income tax-ias12

University of London: Financial Reporting 1

Copyright 2011 by James Kwan Singapore Institute of ManagementAll rights reserved.

TOPIC 13: ACCOUNTING FOR INCOME TAX****Reference: International Financial Reporting and Analysis (4th Edition) by

Alexander, Britton and Jorissen, Chapter 20Financial Accounting and Reporting (12th Edition) by Barry Elliott and Jamie Elliott, Chapter 14

Lecture Outline: Page

A. Current Tax** 1

B. Deferred Tax*** 3

C. Measurement and Recognition of Deferred Tax**** 11

D. Presentation and Disclosure Requirement 15

E. Exercises 18

A. Current Tax**

1. The taxable profits of an enterprise essentially comprise its net profit before dividends, adjusted for certain items where the tax treatment differs from the accounting treatment.

The amount of tax to which a company is assessed on its profit for an accounting period is called its tax liability for that period, In general, an enterprise must pay its tax liability a certain amount of time after the period end.

2. Current tax is the amount actually payable to the tax authorities in relation to the trading activities of the enterprise during the period.

Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting impact and thereby produce less distorted results.



3. IAS 12 as requires any unpaid tax in respect of the current or prior periods to be recognised as a liability.

Conversely, any excess tax paid in respect of current of prior periods over what is due should be recognised as an asset.

4. Taking this a stage further, IAS 12 also requires recognition as an asset of the benefit relating to any tax loss that can be carried back to recover current tax of a previous period. This is acceptable because it is probable that the benefit will flow to the enterprise and it can be reliably measured.

5. Measurement of current tax liabilities (assets) for the current and prior periods is very simple. They are measured at the amount expected to be paid to (recovered from) the tax authorities. The tax rates (and tax laws) used should be those enacted (or substantively enacted) by the balance sheet date.

6. Normally, current tax is recognised as income or expense and included in the net profit or loss for the period, except in two cases.

(a) Tax arising from a business combination which in an acquisition is treated differently.

(b) Tax arising from a transaction or event which is recognised directly in equity (in the same or a different period).

The rule in (b) is logical. If a transaction or event is charged or credited directly to equity, rather than to the income statement, then the related tax should be having the same treatment. An example of such a situation is where under IAS 8, an adjustment is made to the opening balance of retained earnings due to either a change in accounting policy that is applied retrospectively, or to the correction of a fundamental error.



B. Deferred Tax***

7. When a company recognizes an asset or liability, it expects to recover or settle the carrying amount of that asset or liability. In other words, it expects to sell or use up assets, and to pay off liabilities. What happens if that recovery or settlement is likely to make future tax payments larger (or smaller) than they would otherwise have been if the recovery or settlement had no tax consequences? In these circumstances, IAS 12 requires companies to recognize a deferred tax liability (or deferred tax asset).

8. Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences.

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:

Deductible temporary differences

The carry forward of unused tax losses

The carry forward of unused tax credits

Temporary differences are differences between the carrying amount of an asset of liability in the balance sheet and its tax base. Temporary differences may be either:

Taxable temporary differences, which are temporary differences that will result in taxable amounts in determining profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.

Deductible temporary differences, which are temporary differences that will result in amounts that are deductible in determining taxable profits (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.



9. We can expand on the definition given above by stating that the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the enterprise when it recovers the carrying value of the asset. Where those economic benefits are not taxable, the tax base of the asset is the same as its carrying amount.

10. In the case of a liability, the tax base will be its carrying amount, less any amount that will be deducted for tax purpose in relation to the liability in future periods. For revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will notbe taxable in future periods.

11. IAS 12 gives the following examples of circumstances in which the carrying amount of an asset or liability will be equal to its tax base.

Accrued expenses have already been deducted in determining an enterprise’s current tax liability for the current or earlier periods.

A loan payable is measured at the amount originally received and this amount is the same as the amount repayable on final maturity of the loan.

Accrued expenses will never be deductible for tax purposes.

Accrued income will never be taxable.

