Week 4 - Accounting for income tax

Question 1

Why can tax comparability be difficult and forecasting uncertain?

Answer 1

Corporate tax (CT) is calculated under rules set by Parliament ANNUALLY in the Finance Act.
The Finance Act may alter the existing rules.

Question 2

Tax avoidance vs Tax evasion

Answer 2

Avoidance = reducing tax liability legally
Evasion = avoiding tax ILLEGALLY

Traditionally assumed that avoidance activities are costless to owners. In practice, they are costly.

Question 3

2 main issues of tax avoidance & their implications

Answer 3

1. Research shows that firms w/ aggressive tax planning (=engage in tax avoidance schemes for tax savings) has LOWER CORPORATE TRANSPARENCY
   - Balakrishnan et al,. 2019
   - the corporate info is potentially misleading, not faithfully representing, cannot help make investing decisions
2. Research shows that incentives to increase earnings by reducing tax is linked to MANAGERIAL DIVERSION (= transfer of wealth from shareholders to managers) / malpractice
   - opens room for manipulation & managers take advantage; owners lose accountability
   - Desai and Dharmapala, 2006

Question 4

Tax expense includes __ tax and __ tax

Answer 4

Tax expense = current tax + deferred tax

Question 5

Tax principles vs Accounting principles: expenses are taxed according to __ basis?

Answer 5

Cash basis instead of accrual basis. Expenses are only tax deductible when paid.

Remember that tax rules are cash-based!!!

Question 6

How should the deferred tax account be recorded in the entity’s SoFP?

Answer 6

ALWAYS show as a NON-CURRENT liability/asset, whether or not have current implications

Question 7

Definition of the tax base of an asset according to IAS 12 Income Taxes

Answer 7

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

Question 8

Formula for calculating Taxable/Deductible temporary differences

Answer 8

1. If carrying amount of asset > tax base of asset, (ie. +ve amount) -> TAXABLE temp. diff.
2. If carrying amount of liability > tax base of liability -> DEDUCTIBLE temp. diff.
   > both vice versa
   > technically liabilities tend to have no effect on taxable profit & so tend not to cause deferred tax problems

Then, Taxable/Deductible temporary differences * tax rate = Deferred tax liabilities/assets

If the economic benefits derived from an asset are NOT taxable, the tax base of the asset = its carrying amount.

Question 9

Which tax rates should deferred tax assets & liabilities be measured at? (IAS 12 requirements)

Answer 9

The tax rates that are expected to apply to the period in which the asset is realised or the liability is settled

Additional notes:
1. The carrying amount of deferred tax assets must be reviewed at the end of each accounting period
2. Deferred tax assets and liabilities must not be discounted

Question 10

Evaluations of deferred tax provision - 6 arguments supporting DT

+ 3 overall conclusions

Answer 10

1. entity is a going concern, need to account for future tax
2. deferral treated as accrual concept by IASB Framework, as tax is a biz expense so needs to be treated like any other cost
3. FUTURE OBLIGATIONS, FUTURE CASH OUTFLOW needs to be accounted for, since IASB Framework states ‘accounts inform of obligations to pay cash in the future’
   *4. achieves INCOME SMOOTHING & REDUCES VOLATILITY by smoothing the tax provision due to timing difference -> shows what tax the co. is obliged to pay
4. investors are used to uncertainty of future cash flows & they make decisions based on PREDICTED cash flows
5. {meets the} IASB Framework’s SUBSTANCE OVER FORM criterion (= fin. stt.s & biz disclosures should reflect the economic substance of a transaction & not just its legal form)

Overall:
- DT helps investors think about future cash flows/implications of the co. for making decisions
- & income smoothing provides MORE INFO ahead of time for more PREDICTABILITY
- since actual tax charge is objective & the best way to determine mgmt’s success at running the biz and managing tax affairs

Question 11

Evaluations of deferred tax provision - 4 arguments against DT

Answer 11

1. tax is not related to acct. profit, but a charge on taxable profit, so ACCRUAL concept & MATCHING principle does not apply b/c CASH-BASED
2. NOT a LEGAL LIABILITY until accrues:
   ^tax expense should be = to the amount based on income tax return for the year
   - ACCRUE as a PAYABLE any unpaid tax
   - BUT this argument is against the principle of ‘SUBSTANCE OVER FORM’ {& substance over form criterion is a point that supports DT}

(= fin. stt.s & biz disclosures should reflect the economic substance of a transaction & not just its legal form)

3. investors CONFUSED by deferred tax & how to evaluate performance; Investors can use EBT {earnings before tax} to evaluate firm performance/profitability
4. DT does NOT ALTER TAX PAYABLE, so NO cash flow implications. How does this deem necessary to smooth tax charge?

-> can argue that in future, potential cash flow implications
-> smoothing provides more info ahead of time, more predictability
- actual tax charge is objective & the best way to determine mgmt’s success at running the biz and managing tax affairs

^same as the overall conclusions