University of London: Financial Reporting 1

TOPIC 13: ACCOUNTING FOR INCOME TAX****

Reference: International Financial Reporting and Analysis (4th Edition) by
Alexander, Britton and Jorissen, Chapter 20
Financial Accounting and Reporting (12th Edition) by Barry Elliott
and Jamie Elliott, Chapter 14

Lecture Outline: Page

A. Current Tax** 1

B. Deferred Tax*** 3

C. Measurement and Recognition of Deferred Tax**** 11

D. Presentation and Disclosure Requirement 15

E. Exercises 18

A. Current Tax**
1. The taxable profits of an enterprise essentially comprise its net profit before
dividends, adjusted for certain items where the tax treatment differs from the
accounting treatment.

The amount of tax to which a company is assessed on its profit for an

accounting period is called its tax liability for that period, In general, an
enterprise must pay its tax liability a certain amount of time after the period
end.

2. Current tax is the amount actually payable to the tax authorities in relation
to the trading activities of the enterprise during the period.

Deferred tax is an accounting measure, used to match the tax effects of

transactions with their accounting impact and thereby produce less distorted
results.

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University of London: Financial Reporting 2

3. IAS 12 as requires any unpaid tax in respect of the current or prior periods
to be recognised as a liability.

Conversely, any excess tax paid in respect of current of prior periods over
what is due should be recognised as an asset.

4. Taking this a stage further, IAS 12 also requires recognition as an asset of

the benefit relating to any tax loss that can be carried back to recover
current tax of a previous period. This is acceptable because it is probable
that the benefit will flow to the enterprise and it can be reliably measured.

5. Measurement of current tax liabilities (assets) for the current and prior
periods is very simple. They are measured at the amount expected to be
paid to (recovered from) the tax authorities. The tax rates (and tax laws)
used should be those enacted (or substantively enacted) by the balance sheet
date.

6. Normally, current tax is recognised as income or expense and included in the

net profit or loss for the period, except in two cases.

(a) Tax arising from a business combination which in an acquisition is

treated differently.

(b) Tax arising from a transaction or event which is recognised directly

in equity (in the same or a different period).

The rule in (b) is logical. If a transaction or event is charged or credited

directly to equity, rather than to the income statement, then the related tax
should be having the same treatment. An example of such a situation is
where under IAS 8, an adjustment is made to the opening balance of
retained earnings due to either a change in accounting policy that is applied
retrospectively, or to the correction of a fundamental error.

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University of London: Financial Reporting 3

B. Deferred Tax***
7. When a company recognizes an asset or liability, it expects to recover or
settle the carrying amount of that asset or liability. In other words, it
expects to sell or use up assets, and to pay off liabilities. What happens if
that recovery or settlement is likely to make future tax payments larger (or
smaller) than they would otherwise have been if the recovery or settlement
had no tax consequences? In these circumstances, IAS 12 requires
companies to recognize a deferred tax liability (or deferred tax asset).

8. Deferred tax liabilities are the amounts of income taxes payable in future
periods in respect of taxable temporary differences.

Deferred tax assets are the amounts of income taxes recoverable in future
periods in respect of:

 Deductible temporary differences

 The carry forward of unused tax losses

 The carry forward of unused tax credits

Temporary differences are differences between the carrying amount of an

asset of liability in the balance sheet and its tax base. Temporary differences
may be either:

 Taxable temporary differences, which are temporary differences

that will result in taxable amounts in determining profit (tax loss) of
future periods when the carrying amount of the asset or liability is
recovered or settled.
 Deductible temporary differences, which are temporary differences
that will result in amounts that are deductible in determining taxable
profits (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.

The tax base of an asset or liability is the amount attributed to that asset or
liability for tax purposes.

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University of London: Financial Reporting 4

9. We can expand on the definition given above by stating that the tax base of
an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to the enterprise when it recovers
the carrying value of the asset. Where those economic benefits are not
taxable, the tax base of the asset is the same as its carrying amount.

10. In the case of a liability, the tax base will be its carrying amount, less any
amount that will be deducted for tax purpose in relation to the liability in
future periods. For revenue received in advance, the tax base of the resulting
liability is its carrying amount, less any amount of the revenue that will not
be taxable in future periods.

11. IAS 12 gives the following examples of circumstances in which the carrying
amount of an asset or liability will be equal to its tax base.

