CFA 31: Income Taxes

Question 1

accounting profit

Differences between Accounting Profit and Taxable Income

Answer 1

Income as reported on the income statement, in accordance with prevailing accounting standards, before the provisions for income tax expense. Also called income before taxes or pretax income.

Question 2

taxable income

Differences between Accounting Profit and Taxable Income

Answer 2

The portion of an entity’s income that is subject to income taxes under the tax laws of its jurisdiction.

Question 3

income tax payable

Differences between Accounting Profit and Taxable Income

Answer 3

The income tax owed by the company on the basis of taxable income.

Question 4

tax expense

Differences between Accounting Profit and Taxable Income

Answer 4

An aggregate of an entity’s income tax payable (or recoverable in the case of a tax benefit) and any changes in deferred tax assets and liabilities. It is essentially the income tax payable or recoverable if these had been determined based on accounting profit rather than taxable income.

Question 5

deferred tax assets

Differences between Accounting Profit and Taxable Income

Answer 5

A balance sheet asset that arises when an excess amount is paid for income taxes relative to accounting profit. The taxable income is higher than accounting profit and income tax payable exceeds tax expense. The company expects to recover the difference during the course of future operations when tax expense exceeds income tax payable.

Question 6

valuation allowance

Differences between Accounting Profit and Taxable Income

Answer 6

A reserve created against deferred tax assets, based on the likelihood of realizing the deferred tax assets in future accounting periods.

Question 7

deferred tax liabilities

Differences between Accounting Profit and Taxable Income

Answer 7

A balance sheet liability that arises when a deficit amount is paid for income taxes relative to accounting profit. The taxable income is less expense the accounting profit and income tax payable is less than tax expense. The company expects to eliminate the liability over the course of future operations when income tax payable exceeds tax expense.

Question 8

income tax paid

Differences between Accounting Profit and Taxable Income

Answer 8

The actual amount paid for income taxes in the period; not a provision, but the actual cash outflow.

Question 9

tax base

Differences between Accounting Profit and Taxable Income

Answer 9

The amount at which an asset or liability is valued for tax purposes.

Question 10

carrying amount

Differences between Accounting Profit and Taxable Income

Answer 10

The amount at which an asset or liability is valued according to accounting principles.

Question 11

tax loss carry forward

Differences between Accounting Profit and Taxable Income

Answer 11

A taxable loss in the current period that may be used to reduce future taxable income.

Question 12

Differences between Accounting Profit and Taxable Income

Answer 12

A company’s current tax liability is the amount payable in taxes and is based on current taxable income. If the company expects to receive a refund for some portion previously paid in taxes, the amount recoverable is referred to as a current tax asset. The current tax liability or asset may, however, differ from what the liability would have been if it was based on accounting profit rather than taxable income for the period. Differences in accounting profit and taxable income are the result of the application of different rules. Such differences between accounting profit and taxable income can occur in several ways, including:

1) Revenues and expenses may be recognized in one period for accounting purposes and a different period for tax purposes;
2) Specific revenues and expenses may be either recognized for accounting purposes and not for tax purposes; or not recognize for accounting purposes but recognized for tax purposes;
3) The carrying amount and tax base of assets and/or liabilities may differ;
4) The deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes;
5) Subject to tax rules, tax losses of prior years might be used to reduce taxable income in later years, resulting in differences in accounting and taxable income (tax loss carry forward); and
6) Adjustments of reported financial data from prior years might not be recognized equally for accounting and tax purposes or might be recognized in different periods.

Question 13

accounting for deferred tax assets and liabilities

Differences between Accounting Profit and Taxable Income

Answer 13

Deferred tax assets represent taxes that have been paid (or often the carrying forward of losses from previous periods) but have not yet been recognized on the income statement. Deferred tax liabilities occur when financial accounting income tax expense is greater than regulatory income tax expense. Deferred tax assets and liabilities usually arise when accounting standards and tax authorities recognize the time of taxes due at different times; for example, when a company uses accelerated depreciation when reporting to the tax authority (to increase expense and lower tax payments in the early years) but uses the straight-line method on the financial statements.

