Accounting for income taxes Chapter 17 Accounting for income taxes Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Objectives Understand that there is typically a difference between an organisation’s income for accounting purposes, and its income for taxation purposes Be able to identify some of the factors that will cause a difference between income for accounting purposes and income for taxation purposes Understand how deferred tax assets and deferred tax liabilities arise (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Introduction to accounting for income taxes Taxation Income Income for taxation purposes is known as taxable income Determined in accordance with Australian income tax legislation, not according to general accounting rules Differences between accounting principles of revenue and expense recognition and taxation principles Accounting profit is therefore not the same as taxable profit Tax expense for accounting purposes (income statement) calculated after applying relevant accounting standards Income tax payable to Tax Office (balance sheet) based on taxable profit derived by the entity applying the rules of taxation law Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation Accounting for income taxes Governed by AASB 112 Applies the ‘balance sheet’ method—recognition of assets and liabilities in the balance sheet based on the differences between accounting and tax values of assets and liabilities Focuses on comparing the carrying value of an entity’s assets and liabilities (determined by accounting rules) with the tax base for those assets and liabilities Effectively involves comparing the balance sheet derived using accounting rules with balance sheet derived from taxation rules Examples of differences between accounting and tax rules—refer to Table 17.1 on page 607 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Carrying amount vs tax base of asset or liability Carrying amount is the amount the asset or liability is recorded at in the accounting records Tax base is defined as the amount that is attributed to an asset or liability for tax purposes(AASB 112)—tax base represents the amount an asset or liability would be recorded at if the balance sheet were prepared applying taxation rules Where the carrying amount of an asset or liability is different from the tax base a ‘temporary difference’ can arise (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Temporary differences can be of two types An assessable 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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) 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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Justification for deferred tax liability (AASB 112, par. 16) It is inherent in the recognition of an asset that its carrying amount will be recovered in the form of economic benefits that flow to the entity in future periods. When the carrying amount of the asset exceeds its tax base, the amount of taxable economic benefits will exceed the amount that will be allowed as a deduction for tax purposes. This difference is a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability. As the entity recovers the carrying amount of the asset, the taxable temporary difference will reverse and the entity will have taxable profit. This makes it probable that economic benefits will flow from the entity in the form of tax payments. (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Income tax expense Represents the sum of the tax attributable to taxable income, 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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Income tax payable The amount of tax generally expected to be paid, as a result of the year’s operations, within the next financial period Under the ‘taxes payable method’ would be same as tax expense, i.e. the amount payable to the Tax Office is also treated as the tax expense by the organisation This method not permitted in Australia Under balance sheet method income tax payable does not necessarily equate to tax expense Tax expense affected by temporary differences (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Calculation of income tax payable Income tax payable is based on taxable income, not accounting profit Necessary to make adjustments to accounting profit to determine tax profit, e.g.: Add back accounting depreciation Deduct depreciation for taxation purposes Tax rate multiplied by tax profit Refer to Worked Example 17.1 on pp. 609–12—Temporary differences caused by the depreciation of a non-current asset (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Journal entry if temporary differences result in deferred tax asset To recognise tax expense that relates to the temporary difference: Dr Deferred tax asset (temp. difference x tax rate) Cr Tax expense To recognise tax expense that relates to the entity’s taxable profit: Dr Taxation expense Cr Income tax payable (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Balance sheet approach to accounting for taxation (cont.) Journal entry if temporary differences result in deferred tax liability To recognise tax expense that relates to the temporary difference: Dr Tax expense Cr Deferred tax liability (temp. difference x tax rate) To recognise tax expense that relates to the entity’s taxable profit: Dr Taxation expense Cr Income tax payable (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 carrying amount of asset exceeds tax base there is a deferred tax liability If the carrying amount of the asset is less than the tax base there is will be a deferred tax asset (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Tax base of asset and liabilities: further consideration (cont.) Consideration of doubtful debts when examining accounts receivable Amounts provided for doubtful debts are not deductible for tax purposes Deductible only when the account receivable is actually written off Any provision 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 17.2 on page 614—Determining the tax base of assets (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 that is in the nature of ‘revenue received in advance’ must be calculated as the liability’s carrying amount less any amount of the revenue received in advance that has been included in assessable amounts in the current or a previous reporting period This will result in a deferred tax asset (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Tax base of asset and liabilities: further consideration (cont.) Tax base of a liability for ‘revenue received in advance’ Tax base of the liability is equal to the carrying amount of the liability where the ‘revenue received in advance’ is taxed in a reporting period subsequent to the reporting period in which received The tax base of the liability is equal to zero where ‘revenue received in advance’ is taxed in the reporting period when received Carrying amount – amount of revenue received in advance that will not be subject to tax in future periods = tax base Refer to Worked Example 17.3 