 Accrued expenses have already been deducted in determining an

enterprise’s current tax liability for the current or earlier periods.

 A loan payable is measured at the amount originally received and this

amount is the same as the amount repayable on final maturity of the
loan.

 Accrued expenses will never be deductible for tax purposes.

 Accrued income will never be taxable.

12. Accounting profits form the basis for computing taxable profits, on which
the tax liability for the year is calculated; however, accounting profits and
taxable profits are different. There are two reasons for the differences:

(a) Permanent differences. These occur when certain items of revenue

or expense are excluded from the computation of taxable profits (for
example, entertainment expenses may not be allowable for tax
purposes).

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University of London: Financial Reporting 5

(b) Temporary differences. These occur when items of revenue or

expense are included in both accounting profits and taxable profits,
but not for the same accounting period. For example, an expense
which is allowable as a deduction in arriving at taxable profits for
20X7 might not be included in the financial accounts until 20X8 or
later. In the long run, the total taxable profits and total accounting
profits will be the same (except for permanent differences) so that
timing differences originate in one period and are capable of reversal
in one or more subsequent periods. Deferred tax is the tax attributable
to temporary differences.

13. Transactions that affect the income statement:

(a) Interest revenue received in arrears and included in accounting profit

on the basis of time apportionment. It is included in taxable profits,
however, on a cash basis.

(b) Sales of goods revenue is included in accounting profit when the

goods are delivered, but only included in taxable profit when cash is
received.

(c) Depreciation of an asset is accelerated for tax purposes. When new

assets are purchased, allowances may be available against taxable
profits which exceed the amount of depreciation chargeable on the
assets in the financial accounts for the year of purchase.

(d) Development costs which have been capitalized will be amortised in

the income statement, but they were deducted in full from taxable
profit in the period in which they were incurred.

(e) Prepaid expenses have already been deducted on a cash basis in

determining the taxable profit of the current or previous periods.

14. Transactions that affect the balance sheet:

(a) Depreciation of an asset is not deductible for tax purposes. No

deduction will be available for tax purposes when the asset is
sold/scrapped.

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University of London: Financial Reporting 6

(b) A borrower records a loan at proceeds received (amount due at

maturity) less transaction costs. The carrying amount of the loan is
subsequently increased by amortisation of the transaction costs against
accounting profit. The transaction costs were, however, deducted for
tax purposes in the period when the loan was first recognised.

15. Fair value adjustment and revaluations

(a) Financial assets or investment property are carried at fair value.

This exceeds cost, but no equivalent adjustment is made for tax
purposes.

(b) Property, plant and equipment is revalued by an enterprise, but no

equivalent adjustment is made for tax purposes (IAS 12 requires the
related deferred tax to be charged directly to equity)

16. All taxable temporary differences give rise to a deferred tax liability. There
are two circumstances given in the standards where this does not apply:

(a) The deferred tax liability arises from goodwill for which amortisation
is not deductible for tax purposes.

(b) The deferred tax liability arises from the initial recognition of an
asset or liability in a transaction which:

(i) Is not a business combination

(ii)At the time of the transaction affects neither accounting profit
nor taxable profit
The reasoning behind the recognition of deferred tax liabilities on taxable
temporary differences:

(a) When an asset is recognised, it is expected that its carrying amount

will be recovered in the form of economic benefits that flow to the
enterprise in future periods.

(b) If the carrying amount of the asset is greater than its tax base, then
taxable economic benefits will also be greater than the amount that
will be allowed as a deduction for tax purposes.

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University of London: Financial Reporting 7

(c) The difference is therefore a taxable temporary difference and the

obligation to pay the resulting income taxes in future periods is a
deferred tax liability,

(d) As the enterprise recovers the carrying amount of the asset, the
taxable temporary difference will reverse and the enterprise will have
taxable profit.

(e) It is then probable that economic benefits will flow from the
enterprise in the form of tax payments, and so the recognition of all
deferred tax liabilities (except those excluded above) is required by
IAS 12.

17. Some temporary differences are often called timing differences, when
income or expense is included in accounting profit in one period, but is
included in taxable profit in a different period. The main types of taxable
temporary differences which are timing differences and which result in
deferred tax liabilities.

 Interest received which is accounted for on an accruals basis, but

which for tax purposes is included on a cash basis.

 Accelerated depreciation for tax purposes.

 Capitalised and amortised development costs.

