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Accounting for Income Taxes

| April 20, 2012 | 0 Comments

Students attempting financial reporting papers in the upcoming diet of Summer examinations may need to ensure they have a sound grasp of the accounting for income taxes.  Whilst the concept may appear to be ‘simple’, it is surprising how many students go into the examination without sufficient knowledge of IAS 12 Income Taxes.

Objective of IAS 12

The overarching aim of IAS 12 is to deal with how an entity accounts for income tax (current and deferred tax) and deals with all other taxes such as domestic and foreign taxes which are all based on taxable profits of an entity.  For the purposes of IAS 12, it is worth noting that income taxes also include withholding taxes.

Students tend to deal with the accounting for current taxes well; the difficulties come along when it comes to dealing with the problem child that is deferred tax.  This article will consider a few of the more common ways in which deferred tax can arise and the ways in which students should deal with such issues.

Deferred tax

The most significant question in terms of accountancy which arises in relation to taxation is how to allocate the income tax expense between accounting periods.  IFRS governs the way that transactions in a particular accounting period are recognised in the financial statements, but the timing of these transaction for the purposes of measuring taxable profit is governed by tax legislation.  It is therefore widely known that sometimes IFRS will prescribe one accounting treatment for a transaction(s), whereas tax legislation may dictate something else.  The generally accepted view is that it is necessary to seek some sort of reconciliation between these two different treatments and this reconciliation is known as ‘deferred taxation’.  The main thrust of deferred tax is therefore to recognise the tax effects of transactions in the financial statements in the same period as the transactions themselves.

Timing and temporary differences

IAS 12 works on the ‘temporary difference’ approach.  Broadly speaking, the temporary difference approach calculates the tax that would be paid if the net assets of the reporting entity were sold at book value.  A temporary difference is the difference between the carrying amount of an asset or a liability and its ‘tax base’.  The ‘tax base’ is basically the amount at which an item is recognised for the purposes of tax.

Some students (particularly UK-based students) may have come across the ‘timing difference’ approach (which is the way the UK’s FRS 19 Deferred Tax works).  Timing differences represent items of income or expenditure which are taxable or tax-deductible, but in periods different from those in which they are dealt with in the financial statements. They therefore arise when items of income and expenditure enter into the measurement of profit for both accounting and tax purposes, but in different accounting periods. The essential difference between the ‘timing’ and ‘temporary’ difference approach is that the timing difference approach focuses on the statement of comprehensive income, whereas the temporary difference approach focuses on the statement of financial position.

Illustration 1

Gabriella has an item of plant with a carrying amount in the financial statements amounting to $10,000.  The same item of plant has a tax base (a tax written down value) of $5,000.  This results in a temporary difference of $5,000.  Gabriella pays tax at 30%, so the deferred tax liability that should be recognised by Gabriella amounts to ($5,000 x 30%) = $1,500.  To recognise this liability, Gabriella should:

Debit income tax expense           $1,500

Credit deferred tax liability          $1,500

Deferred tax is always shown as a non-current liability in the statement of financial position.

Because the tax authority is essentially ‘consuming’ the asset at a faster rate than Gabriella (net book value vs. tax base) then the tax effects (usually because of accelerated tax allowable depreciation) will be felt in the financial statements in future periods.  If you assume that Gabriella already had a deferred tax provision brought forward amounting to $500 then from the perspective of the statement of financial position, the difference is taken to the income statement as follows:

Opening balance b/f                       $500

Movement in deferred tax          $1,000

Closing deferred tax balance      $1,500

It is only the movement between the opening and closing provision for deferred tax that gets charged or (credited) to the income statement.

Temporary differences

Debit balances in the financial statements compared to the tax written down values give rise to deferred tax liabilities and are known as taxable temporary differences.

Credit balances in the financial statements compared to the tax written down values give rise to deferred tax assets which are known as deductible temporary differences.

Temporary differences can also arise in the following situations:

  • Revenue recognised for  financial reporting purposes before being recognised for tax purposes.  Such instances are taxable temporary differences which give rise to deferred tax liabilities.
  • Expenses that are deductible for tax purposes prior to recognition in the financial statements.  An example of this is where the tax authority will grant tax allowable depreciation which is higher than the depreciation charged in the financial statements and these differences will give rise to deferred tax liabilities.
  • Expenses that are accounted for in the financial statements prior to becoming deductible for tax purposes.  An example of these are warranty costs – these are deductible temporary differences which give rise to deferred tax assets.
  • Revenue recognised for tax purposes prior to recognition in the financial statements.  A typical example of this would be prepaid rental income which would give rise to deductible temporary differences and a deferred tax asset.

Illustration 2 – the Temporary Difference Approach

Aidan purchase a machine on 1 January 2012 for $48,000 which is estimated to have a useful economic life of seven years with a residual value at the end of this useful life of $6,000.  Depreciation will therefore be $6,000 per annum ($48,000 – $6,000) / 7.  For the purposes of this illustration assume Aidan pays tax at 30%.  Aidan’s tax authority grants tax allowable depreciation (sometimes referred to as ‘capital allowances’) at a rate of 25% on a reducing balance basis (rounded up to the nearest thousand).  Aidan’s profit for each year (before taxation) amounts to $80,000.

Aidan would determine its deferred tax by first calculating the temporary differences as follows (all figures are in $s).