12. Accounting profits form the basis for computing taxable profits, on which the tax liability for the year is calculated; however, accounting profits and taxable profits are different. There are two reasons for the differences:

(a) Permanent differences. These occur when certain items of revenue or expense are excluded from the computation of taxable profits (for example, entertainment expenses may not be allowable for tax purposes).



(b) Temporary differences. These occur when items of revenue or expense are included in both accounting profits and taxable profits, but not for the same accounting period. For example, an expense which is allowable as a deduction in arriving at taxable profits for 20X7 might not be included in the financial accounts until 20X8 or later. In the long run, the total taxable profits and total accounting profits will be the same (except for permanent differences) so that timing differences originate in one period and are capable of reversal in one or more subsequent periods. Deferred tax is the tax attributable to temporary differences.

13. Transactions that affect the income statement:

(a) Interest revenue received in arrears and included in accounting profit on the basis of time apportionment. It is included in taxable profits, however, on a cash basis.

(b) Sales of goods revenue is included in accounting profit when the goods are delivered, but only included in taxable profit when cash is received.

(c) Depreciation of an asset is accelerated for tax purposes. When new assets are purchased, allowances may be available against taxable profits which exceed the amount of depreciation chargeable on the assets in the financial accounts for the year of purchase.

(d) Development costs which have been capitalized will be amortised in the income statement, but they were deducted in full from taxable profit in the period in which they were incurred.

(e) Prepaid expenses have already been deducted on a cash basis in determining the taxable profit of the current or previous periods.

14. Transactions that affect the balance sheet:

(a) Depreciation of an asset is not deductible for tax purposes. No deduction will be available for tax purposes when the asset is sold/scrapped.



(b) A borrower records a loan at proceeds received (amount due at maturity) less transaction costs. The carrying amount of the loan is subsequently increased by amortisation of the transaction costs against accounting profit. The transaction costs were, however, deducted for tax purposes in the period when the loan was first recognised.

15. Fair value adjustment and revaluations

(a) Financial assets or investment property are carried at fair value. This exceeds cost, but no equivalent adjustment is made for tax purposes.

(b) Property, plant and equipment is revalued by an enterprise, but no equivalent adjustment is made for tax purposes (IAS 12 requires the related deferred tax to be charged directly to equity)

16. All taxable temporary differences give rise to a deferred tax liability. There are two circumstances given in the standards where this does not apply:

(a) The deferred tax liability arises from goodwill for which amortisation is not deductible for tax purposes.

(b) The deferred tax liability arises from the initial recognition of an asset or liability in a transaction which:

(i) Is not a business combination(ii) At the time of the transaction affects neither accounting profit

nor taxable profitThe reasoning behind the recognition of deferred tax liabilities on taxable temporary differences:

(a) When an asset is recognised, it is expected that its carrying amount will be recovered in the form of economic benefits that flow to the enterprise in future periods.

(b) If the carrying amount of the asset is greater than its tax base, then taxable economic benefits will also be greater than the amount that will be allowed as a deduction for tax purposes.



(c) The difference is therefore a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability,

(d) As the enterprise recovers the carrying amount of the asset, the taxable temporary difference will reverse and the enterprise will have taxable profit.

(e) It is then probable that economic benefits will flow from the enterprise in the form of tax payments, and so the recognition of all deferred tax liabilities (except those excluded above) is required by IAS 12.

17. Some temporary differences are often called timing differences, when income or expense is included in accounting profit in one period, but is included in taxable profit in a different period. The main types of taxable temporary differences which are timing differences and which result in deferred tax liabilities.

Interest received which is accounted for on an accruals basis, but which for tax purposes is included on a cash basis.

Accelerated depreciation for tax purposes.

Capitalised and amortised development costs.

18. Under IAS 16 assets may be revalued. If this affects the taxable profits for the current period, the tax base of the asset changes and no temporary difference arises.

If, however (as in some countries), the revaluation does not affect current taxable profits, the tax base of the asset is not adjusted. Consequently, the taxable flow of economic benefits to the enterprise as the carrying value of the asset is recovered will differ from the amount that will be deductible for tax purposes. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset.



19. A temporary difference can arise on initial recognition of an asset or liability, e.g. if part or all of the cost of an asset will not be deductible for tax purposes. The nature of the transaction which led to the initial recognition of the asset is important in determining the method of accounting for such temporary differences.