18. Under IAS 16 assets may be revalued. If this affects the taxable profits for
the current period, the tax base of the asset changes and no temporary
difference arises.

If, however (as in some countries), the revaluation does not affect current
taxable profits, the tax base of the asset is not adjusted. Consequently, the
taxable flow of economic benefits to the enterprise as the carrying value of
the asset is recovered will differ from the amount that will be deductible for
tax purposes. The difference between the carrying amount of a revalued
asset and its tax base is a temporary difference and gives rise to a deferred
tax liability or asset.

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University of London: Financial Reporting 8

19. A temporary difference can arise on initial recognition of an asset or

liability, e.g. if part or all of the cost of an asset will not be deductible for tax
purposes. The nature of the transaction which led to the initial recognition
of the asset is important in determining the method of accounting for such
temporary differences.

20. If the transaction affects either accounting profit or taxable profit, an

enterprise will recognize any deferred tax liability or asset. The resulting
deferred tax expense or income will be recognised in the income statement.

21. Where a transaction affects neither accounting profit nor taxable profit it
would be normal for an enterprise to recognize a deferred tax liability or
asset and adjust the carrying amount of the asset or liability by the same
amount. However, IAS 12 does not permit this recognition of a deferred tax
asset or liability as it would make the financial statements less transparent.
This will be the case both on initial recognition and subsequently, nor should
any subsequent changes in the unrecognized deferred tax liability or asset is
depreciated be made.

22. There is a proviso, however. The deferred tax asset must also satisfy the
recognition criteria given in IAS 12. This is that a deferred tax asset should
be recognised for all deductible temporary differences to the extent that it is
probable that taxable profit will be available against which it can be
utilized. This is an application of prudence.

23. Transactions that affect the income statement:

 Retirement benefit costs (pension costs) are deducted from

accounting profit as service is provided by the employee. They are not
deducted in determining taxable profit until the enterprise pays either
retirement benefits or contributions to a fund. (This may also apply to
similar expenses).

 Accumulated depreciation of an asset in the financial statements is

greater than the accumulated depreciation allowed for tax purposes up
to the balance sheet date.

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 The cost of inventories sold before the balance sheet date is deducted
from accounting profit when goods/services are delivered, but is
deducted from taxable profit when the cash is received. (Note: There
is also a taxable temporary difference associated with the related trade
receivable).

 The NRV of inventory, or the recoverable amount of an item or

property, plant and equipment falls and the carrying value is therefore
reduced, but that reduction is ignored for tax purposes until the asset
is sold.

 Research costs (or organization/other start-up costs) are recognised as

an expense for accounting purposes but are not deductible against
taxable profits until a later period.

 Income is deferred in the balance sheet, but has already been

included in taxable profit in current/prior periods.

 A government grant is included in the balance sheet as deferred

income, but it will not be taxable in future periods. (Note: A deferred
tax asset may not be recognised here according to the standard).

24. Current investments or financial instruments may be carried at fair value

which is less than cost, but no equivalent adjustment is made for tax
purposes.

Other situations discussed by the standard relate to business combinations

and consolidation.

25. The reasoning behind the recognition of deferred tax assets arising from
deductible temporary differences:

(a) When a liability is recognised, it is assumed that its carrying amount

will be settled in the form of outflows of economic benefits from the
enterprise in future periods.

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University of London: Financial Reporting 10

(b) When these resources flow from the enterprise, part or all may be
deductible in determining taxable profits of a period later than that in
which the liability is recognizes.

(c) A temporary tax difference then exists between the carrying amount
of the liability and its tax base.

(d) A deferred tax asset therefore arises, representing the income taxes
that will be recoverable in future periods when that part of the liability
is allowed as a deduction from taxable profit.

(e) Similarly, when the carrying amount of an asset is less than its tax
base, the difference gives rise to a deferred tax asset in respect of the
income taxes that will be recoverable in future periods.

26. An enterprise may have unused tax losses or credits (i.e. which it can offset
against taxable profits) at the end of a period. Should a deferred tax asset be
recognised in relation to such amounts? IAS 12 states that a deferred tax
asset may be recognised in such circumstances to the extent that it is
probable future taxable profit will be available against which the
unused tax losses/credits can be utilized.

27. For all unrecognized deferred tax assets, at each balance sheet date an
enterprise should reassess the availability of future taxable profits and
whether part or all of any unrecognized deferred tax assets should now be
recognised. This may be due to an improvement in trading conditions which
is expected to continue.

