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ACT3127 Advanced Financial Accounting II

ACT3127 Advanced Financial Accounting II. FRS 112: Income Tax (Deferred Tax) Part 1. Contents. Introduction Methods of computation Basis of provisions Emphasis on temporary differences. Issue: Deferred Tax Air Asia. In reference to its F/S 2006,2007 and up to now…

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ACT3127 Advanced Financial Accounting II

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  1. ACT3127 Advanced Financial Accounting II FRS 112: Income Tax (Deferred Tax) Part 1

  2. Contents • Introduction • Methods of computation • Basis of provisions • Emphasis on temporary differences

  3. Issue: Deferred Tax Air Asia In reference to its F/S 2006,2007 and up to now… Huge amt of its deferred tax assets (DTA) is recognised on unutilised investment tax allowances. The tax charge posted as a credit/income instead of expense in its P&L Dec 2008 P&L :PBT a loss, tax expense a credit balance, B/S: DTA greater than Retained earnings figure Unutilized Reinvestment Allowances/ Investment Tax Allowances - Met Exception Rule? Unutilised Tax credit hence DTA? Or else?

  4. Is Deferred Tax Difficult to Understand? • Based on actg concept or model, rather than transaction or documented event. Hence DTA / DTL x really asset or liab? What is it really? • Std unclear in many areas including concept/principles…tax rules set based on jurisdiction. Temporary Differences & harmonisation process with US GAAP sources of unclearness and inconsistencies • Differences in tax laws and accountant knowledge and skills about it contribute to the problem

  5. What is Deferred Tax and Implications? • Deferred Tax is essentially a concept Outcome?..... Special Class of Assets or Liabilities? • Actg profit realistic picture of income – matching concept • Ensure consistency wrt current actg theory that holds that both current and deferred tax must be recognised in consideration of events that have been recorded in f/s. • If income tax is not deferred, co’s future c/flows will be misleading . For instance readers’ of finl stat would not be informed about reversals that would take place arising from timing differnce bet f/s and tax’ble income

  6. FRS 112: Income Taxes • Earlier Effect 1/7/2002 • Based on IAS 12 with some local interpretation and guidance • FRS 112 (2007) : Effect 1/7/2007 • Sig difference- Emphasis Temporary Differences , B/S Liab Method, New Recog Rules and Criteria for DTA and DTL • ED on new IFRS for Income Taxes issued 31/3/2009

  7. Continue… • Income Taxes include all domestic and foreign taxes that based on taxable profits • Deferred Tax Liabilities: Amt of Income Taxes payable in future periods based on taxable temporary differences • Deferred Tax Assets Amt of Income Taxes recoverable in future periods in respect of: • Deductible temporary difference • Unused tax losses c/f • Unused tax credits To compute deferred tax, need to know temporary difference

  8. Deferred Tax Under proposed New IFRS Std..(ED) Deferred Taxation is the income tax payable (recoverable) in respect of taxable profit (tax loss) for future reporting periods as a result of past transactns or events

  9. FRS 112 (2007): Temporary Differences Temporary Difference (TD) = CA (of A/L) – Tax Base Tax Base: Amt attributed to A / L for tax purposes (e.g capital allowance on non-current assets, deductible liability expense); Knowledge of taxation, inputs from tax consultant importance. (Refer Para 7 & 8) Nevertheless, timing difference is still relevant.. NBV

  10. Continue… • TD can either be Tax’ble or Deductible TD • Tax’ble TD: (i) Gives rise to DTL, (ii) Amt taxable in determining tax’ble profit /loss • Deductible TD (i) Gives rise to DTA (ii) Amt deductible in determining tax’ble profit/loss

  11. Tax Base • Assets (Para 7): Amt that will be deductible for tax purposes against taxable economic benefits. If those economic benefits NOT taxable, tax base of the asset = CA • Liabilities (Para 8): CA less Amt that will be deductible for tax purposes in respect of that liab in future periods [ For revenue received in advance (deferred revenue) tax base is its CAlessamt of that rev that NOT taxable in future]

  12. Continue • PPE (Qualfyg Asset), TB = Tax Written Down Value (TWDV) • PPE (NQA) , TB = 0 • Deferred Dev Expenditure: TB =0 (if not deductible or already deductible when incurred) Inventories, TB = CA

  13. Introduction: Timing difference • Accounting profit vs. taxable income/profit • Timing difference: the period when the items included in calculation of accounting profits not equal to period when they are included in taxable profits • It gives rise to “tax obligation” or “ tax benefits”in the future periods • Deferred Tax Liability or Deferred Tax Asset? If you owe the tax man deferred tax liability and vice versa

