ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 15: Taxation
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The tax payable account for Year 2 would appear as follows:
Taxpayable
Year2
$
Year2
$
Cash 85,000
Balancebroughtforward 90,000
Profitandloss 5,000
90,000
90,000
Balancecarriedforward 100,000
Profitandloss 100,000
100,000
100,000
A note to the financial statements should disclose the breakdown of the total tax
charge as follows. The current tax liability in the statement of financial position at the
end of Year 2 is $100,000. The tax charge in profit or loss for Year 2 is $95,000.
$
Currenttaxfortheyear 100,000
Over‐provisionoftaxinthepreviousyear (5,000)
––––––––––––––––––
Totaltaxcharge 95,000
––––––––––––––––––
Tax losses
Where an entity makes a tax-allowable loss it is usually entitled to ‘carry back’ the loss
against profits of a previous year, and so to recover some of the current tax paid for an
earlier year.
When this happens, the recoverable tax is an asset. It is probable that benefits (refund
of tax) will flow to the entity and the amount can be reliably measured. The benefit
therefore meets the IASB Framework’s definition of an asset. Therefore an asset is
recognised in the period in which the tax loss occurs.
1.2 Deferred tax
An entity pays tax on its profits to the tax authorities. This tax is calculated by
multiplying the taxable profits by the appropriate tax rate. However, taxable profits
are rarely the same as profit before tax as disclosed in profit or loss. This is because
certain items that have been included in the calculation of profit or loss for financial
reporting purposes are not allowable for tax purposes.
The differences between accounting profit and taxable profit for any financial year can
be classified as:
permanent differences, and
temporary differences.
Permanent differences
Permanent differences arise from items of income and expenditure:
that have been included the calculation of accounting profit)
but will never be included in at the calculation of taxable profits.
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This is because the item of expense is not allowable for tax purposes. For example,
some countries do not allow entertainment expenses to be deducted in arriving at
taxable profits. Such expenses have to be ‘added back’ to the accounting profit in order
to compute the taxable profit. As a result the entity will pay more tax.
Temporary differences
Temporary differences arise from items of income and expenditure that are:
included in both accounting profits and taxable profits
but in different accounting periods.
For example, tax relief for capital expenditure on non-current assets may be given at a
faster rate than depreciation is charged on the non-current assets in the financial
statements. Over the full life of the asset, the total amount allowed as deductions from
taxable profits will be the same as the total depreciation charge in the financial
statements. However, in each individual financial year, the amount of ‘depreciation’
allowed for tax purposes and the depreciation charge in the financial statements are
different.
The tax effect of these temporary differences is accounted for in the financial
statements by means of deferred tax.
Deferred tax liability
When a transaction is recognised in the accounts of an entity is not subject to tax until
a later year, there is an amount for deferred tax. This is tax that will eventually become
payable in a later year. This deferred tax satisfies the definition of a liability in the
IASB Framework, because it represents a legal obligation where a probable outflow of
cash will be required. Deferred tax payments are therefore shown as a liability in the
statement of financial position.
Example
A company receives interest of $50,000 in January 20X7 relating to the year ended 31
December 20X6. According to the rules IAS 18 Revenue the interest is recognised
under the accruals concept and will be included as revenue in profit and loss for
20X6. The tax authorities assess the income on a cash received basis and so tax will
not be levied until 20X7.
The company must recognise the deferred tax on the interest in its 20X6 accounts.
Assuming a tax rate of 30%, a deferred tax expense and a deferred tax liability for
$15,000 will be recognised.
Chapter 15: Taxation
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Deferred tax: principles
Identifying the temporary difference
Calculating the deferred tax liability
Deferred tax expense (profit and loss)
Further examples of when a deferred tax provision might arise
Deferred tax and asset revaluations (or fair value adjustments)
Alternative approaches to accounting for deferred tax
Discounting deferred tax liabilities?
2 Deferred tax: principles
2.1 Identifying the temporary difference
Taxable profits are usually different from accounting profits because the tax
authorities make their calculations using different rules from the accounting rules in
the international accounting standards. For example most tax authorities do not accept
depreciation as an allowable deduction and instead use their own rules to provide tax
relief on the asset. In any one year, the depreciation and the tax allowance will not
match and so the carrying amount in the balance sheet and the tax base will differ.
This difference is a temporary difference because over the life of the asset, the total
depreciation expenses for the asset in the accounts and the total tax relief given by the
tax authorities will be equal.