20. If the transaction affects either accounting profit or taxable profit, an enterprise will recognize any deferred tax liability or asset. The resulting deferred tax expense or income will be recognised in the income statement.

21. Where a transaction affects neither accounting profit nor taxable profit it would be normal for an enterprise to recognize a deferred tax liability or asset and adjust the carrying amount of the asset or liability by the same amount. However, IAS 12 does not permit this recognition of a deferred tax asset or liability as it would make the financial statements less transparent. This will be the case both on initial recognition and subsequently, nor should any subsequent changes in the unrecognized deferred tax liability or asset is depreciated be made.

22. There is a proviso, however. The deferred tax asset must also satisfy the recognition criteria given in IAS 12. This is that a deferred tax asset should be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which it can be utilized. This is an application of prudence.

23. Transactions that affect the income statement:

Retirement benefit costs (pension costs) are deducted from accounting profit as service is provided by the employee. They are not deducted in determining taxable profit until the enterprise pays either retirement benefits or contributions to a fund. (This may also apply to similar expenses).

Accumulated depreciation of an asset in the financial statements is greater than the accumulated depreciation allowed for tax purposes up to the balance sheet date.



The cost of inventories sold before the balance sheet date is deducted from accounting profit when goods/services are delivered, but is deducted from taxable profit when the cash is received. (Note: There is also a taxable temporary difference associated with the related trade receivable).

The NRV of inventory, or the recoverable amount of an item or property, plant and equipment falls and the carrying value is therefore reduced, but that reduction is ignored for tax purposes until the asset is sold.

Research costs (or organization/other start-up costs) are recognised as an expense for accounting purposes but are not deductible against taxable profits until a later period.

Income is deferred in the balance sheet, but has already been included in taxable profit in current/prior periods.

A government grant is included in the balance sheet as deferred income, but it will not be taxable in future periods. (Note: A deferred tax asset may not be recognised here according to the standard).

24. Current investments or financial instruments may be carried at fair value which is less than cost, but no equivalent adjustment is made for tax purposes.

Other situations discussed by the standard relate to business combinationsand consolidation.

25. The reasoning behind the recognition of deferred tax assets arising from deductible temporary differences:

(a) When a liability is recognised, it is assumed that its carrying amount will be settled in the form of outflows of economic benefits from the enterprise in future periods.



(b) When these resources flow from the enterprise, part or all may be deductible in determining taxable profits of a period later than that in which the liability is recognizes.

(c) A temporary tax difference then exists between the carrying amount of the liability and its tax base.

(d) A deferred tax asset therefore arises, representing the income taxes that will be recoverable in future periods when that part of the liability is allowed as a deduction from taxable profit.

(e) Similarly, when the carrying amount of an asset is less than its tax base, the difference gives rise to a deferred tax asset in respect of the income taxes that will be recoverable in future periods.

26. An enterprise may have unused tax losses or credits (i.e. which it can offset against taxable profits) at the end of a period. Should a deferred tax asset be recognised in relation to such amounts? IAS 12 states that a deferred tax asset may be recognised in such circumstances to the extent that it is probable future taxable profit will be available against which the unused tax losses/credits can be utilized.

27. For all unrecognized deferred tax assets, at each balance sheet date an enterprise should reassess the availability of future taxable profits and whether part or all of any unrecognized deferred tax assets should now be recognised. This may be due to an improvement in trading conditions which is expected to continue.



C. Measurement and Recognition of Deferred Tax****

28. There are various methods of accounting for deferred tax, only one of which is adopted by IAS 12:

Flow-through method

Full provision method (as under IAS 12)

Partial provision method (as adopted in some countries, e.g. the UK)

29. Under the flow-through method, the tax liability recognised is the expected legal tax liability for the period (i.e. no provision is made for deferred tax).

The main advantages of the method are that it is straightforward to apply and the tax liability recognised is closer to many people’s idea of a ‘real’ liability than that recognised under either full or partial provision.