Although not similar in treatment on a year-to-year basis (e.g. depreciation of 5 percent on a straight-line basis may be permitted for accounting purposes whereas 10 percent is allowed for tax purposes) over the life of the asset, both approaches allow for the total cost of the asset to be depreciated (or amortized). Because these timing differences will eventually reverse or self-correct over the course of the asset’s depreciable life, they are called “temporary differences”.

Under IFRS, deferred tax assets and liabilities are always classified as noncurrent.

Under US GAAP, deferred tax assets and liabilities are classified on the balance sheet as current and noncurrent based on the classification of the underlying asset or liability.

Any deferred tax asset or liability is based on temporary differences that result in an excess or a deficit amount paid for taxes, which the company expects to recover from future operations. Because taxes will be recoverable or payable at a future date, it is only a temporary difference and a deferred tax asset or liability is created. Changes in the deferred tax asset or liability on the balance sheet reflect the difference between the amounts recognized in the previous period and the current period. The changes in deferred tax assets and liabilities are added to income tax payable to determine the company’s income tax expense (or credit) as it is reported on the income statement.

At the end of each fiscal year, deferred tax assets and liabilities are recalculated by comparing the tax bases and carrying amounts of the balance sheet items. Identified temporary differences should be assessed on whether the difference will result in future economic benefits.

A deferred tax item may only be created if it is not doubtful that the company will realize economic benefits in the future. If a company is a going concern and stable, there should be no doubt that future economic benefits will result from the equipment and it would be appropriate to create the deferred tax item.

Should it be doubtful that future economic benefits will be realized from a temporary difference, the temporary difference will not lead to the creation of a deferred tax asset of liability.

If a deferred tax asset or liability resulted in the past, but the criteria of economic benefits is not met on the current balance sheet date, then, under IFRS, an existing deferred tax asset or liability related to the item will be reversed. Under US GAAP, a valuation allowance is established. In assessing future economic benefits, much is left to the discretion of the auditor in assessing the temporary differences and the issue of future economic benefits.

Question 14

determining the tax base of an asset

Determining the Tax Base of Assets and Liabilities

Answer 14

The tax base of an asset is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized and the company recovers the carrying amount of the asset.

For example, a company depreciates equipment on a straight-line basis at a rate of 10 percent per year. The tax authorities allow depreciation of approximately 15 percent per year. At the end of the fiscal year, the carrying amount of equipment for accounting purposes is greater than the asset tax base thus resulting in a temporary difference.

Question 15

determining the tax base of a liability

Determining the Tax Base of Assets and Liabilities

Answer 15

The tax base of a liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future. With respect to payments from customers received in advance of providing the goods and services, the tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in future.

Keep in mind the following fundamental principle: In general, a company will recognize a deferred tax asset or liability when recovery/ settlement of the carrying amount will affect future tax payments by either increasing or reducing the taxable profit. Remember an analyst is not only evaluating the difference between the carrying amount and the tax base, but the relevance of that difference on future profits and losses and thus by implication future taxes.

IFRS states that the tax base is the carrying amount less any amount of the revenue that will not be taxed at a future date.

Under US GAAP, an analysis of the tax base would result in a similar outcome. The tax legislation within the jurisdiction will determine the amount recognized on the income statement and whether the liability (revenue received in advance) will have a tax base greater than zero. This will depend on how tax legislation recognizes revenue received in advance.

Question 16

accounting for changes in income tax rates

Determining the Tax Base of Assets and Liabilities

Answer 16

The measurement of deferred tax assets and liabilities is based on current tax law. But if there are subsequent changes in tax laws or new income tax rates, existing deferred tax assets and liabilities must be adjusted for the effects of these changes. The resulting effects of the changes are also included in determining accounting profit in the period of change.

