IAS 12 - Accounting for income taxes

Executive summary Despite the similar approaches to accounting for taxation under IFRS and US GAAP, deferred taxation is one of the most common areas where differences arise. The reason is that a high proportion of transactions recognized in either the statement of income or balance sheet will have consequential effects on deferred taxes. US GAAP requires a two-step approach for deferred tax assets that involves first recognizing the full asset and then reducing the asset to the extent that it is more likely than not that the deferred tax assets will not be realized. The valuation allowance account is used for this. IFRS requires a one-step approach that provides for recognition of the deferred tax assets only to the extent it is probable that they will be realized. Although there is no valuation allowance account used under IFRS, there should not be any differences in the net asset under US GAAP versus IFRS. US GAAP contains extensive guidance on accounting for uncertain tax positions in ASC 740-10. IFRS does not currently include specific guidance on this issue.

Executive summary Both IFRS and US GAAP require a numerical reconciliation to explain the relationship between tax expense (income) and pretax accounting profit in the footnote disclosures. However, there are differences regarding the particular tax rate or rates to be used for preparing that reconciliation. US GAAP requires that the domestic federal statutory rate be used as the starting point whereas IFRS allows this approach and also allows a statutory rate that aggregates domestic rates in various jurisdictions to be used. IFRS classifies deferred tax assets and liabilities as noncurrent in a classified balance sheet while US GAAP classifies these items based on the classification of the related asset or liability, or for tax losses and credit carry forwards, based on the expected timing of realization. IFRS offsets deferred tax assets and liabilities when specific conditions are met which includes when an entity has a legally enforceable right to offset and when the taxes are levied by the same taxing authority for the same taxable entity. US GAAP offsets these balances and reports them net by current and noncurrent classification.

Progress on convergence The IASB released an Exposure Draft (ED) of an IFRS to replace IAS 12 in March 2009. This was initially begun as a convergence project. However, the IASB has now decided to perform a fundamental review of accounting for income taxes in the future. The Board has changed the project objective to resolve problems in practice under IAS 12. One of the primary areas that they will address is uncertain tax positions. However, they will not do this until the revision of IAS 37, Provisions, Contingent Liabilities and Contingent Assets is finalized. An ED for a revised IAS 37 was released in January 2010 and the comment period ended in May 2010. Discussion on this project will not be resumed until after June 2011. In December 2010, the IASB issued Deferred Tax: Recovery of Underlying Assets (amendments to IAS 12) concerning the determination of deferred tax on investment property measured at fair value. The amendments are to provide practical solutions for jurisdictions where entities currently find it difficult and subjective to determine the expected manner of recovery for investment property that is measured using the fair value model in IAS 40, Investment Property.

General US GAAP IFRS Takes an asset-liability approach to accounting for income taxes and thus records deferred tax assets and liabilities. Similar Despite the similar approaches to accounting for taxation under US GAAP and IFRS, accounting for income taxes is one of the most common areas where differences arise between US GAAP and IFRS. The reason is that a high proportion of business transactions that do not have anything directly to do with income taxes will nonetheless have consequential effects on the accounting for income taxes.

Temporary differences General US GAAP IFRS A deferred tax liability or asset generally should be recognized for the future tax effects of all temporary differences and carryforwards. Similar Deferred taxes are calculated using the asset or liability approach, which is intended to recognize, in the balance sheet, the future tax consequences of events that have been either recognized in the financial statements or the tax return. A temporary difference is the difference between the book and tax basis of an asset or liability multiplied by the appropriate tax rate. Similar

Temporary differences General US GAAP IFRS Deferred taxes are measured on an undiscounted basis. Similar

Temporary differences Deferred tax liabilities US GAAP IFRS A deferred tax liability is recorded if the book basis of the underlying asset (liability) is greater (less) than the tax basis of the underlying asset (liability). Similar Precludes recognition of a deferred tax liability for the excess of the book basis over the tax basis of goodwill if it arises at the initial recognition of goodwill. Allows the recognition of a deferred tax liability subsequently if the goodwill is tax deductible. Similar