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C. Measurement and Recognition of Deferred Tax****

28. There are various methods of accounting for deferred tax, only one of which
is adopted by IAS 12:

 Flow-through method

 Full provision method (as under IAS 12)

 Partial provision method (as adopted in some countries, e.g. the UK)

29. Under the flow-through method, the tax liability recognised is the expected
legal tax liability for the period (i.e. no provision is made for deferred tax).

The main advantages of the method are that it is straightforward to apply

and the tax liability recognised is closer to many people’s idea of a ‘real’
liability than that recognised under either full or partial provision.

The main disadvantages of flow-through are that it can lead to a large

fluctuation in the tax charge and that it does not allow tax relief for non-
current liabilities to be recognised until those liabilities are settled. In
addition, profits may be overstated because there is no deferred tax charge
leading to excessive dividend payments, distortion of earnings per share and
of results in the eyes of shareholders.

30. The full provision method has the advantage that it recognises that each
timing difference at the balance sheet date has an effect on future tax
payments. If a company claims an accelerated tax allowance on an item of
plant, future tax assessments will be bigger than they would have been
otherwise. Future transactions may well affect those assessments still
further, but that is not relevant in assessing the position at the balance sheet
date.

The disadvantage of full provision is that, under certain types of tax

system, it gives rise to large liabilities that may fall due only far in the
future, if at all. Furthermore, it may be said to be less realistic than the
partial provision method, if more objective.

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31. The partial provision method addresses this disadvantage by providing for
deferred tax only to the extent that it is expected to be paid in the foreseeable
future. This has an obvious intuitive appeal, but its effect is that deferred tax
recognised at the balance sheet date includes the tax effects of future
transactions that have not been recognised in the financial statements, and
which the reporting company has neither undertaken nor even committed to
undertake at that date. It is difficult to reconcile this with the IASC’s
Framework document, which defines assets and liabilities as arising from
past events. Where partial provision is required, the difference between the
amount provided and the maximum (i.e. under the full provision method)
should usually be disclosed.

Illustration:

Suppose that Benson Co begins trading on 1 January 20x7. In its first year it
makes profits of $5m, the depreciation charge is $1m and the tax allowance
on those assets is $1.5m. The rate of corporation tax is 30%.

Solution: Flow Through Method

The tax liability for the year is 30% x $(5 + 1 – 1.5)m = $1.35m. The
potential deferred tax liability of 30% x ($1.5m - $1m) is completely ignored
and no judgement is required on the part of the preparer.

Solution: Full Provision

The tax liability is $1.35m again, but the debit in the income statement is
increased by the deferred tax liability of 30% x $0.5m = $150,000. The total
charge to the income statement is therefore $1.5m which is an effective tax
rate of 30% on accounting profits (i.e. 30% x $5m). Again, no judgement is
involved in using this method.

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University of London: Financial Reporting 13

Solution: Partial Provision

Is a deferred tax provision necessary under partial provision? We need to

look ahead at future capital expenditure plans. Will tax allowances exceed
depreciation over the next few years? If yes, no provision for deferred tax is
required. If no, then a reversal is expected, i.e. there will be a year in which
depreciation is greater than tax allowances. The deferred tax provision is
made on the maximum reversal which will be created, and any not provided
is disclosed by note.

If we assume that the review of expected future capital expenditure under

the partial method required a deferred tax charge of $75,000 (30% x
$250,000), we can then summarise the position.

The method can be compared as follows:

Method Provision Disclosure

$ $
Flow-through -- --
Full provision 150,000 --
Partial provision 75,000 75,000

32. Where the corporate rate of income tax fluctuates from one year to
another, a problem arises in respect of the amount of deferred tax to be
credited (debited) to the income statement in later years. The amount could
be calculated using either of two methods.

(a) The deferral method assumes that the deferred tax account is an item
of ‘deferred tax relief’ which is credited to profits in the years in
which the timing differences are reversed. Therefore the tax effects of
timing differences are calculated using tax rates current when the
differences arise.

(b) The liability method assumes that the tax effects of timing
differences should be regarded as amounts of tax ultimately due by or
to the company. Therefore deferred tax provisions are calculated at
the rate at which it is estimated that tax will be paid (or recovered)
when the timing differences reverse.

