ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 15: Taxation

Consequently, the full provision method may be over-prudent and contradictory to

the principles in the IASB Framework and IAS 37, which state that a liability should

only be recognised if it is probable that it will be payable.

Partial provision method

The partial provision method addresses the above criticisms of the full provision

method by requiring that deferred tax is only provided for, to the extent that tax is

expected to become payable.

At the end of a reporting period, the company identifies all temporary differences, but

then looks at its capital expenditure forecasts and other forecasts, to identify the tax

liabilities that are expected to ‘crystallise’ and become payable. A liability is only

recorded on those items that are expected to ‘crystallise’ (become payable) in the

foreseeable future. The balance of the tax is not provided for. This balance is simply

disclosed by way of a note to the accounts.

The partial provision method is perhaps a more realistic estimate of the tax that will

actually be paid, but its calculation is more subjective than the full provision method

because it is based on forecasts, which could be subject to manipulation in order to

affect the deferred tax charge. (A careful choice of the number of years of capital

expenditure forecasting to be used plus the selection of suitable forecast figures could

be used to manipulate the financial statements.)

Nil provision method

The nil provision method (also know as the ‘flow through method’) ignores deferred

tax completely and only accounts for current tax. This method contradicts the accruals

concept and the liability recognition rules of the IASB Framework.

Alternative to the liability method: deferral method

The liability method uses the tax rates which will be in place when the temporary

differences reverse. The deferred tax liability is then adjusted as the assessment of the

future rate changes.

An alternative approach is to use the tax rates in existence when the timing difference

arose. This rate is then not updated, and the deferred tax liability remains unadjusted.

This method is not considered as accurate as the liability method, and IAS 12 calls for

the use of the liability method.

2.6 Discounting deferred tax liabilities?

The full provision method requires that the total temporary differences be provided

for. However where deferred tax liability may not be settled until several years in the

future, it may be considered more accurate to discount the liability.

The original IAS 12 did not state explicitly whether discounting should be used, but

the revised version of IAS 12 prohibits its use, stating that for discounting to be

reliable, a detailed schedule of the timing of the reversal of each temporary difference

would be needed. This is too difficult in many cases, and so to achieve consistency of

treatment, no entity is permitted to discount its deferred tax liabilities (or assets).

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Deferred tax: individual company

 Temporary differences

 Deferred tax assets

 Deferred tax relating to revaluations and other items recognised outside profit

or loss

3 Deferred tax: individual company

This section provides some additional notes on deferred tax in the accounts of an

individual company.

3.1 Temporary differences

IAS 12 defines temporary differences as the difference between the tax base of an asset

or liability and its carrying amount in the statement of financial position. Temporary

differences may arise in the following circumstances:

 Accounting depreciation does not equal tax-allowable depreciation (capital

allowances).

 An item of income or expense is included in the accounting profit in one period but

included in the taxable profit in another. For example, capitalised development

costs are amortised over several years in the financial statements, but tax relief is

given as the costs are incurred (on a cash basis).

 Leases may be treated as finance leases under IAS 17, but treated as operating

leases under the tax legislation of the local country. (Some tax authorities do not

allow finance lease accounting)

IAS 12 states that if an item is not taxed, its tax base should be equal to its carrying

amount. This will not then attract a temporary difference. For example, a loan has a

carrying value of $100,000, but repayment of the loan itself has no tax consequences.

The tax base of the loan (which ought to be $0) is treated as $100,000, so that no

temporary difference and no deferred tax arises.

Similarly, a deferred tax liability does not arise for the impairment of goodwill, which

is not deductible for tax purposes.

3.2 Deferred tax assets

Most temporary differences give rise to deferred tax liabilities. However deferred tax

assets can also arise.

A deferred tax asset must only be recognised to the extent that it is probable that

taxable profit will be available against which the deductible temporary difference can

be used.

Chapter 15: Taxation



Example

An entity recognises a liability of $100,000 for accrued product warranty costs. For

tax purposes, the product warranty costs will not be deductible until the entity pays

any warranty claims. The tax rate is 30%.

The tax base of the liability is nil (carrying amount $100,000 minus the amount that

will be deductible for tax purposes in future periods). In settling the liability, the

entity will reduce its future taxable profits by $100,000 and so will reduce its future

tax payments by $30,000 (30% × $100,000).