Temporary differences Deferred tax assets US GAAP IFRS A deferred tax asset is recorded if the book basis of the underlying asset (liability) is less (greater) than the tax basis of the underlying asset (liability). Similar

Temporary differences Deferred tax assets US GAAP Requires a two-step approach for deferred tax assets. First, deferred taxes should be recognized in full for all temporary differences between the book and tax basis of assets and liabilities. Second, any net amount of a deferred tax asset is assessed to determine whether it should be reduced by a valuation allowance to the extent it is "more likely than not" * that the deferred tax asset will not be realized. * “More likely than not” is defined as a likelihood of more than 50%. IFRS Requires a one-step approach that provides for recognition of the deferred tax assets only to the extent it is probable that they will be realized. A difference should not result in determining the amount of net deferred tax assets to recognize since similar judgment should be applied under both standards in the determination of whether net deferred tax assets should be recognized and their amount. “Probable” is not defined in the IFRS income tax standard. Note that it is defined in IAS 37 as a likelihood greater than 50%.

Valuation allowance example During the fiscal year ended December 31, 2010, KMR Corporation (KMR) experienced a net operating loss of $450,000. Since KMR has experienced losses in the last several years, it cannot utilize a net operating loss carryback. However, since KMR has entered into some new profitable contracts, the management of KMR expects that it is more than 50% likely that they will only be able to utilize one-third of the net operating loss to offset against future taxable income. The tax rate for KMR is 40%. Show the journal entries for US GAAP and IFRS.

Valuation allowance example Example 1 solution: US GAAP: Deferred tax asset $180,000 Income tax benefit $180,000 Income tax benefit $120,000 Valuation allowance $120,000 IFRS: Deferred tax asset $60,000 Income tax benefit $60,000

Temporary differences Tax rate considerations US GAAP IFRS Deferred tax liabilities and assets are measured using the applicable tax rate. Similar

Temporary differences Tax rate considerations US GAAP The enacted tax rate and tax law are applicable when measuring current and deferred taxes. IFRS The enacted or "substantively enacted" tax rates and tax laws are used. For current taxes, the appropriate rate is determined considering when the amount is to be recovered or paid. For deferred taxes, the rate is determined considering when the asset or liability is expected to be realized or settled. The interpretation of substantively enacted will vary from country to country. To help make this assessment, the IASB has published guidelines that address the point in time when a tax law change is substantively enacted in many of the jurisdictions that apply IFRS.

Enacted versus substantively enacted tax rates example KR Bookstores (KRB) operates in three countries in addition to the United States. The following table reports KRB’s taxable income and book income in these countries for the year ended December 31, 2010 (tax rates are also included in the table). All differences between book and taxable income are temporary differences that arise from assets and liabilities that are classified as current. Note that the substantively enacted tax rate is not a retroactive provision that will apply to the current year tax liability. Prepare the journal entry under both US GAAP and IFRS to record KRB’s income tax expense and liabilities.

Enacted versus substantively enacted tax rates example Example 2 US GAAP solution: Income tax expense $927,500 Current tax liability $917,500 Deferred tax liability – current*** 10,000 *The current tax liability is the taxable income multiplied by the enacted tax rates. **The deferred tax asset or liability is the temporary difference multiplied by the enacted tax rate. ***The deferred tax liability is presented net and is classified as current as the assets and liabilities for which the temporary differences arise are classified as current.

Enacted versus substantively enacted tax rates example Example 2 IFRS solution: Income tax expense $932,500 Deferred tax asset – non-current*** 40,000 Current tax liability $917,500 Deferred tax liability – non-current*** 55,000 *The current tax liability is the taxable income multiplied by the enacted tax rates. *The deferred tax asset or liability is the temporary difference multiplied by the substantively enacted tax rate. ***The total of the deferred tax assets ($17,500 + $22,500 = $40,000) and the total of the deferred tax liabilities ($10,000 + $45,000 = $55,000) are presented (no right of offset and differing tax jurisdictions) and classified as a non-current.

Permanent differences US GAAP IFRS If an item is included in the computation of taxable income but it is never included in book income, or if it is included in the computation of book income but never in taxable income, then it gives rise to a permanent difference. Similar

Net operating losses US GAAP IFRS An asset (tax receivable or deferred tax asset) and a tax benefit are recognized in the period that a company experiences a net operating loss that it will carry back or carry forward. In the case of a deferred tax asset recognized in conjunction with a net operating loss carryback, the asset needs to be measured and, thus, might be reduced to zero if no future benefit is expected. Similar

Uncertain tax positions US GAAP IFRS Tax contingencies are reported as a liability on the balance sheet. Similar Both US GAAP and IFRS report tax contingencies as a liability on the balance sheet.  A contingent liability is created for an unrecognized tax benefit because it represents an enterprise’s potential future obligation to the taxing authority for a tax position that was taken. An entity that presents a classified statement of financial position classifies a liability associated with an unrecognized tax benefit as a current liability, to the extent the enterprise anticipates payment (or receipt) of cash within one year or the operating cycle, if longer. The liability for unrecognized tax benefits should not be combined with deferred tax liabilities or assets. Similar

Uncertain tax positions US GAAP ASC 740-10 provides extensive guidance on accounting for uncertain tax positions. A two-step approach to uncertain tax positions – first is the decision whether to recognize and second is the determination of the measurement. A benefit is recognized when it is more likely than not to be sustained based on the technical merits of the position. The amount of the benefit to be recognized is based on the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement. Detection risk is precluded from being considered in the analysis by the assumption that the regulators have knowledge of all relevant facts and information. IFRS Does not address uncertain tax positions. Under IAS 12, tax assets and liabilities should be measured at the amount expected to be paid. In practice, this frequently results in the recognition principles in IAS 37, Provisions, Contingent Liabilities and Contingent Assets, being applied. IAS 12 clarifies that, while IAS 37 generally excludes income taxes from its scope, its principles may be relevant to tax-related contingent assets and contingent liabilities. This is not intended to imply that such items fall within the scope of IAS 37 because, ultimately, such assets and liabilities are a measurement of current tax.

Financial statement presentation US GAAP IFRS The total income tax expense reported on the statement of income is the sum of the current tax expense and the deferred tax expense. Both the current and deferred tax expenses do not include any tax expense that is recognized directly in equity. Similar Certain items may be accounted for directly in equity instead of going through the statement of income (e.g., excess tax benefits arising from stock compensation arrangements, available-for-sale investments and certain transactions with shareholders). The tax effects of those items also are recognized directly in equity in the period they arise. Similar

Backward tracing example Bad Investments Incorporated (BII) holds equity investments at a cost basis of $250,000. It accounts for these investments as available-for-sale securities. At the end of 2010, the market value of these investments has declined to $220,000. Consequently, BII reports an unrealized loss for financial reporting purposes of $30,000 through OCI which creates a temporary tax difference. As of December 31, 2010, BII determines that it is more likely than not that it will be able to deduct these capital losses for tax purposes if they are realized. As of December 31, 2011, BII changes its assessment as to whether it can utilize this deduction and determines that it is more likely than not that it will not be able to take the deduction for the capital loss. BII’s tax rate is 40%. Show the necessary journal entries for 2010 and 2011 under both US GAAP and IFRS.

