The ‘New’ Deferred Tax: a Comment on AARF Discussion Paper No. 22 ‘Accounting for Income Tax’

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<ul><li><p>BALJIT K. SIDHU </p><p>THE NEW DEFERRED TAX: A COMMENT ON AARF </p><p>DISCUSSION PAPER No. 22 ACCOUNTING FOR INCOME TAX </p><p>he release of Discussion Paper No. 22 Accounting for Income Tax (DP 22) by T the Australian Accounting Research </p><p>Foundation (AARF 1995a) has given impetus to the debate about whether, and how, to account for income taxes. T h e DP 22 proposals, if pursued, will effectively take Australian reporting for income taxes closer to the recently revised US Standard, SFAS 109 Accoanting for Income Tuxes (FASB 1992) and the current International Exposure Draft E49 Income Taxes, issued by the International Accounting Standards Committee (IASC 1994). DP 22 represents significant change through its advocacy of a balance sheet approach, rather than the currently prescribed income statement approach for the recognition of deferred tax assets and liabilities. T h e latter accounts for timing differences only, while the balance-sheet approach, a US innovation, accounts for all temporary differences. </p><p>in terms of making Australian accounting requirements consistent with our conceptual framework. The re may also be an implicit desire to move closer to North American and international requirements. No judgment is made here on either motivation. This paper is intended to contribute to informed debate by demonstrating that a number of the arguments presented in D P 22 in support of the balance- sheet approach are logically inconsistent. </p><p>T h e motivation for this change is expressed </p><p>Discussion Paper No. 22 Accounting for Income Tax (DP 22), issued by the Australian Accounting Research Foundation, represents significant change through its advocacy of a balance sheet rather than the currently prescribed income statement approach for the recognition of deferred tax assets and liabilities. This paper clarifies the differences between the two methods and illustrates their effects on financial statements. I t evaluates D P 22s arguments in favour of the balance-sheet approach and provides some guidance on the usefulness of deferred tax numbers. The paper concludes that the logical inconsistencies in D P 22, coupled with the available evidence on income-tax al~ocat~on, suggest that we should be cautious in making changes to current reporting requirements. </p><p>V O L . 6 N O . l 1 9 9 6 A U S T R A L I A N A C C O U N T I N G R E V I E W 3 7 </p></li><li><p>Further, the empirical evidence on the usefulness of income-tax allocation is equivocal and indicates that a narrower, rather than wider, structure for recognising deferred tax assets or liabilities might be preferable. Indeed, the recent US debate questioned the credibility of the comprehensive approach to tax allocation; some have suggested a move to partial allocation. </p><p>TIMING V TEMPORARY </p><p>DOES IT MEAN? DIFFERENCES - WHAT </p><p>T h e income-statement approach promulgated in AASB 1020 Accounting for Income Tax accounts for differences between accounting and taxable income that are expected to reverse in time. That is, it only accounts for the tax effects of timing differences between the two income measures. T h e tax effects of permanent differences are not allocated between accounting periods. </p><p>suggests, takes account of (temporary) differences between tax and accounting balances in asset and liabilig accounts that give rise to future tax consequences. DP 22 describes temporary differences (p. 27) as those differences between carrying amounts and tax balances that have future tax consequences. </p><p>items that affect current as well as future accounting or taxable income computations. These differences filter into accounting and tax balances (carrying amounts) of assets and liabilities. However, these carrying amounts also reflect permanent differences, if any. Since temporary differences are the difference between tax and accounting balances (carrying amounts), then, conceptually a t least, they must include both timing and permanent differences. </p><p>However, in its application of the concept of temporary differences, DP 22 includes all timing but only certain permanent differences - ie, only those that have future tax consequences. T h e latter include revaluation increments (that are non-depreciable for tax purposes). Permanent differences arising from items that do not have future tax consequences, such as non-taxable income or non-deductible costs (eg, goodwill or certain long-term assets) are not to be accounted for under the balance-sheet approach. </p><p>T h e balance-sheet approach, as its name </p><p>Timing differences, by definition, arise from </p><p>T h e following example illustrates the difference between the two approaches with respect to the deferred tax asset/liability recognised in the case of an asset revaluation, assuming that the asset is to be recovered through use rather than sale. It also illustrates how the computation of temporary differences under the balance-sheet approach effectively amounts to accounting for the more familiar timing as well as permanent