The difference between the tax base of nil and the carrying value of the warranty

liability of $100,000 is a deductible temporary difference of $100,000. Therefore the

company should recognise a deferred tax asset of $30,000, but only if it is probable that

the entity will earn sufficient taxable profit in future periods to benefit from the

reduction in tax payments.

Where a deferred tax asset is recognised it should be:

 separately disclosed in the statement of financial position in accordance with IAS 1

 reviewed at the end of each reporting period and reduced to the extent that it is no

longer probable that it can be recovered against future taxable profits.



Example

A company has made a trading loss of $500,000 for the year to 31 December 20X6

and as it is unable to relieve the loss against earlier years it wishes to carry it

forward to relieve against future profits. The company anticipates it will return to

profitability in the next year. The company has a tax rate of 30% in 20X6.

The carry forward of the trading loss will result in less tax being paid in future years

once the company returns to profit. The trading loss of $500,000 therefore represents a

temporary difference that will result in a deferred tax asset. If the company’s rate of

tax is 30%, the deferred tax asset should be recognised as $150,000 (30% × $500,000).

3.3 Deferred tax relating to revaluations and other items recognised outside

profit or loss

IAS 12 specifies that a change in the deferred tax provision is recognised as an income

or expense for the period and is included in the income statement (profit or loss) for

the period, except to the extent that the tax arises from:

 a transaction or event that is recognised outside profit or loss, either in other

comprehensive income or directly in equity

 a business combination (see next section).

Where a transaction or event is recognised outside profit or loss and in other

comprehensive income, any current or deferred tax associated with it should be

recognised in other comprehensive income. A gain on the revaluation of a non-current

asset is an example.

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Where an entity reports a revaluation gain in other comprehensive income, the total

gain is recorded as:

Credit: Revaluation reserve (gain net of deferred tax provision)

Credit: Deferred tax provision on the gain (= revaluation gain × tax rate).

(Note: The timing difference arises as the revaluation is reflected in the balance sheet

carrying value, but no further tax relief is given by the authorities. As the tax base does

not change, a temporary difference will arise and deferred tax must be provided.)

Similarly where a transaction or event is recognised outside profit or loss and outside

other comprehensive income, and is recognised instead directly in equity, any current

or deferred tax associated with it should be recognised directly in equity. An

adjustment to the opening balance on retained earnings following the correction of a

prior year error is an example.



Example

A company recently re-valued a non-current asset from its carrying amount of

$300,000 to a re-valued amount of $400,000. The revaluation surplus is $100,000. The

tax rate is 25%.

On revaluation, a deferred tax liability should be created. This is $25,000 (25% ×

$100,000). The balance on the revaluation reserve is $75,000 (the revaluation of

$100,000, minus the deferred tax provision of $25,000).

The increase in the deferred tax liability is not included in the total tax charge for the

year in the income statement. In the statement of comprehensive income, the

revaluation gain is reported as $100,000 less the deferred tax provision of $25,000.

However, when the asset is eventually sold, and the tax on the gain is based on the

historical cost of the asset, the deferred tax liability is reduced to $0, reducing the total

reported tax charge for the year in which the disposal occurs.



Example

A company has held an asset for a number of years. The carrying amount in the

statement of financial position at 1 January is 1,000 and the tax base is 800. During

the year depreciation of 10% is charged on a reducing balance basis, and a there is a

capital allowance for tax purposes of 150. On the last day of the year the company

re-values the asset upwards by 350.

The company has a deferred tax liability on 1 January of 60. The tax rate is 30%.

The temporary difference as at the 31 December is calculated as follows:

Carrying

amount

Tax

base

Temporary

difference

1January

1,000 800 200

Depreciation/Capitalallowance (100) (150) 50

––––––––––––– ––––––––––––– –––––––––––––

900 650 250

Revaluation

350 ‐ 350

––––––––––––– ––––––––––––– –––––––––––––

At31December 1,250 650 600

––––––––––––– ––––––––––––– –––––––––––––

Chapter 15: Taxation

Two additional temporary differences have arisen, one due to the difference between

the depreciation charge (100) and the capital allowance in the year (150), and the

second due to the revaluation of the asset. A deferred tax provision must be

recognised on both differences at 30%. Therefore a liability of 180 (600 × 30%) is

required at the year end.

 As the depreciation is an expense in profit or loss, this temporary difference should

be also be recognised in profit or loss.