  14. Continue Tax obliga. to be settled in future period Deferred Tax Liabilityarises when : Pre-tax accounting profit >tax’ble income, result in amt of tax pay’ble (based on tax’ble profit) for current yr < income tax expense (based on actg profit). Eg: PBT = RM75K, Tax’ble profit = RM 60K, , Tax rate =26% Computation Income tax expense = 75K x 26% = 19.5K Income tax pay’ble = 60K x 26% = 15.6K Journal entries Dr Tax Expense RM 19.5K Cr Tax Payable RM15.6K Cr Deferred Tax Liability RM3.9K (To record income tax expense and deferred tax liability)

  15. Continue Tax benefit to be recovered in future period Deferred Tax Asset arises when: Taxable Income > Pre-tax accounting profit, resulting in > tax being paid in current yr than later yrs. It becomes a prepayment of tax for future periods. The prepayment is an asset bec provides future benefit (savings) or an asset and reduces tax for the future period. E.g: PBT = RM70K, Tax’ble profit = RM100K, Tax rate = 26% Computation Income Tax expense = 70K x 26% = RM18.2K Tax Pay’ble = 100K x 26% = RM26K Journal Entries Dr Tax expense 18.2K Dr Deferred Tax Assets 7.8K Cr Tax Pay’ble 26K (To record income tax expense and deferred tax asset)

  16. Illustration 1: timing difference • Advance rental income [income] Received in advance a rental income of RM1,000,000 for 4 years. For accounting purposes, the rental income will be spread over four years. The advanced rental income is taxable in the year it is received. Tax rate is 26% on income. Accounting : rental exp. RM250k (Year 1 - 4) Tax : rental income RM1,000k (Year 1)

  17. Rental income (taxable profit) Rental income (amortisation) Timing difference originating / (reversing) Year 1 RM’000 1,000 250 750 - Illustration 1: timing difference(To show difference in amt of income recogd under actg principle and tax rule that result in deferred tax) Year 2 RM’000 - 250 (250) Year 3 RM’000 - 250 (250) Year 4 RM’000 - 250 (250)

  18. As per tax law (1 Mil x 26%) As per acctg law (250K x 26%) Timing difference Originating / (reversing) Year 1 RM’000 260 65 195 - Illustration 1: taxation(To show difference in amt of income tax expense recogd under actg principle and tax rule that result in deferred tax) Year 3 RM’000 - 65 (65) Year 4 RM’000 - 65 (65) Year 2 RM’000 - 65 (65)

  19. Year 1 Tax expense: Current tax 65 Transfer to deferred tax asset195 260 Year 2 Tax expense: Current tax 65 Transfer from deferred tax asset(65) - Illustration 1: effect on tax expense

  20. Illustration 2: timing difference • Depreciation [expense] Acquired a plant at RM400,000, depreciated at 10% per annum at cost. The initial and annual capital allowance is 20% for the first 3 years. PBT RM800,000 a year. Tax rate is 26% on income. Annual depreciation = 40k Initial allowance = 80k Annual allowance = 80k Capital allowance > Depreciation Expense Resulting in tax’ble income < pre-tax actg profit Tax pay’ble in current yr < Tax expense. Deferred Tax Assets or Liability?....

  21. Other differences • Permanent difference: differences that are not capable for reversal e.g. donation to unapproved charities, entertainments, penalties and fines, tax-free dividends  ignored • Temporary difference: differences between the carrying amount of an assets or a liability in the balance sheet and its tax base [TB]

  22. Methods of computation • Deferral – I/S emphasis Dr / Cr Income Statement Cr / Dr Balance Sheet (DTL/DTA) • Liability – B/S emphasis Cr / Dr Income Statement / Equity / B/S Dr / Cr Balance Sheet (DTL/DTA)

  23. Principal bases of tax effect accounting • Nil provision basis • ‘flow through’ / ‘tax payable’ • tax expense = current income tax • Full provision basis • ‘comprehensive allocation’ • consistent with recognition principles of elements • Partial provision basis • only when it is probable to become payable in the future • by reversal amount foreseeable

  24. Illustration 3: nil vs. full Acquired a plant at a cost of RM2,200,000. Accounting: depreciation  S-L over 10 years Tax: initial allowance of 20% + accelerated annual allowance of 40%. End of year, profit before tax : RM5,000,000 Timing difference: capital allowances in excess of depreciation. Income tax rate is 26%.

  25. Illustration 3: Nil provision(Recognises taxable income as calculated by tax return, ignore tax consequences)View income tax not as an expense but allocation of income)Income Tax Payable = Income Tax Expense Use Taxable Income to calculate Income Tax Expense) RM’000 Profit before tax 5,000 Add: depr. [2,200 / 10] 220 Less: Cap allowance [2,200 x (20% + 40%)] (1,320) Taxable profit 3,900 Current income tax at 26% 1,014

  26. Illustration 3: Full provision(Recognises the tax consequences of timing differences) Timing difference = RM1,100,000. (5M-3.9M) Thus deferred tax = RM286,000 [26%] (1.1M X 26%) Tax expense RM’000 Current tax 1,014 Deferred tax 286 Total tax 1,300

  27. Accounting for Deferred Tax • IAS 12 (1983) • Allow deferral/liability method/ Income Stat Method • Recognition – full / partial provision • Recognition – timing differences only • IAS 12 = MASB 25 = FRS 112 (2007) • Allow liability method –B/S LIAB METHOD • Recognition – full provision • Recognition – all temporary (or timing) differences

  28. Emphasis on Temporary difference • Taxable temporary differences (TTD) - result in taxable amounts in determining taxable profit (tax loss) of future periods when CA of A/L recovered/settled. - DT Liability should be provided for all TTD e.g. Machine NBV = RM10,000. TB = RM4,000 Tax rate 26%

  29. Example : TTD Taxable profits that will accrue to the enterprise 10,000 Enterprise will be able to Deduct capital allowance of (4,000) Taxable amount when asset recovered 6,000 Income tax payable when asset is recovered – Deferred tax liability 1,560 (6K x 26%)

  30. Emphasis on Temporary difference • Deductible temporary differences (DTD) - result in deductible amounts in determining taxable profit (tax loss) of future periods when CA of A/L recovered/settled - DT Asset should be recognised for all DTD (when probable that taxable profit will be available) e.g. Provision for warranty cost = RM8,000. TB = 0 (deductible when paid). Tax rate is 26%

  31. Example: DTD Warranty paid will not change the flow of future economics benefits, thus no taxable profits 0 Able to deduct the cost when paid (8,000) Deductible amount when settled (8,000) Income tax recoverable – deferred tax asset 2,080 (8K x 26%)

  32. Temporary difference & tax effects

  33. Tax base : Assets - PPE • Amount deductible for tax purpose – e.g. machine with capital allowances RM’000 TB for initial recognition 10 Yr 1 – initial 20% + annual 20% (4) TB for Yr 2 6 Yr 2 – annual 20% (2) TB for Yr 3 4 Yr 3 – annual 20% (2) TB for Yr 4 2 Yr 4 – annual 20% (2) TB at the end of Yr 4 -

  34. Tax base: Assets – deferred expenditure capitalised as an asset in B/S • Nil : if its related cost have been claimed for tax expense in current or previous years (no more claim to be made) e.g. Deferred development cost as asset in B/S, its research expense has been claimed for tax allowance

  35. TB: Assets – interest / other receivables recognised on an accrual basis • Nil – its economic benefits recognised on accrual assumption, benefits will only be taxable on receipt basis (when cash received) e.g. accrued interest income

  36. Assets with TB = its carrying amount • If future economics benefits not taxable – debtors e.g. debtors of RM20,000, TB = RM20,000 if its sales revenue has already included in taxable profit (tax loss) in current or prior period.

  37. TB: Liabilities – accrued expenses and provisions • Its carrying amount less any amount deductible for tax purposes for future periods • Nil, if related accrued expense is deductible on cash basis • Its carrying amount, if already deducted for tax purpose in current or previous year / not deductible for tax purpose

  38. TB: Liabilities – accrued expenses and provisions e.g. RM2,000 accrued interest – RM2,000 (deductible when paid) = Nil – RM0 (no more deductible) = RM2,000 e.g. RM2,000 accrued entertainment – RM0 (not deductible for tax purposes)

  39. TB: Liabilities – Loans and other borrowings • Its carrying amount, payment of principal has no tax effect

  40. TB: Liabilities – deferred revenue and income • For liability that represents revenue received in advance, its carrying amount less any amount of revenue that will not be taxable in the future e.g. royalty receive in advance (long-term liability)

  41. Illustration 4: Timing vs. temporary Acquired a machine at a cost of RM100,000. Accounting: depreciation  S-L over 10 years Tax: initial and annual allowance of 20%. End of year, profit before tax : RM50,000 Included in this profit is provision for warranty expense of RM12,000 recognised as a liability in the balance sheet. Income tax rate is 26%.

  42. Illustration 4: deferred tax by ‘timing’ Capital allowance – initial 20,000 - annual 20,000 40,000 Depreciation (10,000) Capital allowances in excess of depreciation 30,000 Warranty expense for tax Nil Warranty expense for acctg (12,000) Accounting expenses in excess of tax (12,000) Net timing differences 18,000 Deferred tax expense at 26% 4,680 Deferred tax liability in B/S 4,680

  43. Illustration 4: deferred tax by ‘temporary’ Carrying amount of machine (100k – 10k) 90,000 Tax base for machine (100k – 40k) 60,000 Taxable temporary difference 30,000 Deferred tax liability at 26% (30K x 26%) 7,800 Carrying amount of provision (12,000) Tax base Nil Deductible temporary difference (12,000) Deferred tax asset at 26% (12K x 26%) (3,120) Net deferred tax liability in B/S (7.8K-3.12K) 4,680 Opening deferred tax liability Nil Deferred tax expense in I/S 4,680

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