When income tax rates change, the deferred tax assets and liabilities are adjusted to the new tax rate. If income tax rates increase, deferred taxes (that is, the deferred tax assets and liabilities) will also increase. Likewise, if income tax rates decrease, deferred taxes will decrease. A decrease in tax rates decreases deferred tax liabilities, which reduces future tax payments to the taxing authorities. A decrease in tax rates will also decrease deferred tax assets, which reduces their value towared the offset of future tax payments to the taxing authorities.

Question 17

permanent differences

Temporary and Permanent Differences Between Taxable and Accounting Profit

Answer 17

Reported effective tax rate

Permanent differences are differences between tax and financial reporting of revenue (expenses) that will not be reversed at some future date. Because they will not be reversed at a future date, these differences do not give rise to deferred tax.

These items typically include:

• Income or expense items not allowed by tax legislation
• Tax credits for some expenditures that directly reduce taxes

Because no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s effective tax rate and statutory tax rate The effective tax rate is also influenced by different statutory taxes should an entity conduct business in more than one tax jurisdiction.

The formula for reported effective tax rate is thus equal to:

Income tax expense/ pretax income (accounting profit)

The net change in deferred tax during a reporting period is the difference between the balance of the deferred tax asset or liability for the current period and the balance of the previous period.

Question 18

taxable temporary differences

Temporary and Permanent Differences Between Taxable and Accounting Profit

Answer 18

Temporary differences that result in a taxable amount in a future period when determining the taxable profit as the balance sheet item is recovered or settled. Taxable temporary differences result in a deferred tax liability when the carrying amount of an asset exceeds its tax base and, in the case of a liability, when the tax base of the liability exceeds its carrying amount.

Under US GAAP, a deferred tax asset or liability is not recognized for unamortizable goodwill.

Under IFRS, a deferred tax account is not recognized for goodwill arising in a business combination.

Since goodwill is a residual, the recognition of a deferred tax liability would increase the carrying amount of goodwill. Discounting deferred tax assets or liabilities is generally not allowed for temporary differences related to business combinations as it is for other temporary differences.

IFRS provides an exemption (that is, deferred tax is not provided on the temporary difference) for the initial recognition of an asset or liability in a transaction that:

a) is not a business combination (e.g. joint ventures branches and unconsolidated investments); and
b) affects neither accounting profit nor taxable profit at the time of the transaction. US GAAP does not provide an exemption for these circumstances.

As a simple example of a temporary difference with no recognition of deferred tax liability, assume that a fictitious holding company of various leisure related businesses and holiday resorts buys an interest in a hotel in the current financial year. The goodwill related to the transaction will be recognized on the financial statements, but the related tax liability will not, as it relates to the inital recognition of goodwill.

Question 19

deductible temporary differences

Temporary and Permanent Differences Between Taxable and Accounting Profit

Answer 19

Temporary differences that result in a reduction or deduction of taxable income in a future period when the balance sheet item is recovered or settled. Deductible temporary differences result in a deferred tax asset when the tax base of an asset exceeds its carrying amount and, in the case of a liability, when the carrying amount of the liability exceeds its tax base.

The recognition of a deferred tax asset is only allowed to the extent there is a reasonable expectation of future profits against which the asset or liability (that gave rise to the deferred tax asset) can be recovered or settled.

To determine the probability of sufficient future profits for utilization, one must consider the following:

1) Sufficient taxable temporary differences must exist that are related to the same tax authority and the same taxable entity; and
2) The taxable temporary differences that are expected to reverse in the same periods as expected for the reversal of the deductible temporary differences.

As with deferred tax liabilities, IFRS states that deferred tax assets should not be recognized in cases that would arise from the initial recognition of an asset or liability in transactions that are not a business combination and when, at the time of the transaction, there is no impact on either accounting or taxable profit. Subsequent to initial recognition under IFRS and US GAAP, any deferred tax assets that arise from investments in subsidiaries, branches, associates, and interest in joint ventures are recognized as a deferred tax asset.