The main disadvantages of flow-through are that it can lead to a large fluctuation in the tax charge and that it does not allow tax relief for non-current liabilities to be recognised until those liabilities are settled. In addition, profits may be overstated because there is no deferred tax charge leading to excessive dividend payments, distortion of earnings per share and of results in the eyes of shareholders.

30. The full provision method has the advantage that it recognises that each timing difference at the balance sheet date has an effect on future tax payments. If a company claims an accelerated tax allowance on an item of plant, future tax assessments will be bigger than they would have been otherwise. Future transactions may well affect those assessments still further, but that is not relevant in assessing the position at the balance sheet date.

The disadvantage of full provision is that, under certain types of tax system, it gives rise to large liabilities that may fall due only far in the future, if at all. Furthermore, it may be said to be less realistic than the partial provision method, if more objective.



31. The partial provision method addresses this disadvantage by providing for deferred tax only to the extent that it is expected to be paid in the foreseeable future. This has an obvious intuitive appeal, but its effect is that deferred tax recognised at the balance sheet date includes the tax effects of future transactions that have not been recognised in the financial statements, and which the reporting company has neither undertaken nor even committed to undertake at that date. It is difficult to reconcile this with the IASC’s Framework document, which defines assets and liabilities as arising from past events. Where partial provision is required, the difference between the amount provided and the maximum (i.e. under the full provision method) should usually be disclosed.

Illustration:

Suppose that Benson Co begins trading on 1 January 20x7. In its first year it makes profits of $5m, the depreciation charge is $1m and the tax allowance on those assets is $1.5m. The rate of corporation tax is 30%.

Solution: Flow Through Method

The tax liability for the year is 30% x $(5 + 1 – 1.5)m = $1.35m. The potential deferred tax liability of 30% x ($1.5m - $1m) is completely ignored and no judgement is required on the part of the preparer.

Solution: Full Provision

The tax liability is $1.35m again, but the debit in the income statement is increased by the deferred tax liability of 30% x $0.5m = $150,000. The total charge to the income statement is therefore $1.5m which is an effective tax rate of 30% on accounting profits (i.e. 30% x $5m). Again, no judgement is involved in using this method.



Solution: Partial Provision

Is a deferred tax provision necessary under partial provision? We need to look ahead at future capital expenditure plans. Will tax allowances exceed depreciation over the next few years? If yes, no provision for deferred tax is required. If no, then a reversal is expected, i.e. there will be a year in which depreciation is greater than tax allowances. The deferred tax provision is made on the maximum reversal which will be created, and any not provided is disclosed by note.

If we assume that the review of expected future capital expenditure under the partial method required a deferred tax charge of $75,000 (30% x $250,000), we can then summarise the position.

The method can be compared as follows:

Method Provision Disclosure$ $

Flow-through -- --Full provision 150,000 --Partial provision 75,000 75,000

32. Where the corporate rate of income tax fluctuates from one year to another, a problem arises in respect of the amount of deferred tax to be credited (debited) to the income statement in later years. The amount could be calculated using either of two methods.

(a) The deferral method assumes that the deferred tax account is an item of ‘deferred tax relief’ which is credited to profits in the years in which the timing differences are reversed. Therefore the tax effects of timing differences are calculated using tax rates current when the differences arise.

(b) The liability method assumes that the tax effects of timing differences should be regarded as amounts of tax ultimately due by or to the company. Therefore deferred tax provisions are calculated at the rate at which it is estimated that tax will be paid (or recovered) when the timing differences reverse.



33. The deferral method involves extensive record keeping because the timing differences on each individual capital asset must be held. In contrast, under the liability method, the total originating or reversing timing difference for the year is converted into a deferred tax amount at the current rate of tax (and if any change in the rate of tax has occurred in the year, only a single adjustment to the opening balance on the deferred tax account is required).

34. IAS 12 requires deferred tax assets and liabilities to be measured at the tax rates expected to apply in the period when the asset is realized or liability settled, based on tax rates and laws enacted (or substantively enacted) at the balance sheet date. In other words, IAS 12 requires the liability method to be used.

35. IAS 12 states that deferred tax assets and liabilities should not be discounted because of the complexities and difficulties involved.