differences. </p><p>Example 1* An item of plant, which had originally cost </p><p>$16,000 with an expected usejid l$e of 16 years and a residual value of ni&amp; has been depreciated at annual amounts of $1,000 and$2,OOO for accounting and tax purposes respectively. By the end of 19x0, the carrying amounts in the accounting and tax balance sheets are $10,000 and$4,000 respectively. The tax rate is 40% and the dien-ed tux liability for this item ofplant is $2,400 (ie, 40% of $6,000). </p><p>The asset is revalued to $20,000 at the beginning of 19x1 and accounting depreciation is increased to $Z,OOOperyear The reualuation does not afect the tax base of the asset. Assume that the asset will be used until the end of its ust$ul lqe (the remaining 10 years); that is, the asset? value is to be recovered through use rather than sale. </p><p>Table1 illustrates the accounting and tax treatments with respect to depreciation of the asset for the years 19x0 to 19x10, including the year of the revaluation, 19x1. T h e effects on 19x1 itself are demonstrated both at the start and the end of that year. </p><p>T h e annual depreciation charges and resulting carrying balances under accounting (Panel A) and tax (Panel B) treatments are straightforward. By the end of 19x2 the asset is fully depreciated for tax purposes and has a tax basis or tax carrying value of zero. (Notice that under the income-statement approach, timing differences start to reverse after this year, reducing to zero in 19x10). When the asset is revalued at the start of 19x1, the accounting treatment is to set accumulated depreciation to zero (by writing off the previously accumulated balance against the historical cost of the asset) and the excess of the new value over the written-down (book) value is credited to a revaluation reserve. For tax purposes nothing has changed. It can readily be seen that permanent differences between accounting and taxable income are introduced when the asset is revalued at the start of 19x1. This is equal to the revaluation </p><p>3 8 A U S T R A L I A N A C C O U N T I N G R E V I E W </p></li><li><p>TABLE 1: ASSET REVALUATION </p><p>Year X(-l) XOXl-beaX1-clsa X2 X3 X4 X5 X6 X7 X8 X9 XI0 </p><p>PANEL A: Accounting Depr Exp 1000 1000 0 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 Cost 16000 16000 20000 20M)O 20000 20000 20000 2oooO Zoo00 2oooO 2oo00 20000 ZoOO() Acc Depr 5000 6000 0 2000 4000 6000 8000 loo00 I2000 14ooo 16OOO 18000 2oooO CarryingAmt 11000 10000 20000 18000 I6000 14000 12000 I0000 8000 6OOO 4ooO 2000 0 </p><p>PANEL B: Tax </p><p>Cost 16OOO I6000 10000 16000 16000 0 0 0 0 0 0 0 0 Depr Exp 20(0 2000 0 2000 2000 0 0 0 0 0 0 0 0 </p><p>AccDepr loo00 12000 12000 l4O()O 16OOO 0 0 0 0 0 0 0 0 CarryingAmt 6000 4000 4000 2MH) 0 0 0 0 0 0 0 0 0 </p><p>PANEL C: Income Stmt Approach Perm diffs 0 0 -10000 -9000 -8000 -7000 -6OOO -5000 -4000 -3000 -2000 -1000 0 </p><p>remaining </p><p>diffs Cum timing -5000 -6000 -6000 -7000 -8000 -7000 -6OOO -5000 -4000 -3000 -2000 -1000 0 </p><p>DTL ZOO0 2400 2400 2800 3200 2800 2400 2000 1600 1200 800 400 0 (4096xtiming diffs) </p><p>DTE 400 400 n.a. 40 400 -400 -400 -400 -400 -400 -400 400 -400 (DTL t - DTL t-I) </p><p>PANEL D Bal. Sheet Approach Temporary -5000 -6000 -16000 -16000 -164 -14OOO -12000 -loo00 -8000 -6000 -4OOO -2000 0 </p><p>DrL 2000 2400 6100 6400 6400 5600 4800 40 3200 2400 1600 800 0 differences </p><p>(40%xtemporary diffs) DTE 400 400 n.a. 4000 0 -800 -800 -800 -800 -800 -800 -800 -800 </p><p>(DTL t - DTL t-I) </p><p>increment to the value of the asset which will never be tax-deductible. Thus the difference in the accounting and tax carrying amounts at the beginning of 19x1 represents a cumulative timing difference of -$6,000 and a permanent difference of -$lO,OOO. T h e timing difference continues to accumulate until the asset is completely written off for tax purposes (in 19x2) and then starts to reverse. T h e permanent difference between accounting and tax carrying amounts diminishes each year by the incremental amount of book depreciation now being charged ($2,000 instead of the previous $1,000; that is, the useful life of the asset is unchanged). </p><p>Under the balance-sheet approach, it is assumed that the book value of the asset (including the revaluation increment) will be recovered either through use over the assets life or through sale. Recovery through use is </p><p>assumed in the example here.3 Consequently, the difference between accounting and tax carrying amounts is considered to be a future taxable amount; a deferred tax liability is calculated by applying the enacted tax rate to this temporary difference. Notice that this temporary difference each year is the sum of timing and permanent differences. </p><p>In summary, temporary differences or the difference between accounting and tax carrying amounts also amount to the sum of cumulative timing differences and remaining permanent differences. T h e emphasis under this approach is to ascertain the expected tax liability of recovering that asset through use or sale (assuming a sale would take place at the revalued amount at a minimum). </p><p>Brief descriptions of the types of temporary differences recognised in DP 22 follow. These