The terminology of IAS 12
IAS 12 refers to the tax base of assets or liabilities. This is the amount attributed to an
asset or liability for the purpose of calculating tax. The tax base might be different from
the amount shown for the asset or liability in the statement of financial position. For
example, suppose that an entity has reported interest income of $2,000 in profit and
loss and this is receivable as at the end of the financial year. If the tax authorities tax
interest on a cash basis (cash received):
there will be an asset of $2,000 in the statement of financial position, but
the tax base is $0, because the interest is not recognised for tax purposes until the
cash is received.
There is a difference between the tax base and the financial statements, but it is only
temporary. The interest will eventually be recognised for tax purposes when the cash
is received.
The provision for deferred tax is based on differences between:
values in the statement of financial position (carrying values/net book values),
and
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the tax base values (sometimes referred to as tax values or tax written-down
values).
Example
A company with a year end of 31 December buys a non-current asset on 1 January
Year 1 for $18,000. The asset has a useful life of three years and no residual value.
The tax regime relevant to this company does not allow depreciation as an
allowable deduction, but instead grants tax relief (‘capital allowances’) each year as
follows:
Year 1 $8,000
Year 2 $6,000
Year 3 $4,000
Carryingamount,
statementoffinancial
position Taxbase
Temporary
difference
$000 $000 $000
1JanuaryYear1 18 18
Chargeforyear
(depreciation/capitalallowance) (6) (8)
–
––
–
– –––––
31DecemberYear1 12 10 2
Chargeforyear (6) (6)
–
–
–
–
– –––––
31DecemberYear2 6 4 2
Chargeforyear (6) (4)
–
–
–
–– –––––
31DecemberYear3 0 0 0
Temporary difference = the difference between the carrying value in the statement of
financial position and the tax base.
At the end of year 1, the carrying amount is higher than the tax base as the tax
authorities have allowed a tax relief that is greater than the depreciation expensed.
The carrying amount of $12,000 shows that the entity is expecting to recover this
amount against future profits, but the tax authorities will only give future relief of
$10,000. This will result in the entity paying income tax on the $2,000 in future
years.
The entity will recognise a liability in Year 1 for the anticipated tax on this
temporary difference.
2.2 Calculating the deferred tax liability
IAS 12 adopts a full provision method to providing for deferred tax. The liability is
calculated by applying the tax rate for the entity to the temporary difference at the end
of the reporting period.
IAS 12 requires that the liability be measured at the tax rates that are expected to apply
to the period when the deferred tax is settled using rates that have been ‘enacted’. This
is called the liability method.
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In the example above, the deferred tax will be settled in year 3 when the temporary
difference reverses to $0. Unless the tax rates for the next two years have been
announced (‘enacted’) by the tax authorities, the current tax rate will serve as an
approximation. The liability should then be updated each year as further information
relating to future tax rates comes to light.
The company’s tax status may also change as it circumstances change – for example as
the company grows it may move into a new tax bracket. SIC Interpretation 25 Income
taxes – changes in the tax status of an enterprise or its shareholders requires that the
deferred tax liability should be re-measured as the company’s tax status changes.
Example
The previous example will be continued.
The company has a tax rate of 30% for Year 1. At the end of Year 2, the tax
authorities announce that tax rates will increase to 33% with effect from 1st January
Year 3.
The deferred tax liability that will be recognised in the statement of financial position
at the end of each year is as follows:
Temporarydifference Taxrate Deferredtaxliability
Year1
$2,000 30% $600
Year2 $2,000 33% $660
Year3
0 33% 0
The tax rate used is 30% in Year 1, which is the best estimate of what the tax rate will
be in Year 3. At the end of Year 2, the liability is re-measured at 33% not 30%, because
the temporary difference will be settled in Year 3 when the rate will be 33%. As this
information has been announced in Year 2, it should be used to calculate the provision
at the end of Year 2.
A provision for deferred tax of $600 should be recorded in the statement of financial
position for Year 1, and this should be increased to $660 in Year 2, before reducing to
$0 at the end of Year 3.
In some countries, the manner in which the entity will recover or settle the carrying
amount of its assets and liabilities affects the tax rate. For example there may be one
tax rate for trading gains and a different tax rate for capital gains. Where such a
situation exists, the deferred tax liability or asset should reflect the tax rate consistent
with the manner of settlement.
Example
An asset has a carrying amount of $100,000 and a tax base of $60,000. A tax rate of
20% would apply if the asset was sold and a tax rate of 30% would apply to other
income.