The carrying amount of deferred tax assets should be reviewed at each balance sheet date and reduced where appropriate (insufficient future taxable profits). Such a reduction may be reversed in future years.

36. As with current tax, deferred tax should normally be recognised as income or an expense and included in the net profit or loss for the period in the income statement. The exception is where the tax arises from a transaction or event which is recognised (in the same or different period) directly in equity.

37. The figures shown for deferred tax in the income statement will consist of two components.

(a) Deferred tax relating to timing differences

(b) Adjustments relating to changes in the carrying amount of deferred tax assets/liabilities (where there is no change in timing differences) e.g. changes in tax rates/laws, reassessment of the recoverability of deferred tax assets, or a change in the expected recovery of an asset.



Items in (b) will be recognised in the income statement, unless they relate to items previously charged/credited to equity.

38. Deferred tax (and current tax) should be charged/credited directly to equity if the tax relates to items also charged/credited directly to equity (in the same or a different period).

Examples of IASs which allow certain items to be credited/charged directly to equity include:

(a) Revaluations of property, plant and equipment (IAS 16)

(b) The effect of a change in accounting policy (applied retrospectively) or correction of a fundamental error (IAS 8).

D. Presentation and Disclosure Requirement

39. Tax assets and liabilities should be presented separately from other assets and liabilities in the balance sheet. Deferred tax assets and liabilities should be distinguished from current tax assets and liabilities.

In addition, deferred tax assets/liabilities should not be classified as current assets/liabilities, where an enterprise makes such a distinction.

There are only limited circumstances where current tax assets and liabilities may be offset. This should only occur of two things apply:

(a) The enterprise has a legally enforceable right to set off the recognised amounts.

(b) The enterprise intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously.

Similar criteria apply to the offset of deferred tax assets and liabilities.



40. The tax expense or income related to the profit or loss from ordinary activities should be presented on the face of the income statement.

41. As you would expect, the major components of tax expense or income should be disclosed separately. These will generally include the following:

Current tax expenses (income)

Any adjustments recognised in the period for current tax of prior periods (i.e. for over/under statement in prior years)

Amount of deferred tax expense (income) relating to the origination and reversal of temporary differences

Amount of the benefit arising from a previously unrecognized tax loss, tax credit or temporary difference of a prior period that is used to reduce current tax expense

Deferred tax expense arising from the write-down, or reversal of a previous write-down, of a deferred tax asset

Amount of tax expense (income) relating to those changes in accounting policies and fundamental errors which are included in the determination of net profit or loss for the period in accordance with the allowed alternative treatment in IAS 8.

Aggregate current and deferred tax relating to items that are charges or credited to equity

Tax expense (income) relating to extraordinary items recognised during the period

An explanation of the relationship between tax expenses (income)and accounting profit in either or both of the following forms.

A numerical reconciliation between tax expense (income) and the product of accounting profit multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax rate(s) is (are) computed, or



A numerical reconciliation between the average effective tax rate and the applicable tax rate, disclosing also the basis on which the applicable tax rate is computed

An explanation of changes in the applicable tax rate(s) compared to the previous accounting period

The amount (and expiry date, if any) of deductible temporary differences, unused tax losses, and unused tax credits for which no deferred tax is recognised in the balance sheet.

In respect of each type of temporary difference, and in respect of each type of unused tax loss and unused tax credit:

The amount of the deferred tax assets and liabilities recognised in the balance sheet for each period presented

The amount of the deferred tax income or expense recognised in the income statement, if this is not apparent from the changes in the amounts recognised in the balance sheet

In respect of discontinued operations, the tax expense relating to

The gain or loss on discontinuance

The profit or loss from the ordinary activities of the discontinued operation for the period, together with the corresponding amounts for each prior period presented

42. In addition to the above, an enterprise should disclose the amount of a deferred tax asset and the nature of the evidence supporting its recognition, when:

(a) The utilization of the deferred tax asset is dependent on future taxable profits in excess of the profits arising from the reversal of existing taxable temporary differences,

(b) The enterprise has suffered a loss in either the current or preceding period in the tax jurisdiction to which the deferred tax asset relates.



E. Exercises

income tax-ias12

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