 As the revaluation is reported in other comprehensive income, the temporary

difference on the revaluation should also be recognised in other comprehensive

income.

Deferredtaxliabilityat1January(200×30%) 60

Expenseinprofitorloss(500×30%) 15

Recognisedinothercomprehensiveincome(350×30%) 105

Deferredtaxliabilityat31December(600×30%) 180

The accounting entries required (shown here in journal form) are therefore as follows:

DR Incomestatement(expense) 15

DR Othercomprehensiveincome 105

CR Deferredtaxliability

120

Recovery of revalued non-depreciable assets

The same basic principle applies to assets that are re-valued but are not depreciated,

such as land. When land is re-valued its tax base does not change.

SIC Interpretation 21 states that a deferred tax liability arising from the revaluation of

a non-depreciable asset should be measured on the basis of the tax consequences that

would follow from recovery (disposal) of the asset through sale.

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Deferred tax: business combinations

 Revaluation of assets/liabilities in the fair value exercise

 Parent’s deferred tax asset now recognised after an acquisition

 Unremitted earnings of group companies

 Unrealised profit adjustments

4 Deferred tax: business combinations

Additional deferred tax items need to be considered in preparing group accounts,

because new sources of temporary differences arise:

 goodwill (recognition of deferred tax for purchased goodwill is prohibited by IAS

12)

 revaluation of assets/liabilities in the fair value exercise

 unremitted earnings of group companies

 unrealised profit adjustments.

4.1 Revaluation of assets/liabilities in the fair value exercise

When a parent company makes an acquisition, it must perform a fair value exercise on

the assets and liabilities of the entity it has acquired. This will result in a change in the

carrying value of some of the assets and liabilities. However, the tax base will not be

affected, as this is based on the original cost.

Temporary differences arise for all the re-valued assets and liabilities



Example

A company acquires a subsidiary on 31 December 20X6 for $600,000 and performs a

fair value exercise as at that date.

The deferred tax implications of the acquisition may therefore be as follows:

(Numbers are included for the purpose of illustration.)

Fairvalue Taxbase

Temporary

differences

$000 $000 $000

Property,plantandequipment 270 155 115

Accountsreceivable

210 210 ‐

Inventory

174 124 50

Pensionliability

(30) ‐ (30)

Accountspayable

(120) (120) ‐

Deferredtax

(9) Notapplicable ‐

––––––––––––– ––––––––––––– –––––––––––––

495  135

––––––––––––– ––––––––––––– –––––––––––––

Deferred tax must be recognised on timing differences of $135,000. Assuming a tax rate

of 40%, this results in a liability of $54,000 ($135,000 × 40%). However the subsidiary

Chapter 15: Taxation

already has a deferred tax liability of $9,000, so only an additional liability of $45,000

should be recognised.

The recognition of a further liability on acquisition of the subsidiary will give rise to

further goodwill as follows:

Goodwillarising:



$000 $000

Costofinvestment

600

Fair value of net assets acquired (as in the statement of

financialposition)

495 

Deferredtaxarisingonfairvalueexercise

(45) 

–

–––

–

––––––––

(450)



–––––––––––––

Goodwillonacquisition

150



–––––––––––––

The deferred tax is therefore not expensed and charged as a cost in profit or loss.

Instead, it is capitalised by adding it to the amount of the purchased goodwill.

4.2 Parent’s deferred tax asset now recognised after an acquisition

A parent company may have a deferred tax asset that it has not recognised as it does

not believe it probable that taxable profits will be available against which the asset can

be used.

As a result of an acquisition, the parent may be able to utilise the tax position of the

subsidiary to claim group relief against the future profits of the subsidiary. This would

now permit the parent to recognise the deferred tax asset and reflect this in the

goodwill arising on the acquisition.



Example

Entity A acquired 80% of Entity B for $150,000. The fair value of Entity B’s net assets

at acquisition was $120,000. Entity A had unused tax losses of $15,000 at the date of

acquisition but had not been able to recognise a deferred tax asset in relation to

these. Management of Entity A believe that these losses are now recoverable as a

result of the acquisition. If the tax rate is 30%, calculate the deferred tax adjustment.