The entity should recognise a deferred tax liability of $8,000 ($40,000 × 20%) if it
expects to sell the asset, or a liability of $12,000 ($40,000 × 30%) if it expects to keep
the asset and continue using it in the business to generate revenue.
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2.3 Deferred tax expense (profit or loss)
A deferred tax expense is charged in the income statement to obtain the required
liability in the statement of financial position. This expense is recognised in profit or
loss for the period (unless the related transaction was recognised as other
comprehensive income, in which case the tax expense should also be recognised in
other comprehensive income and directly in equity). In simple terms, the tax expense
follows the original recording of the income or expense.
In the previous example, the asset is expensed to profit or loss (the income statement)
through the depreciation charge. Therefore the deferred tax should also be recognised
in profit or loss.
Brought forward
liability
Carried forward
liability
Charge/ (credit) to
profit and loss
$000 $000 $000
Year 1 0 600 600
Year 2 600 660 60
Year 3 660 0 (660)
Example
The previous example will now be continued.
The accounting profit in each year was $50,000.
Required
Show the total tax expense for each year.
Answer
Working: income tax expense
Year1
Year2
Year3
$000
$000
$000
Profitbeforetax 50,000
50,000
50,000
Add:Depreciation
6,000
6,000
6,000
Minus:Capitalallowance
(8,000)
(6,000)
(4,000)
Taxableprofit 48,000
50,000
52,000
Taxrate 30%
30%
33%
Incometaxexpense
14,400
15,000
17,160
Year1
Year2
Year3
$000
$000
$000
Incometax(seeworking) 14,400
15,000
17,160
Deferredtax
600
60
(660)
Totaltaxexpense
15,000
15,060
16,500
In this example, the accounting profit in each year is the same ($50,000), but the
income tax expense fluctuates. This is because tax is levied on the taxable profit which
differs from the accounting profit. This could be confusing for a user of financial
statements.
Chapter 15: Taxation
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By accounting for the deferred tax on the timing difference, the Year 1 total tax
expense ($15,000) is now in line with the accounting profit ($50,000 × 30%).
Similarly in Year 2, the total tax expense ($15,060) is almost in line with the
accounting profit, the only difference arising because of the change in the
anticipated tax rate in Year 3).
The total expense in Year 3 is higher than the previous two years due to the
increase in the tax rate. However, the total expense of $16,500 still equates to the tax
rate applied to the accounting profit (33% × $50,000).
The total tax expense each year is therefore equivalent to the tax rate applied to the
accounting profit and the distortion in tax charges caused by the temporary differences
has been eliminated.
2.4 Further examples of when a deferred tax provision might arise
Because the tax treatment of items varies from country to country any examination
question will have to specify the tax treatment of particular items. However, the
following examples from IAS 12 illustrate the types of situation you might be required
to deal with in your examination.
Interest receivable
Interest may be received in arrears, leading to a receivable in the statement of financial
position. However, this interest may not be taxable until the cash is received.
Example
Entity B has a balance for interest receivable of $4,000 in its financial statements at
31 December Year 1. Interest is not taxed until it is received. The relevant tax rate is
30%.
Required
Calculate the deferred tax provision at 31 December Year 1.
Answer
The interest receivable of $4,000 is included in income in profit or loss for Year 1.
However, it is not included in taxable profits for Year 1, which means that taxable
profits in Year 1 will be higher by $1,200 ($4,000 × 30%).
When the interest is received (in Year 2) taxable profits will be higher than
accounting profits and therefore more tax will be payable.
A deferred tax provision of $1,200 should therefore be set up in Year 1.
This provision will increase the total tax charge in Year 1 and reduce reported profits
after tax. The provision will reverse to $0 in Year 2, and the net tax charge in Year 2
will be computed by subtracting the reduction in the deferred tax liability from the
current tax charge for Year 2.
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Development costs
In calculating accounting profits, development costs may be capitalised and amortised
(in accordance with IAS 38). However, tax relief may be given for the development
costs as they are paid.
Example
In the year ended 30 June Year 1, Entity C incurred development costs of $320,000.
These were capitalised in accordance with IAS 38, with an amortisation charge of
$15,000 in Year 1. Development costs are an allowable expense for tax purposes in
the period in which they are paid. The relevant tax rate is 30%.
Required
Calculate the deferred tax provision at 30 June Year 1.