Financial   Statements

2012

2013

2014

2015

2016

2017

2018

Net   book value b/fwd

48,000

42,000

36,000

30,000

24,000

18,000

12,000

Depreciation

6,000

6,000

6,000

6,000

6,000

6,000

6,000

Net   book value c/fwd

42,000

36,000

30,000

24,000

18,000

12,000

6,000

Tax   Computation

Tax   base b/f

48,000

36,000

27,000

20,000

15,000

11,000

8,000

Tax   depreciation

12,000

9,000

7,000

5,000

4,000

3,000

2,000

Tax   base c/f

36,000

27,000

20,000

15,000

11,000

8,000

6,000

 

 

 

 

 

 

 

Temporary   difference arising

 

 

 

 

 

 

 

Net   book value

42,000

36,000

30,000

24,000

18,000

12,000

6,000

Tax   base

36,000

27,000

20,000

15,000

11,000

8,000

6,000

Temporary   difference

6,000

9,000

10,000

9,000

7,000

4,000

0

 

 

 

 

 

 

 

Deferred   tax provision

 

 

 

 

 

 

 

Temporary   difference above x 30%

1,800

2,700

3,000

2,700

2,100

1,200

0

Aidan’s financial statements will show the following:

2012

2013

2014

2015

2016

2017

2018

Profit   before taxation

80,000

80,000

80,000

80,000

80,000

80,000

80,000

Current   tax at 30%

22,200

23,100

23,700

24,300

24,600

24,900

25,200

Deferred   tax *

1,800

900

300

(300)

(600)

(900)

(1,200)

Profit   after taxation

56,000

56,000

56,000

56,000

56,000

56,000

56,000

* The deferred tax charge/(credit) in the income statement is only the movement in the deferred tax provision from one period to the next.

Deferred Tax in Business Combinations

The above illustrations show a fairly simplistic example of how deferred tax issues arise.  However, for the more advanced financial reporting student, the consideration of deferred tax may extend to more complex scenarios, such as deferred tax in a business combination.

IAS 12 requires the tax effects of the tax-book basis differences of all assets and liabilities to be presented as deferred tax assets and deferred tax liabilities at the date of acquisition.  Consider the following example:

Illustration 3 – Allocation of Purchase Proceeds in a Business Combination

Lucas is involved in the acquisition of Charlotte.  The following information is relevant:

  • Lucas pays tax at the rate of 40%
  • The cost of acquiring Charlotte was $500,000
  • The fair value of Charlotte’s net assets acquired are $750,000
  • The tax base of the assets acquired are $600,000
  • The tax base of the liabilities acquired are $250,000
  • The difference between the tax and fair values of the assets acquired are $150,000 which are made up as follows:
    • Taxable temporary differences of $200,000 and
    • Deductible temporary differences of $50,000
    • The directors have given their assurances that the deductible temporary differences are recoverable

Requirement

Show how the purchase price will be allocated in the above scenario.

Essentially all you are doing here is to show how the purchase proceeds Lucas paid of $500,000 to acquire Charlotte are going to be split.  This can be demonstrated as follows:

$

$

Consideration

500,000

Allocation   to identifiable assets/liabilities
Assets (excluding the goodwill/deferred tax asset)

750,000

Deferred tax asset ($50,000 x 40%)

20,000

Liabilities (excluding deferred tax liability)

(250,000)

Deferred tax liability ($200,000 x 40%)

               (80,000)

440,000

Difference goes to goodwill

    60,000

If the goodwill is tax deductible in Lucas’s jurisdiction, the amortisation period will cause the carrying amount for tax purposes to differ from that of the financial statements.  Under IFRS 3 Business Combinations, goodwill is not amortised over its expected useful life, hence a temporary difference will develop with book values being greater than the tax base.  If impairment charges are taken into consideration, then the carrying amounts may be lower than the corresponding tax basis.

When you encounter negative goodwill, IAS 12 states that the acquirer should reassess the values placed on the net assets and liabilities.  If this does not lead to the elimination of the negative goodwill, that amount is then reported as income in the current period.  This will more than likely result in a difference between the tax and carrying values for the negative goodwill which is also a timing difference to be considered in computing the deferred tax balance for the reporting entity.

In the scenario above, Lucas’s directors are confident that the deferred tax assets are deemed probable of being realised.  However there are circumstances when there is substantial doubt about the ability to recover deferred tax assets, hence it is NOT probable that such an asset will be recovered.  Under IAS 12, the deferred tax asset would not be recognised at the date of acquisition and therefore if the directors of Lucas were NOT confident that the deferred tax asset would be recovered, the allocation of the purchase price would have to reflect that fact and more of the purchase cost would be allocated to goodwill than would have otherwise been the case above.

Illustration 4 – Change in Circumstances

On 1 January 2005, Lucas was involved in a business combination.  At the date of acquisition, the deferred tax asset was calculated at $100,000 and on that date the directors considered that the realisation of the deferred tax asset was NOT probable.

The unrecognised deferred tax asset is allocated to goodwill during the purchase price assignment process.

On 1 January 2006, circumstances change and the directors reassess the likelihood of realising the original deferred tax asset, when it becomes probable that the deferred tax asset WILL be recovered.  On 1 January 2006, the entries are:

Debit deferred tax asset                                               $100,000

Credit goodwill                                                  $100,000

Conclusion

Deferred tax issues often cause an element of confusion amongst students, however it is an important area of financial reporting to get to grips with.  This article has considered some rather simplistic situations to help you along the way in your financial reporting studies, but the only way to get a sound understanding of how deferred tax works (and the situations in which deferred tax under IAS 12 arises) is to do lots of question practise.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011).  He is also the author of ‘IFRS For Dummies’ (Wiley April 2012) and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.

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