on pp. 615–6—Determining the tax base of liabilities Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Deferred tax assets and deferred tax liabilities Deferred tax liability arises when: carrying amount > tax base Deferred tax asset arises when: carrying amount < tax base Liabilities (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Deferred tax assets and deferred tax liabilities (cont.) Summary Carrying amount of assets or liabilities – tax bases of assets or liabilities = assessable or deductible temporary differences Assessable 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 17.4 on pp. 617–8—Temporary differences and the recognition of a deferred tax liability Refer to Worked Example 17.5 on page 618—A deductible temporary difference resulting in a deferred tax asset (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 provides the general rule that a deferred tax asset must be recognised for all deductible temporary differences that reflect the future tax consequences of transactions and other events to the extent that it is probable that future taxable amounts within the entity will be available, against which the deductible temporary differences can be utilised AASB 112 notes that the ‘probable’ test will always be met in relation to deferred tax liabilities Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Unused tax losses Deferred tax assets can arise as a result of tax losses Losses incurred in previous years can generally be carried forward to offset taxable income derived in future years Tax losses can generate subsequent benefits in the form of tax payments saved in future profitable periods 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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Unused tax losses (cont.) AASB 112 (par. 34): A deferred tax asset shall be recognised arising from the carry-forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised As a general principle applicable to all deferred tax assets it is a requirement that they be reviewed at each reporting date to ensure that the assets are not overstated (refer to AASB 112, par. 56) Refer to Worked Example 17.6 on pp. 620–1, which illustrates the utilisation of unused tax losses Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Transfer of tax losses to other entities within a group Transfer of tax losses within a group or economic entity is not addressed in AASB 112 Importance of this issue diminished following introduction (from 1 July 2001) of tax consolidation regime in Australia Loss transfer rules in the Income Tax Assessment Act 1997 no longer apply to most entities (other than in relation to certain transfers Australian branches of foreign banks) New legislation requires corporate groups to form a ‘tax consolidated group’ if they want to be treated as a single entity for income and capital gains tax purposes Election to form a ‘tax consolidated group’ is optional—if entity elects not to form such a group the individual companies will be treated separately and tax losses in one company will not be available to offset taxes payable by another Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 However, any increase in the carrying value of a non-current asset through a revaluation undertaken to recognise an increase in fair value 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) (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Revaluation of non-current assets (cont.) Unlike previous examples where the temporary difference is adjusted against income tax expense, asset revaluations give rise to a special case 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 AASB 112 (par. 61): Current tax and deferred tax shall be charged or credited directly to equity if the tax relates to items that are credited or charged, in the same or a different period, directly to equity (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Revaluation of non-current assets (cont.) As the revaluation is adjusted against equity (revaluation reserve account), the accounting entry to record the recognition of the deferred tax liability is: Dr Revaluation reserve Cr Deferred tax liability Recognition of future tax associated with an asset that has a fair value in excess of its cost as recognised by a revaluation acts to reduce the amount of the revaluation reserve account Entry assumes that the revalued amount of the asset will be recovered by the entity’s continued use of the asset (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Revaluation of non-current assets (cont.) If there is an expectation that the revalued asset is to be sold: Journal entries to record the deferred tax liability will be different If a non-current asset is sold there is often a ‘tax break’ given to the organisation as the tax base is increased by an index that reflects general price increases If the tax that will be assessed in future is to be reduced because of capital gains indexation, the reduction in the amount of tax that would be paid is accounted for by debiting the deferred tax liability and crediting the revaluation reserve Result—the tax base of an asset can depend on the manner in which the entity's management expects to recover the benefits inherent in the asset Refer to Worked Example 17.7 on page 624—Accounting for a revaluation Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Evaluation of the assets and liabilities created by AASB 112 Deferred tax assets vs the AASB ‘Framework for the Preparation and Presentation of Financial Statements’ Deferred tax asset might not meet definition of asset (under AASB Framework)—a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (par. 49) At balance date the company really has no claim against the government for the value of the deferred tax asset The realisation of the benefit will only arise if the company earns sufficient revenue in the future and if the relevant tax legislation does not change It is questionable whether benefits are actually controlled by the entity at balance date as there might be a contingent element involved (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Evaluation of the assets and liabilities created by AASB 112 (cont.) Deferred tax assets vs AASB Framework Definition of liability under AASB Framework—a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits When a deferred tax liability exists the company is not presently obliged to transfer funds of an amount equal to the balance of the account Funds will only be transferred in the future if the company earns sufficient revenue—there is a dependency on future events, not past events Also an assumption that the relevant taxation legislation will not change Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

Summary Main purpose of the chapter 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 values 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 (continues) Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan

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 Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan