Deferred Tax Liability and Deferred Tax Asset---Diferred Charges and Prepaid Expenses

Lots of students of Accounting have the problem relating to these four terms; here is my small endeavor to make them understand these concepts and clear their doubts.

DEFERRED TAX LIABALITY:

Taxing authority generally determine the profit of the enterprises according to the cash basis,  that is, expensed which are paid in the current year and income which are received in the current year. Suppose we have paid prepaid expenses in this year. Now according to the GAAP, this expense will not be deducted from the profit of the current year, but this will be deducted in deriving profit according to the income tax. At this point of time, an enterprise knows that in current year, profit according to the income tax is less therefore, favors the enterprise to pay less tax but when this prepaid expense will be expensed in the next year by the enterprise, the taxation authority will not allow this as expense because they had already recognized this in last year so the profit in the next year will be less according to the enterprise and high according to the income tax, so the enterprise has to pay more tax in next year.  Thus, it creates deferred tax liability for enterprise in current year.

Now if the expenses related to the deferred tax liability are expensed in the one year, it’s a current liability and if the expenses are expensed in more than 1 year (example advance payment for the insurance for next three year) the liability is non-current liability.

It should be noted that DTL is not only related with prepaid expenses but with all those expenses that creates the difference between profit according to tax and profit according to the GAAP. For example—Tax laws allow full depreciation in the first year after a company acquires certain assets; however, a company may actually write off the depreciation over several years on its financial statements. The company may charge depreciation at lower rates than allowed under tax laws. Or it may use a different method of charging depreciation. So in all these cases differed tax liability should be created.

Deferred tax asset:

In the similar way, Tax laws may not recognize some of the expenses that the company has accounted for in its financial statement in the current year say (2013-14). For example-provision for bad debt, which are not fully recognized by tax authorities –in such case, the company is paying the tax for future year so in the future year the profit for tax will be less and thus, it is having differed tax asset in the current year that is (2013-14).

Accounting treatment for both differed tax liability and assets:

DTL should be debited to p/l Account and will come on the liability side of the balance sheet.

DTA should be credited to p/l Account and will come on the asset side of the balance sheet.

 

 

Difference between Deferred charges and prepaid expenses:

 Students sometimes get confused about these two concepts because they look almost similar to each other, but there is a major difference. Here it is….

Prepaid expenses mean expenses paid in advance by the enterprise to receive the service in future.(it will come in the Asset side of the B/S)

Deferred charges mean charges paid by the enterprises the benefit for which is expected to receive in future years also.(it will come in the asset side of B/S and write off accordingly in the P/L account)

In the case of prepaid expenses the enterprise has the legal right to receive the service but in case of deferred charges there is no such right.

Suppose an enterprise paid rent of the building Rs 50000 in advance for the next two year, here the enterprise’s got the legal right to receive the service of building for the next two year this is called pre-paid expenses. Now the same enterprise has paid 25000 to move its all equipment from old building to this new building, here the enterprise will get the benefit of this 25000 as long as it stays in that building so the enterprise has to write off this expenditure accordingly to the estimated years it will stay in that building.  

 

So this was all how I explained about these terms, hope you all like it-I'm coming soon with one more important Accounting topic.