Chapter 13 Income taxes Flashcards
1.1 Objective and scope of IAS 12 Income Taxes
There are two elements to tax that an entity may have to deal with:
- Current tax: amount payable to tax authorities in relation to trading of the current period
- Deferred tax: accounting measure to match the tax effects of transactions with their accounting treatment. It is not a tax which is paid.
2.1 Current tax – accounting treatment
The tax expense is included in the SPL and any outstanding liability is recognised in SFP. Dr Tax charge (SPL) Cr Corporation tax liability (SFP). In the SFP, current tax assets and liabilities are shown separately. An entity shall offset current tax assets and liabilities if, the entity:
- Has a legally enforceable right to set off the recognised amounts, and
- Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously
3.1 Deferred tax
This arises purely as a result of accruals and the matching concept. The purpose is to recognise the tax effect of a transaction in the same period as the income/expense that gave rise to it. This is an issue because accounting profit before tax is not the same as taxable profits. The reasons are:
- Permanent differences: items of revenue and expenditure that are included within the accounting profit but excluded from the taxable profits. Examples are entertaining expenses, fines and dividends received
- Temporary differences: items of revenue or expenditure that are included in both, but not in the same accounting period. Examples include depreciation and capital allowances, employee share option schemes and development costs.
Deferred tax is attributable to temporary differences only. This is an accounting entry that matches the tax consequences to the items the tax relates to in the accounts.
4.1 Measurement and recognition
IAS 12 Income taxes compares the carrying amount of an asset/liability with the tax base of the asset/liability. Carrying amount is simply the amount recognised on the SFP. The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
- If the carrying amounts greater than the tax base, then there are taxable temporary differences’ which means there is future tax to pay so there is a deferred tax liability
- If the carrying amount is less than the tax base, then there are deductible temporary differences, which means there is a deferred tax asset
4.2 The tax base
For assets, the tax base is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset. For PPE, the tax base is the TWDV. If the asset will not generate future taxable revenue, the tax base is the carrying amount (eg trade receivables).
For liabilities, the tax base is its carrying amount, less any amount deductible for tax purposes in future periods. For revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.
4.3 Alternative to a tax base approach
Where the tax base is not immediately apparent, it is helpful to consider the fundamental principal on which the standard is based. An entity shall recognise a DTL/A whenever recovery or settlement of the carrying amount would make future tax payments larger/smaller. Therefore, a DTL arises when:
- PAST: taxable profits < accounting profits, pay less tax and temporary difference originates
- FUTURE: taxable profits > accounting profits, pay more tax and temporary differences reverses
A DTA arises when:
- PAST: taxable profits > accounting profits, pay more tax and temporary differences originates
- FUTURE: taxable profits < accounting profits, pay less tax and temporary difference reverses
4.4 Determining and accounting for the deferred tax balance
To determine the deferred tax balance, multiply the temporary difference by the appropriate rate of tax. Once the balance has calculated it is posted to the accounts:
- Deferred tax liability: Dr Tax charge in SPL Cr Deferred tax liability
- Deferred tax asset: Dr Deferred tax asset Cr Tax charge in the SPL
The amount posted is always the movement between the opening and closing deferred tax balances in the SFP. The DT double entry should always match the accounting treatment of the transaction.
5.1 Application of deferred tax
Deferred tax may arise as a result of the following situations:
- Accelerated capital allowances: arise where CA are received before deductions for depreciation are recognised. Temporary difference is between the carrying amount of the asset and the TWDV. Gives rise to a DTL
- Revaluations: the carrying amount is based on the revalued amount whilst the tax base is the TWDV and is based on the original cost. An upward revaluation gives rise to a DTL. An upward revaluation is recognised in OCI and therefore the deferred tax is recognised in OCI.
- Interest: interest received from difference jurisdictions may not have the same tax and accounting treatment. If interest is shown in the accounts on an accruals basis but in the tax computation on a cash basis, a temporary difference will arise. The interest payable would be a DTA and interest receivable would be a DTL
- Development costs: in the accounts the carrying amount is the amount capitalised less amortisation. Tax relief is given in full immediately so the tax base is nil, resulting in a DTL
- Provisions: a provision may be set up in the accounts for a future liability, but tax rules may only allow a tax deduction on a cash payment basis. Resulting in a deferred tax asset.
- Losses: accounting losses create a DTA, to the extent is it probable that future taxable profit will be available against the losses
- Pensions: if a DB scheme with a net pension liability, the carrying amount is a liability. For tax, the contributions required to clear the liability are allowable when paid, the tax base is nil. This creates a DTA. IAS 12 requires the tax impact must be recognised outside the SPL if the tax relates to items recognised outside profit or loss.
6.1 Share-based payments and deferred tax
Under IFRS 2 Share-based payments, an expense relating to a share option scheme will be charged to the SPL spread over the vesting period. This is based on the FV of the share option at grant date. For tax purposes, a deduction is not given until the exercise date and is based on the intrinsic value of the option. this temporary difference will give rise to a DTA in the accounts. To calculate the deferred tax:
Carrying amount of the share-based payment expense (nil) less the tax base of the share based payment expense (the tax base is the amount accrued to date that the tax authorities will permit as a deduction in future periods).
7.1 Other considerations
The tax base of an asset is deemed to be the amount allowable in the future when revenue is generated (when the value of the asset is recovered). If the value of the asset can be recovered in different ways and different rates of tax apply to each, then the expected recovery method should be considered when determining the tax rate to use to calculate deferred tax.
8.1 Deferred tax and business combinations
When dealing with business combinations there are a number of DT implications:
- Fair value adjustments: under IFRS 3, the carrying amounts of the assets and liabilities are adjusted to FV in the group accounts. The tax base will still be based on original cost, therefore a temporary difference will arise. The DT relating to FV adjustments is also treated as a consolidation adjustment and will have an impact on the calculation of goodwill. Treat the resulting DTA/L’s as one of the assets or liabilities of the acquiree on acquisition, by including it in the group’s SFP and in the goodwill computation. Assuming a 100% acquisition, the journal is Dr Goodwill Cr DT liability.
- Unrealised profits on intra group trading: carrying amount of assets will be based on substance, with unrealised profits eliminated on consolidation. The tax base will be based on legal form, with intra group transactions still recognised, creating a temporary difference. DT is provided for at the receiving company’s tax rate. In the case of inventory, carrying amount is the value of the inventory in the group accounts. The tax base is the value of inventory included in the individual accounts. The difference is the PURP adjustment, which is a temporary difference. The journal is Dr DTA (CSFP) Cr Tax charge (CSPL).
When a foreign operations assets are denominated in a foreign currency, they will be retranslated before consolidation. This results in the carrying amount being different to the tax base and temporary differences will arise.
If a dividend received from a subsidiary is taxable, a potential DTL could arise. IAS 12 states, as the parent controls the subsidiary, it does not need to recognise a DTL where it has determined that those profits will not be distributed.
Recognising deferred tax implications at the date of acquisition of a subsidiary can affect the value of goodwill. The deferred tax on the initial recognition of goodwill is ignored by IAS12 Income taxes.
9.1 Audit and assurance implications of deferred tax
Audit risks Audit procedures
Recoverability of deferred tax asset Consider the assumptions made in the light of auditor knowledge of the business and any other evidence gathered during the course of the audit to ensure reasonableness. Review future forecasts to confirm that losses can be offset against future taxable profits. Review the nature of losses incurred to date. Compare previous forecasts with actual results to assess reliability of client forecasting
Complex calculations lead to an inherent risk Obtain a copy of the deferred tax workings and the corporation tax computation. Check the arithmetical accuracy of the deferred tax working. Agree the figures used to calculate temporary differences to those on the tax computation and the financial statements. Review any correspondence with HMRC for evidence that the tax computation may require changes.
Incorrect disclosures Review disclosures with reference to IAS 12 Income Taxes. Reperform the reconciliation of accounting profits to the tax expense.