Answer
The charge for development costs in Year 1 in the financial accounts is the
amortisation charge of $15,000. However, total development costs were $320,000,
attracting tax relief in full at the rate of 30%. Taxable profits will therefore be much
lower than accounting profits in Year 1.
The development costs incurred but not yet amortised of $305,000 should be deducted
from accounting profits to arrive at taxable profits. In future years, when the
remaining amortisation charges are added back to accounting profits to arrive at
taxable profits, taxable profits will be higher and therefore more tax will be payable.
A deferred tax provision should therefore be set up for $305,000 × 30% = $91,500.
This calculation may be presented more completely in either of two ways:
$
Accountingprofitreducedfordevelopmentcostsamortisationby: (15,000)
Taxableprofitreducedfordevelopmentcostsby: (320,000)
––––––––––––
–
––––––
–
Difference (305,000)
––––––––––––
–
––––––
–
Deferrredtaxliability(×30%) $91,500
Alternatively:
$
Assetvalueinstatementoffinancialposition($320,000‐$15,000)
(305,000)
Taxwritten‐downassetvalue 0
––––––––––––
–
––––––
–
Difference (305,000)
––––––––––––
–
––––––
–
Deferredtaxliability(×30%) $91,500
2.5 Deferred tax and asset revaluations (or fair value adjustments)
When an asset is re-valued and there is no equivalent adjustment in the tax charge for
the year, deferred tax should be recognised for the value adjustment. It should be
recognised in other comprehensive income.
Chapter 15: Taxation
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Example
An asset costing $100,000 on which accumulated depreciation is $30,000 is re-valued
for the first time to $150,000. Related deferred tax on the revaluation gain is $20,000.
The revaluation is accounted for as follows:
The total revaluation gain is $80,000. The balance on the non-current asset account
increases from $100,000 to $150,000, and the balance on the accumulated
depreciation account for the asset is reduced from $30,000 to $0.
For the revaluation gain of $80,000, deferred tax is $20,000. The balance on the
revaluation reserve should therefore increase by $60,000 (= $80,000 - $20,000).
The debit and credit entries are:
Debit Credit
$ $
Asset account 50,000
Accumulated depreciation 30,000
Revaluation reserve
60,000
Deferred tax liability
20,000
In subsequent years, the depreciation charge on a re-valued non-current asset is based
on the re-valued amount rather than historical cost. The annual depreciation charge is
therefore higher than it would have been if the asset had not been re-valued.
As an adjustment, there is a transfer to retained earnings for the difference between the
depreciation charge in the income statement and the depreciation that would have
been charged on historical cost. The adjustment is:
Debit Credit
$ $
Revaluation surplus X
Deferred tax X
Retained (distributable) profits X
Example
An asset has been re-valued by $50,000. The revaluation reserve has been credited
with $40,000 and the deferred tax account (liability) by $10,000.
The new annual depreciation charge on the asset is $15,000. Based on historical cost
it would have been $10,000.
There should therefore be a transfer to retained profits in each subsequent year for the
difference of $5,000 between depreciation on the re-valued amount and re-valuation
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on the original historical cost. If the asset is held until the end of its useful life, the
annual transfer will be as follows:
Debit Credit
$ $
Revaluation surplus 4,000
Deferred tax 1,000
Retained (distributable) profits 5,000
By the end of the useful life of the asset, the balances on the revaluation reserve and
the deferred tax account for the asset will have been reduced to $0.
If the asset is disposed of before the end of its useful life, the remaining balances on the
revaluation reserve and deferred tax account for the asset are transferred to
distributable profits in the same way.
2.6 Alternative approaches to accounting for deferred tax
To account for deferred tax, IAS 12 requires:
a full provision approach, and
the liability method.
In theory, there are three possible ways of identifying the temporary differences on
which to provide for deferred tax.
full provision
partial provision
nil provision (flow through method).
The tax rate applied to these temporary differences in order to calculate the deferred
tax can be ascertained using:
the liability method, or
the deferral method.
Alternatives to the full provision method
The full provision method identifies the temporary differences at the end of the
reporting period and requires deferred tax to be provided on them in full.
One criticism of the method is that to continue in business, companies must continue
to reinvest in assets. As a result, new temporary differences originate every year and
these may be larger than the effect of the temporary differences reversing. As a
consequence, there may be a quantity of timing differences that will exist indefinitely,
into the foreseeable future.
If a full provision is made for all temporary differences, some of the provision may not
be necessary.