Goodwillarising:

$

Costofinvestment 150,000

Shareofnetassetsacquired(80%×120,000)

(96,000)

–––––––––––––––––

54,000

Deferred tax asset now recognised by Entity A on the acquisition

(30%×15,000)

(4500)

–––––––––––––––––

Goodwillonacquisition 49,500

–––––––––––––––––

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4.3 Unremitted earnings of group companies

When a company acquires a subsidiary or associate, it acquires a right to receive

dividends out of its accumulated profits. A temporary difference arises on the profits

of the subsidiary or associate that have not been distributed to the parent.

IAS 12 requires that a deferred tax liability be recognised for these undistributed

earnings, because they will attract tax when the dividends are paid to the parent in the

future.

However, where the parent controls the entity’s dividend policy, it is possible that the

temporary difference will not reverse in the foreseeable future. This might be because

the parent does not intend that the subsidiary should pay dividends, and does not

plan to dispose of its investment in the subsidiary. In this situation no deferred tax

liability should be recognised. However, this will only be the case for subsidiaries, as

the parent is unable to control the dividend policy of an associate.

The IASB has indicated that this rule may change in order to achieve convergence of

IFRSs and US GAAP. The change would require that deferred tax should be provided

in full on undistributed earnings of subsidiaries irrespective of dividend policy

intentions.

4.4 Unrealised profit adjustments

Where inter-company trading takes place between group companies and the inventory

is still held by the group at the year end, an adjustment is made in the group accounts

because the profit has not been realised outside of the group.

However, tax is charged on the profits of the individual companies, not on the group

as a whole. The profit on intra-group sales will therefore be subjected to tax, and this

will create a temporary difference.

The issue to resolve is whose tax rate should be used when providing for the deferred

tax on this temporary difference – the seller’s or the buyer’s? IAS 12 requires that

deferred tax be provided at the buyer’s rate of tax.

Chapter 15: Taxation

Tax: presentation and disclosure

 Multiple temporary differences

 Statement of financial position

 Statement of comprehensive ncome

5 Tax: presentation and disclosure

5.1 Multiple temporary differences

A deferred tax asset can be offset against a deferred tax liability as the existence of

deferred tax liability (to the same tax jurisdiction) is strong evidence that the asset will

be recoverable.



Example

The following deferred tax positions relate to the same entity:

Situation1 Situation2

Deferredtaxliability 12,000 5,000

Deferredtaxasset (8,000) (8,000)

–

––––––––––––

–

––––––––––––

4,000 (3,000)

–

––––––––––––

–

––––––––––––

 In situation 1, the financial statements will report the net position as a liability of

4,000. The existence of the liability indicates that the company will be able to

recover the asset, so the asset can be set off against the liability.

 In situation 2, setting off the asset against the liability leaves a deferred tax asset of

3,000. This asset may only be recognised if the entity believes it probable that it will

be recovered in the foreseeable future.

5.2 Statement of financial position

The main disclosure requirements of IAS 12 in relation to the statement of financial

position include the following:

 Tax assets and liabilities must be presented separately from other assets and

liabilities in the statement of financial position.

 Deferred tax assets and deferred tax liabilities must not be classified as current.

 An entity can offset current tax assets and current tax liabilities if, and only if:

− there is a legally enforceable right to set off the current tax assets against the

liabilities, and

− the deferred tax assets and liabilities relate to taxes levied by the same tax

authority on the same entity (or on different entities that intend to settle the net

amount).

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5.3 Statement of comprehensive income

The total tax expense relating to profit or loss from ordinary activities should be

shown in the statement of comprehensive income. (However if the entity presents the

components of profit or loss in a separate income statement, the tax relating to profit

or loss on ordinary activities should be reported in the income statement.)

The major components of tax expense (or income) should be shown separately. These

may include:

 current tax

 over-provision or under-provision in the previous year

 the deferred tax expense (or income) relating to the origination or reversal of

temporary differences

 the deferred tax expense (or income) relating to changes in tax rates or the

imposition of new taxes.

These components of tax expense make up the tax charge to include in profit or loss

for the period.

An entity should also disclose separately:

 the total current and deferred tax relating to items that have been charged to or

credited to equity, and

 the amount of tax relating to each component of other comprehensive income.

6 ED 2009/2: Income tax (withdrawn)

The IASB withdrew this ED in October 2009. The IASB intend to make short term

changes to IAS 12 and enter into a joint project with FASB which will reconsider the

fundamental approach to accounting for income taxes.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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