include all items currently described as timing differences plus certain (but not all) </p><p>A U S T R A L I A N A C C O U N T I N G R E V I E W 3 9 </p></li><li><p>types of permanent differences. T h e types of permanent differences included are: </p><p>Revaluation of long-term assets DP 22 advocates accounting for the </p><p>(temporary) differences between accounting and tax carrying amounts caused by the revaluation of an asset purchased after the implementation of capital gains tax (CGT) legislation. T h e amount of deferred tax recognised is dependent on whether the asset is expected to be recovered through use or sale: the treatment under the assumption of recovery through use is illustrated in Example 1 above, where the written-down tax base is relevant for computation of the temporary difference. If, on the other hand, recovery through sale is assumed, then potential C G T liabilities are to be recognised and the indexed cost base becomes relevant instead. Revaluation of pre-CGT assets is not considered to result in a tax liability, on the basis that the amount of deferred tax liability is dependent on the mode of recovery (zero C G T in the case of recovery through sale as against a non-zero future tax liability through non- deductibility of buildings in the case of recovery through use). Given that the incurring of any tax liability is completely at the discretion of management, no tax liability is considered to exist. </p><p>Annual adjustments to the revaluation-related tax asset or liability are to be charged to income rather than equity. This asymmetrical treatment of the revaluation (typically taken to a revaluation reserve) and the annual adjustment is considered later in this paper. </p><p>Tax losses </p><p>acquisitions. First, in the presence of goodwill, while a future tax asset or liability would not be recognised under the income-statement approach (since goodwill represents a permanent difference), it would be recognised under the balance-sheet approach. Second, any revaluation of the subsidiarys net assets would give rise to tax assets or liabilities as in Example 1 above, regardless of whether </p><p>the revaluation is done in the books of the subsidiary or as a consolidation adjustment. </p><p>GIVEN THAT </p><p>THE </p><p>INCURRING OF </p><p>ANY TAX </p><p>LIABILITY IS </p><p>COMPLETELY </p><p>AT THE </p><p>DISCRETION OF </p><p>MANAGEMENT, </p><p>NO TAX </p><p>LIABILITY IS </p><p>CONSIDERED </p><p>TO EXIST. </p><p>Retroactive adjustments These relate to adjustments made </p><p>on adoption of an accounting standard which represents a change in accounting policy; for example, in changing from reporting leases as operating leases to finance leases. This involves booking a lease liability and a lease asset for financial reporting, the carrying amounts of which might vary from their tax bases. Such variations (temporary differences) would result in the recognition of tax assets and liabilities under the balance-sheet approach but not under the income- statement approach. </p><p>Consolidation of an integrated </p><p>Non-monetary assets of foreign operation </p><p>integrated foreign operations are translated at their relevant historical rates of exchange. A curious example is given (p. 62) to illustrate why the balance-sheet approach might result in a tax asset or liability, while the income-statement approach would not. This example is evaluated later in the paper. </p><p>T h e situation with tax losses is essentially unchanged. </p><p>Acquisition of a subsidiary (where the purchase price exceeds the fair market value of the net assets of the subsidiary) </p><p>DP 22 raises two issues concerning </p><p>Unrealised profit on the intra- group sale of inventory (where </p><p>the buying entity is a foreign entity) Under the income-statement approach, the </p><p>tax paid by the selling entity on the unrealised inter-company profit will give rise to a deferred tax asset, to be realised when the goods are sold on to an external party. T h e situation remains the same if the buying entity is a foreign one, with a different tax rate. Under the balance-sheet approach, however, while the amount of the temporary difference is the </p><p>4 0 A U S T R A L I A N A C C O U N T I N G R E V I E W </p></li><li><p>same (assuming a stable exchange rate) as the timing difference above, the deferred tax asset would not have the same value because of differential tax rates. </p><p>effectively widens the coverage of differences between tax and accounting treatments of transactions beyond just the timing differences accounted for under the income-statement approach. </p><p>In short, the balance-sheet approach </p><p>CRITICAL E VAL U AT1 0 N OF AARF ARGUMENTS IN </p><p>FAVOUR OF THE </p><p>APPROACH BALANCE-SHEET </p><p>T h e essential nature of the tax-related assets or liabilities arising from the timing difference components of temporary differences under the balance-sheet approach is no different from those recognised under the income-statement approach. Changing their label does not make them more or less hypothetical under different approaches. Further, the recognition...</p></li></ul>

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