Backward tracing example Example 5 solution: US GAAP: The entry for 2010 is as follows: Unrealized loss – OCI $30,000 Allowance to reduce AFS securities to market $30,000 Deferred tax asset $12,000 Income tax expense – OCI $12,000 The entry for 2011 is as follows: Income tax expense $12,000 Valuation allowance $12,000

Backward tracing example Example 5 solution (continued): IFRS: The entry for 2010 is as follows: Unrealized loss – OCI $30,000 Allowance to reduce AFS securities to market $30,000 Deferred tax asset $12,000 Income tax expense – OCI $12,000 The entry for 2011 is as follows: Income tax expense – OCI $12,000 Deferred tax asset $12,000

Financial statement presentation Classification and netting of deferred tax assets and liabilities US GAAP In a classified balance sheet, deferred tax assets and liabilities are generally classified based on the classification of the related asset or liability, or for tax losses and credit carryforwards, based on the expected timing of realization. The net deferred current tax amount is reported on the face of the balance sheet and the net deferred non-current tax amount is reported on the face of the balance sheet. IFRS In a classified balance sheet, deferred tax assets and liabilities are only classified as non-current. Deferred tax assets and liabilities are offset when specific conditions are met which includes when an entity has a legally enforceable right to offset and when the taxes are levied by the same taxing authority for the same taxable entity.

Financial statement presentation

Classification and netting of deferred tax assets and liabilities example Fun Flowers Consolidated (FFC), has the following deferred tax assets and liabilities: FFC has the legal right of offset for the deferred tax assets and liabilities applicable to the US taxing jurisdiction. Provide the financial presentation for the deferred tax assets and liabilities for FFI under US GAAP and IFRS.

Classification and netting of deferred tax assets and liabilities example Example 6 US GAAP solution: Under US GAAP, deferred tax assets and liabilities are generally classified based on the classification of the related asset or liability, or for tax losses and credit carryforwards, based on the expected timing of realization. Additionally, the balances determined as current are offset and the balances determined as non-current are offset. Therefore, for FFC, a $5,000 current deferred tax asset is reported and a $32,000 non-current deferred tax asset is also reported.

Classification and netting of deferred tax assets and liabilities example Example 6 IFRS solution: Under IFRS, deferred tax assets and liabilities are only classified as noncurrent and are offset when specific conditions are met which includes when an entity has a legally enforceable right to offset and when the taxes are levied by the same taxing authority for the same taxable entity. Therefore, for FFC, a $62,000 non-current deferred tax asset is reported and a $25,000 non-current deferred tax liability.

Disclosures US GAAP IFRS Requires disclosure of: The components of the deferred tax liabilities and deferred tax assets. The components of tax expense. The amounts and expiration dates of operating loss and tax credit carryforwards for which tax benefits have not been recognized. The amounts of temporary differences that aren’t recorded due to the permanent reinvestment of undistributed foreign earnings. Similar

Disclosures US GAAP IFRS Both US GAAP and IFRS require a numerical reconciliation to explain the relationship between tax expense (income) and pretax accounting profit. However, there are differences regarding the particular tax rate or rates to be used for preparing that reconciliation. US GAAP ASC 740-10-50-12 requires use of "domestic federal statutory tax rates" based on the premise that those rates provide the most meaningful information for domestic users of an enterprise's financial statements. An aggregation of separate reconciliations using foreign tax rates is not permitted. IFRS IAS 12, paragraph 85, states that: “Often, the most meaningful rate is the domestic rate of tax in the country in which the enterprise is domiciled, aggregating the tax rate applied for national taxes with the rates applied for any local taxes which are computed on a substantially similar level of taxable profit (tax loss). However, for an enterprise operating in several jurisdictions, it may be more meaningful to aggregate separate reconciliations prepared using the domestic rate in each individual jurisdiction."

Disclosures US GAAP IFRS Does not have this requirement. Requires considerable disclosures regarding any unrecognized tax benefits. The specific requirements vary from those under IFRS. The requirements for US GAAP can be found in paragraphs 15 and 15A of ASC 740-10-50. IFRS Requires, in certain circumstances, disclosure of "the nature of the evidence" supporting recognition of certain deferred tax assets. Scheduling the future reversals of temporary differences and carryforwards often will be necessary to develop the information required to comply with that disclosure requirement. Also requires considerable disclosures regarding unrecognized tax benefits. The requirements are found in IAS 37, paragraphs 84 through 92.