Income taxes Flashcards
Objective and scope of IAS 12 Income
Taxes 1.1 Objective
Taxation is a major expense for business entities and has a direct effect on
performance and cash flow. There are two elements to tax that an entity may have to
deal with:
Current tax – the amount payable to the tax authorities in relation to the trading
activities of the current period.
Deferred tax – an accounting measure used to match the tax effects of
transactions with their accounting treatment. It is not a tax that is levied by the
government that needs to be paid, but simply an application of the accruals
concept.
The objective of IAS 12 Income Taxes is to produce rules that an entity should follow
for the treatment of both current and deferred tax.
Current tax
Current tax is known as ‘Corporation Tax’ in the UK. The measurement of the
corporation tax in the financial statements is the amount expected to be paid to the
tax authorities applying the tax laws and tax rates in place at the reporting date.
Current tax 2.1 Accounting treatment
The tax expense is included in the statement of profit or loss and any tax liability
outstanding at the reporting date is recognised in the statement of financial position.
*Dr Tax charge in the statement of profit or loss
Cr Corporation tax liability in the statement of financial position *
In the statement of financial position, current tax assets and liabilities should be
shown separately.
‘An entity shall offset current tax assets and current tax liabilities
if, and only if, the entity:
(a) has a legally enforceable right to set off the recognised
amounts, and
(b) intends either to settle on a net basis, or to realise the asset
and settle the liability simultaneously.’ (IAS 12, para 71)
Deferred tax – an overview
Deferred tax arises purely as a result of accruals accounting and the matching
concept.
Its purpose is to recognise the tax effect of a transaction in the same period as the
income/expense that gave rise to it.
The reason it is an issue is because accounting profit before tax (PBT) is not the
same as taxable profits (Total Taxable Profit – TTP).
There are two reasons for the differences
Deferred tax – an overview Permanent differences
Permanent differences – items of revenue or expenditure that are included within
the accounting profit but excluded from the taxable profits. Examples include:
Entertaining expenses
Fines
Dividends received
(Note: The term ‘permanent differences’ is UK GAAP and not specifically identified
by IAS 12 Income Taxes)
Deferred tax – an overview Temporary differences
Temporary differences – items of revenue or expenditure that are included in both
the accounting profit and the taxable profits, but not at the same amount in the same
accounting period. In the long run, total accounting profits and total taxable profits will
be the same. Examples include:
Depreciation and capital allowances
Employee share option schemes
Development costs
Deferred tax is the tax attributable to temporary differences only.
Deferred tax is an accounting entry that matches the tax consequences to the items
the tax relates to in the financial statements.
Measurement and recognition of
deferred tax 4.1 IAS 12 Income Taxes – Net assets approach
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 statement of financial
position.
‘The tax base of an asset or liability is the amount attributed
to that asset or liability for tax purposes.’ (IAS 12, para 5)
Comparing the two:
If the carrying amount is > 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 < tax base, then there are ‘deductible
temporary differences’ which means future tax payments will be
reduced so there is a deferred tax asset.
Measurement and recognition of
deferred tax 4.2 Tax base
The tax base has a different definition depending upon whether we are
considering an asset or a liability.
Other 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.’ (IAS 12, para 7)
For PPE, the tax base of an asset is its tax written down value.
If the asset will not generate future taxable revenue, then the tax base = the
carrying amount. An example of this is a trade receivable.
Other Liabilities (except revenue received in advance) – the tax base is ‘its carrying
amount, less any amount that will be deductible for tax purposes in
respect of that liability in future periods.’ (IAS 12, para 8)
For example, if a company has provided for a cost that will be deductible on a
cash basis then the tax base of the provision is nil.
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.’ (IAS 12, para 8)
For example, if a company has deferred income of £3,000 which has already
been taxed on a receipts basis, the tax base is nil as there is no revenue to be
taxed in the future. If the revenue is taxed on an accruals basis the tax base
equals the carrying amount as the revenue is still to be taxed.
Measurement and recognition of
deferred tax 4.3 Alternative to a tax base approach
Sometimes it can be difficult to identify a tax base. In these circumstances IAS 12
suggests the following:
‘Where the tax base of an asset or liability is not immediately
apparent, it is helpful to consider the fundamental principle on
which this Standard is based: that an entity shall, with certain
limited exceptions, recognise a deferred tax liability (asset)
whenever recovery or settlement of the carrying amount of an
asset or liability would make future tax payments larger
(smaller)…’ (IAS 12, para 10)
Therefore, a deferred tax liability arises when:
PAST
Taxable profits < Accounting profits
Pay LESS tax
Temporary difference originates
FUTURE
Taxable profits > Accounting profits
Pay MORE tax
Temporary difference reverses
Therefore, a deferred tax asset arises when:
PAST
Taxable profits > Accounting profits
Pay MORE tax
Temporary difference originates
FUTURE
Taxable profits < Accounting profits
Pay LESS tax
Temporary difference reverses
This is sometimes referred to as an income based approach to deferred tax.
Measurement and recognition of
deferred tax 4.4 Determining the deferred tax balance
So far we have simply calculated the temporary differences and considered whether
this will give rise to a deferred tax asset or liability.
To determine the deferred tax balance – multiply the temporary difference by the
appropriate rate of tax
Measurement and recognition of
deferred tax 4.5 Accounting for the deferred tax balance: Where does the expense go?
In P&L / OCI depending on underlying transaction
Once the deferred tax balance is calculated it can then be posted to the accounts.
Deferred tax liability
Dr Tax charge in the statement of profit or loss
Cr Deferred tax liability
Deferred tax asset
*Dr Deferred tax asset
Cr Tax charge in the statement of profit or loss *
The amount posted is always the movement between the opening and closing
deferred tax balances in the statement of financial position.
The DT double entry should always match the accounting treatment of the transaction causing the deferred tax
For example:
If the transaction causes impacts to profit or loss, DT should be
recognised in the SPL (e.g. accelerated capital allowances).
If the transaction causes impacts outside profit or loss (in OCI or
equity) then the DT impact should be matched to the accounting
treatment (e.g. revalued assets – see section 5).
NB: Deferred tax assets can only be recognised up to the amount that
is expected to be recoverable in the future.
Measurement and recognition of
deferred tax 4.6 Summary steps for deferred tax
Step 1: Calculate temporary differences (in the exam, this is often best set up in a
table).
Step 2: Multiply the temporary differences by the appropriate tax rate.
Step 3: Post the movement on the deferred tax asset or liability.
Application of deferred tax Accelerated capital allowances
Arise where capital allowances are received before deductions for depreciation
are recognised. The temporary difference is the difference between the carrying
amount of the asset and the tax base which is the tax WDV. This gives rise to a
deferred tax liability.
Application of deferred tax Revaluations
Upward reval? -> OCI
Temporary differences arise because the carrying amount is based on the
revalued amount whilst the tax base is the tax WDV and is based on the original
cost. An upward revaluation will give rise to a deferred tax liability.
An upward revaluation is recognised in OTHER COMPREHENSIVE INCOME and
therefore the deferred tax is also recognised in OCI.
Application of deferred tax Interest
In the UK the treatment of both interest paid and interest received is the
same for accounting and tax. This means no deferred tax arises.
However in different tax jurisdictions this may not be the case. If interest is
shown in the accounts on an accruals basis but in the tax computation on a
cash basis, then a temporary difference will arise.
If the interest is taxed on a cash basis the deferred tax consequences are as
follows:
– For interest payable there will be a deferred tax asset.
– For interest receivable there will be a deferred tax liability.
