Simple Explanation on Taxation and Deferred Taxation

Recently, depreciation, capital allowance and deferred taxation have become one of the hottest issues among my investment friends. My friends asked me to blog about it.

Okay, it’s time to utilize my experience of working in audit firm. I think I shall explain what’s that to my investment friend through my blog.

First of all, let me explain what is depreciation.

When a company purchases an asset, such as a machine, it would be recorded as an asset in account and then being depreciated when time passes. There are several method of depreciation such as straight line method, reducing balance and sum of digit. Commonly, straight line method is being used. Straight line method means, the asset will be depreciated equally throughout the useful life. Thus, useful life has to be determined. Useful life will be determined basically base on how long can the equipment being used.

Example: Company XYZ bought twenty computers that cost RM60,000 with estimated useful life of 5 years. By using straight line method, the computer will be depreciated RM 12,000 a year.

	Year 1	Year 2	Year 3	Year 4
Revenue	200,000	220,000	250,000	280,000
Cost of sales	100,000	120,000	130,000	135,000
Gross profit	100,000	100,000	120,000	145,000
Marketing expenses	10,000	20,000	25,000	40,000
Depreciation	12,000	12,000	12,000	12,000
Other expenses	13,000	10,000	15,000	17,000
Profit before tax	65,000	58,000	68,000	76,000

After the profit before tax is computed, tax computation is required to compute the taxation.

	Year 1	Year 2	Year 3	Year 4
Profit before tax	65,000	58,000	68,000	76,000
Add: non allowable expenses             - Depreciation             - Greeting and gift	12,000 2,000	12,000 3,000	12,000 2,000	12,000 3,000
Adjusted income	79,000	73,000	82,000	91,000

In computation of tax, we need to add back all the non-allowable income, such as depreciation to derive to adjusted income. Depreciation is not applicable for deduction for tax. However, there is application of capital allowance for tax. Capital allowance is similar to depreciation. The asset purchased will be deducted portion by portion year after years.

There are two common types of capital allowance, which are initial allowance and annual allowance. Initial allowance are tax deductible for the first year of purchase (20%), while annual allowance is deducted annually until the value is fully claimed. The rate for annual allowance for each type of asset is different.

	Year 1	Year 2	Year 3	Year 4
Adjusted income	79,000	73,000	82,000	91,000
Capital allowance	36,000	24,000	-	-
Statutory income	43,000	49,000	82,000	91,000
Tax payable (25%)	10,750	12,250	20,500	22,750

* initial allowance and annual allowance for computer are 20% and 40% respectively

Tax payable is tax that needs to be paid for the year by the company.

However, as there is capital allowance method doesn’t fulfill the concept of matching principle by accounting standard. Deferred tax exists to reconcile the taxation part.

	Year 1	Year 2	Year 3	Year 4	Year 5
Net book value	48,000	36,000	24,000	12,000	-
Residual expenditure	24,000	-	-	-	-
Difference X 25% (tax rate) =	24,000 6,000	36,000 9,000	24,000 6,000	12,000 3,000	- -
Changes from last year	6,000	3,000	(3,000)	(3,000)	(3,000)

Net book value = Cost of asset – accumulated depreciation

Residual expenditure = Qualified expenditure (value asset that qualified for tax deduction) – accumulated capital allowance

The difference will be the figure appear as balance in statement of financial position (formerly known as balance sheet) while the changes will be appear in income statement.

Thus the final part of income statement and notes to the account will be look like this:-

 Note to the account (to see the real report, you may refer page 77 of Power Root Berhad’s 2012 annual report)

	Year 1	Year 2	Year 3	Year 4
Major components of income tax expense : Current tax expense Deferred tax (income)/expenses -          Origination and reversal of temporary difference	10,750 6,000	12,250 3,000	20,500 (3,000)	22,750 (3,000)
	16,750	15,250	17,500	19,750

	Year 1	Year 2	Year 3	Year 4
Reconciliation of effective tax expense Profit before tax Income tax using Malaysian tax rate Non-deductible expenses	65,000 16,250 500	58,000 14,500 750	68,000 17,000 500	76,000 19,000 750
	16,750	15,250	17,500	19,750

Income statement:

	Year 1	Year 2	Year 3	Year 4
Profit before tax	65,000	58,000	68,000	76,000
Taxation	16,750	15,250	17,500	19,750
Profit after tax	48,250	42,750	50,500	56,250