Deferred tax in practice: where are the risks hidden?

Deferred tax is one of those items in financial statements that is rarely read first. Audit firms often observe that many accountants preparing financial statements treat this element of the profit and loss account as a technical obligation, while users of financial statements (especially those without an accounting background) regard it as an “accounting abstraction”. In practice, however, deferred income tax can materially alter the overall message conveyed by a set of financial statements. Why?

When analysing deferred tax, it is worth bearing in mind that, apart from the information presented directly, this item often reflects management’s genuine assessment of the company’s expected future financial performance. At the same time, for those involved in preparing financial statements, it is an area particularly susceptible to errors and, for the statutory auditor, an area of special interest.

What is deferred tax and when does it arise?

Put simply, deferred tax arises from temporary differences between the carrying amount of assets and liabilities and their tax base.

• Taxable temporary differences give rise to a deferred tax liability.
• Deductible temporary differences give rise to a deferred tax asset.

In practice, for Polish companies, the most common temporary differences arise from:

• different rates of tax depreciation and accounting depreciation,
• different classification and accounting treatment of lease agreements,
• impairment allowances (inventories, receivables and fixed assets),
• provisions,
• tax losses carried forward from previous years,
• foreign currency valuation, where unrealised foreign exchange differences may present particular challenges.

Example of a deferred tax liability

Company X depreciates a fixed asset more quickly for tax purposes than for accounting purposes (and therefore applies higher depreciation rates).

Effect: as a result, the entity reports lower taxable income today (because it incurs higher expenses), but can expect higher taxable income in the future (because tax depreciation will be completed sooner). 

Consequently, a deferred tax liability should be recognised in the balance sheet, because the current tax “saving” will produce the opposite effect in the future.

Deferred income tax through the eyes of an audit team

From a financial audit perspective, deferred tax is an area where irregularities most commonly stem not from incorrect arithmetic, but from flawed assumptions and an inappropriate calculation model.

Deferred tax assets (dependent on future profits)

The most common problem:

• The company recognises a deferred tax asset but has been generating losses for years.
• There is no convincing strategy for improving performance.

In practice, audit teams conducting a financial statement audit pay particular attention to assets that depend on the company’s future performance, especially where their realisation relies on ambitious forecasts that are exceptionally difficult to substantiate. In such cases, the key issue is not the calculation itself, but the credibility of the assumptions adopted.

Incomplete identification of temporary differences in the tax model

Many deferred tax models are based primarily on an analysis of balance sheet items, making it possible to determine whether temporary differences exist within a given line item. However, this does not guarantee the complete identification of all temporary differences.

An approach based solely on analysing balance sheet items may overlook areas such as: 

• tax losses carried forward from previous years, 
• unused tax reliefs, 
• discrepancies arising from differences in the timing of revenue or expense recognition (which do not always have a direct counterpart within specific balance sheet items).

Deferred tax, like many other areas, requires a broader perspective and effective information flow between accounting, tax, controlling and management functions. Indeed, information that is critical for completeness often arises outside the balance sheet itself.

A “rolled forward” model used without reflecting on balance sheet changes

In practice, situations frequently occur where a model from the previous year is simply copied. While accountants may update the input data, they often omit a renewed assessment of the assumptions and completeness of the model.

The problem is that deferred tax changes together with both the balance sheet and the business.

We often observe that this issue of copying models also affects companies that use the support of external tax advisers.

How is it possible for a tax adviser to make such a mistake? Experts rely on information received from their clients. For example, if a new provision account is created during the current year and has a non-zero balance at the end of the reporting period, but the tax adviser is not informed of this by the client, the adviser may perform their work correctly but nonetheless be misled.

Example 

Manufacturing company X has been generating losses for several years but still reports a significant deferred tax asset.

Where could the problem lie?

• lack of realistic profit forecasts,
• overly optimistic assumptions by management,
• no correlation with operating results.

If, during the audit, the statutory auditor does not obtain appropriate and sufficient audit evidence demonstrating that the asset will be realised, this may result in the need to write down at least part of the deferred tax asset. This would in turn reduce net profit and require additional disclosures in the financial statements.

The Accounting Act and IFRS – key differences in determining deferred income tax

With regard to the recognition of deferred tax assets, the Accounting Act and the International Financial Reporting Standards (IFRS) are based on the principle that such assets should be recognised only to the extent that their realisation is probable.

Under IFRS (more specifically, International Accounting Standard 12), however, this requirement is more explicitly linked to an analysis of future taxable profits and constitutes a central element of the recognition process. In practice, this means that: 

• under IFRS, a deferred tax asset is recognised at a “net” amount corresponding to the benefit that is expected to be utilised, 
• under the Accounting Act, deferred tax assets are determined in relation to all deductible temporary differences, tax losses available for future deduction and unused tax reliefs, while valuation allowances are recognised where necessary.

At a conceptual level, IFRS provides a more structured framework for identifying and assessing temporary differences, placing strong emphasis on completeness and the reliability of forecasts. The Accounting Act leaves more room for an entity’s judgement and market practice.

Checklist for practitioners

When determining deferred tax assets and liabilities, it is worth asking the following questions:

• Have all temporary differences been identified?
• Is the deferred tax asset genuinely supported by future taxable profits?
• Is the model reviewed for necessary updates rather than simply being “rolled forward”?
• Have changes in legislation and business structure been taken into account?
• Is the documentation supporting the deferred tax calculation complete and adequate?

Due care should be exercised when fulfilling the obligation to determine deferred tax

Deferred tax is an area where the boundary between accounting and taxation becomes somewhat blurred, and many issues depend on judgement and estimates. For this reason, it is worth seeking assistance in situations of uncertainty. A good practice is to consult significant matters with a tax adviser, even if they are not formally responsible for the deferred tax calculation. Equally valuable may be the perspective of a statutory auditor, who assesses not only technical accuracy but also the completeness and reasonableness of the assumptions adopted, as well as the quality of the supporting documentation.