Weeks 3 & 4 - Chapter 18

1. Weeks 3 & 4 - Chapter 18 Accounting for income taxes

2. Objectives of this lecture • Understand that there is typically a difference between an organisation’s profit or loss for accounting purposes, and its profit or loss for taxation purposes • Be able to identify some of the factors that will cause a difference between profit or loss for accounting purposes and profit or loss for taxation purposes • Understand that a difference between the carrying amount of an asset or liability will lead to a ‘temporary difference’ and understand when a temporary difference causes a deferred tax asset, or a deferred tax liability • Understand how deferred tax assets and deferred tax liabilities arise

3. Objectives (cont.) • Understand how to account for taxation losses incurred by companies and understand how, in certain circumstances, taxation losses can lead to the recognition of assets in the form of deferred tax assets • Be able to critically evaluate the balance sheet approach to accounting for taxation and the associated asset, deferred tax asset, and liability, deferred tax liability

4. Introduction to accounting for income taxes • Profit for taxation purposes is known as taxable profit • Accounting profit is based on applying accounting standards and conventions • Tax expense for accounting purposes calculated after applying relevant accounting standards • Income tax payable based on taxable profit derived by the entity applying the rules of taxation law • The difference between tax expense and income tax payable creates ‘temporary differences’ Worked Example 18.1 (p. 631) shows the difference between taxable profit and accounting profit

5. Some differences between accounting and tax rules

6. Balance sheet approach to accounting for taxation Accounting for income taxes • Governed by AASB 112 • Applies the ‘balance sheet’ method • Focuses on comparing the carrying value of an entity’s assets and liabilities with the tax base for those assets and liabilities Carrying amount vs tax base of asset or liability • Carrying amount is the amount the asset or liability is recorded in the accounting records • Tax base is defined as the amount that is attributed to an asset or liability for tax purposes (AASB 112) • Where the carrying amount of an asset or liability is different from the tax base a ‘temporary difference’can arise

7. Balance sheet approach to accounting for taxation (cont.) Temporary differences can be of two types: • A taxable temporary difference • will result in an increase (decrease) in income tax payable (recoverable) in future periods when the carrying amount of the asset or liability is recovered or settled • Creates a liability—deferred tax liability • A deductible temporary difference • will result in a decrease (increase) in income tax payable (recoverable) in future periods when the carrying amount of the asset or liability is recovered or settled • Creates an asset—deferred tax asset

8. Balance sheet approach to accounting for taxation (cont.) • Deferred tax liability • The carrying amount of the asset exceeds the tax base • Taxation payments have effectively been deferred to future periods • Tax is reduced or ‘saved’ in early years, but additional tax will need to be paid later • Example of deferred tax liability • Carrying amount of a non-current depreciable asset exceeds the tax base in early years, as depreciation allowable as a deduction for tax purposes is greater than depreciation for accounting purposes • This will be reversed in later years when no depreciation is allowable for tax purposes

9. Balance sheet approach to accounting for taxation (cont.) Deferred tax asset • The carrying amount of an asset is less than the tax base Example of deferred tax asset: • Tax base of a depreciable asset exceeds the carrying amount in early years, as depreciation allowable as a deduction for tax purposes is less than depreciation for accounting purposes • This will be reversed in later years when the asset is fully depreciated for accounting purposes, but depreciation is still allowable as a deduction for tax purposes

10. Balance sheet approach to accounting for taxation (cont.) Income tax expense • Represents the sum of the tax attributable to taxable profit, plus or minus any adjustments relating to temporary differences • Defined in AASB 112 as: • the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax

11. Balance sheet approach to accounting for taxation (cont.) Income tax payable • The amount of tax generally expected to be paid to the tax office, as a result of the year’s operations, within the next financial period • Under the ‘taxes payable method’ would be same as tax expense • Under balance sheet method income tax payable does not necessarily equate to tax expense • Calculation of income tax payable Refer to Worked Example 18.2, pp. 632–35—Temporary differences caused by the depreciation of a non-current asset

12. Balance sheet approach to accounting for taxation (cont.) Overview of journal entries • To recognise tax expense that relates to the entity’s taxable profit Dr Taxation expense Cr Income tax payable End of Week 3

13. Balance sheet approach to accounting for taxation (cont.) • Journal entry if temporary differences result in deferred tax asset (DTA) • To recognise tax expense that relates to the temporary difference Dr Deferred tax asset (temp. difference x tax rate) Cr Tax expense • Journal entry if temporary differences result in deferred tax liability (DTL) • To recognise tax expense that relates to the temporary difference Dr Tax expense Cr Deferred tax liability (temp. difference x tax rate)

14. Balance sheet approach to accounting for taxation (cont.) Reversal in future periods • In future periods, timing differences will reverse: • Deferred tax asset will be credited • Deferred tax liability will be debited

15. Tax base of asset and liabilities: further consideration Calculation of tax base for assets • Carrying amount + future deductible amount—future assessable amount • Although an asset might be expected to give rise to future assessable amounts that exceed the asset’s carrying amount, AASB 112 focuses on the tax consequences of recovering an asset to the extent of its carrying amount only • Where the carrying amount of an asset exceeds the tax base there is a deferred tax liability • If the carrying amount of the asset is less than the tax base there will be a deferred tax asset