IFRS and US GAAP allow the creation of a deferred tax asset in the case of tax losses and tax credits. IAS 12 does not allow the creation of a deferred tax asset arising from negative goodwill. Negative goodwill arises when the amount that an entity pays for an interest in a business is less than the net fair market value of the portion of assets and liabilities of the acquired company, based on the interest of the entity.

Question 20

accounting for temporary differences at initial recognition of assets and liabilities

Temporary and Permanent Differences Between Taxable and Accounting Profit

Answer 20

In some situations the carrying amount and tax base of a balance sheet item may vary at initial recognition. For example, a company may deduct a government grant from the initial carrying amount of an asset or liability that appears on the balance sheet. For tax purposes, such grants may not be deducted when determining the tax base of the balance sheet item. In such circumstances, the carrying amount of the asset or liability will be lower than its tax base. Differences in the tax base of an asset or liability as a result of the circumstances described above may not be recognized as deferred tax assets or liabilities.

For example, a government may offer grants to Small, Medium, and Micro Enterprises (SMME). Assume that a particular grant is offered for infrastructure needs (office furniture, property, plant, and equipment, etc).

In these circumstances, although the carrying amount will be lower than the tax base of the asset, the related deferred tax may not be recognized. As mentioned earlier, deferred tax assets and liabilities should not be recognized in cases that would arise from the initial recognition of an asset or liability in transactions that are not a business combination and when, at the time of the transaction, there is no impact on either accounting or taxable profit.

Question 21

accounting for business combinations and deferred taxes

Temporary and Permanent Differences Between Taxable and Accounting Profit

Answer 21

The fair value of assets and liabilities acquired in a business combination is determined on the acquisition date and may differ from the previous carrying amount. It is highly probable that the values of acquired intangible assets, including goodwill, would differ from their carrying amounts. This termporary difference will affect deferred taxes as well as the amount of goodwill recognized as a result of the acquisition.

Question 22

accounting for investments in subsidiaries, branches, associates, and interest in joint ventures

Temporary and Permanent Differences Between Taxable and Accounting Profit

Answer 22

Investments in subsidiaries, branches, associates and interests in joint ventures may lead to temporary differences on the consolidated versus the parent’s financial statements. The related deferred tax liabilities as a result of temporary differences will be recognized unless both of the following criterion are satisfied:

1) The parent is in a position to control the timing of the future reversal of the temporary difference, and
2) It is probable that the temporary difference will not reverse in the future.

With respect to deferred tax assets related to subsidiaries, branches, and associates and interests, deferred tax assets will only be recognized if the following criteria are satisfied:

1) The temporary difference will reverse in the future, and
2) Sufficient taxable profits exist against which the temporary difference can be used.

Question 23

unused tax losses and tax credits

Answer 23

IAS 12 allows the recognition of unused tax losses and tax credits only to the extent that it is probable that in the future there will be taxable income against which the unused tax losses and credits can be applied.

Under US GAAP, a deferred tax asset is recognized in full but is then reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized. The same requirements for creation of a deferred tax asset as a result of deductible temporary differences also apply to unused tax losses and tax credits. The existence of tax losses may indicate that the entity cannot reasonably be expected t generate sufficient future taxable income. All other things held constant, the greater the history of tax losses, the greater the concern regarding the company’s ability to generate future taxable profits.

Should there be concerns about the company’s future profitability, then the deferred tax asset may not be recognized until it is realized. When assessing the probability that sufficient taxable profit will be generated in the future, the following criteria can serve as a guide:

• If there is uncertainty as to the probability of future taxable profits, a deferred tax asset as a result of unused tax losses or tax credits is only recognized to the extent of the available taxable temporary differences;
• Assess the probability that the entity will in fact generate future taxable profits before the unused tax losses and/or credits expire pursuant to tax rules regarding the carry forward of the unused tax losses;
• Verify that the above is with the same tax authority and based on the same taxable entity;
• Determine whether the past tax losses were a result of specific circumstances that are unlikely to be repeated; and
• Discover if tax planning opportunities are available to the entity that will result in future profits. These may include changes in tax legislation that is phased in over more than on financial period to the benefit of the entity.

