing item in the year when it is generated and it is a tax base decreasing item when it is released); therefore, it is clearly understandable pursuant to the balance sheet principle that the full value of the aggregate amount of risk reserves that are accounted for in the balance sheet generates tax profit in the future when they are released, and they can therefore be taken into account as a basis for deferred tax receivables.

 

  • Accrued losses of previous years: Tax receivables calculated from the balance of accrued losses from previous years that can be realised in the coming years as a tax base decreasing item can be taken into account in the calculation of deferred taxes if future business plans certify certain recovery, in other words, profitable operation, and the accrued loss can be deducted from the related positive tax base (perhaps through several years). It is extremely important to keep accurate records of the unused, accrued negative tax bases of previous years and of the current year, and a considerable corporate income tax impact can be accounted for (under receivables) in the calculation of deferred taxes for the given year based on its aggregate balance, promising future recovery. But at the same time its is important to emphasize that the management of the company must have an accurate estimate indicating that in the coming years operations will generate profits at such a scale that from their tax bases the total amount of the accrued losses can be deducted.

 

  • Development reserves: We will not discuss this category in detail because the latent tax impact in this case is also based on the difference between the rates of depreciation specified in the above-mentioned tax act and in the accounting records. In the case of development reserves, deferred tax liabilities may be recognised because the tax base is reduced in the year when the development reserves are generated, then in the years after that the depreciation specified in the tax act does not reduce the tax base while the tax base increasing item of the accounting depreciation is incurred throughout the useful life of the asset.

 

  • Differences based on the discrepancies between the valuation methods of the IFRS statements and the statements prepared pursuant to the accounting act: In addition to the differences between the tax balance sheet and the accounting balance sheet, the potential impact on deferred taxes arising from the differences between Hungarian and IFRS statements must be taken into account when putting together IFRS statements, similarly to the methods described above (simply: "AN" in this case will mean the book value according to IFRS).

 

It is important to note once again that the definitive difference between the tax balance sheet and the accounting balance sheet that will not be reversed in the future (e.g. costs that were not incurred in the interests of the company) cannot be taken into account when calculating deferred taxes.

 

After aggregating the latent tax receivables and liabilities that are calculated on the basis of the temporary differences which are determined pursuant to the balance sheet approach described above (with the help of the future tax rate which is expected to apply to the period when the assets are enforced or the liabilities are paid),

 the deferred tax receivable or liability to be included in the company's balance sheet of the given year will be determined which modifies the actually payable tax heading in the profit and loss account (it is reduced in the case of deferred tax receivables and it is increased in the case of liabilities).

It is important to note that deferred tax receivables can be accounted for if it is likely that in the future the business will realise an amount of taxable profit from which the deferred loss or the tax reductions can be enforced.

 

In summary, please note that the following must be accounted for separately in the IFRS statement:

  • The amount of actual and deferred tax receivables and liabilities from all other balance sheet items
  • Deferred tax receivables must be accounted for under fixed assets while deferred tax liabilities must be recognised under long-term liabilities in a net amount, in other words, as an aggregate sum, either under assets or liabilities depending on whether the sum is positive or negative
  • The sum of actual and deferred taxes must be generally accounted for under revenues or expenditures in the profit and loss statement (except if the transaction, which results in the deferred tax impact, must be accounted for under "other comprehensive income" pursuant to the rules of the IFRS because in this case the related deferred tax will also be added to or deducted from the other comprehensive income).