16. Tax base of asset and liabilities: further consideration (cont.) • Consideration of doubtful debts when examining accounts receivable • amounts provided for doubtful debts via an allowance for doubtful debts are not deductible for tax purposes • deductible only when the account receivable is actually written off • any allowance for doubtful debts will result in a difference between carrying amount and tax base • this will result in a deferred tax asset Refer to Worked Example 18.3 on p. 636—Determining the tax base of assets

17. Tax base of asset and liabilities: further consideration (cont.) Calculation of tax base for liabilities • Carrying amount—future deductible amount + future assessable amount • Exception to the rule • Tax base of a liability for ‘revenue received in advance’ Refer to Worked Example 18.4 on pp. 637—Determining the tax base of liabilities

18. Deferred tax assets and deferred tax liabilities

19. Deferred tax assets and deferred tax liabilities (cont.) Summary • Carrying amount of assets or liabilities—tax bases of assets or liabilities = taxable or deductible temporary differences • Taxable or deductible temporary differences x tax rate = deferred tax liabilities or deferred tax assets • Assessable temporary difference results in increase in tax payable in future years • Deductible temporary difference results in decrease in tax payable in future years Refer to Worked Example 18.5 on p. 639—Temporary differences and the recognition of a deferred tax liability Refer to Worked Example 18.6 on p. 640—A deductible temporary difference resulting in a deferred tax asset

20. Deferred tax assets and deferred tax liabilities (cont.) Deferred tax asset—Recognition criteria • A number of assumptions are made: • The entity will remain in business (going concern) • Taxable income will be derived in future years • Recognition of deferred tax asset same as applied to other assets—reliance on ‘probability’ test • AASB 112 notes that the ‘probable’ test will always be met in relation to deferred tax liabilities

21. Unused tax losses • Deferred tax assets can arise as a result of tax losses • Tax losses can generate subsequent benefits • Consistent with the test for deferred tax assets generated by temporary differences, deferred tax assets generated as a result of unused tax losses must also be able to satisfy the ‘probable’ test before they are recognised as assets • Recognition of a deferred tax asset arising from the carry-forward of unused tax losses and unused tax credits • As a general principle applicable to all deferred tax assets it is a requirement that they be reviewed at the end of each reporting period to ensure that the assets are not overstated (refer to AASB 112, par. 56) Refer to Worked Example 18.7 on p. 641, which illustrates the utilisation of unused tax losses

22. Revaluation of non-current assets • According to AASB 112 (par. 20) revaluations of non-current assets can create temporary differences • When non-current assets are revalued, the revaluation increment is not deductible for tax purposes, even though depreciation for accounting purposes will be based on the revalued amount • The tax base is not affected by the revaluation because depreciation for tax purposes will be based on the original cost of the asset • Any increase in the carrying value of a non-current asset through a revaluation implies an expected increase in the future flow of economic benefits • This increase can be taxable and can lead to a deferred tax liability if the carrying amount is greater than the tax base (refer to AASB 112, par. 20)

23. Revaluation of non-current assets (cont.) • AASB 112 requires that, to the extent that the deferred tax relates to amounts that were previously recognised in equity as either direct credits or direct debits, the journal entry to recognise the deferred tax asset or liability must also be adjusted against the equity account • As the revaluation is adjusted against equity, the accounting entry to record the recognition of the deferred tax liability is Dr Revaluation surplus Cr Deferred tax liability • Recognition of future tax associated with an revalued asset acts to reduce the amount of the revaluation surplus account • Entry assumes that the revalued amount of the asset will be recovered by the entity’s continued use of the asset

24. Offsetting deferred tax assets and deferred tax liabilities • Given that in most cases the tax is payable to the same authority, AASB 112 requires that, if certain conditions are met, then both the current tax liabilities and current tax assets as well as the deferred tax liabilities and deferred tax assets be set off against one another and that only the net amount of each set off be disclosed in the statement of financial position • The requirements pertaining to offsetting deferred tax assets and deferred tax liabilities are included at paragraph 74 of AASB 112

25. Change of tax rates • Tax rates will change across time • Will have implications for value to be attributed to pre-existing deferred tax assets and deferred tax liabilities • An increase in tax rates will create an expense (which will be of the nature of income tax expense) when an entity has deferred tax liabilities, and will create income in the presence of deferred tax assets • Conversely, a decrease in tax rates will create income when an entity has deferred tax liabilities, whereas a decrease will create an expense in the presence of deferred tax assets Refer to Worked Examples 18.11—Change in tax rates—and 18.12—Impact of changing tax rates (p. 651)

26. Summary • The main purpose of the lecture is to consider how to account for tax • Taxable profit and accounting profit will often be different because expense and recognition rules used in accounting are often different from those applied for taxation purposes • AASB 112 Income Taxes applies the balance sheet method in accounting for taxes—carrying values and tax bases are compared for assets and liabilities • The difference between carrying amounts and tax bases leads to either deductible temporary differences or taxable (assessable) temporary differences—multiplying these differences by the tax rate gives rise to either a deferred tax asset or deferred tax liability

27. Summary (cont.) • Generally speaking, if the carrying amount of an asset is greater than its tax base there will be a deferred tax liability and if the carrying amount of an asset is less than its tax base there will be a deferred tax asset • If the carrying amount of a liability is greater than its tax base there will be a deferred tax asset and if the carrying amount is less than the tax base there will be a deferred tax liability • For an entity to recognise deferred tax assets there is a requirement that the derived associated economic benefits be probable • When a temporary difference associated with the revaluation of a non-current asset takes place the balance of the revaluation reserve account is reduced