It is imperative that the timing of taxable and deductible temporary differences also be considered before creating a deferred tax asset based on unused tax credits.

Question 24

accounting for recognition and measurement of current and deferred tax

Recognition and Measurement of Current and Deferred Tax

Answer 24

Current taxes payable or recoverable from tax authorities are based on the applicable tax rates at the balance sheet date. Deferred taxes should be measured at the tax rate that is expected to apply when the asset is realized or the liability settled. With respect to the income tax for a current or prior period not yet paid, it is recognized as a tax liability until paid. Any amount paid in excess of any tax obligation is recognized as an asset. The income tax paid in excess or owed to tax authorities is separate from deferred taxes on the company’s balance sheet.

Although deferred tax assets and liabilities are related to temporary differences expected to be recovered or settled at some future date, neither are discounted to present value in determining the amounts to be booked. Both must be adjusted for changes in tax rates.

Deferred taxes as well as income taxes should always be recognized on the income statement of an entity unless it pertains to:

• taxes or deferred taxes charged directly to equity, or
• A possible provision for deferred taxes related to a business combination.

The carrying amount of the deferred tax assets and liabilities should also be assessed. The carrying amounts may change even though there may have been no change in temporary differences during the period evaluated. This can result from:

• Changes in tax rates;
• Reassessments of the recoverability of deferred tax assets; or
• Changes in the expectations for how an asset will be recovered and what influences the deferred tax asset or liability.

All unrecognized deferred tax assets and liabilities must be reassessed at the balance sheet date and measured against the criteria of probable future economic benefits. If such a deferred asset is likely to be recovered, it may be appropriate to recognize the related deferred tax asset.

Question 25

accounting for recognition of a valuation allowance

Recognition and Measurement of Current and Deferred Tax

Answer 25

Deferred tax assets must be assessed at each balance sheet date. If there is any doubt whether the deferral will be recovered, then the carrying amount should be reduced to the expected recoverable amount. Should circumstances subsequently change and suggest the future will lead to recovery of the deferral, the reduction may be reversed.

Under US GAAP, deferred tax assets are reduced by creating a valuation allowance. Establishing a valuation allowance reduces the deferred tax asset and income in the period in which the allowance is established. Should circumstances change to such an extent that a deferred tax asset valuation allowance may be reduced, the reversal will increase the deferred tax asset and operating income. Because of the subjective judgment involved, an analyst should carefully scrutinize any such changes.

Question 26

accounting for recognition of current and deferred tax charged directly to equity

Recognition and Measurement of Current and Deferred Tax

Answer 26

In general, IFRS and US GAAP require that the recognition of deferred tax resulting and current income tax should be treated similarly to the asset or liability that gave rise to the deferred tax liability or income tax based on accounting treatment. Should an item that gives rise to a deferred tax liability be taken directly to equity, the same should hold true for the resulting deferred tax.

The following are examples of such items:

• Revaluation of property, plant, and equipment (revaluations are not permissible under US GAAP);
• Long-term investments at fair value;
• Changes in accounting policies;
• Errors corrected against the opening balance of retained earnings;
• Initial recognition of an equity component related to complex financial instruments; and
• Exchange rate differences arising from the currency translation procedures for foreign operations.

Whenever it is determined that a deferred tax liability will not be reversed, an adjustment should be made to the liability. The deferred tax liability will be reduced and the amount by which it is reduced should be taken directly to equity. Any deferred taxes related to a business combination must also be recognized in equity.

Depending on the items that gave rise to the deferred tax liabilities, an analyst should exercise judgment regarding whether the taxes should be included with deferred tax liabilities or whether it should be taken directly to equity. It may be more appropriate simply to ignore deferred taxes.