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University of London: Financial Reporting 14

33. The deferral method involves extensive record keeping because the timing
differences on each individual capital asset must be held. In contrast, under
the liability method, the total originating or reversing timing difference for
the year is converted into a deferred tax amount at the current rate of tax
(and if any change in the rate of tax has occurred in the year, only a single
adjustment to the opening balance on the deferred tax account is required).

34. IAS 12 requires deferred tax assets and liabilities to be measured at the tax
rates expected to apply in the period when the asset is realized or liability
settled, based on tax rates and laws enacted (or substantively enacted) at the
balance sheet date. In other words, IAS 12 requires the liability method to
be used.

35. IAS 12 states that deferred tax assets and liabilities should not be
discounted because of the complexities and difficulties involved.

The carrying amount of deferred tax assets should be reviewed at each

balance sheet date and reduced where appropriate (insufficient future
taxable profits). Such a reduction may be reversed in future years.

36. As with current tax, deferred tax should normally be recognised as income
or an expense and included in the net profit or loss for the period in the
income statement. The exception is where the tax arises from a transaction
or event which is recognised (in the same or different period) directly in
equity.

37. The figures shown for deferred tax in the income statement will consist of
two components.

(a) Deferred tax relating to timing differences

(b) Adjustments relating to changes in the carrying amount of deferred

tax assets/liabilities (where there is no change in timing differences)
e.g. changes in tax rates/laws, reassessment of the recoverability of
deferred tax assets, or a change in the expected recovery of an asset.

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University of London: Financial Reporting 15

Items in (b) will be recognised in the income statement, unless they relate to
items previously charged/credited to equity.

38. Deferred tax (and current tax) should be charged/credited directly to

equity if the tax relates to items also charged/credited directly to equity (in
the same or a different period).

Examples of IASs which allow certain items to be credited/charged directly

to equity include:

(a) Revaluations of property, plant and equipment (IAS 16)

(b) The effect of a change in accounting policy (applied retrospectively)

or correction of a fundamental error (IAS 8).

D. Presentation and Disclosure Requirement

39. Tax assets and liabilities should be presented separately from other assets
and liabilities in the balance sheet. Deferred tax assets and liabilities should
be distinguished from current tax assets and liabilities.

In addition, deferred tax assets/liabilities should not be classified as current

assets/liabilities, where an enterprise makes such a distinction.

There are only limited circumstances where current tax assets and liabilities
may be offset. This should only occur of two things apply:

(a) The enterprise has a legally enforceable right to set off the recognised
amounts.

(b) The enterprise intends either to settle on a net basis, or to realize the
asset and settle the liability simultaneously.

Similar criteria apply to the offset of deferred tax assets and liabilities.

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University of London: Financial Reporting 16

40. The tax expense or income related to the profit or loss from ordinary
activities should be presented on the face of the income statement.

41. As you would expect, the major components of tax expense or income
should be disclosed separately. These will generally include the following:

 Current tax expenses (income)

 Any adjustments recognised in the period for current tax of prior

periods (i.e. for over/under statement in prior years)

 Amount of deferred tax expense (income) relating to the origination

and reversal of temporary differences

 Amount of the benefit arising from a previously unrecognized tax

loss, tax credit or temporary difference of a prior period that is used to
reduce current tax expense
 Deferred tax expense arising from the write-down, or reversal of a
previous write-down, of a deferred tax asset

 Amount of tax expense (income) relating to those changes in

accounting policies and fundamental errors which are included in
the determination of net profit or loss for the period in accordance
with the allowed alternative treatment in IAS 8.

 Aggregate current and deferred tax relating to items that are charges
or credited to equity

 Tax expense (income) relating to extraordinary items recognised

during the period

 An explanation of the relationship between tax expenses (income)

and accounting profit in either or both of the following forms.

A numerical reconciliation between tax expense (income) and the

product of accounting profit multiplied by the applicable tax rate(s),
disclosing also the basis on which the applicable tax rate(s) is (are)
computed, or

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A numerical reconciliation between the average effective tax rate and

the applicable tax rate, disclosing also the basis on which the
applicable tax rate is computed

 An explanation of changes in the applicable tax rate(s) compared to

the previous accounting period

 The amount (and expiry date, if any) of deductible temporary

differences, unused tax losses, and unused tax credits for which no
deferred tax is recognised in the balance sheet.

 In respect of each type of temporary difference, and in respect of

each type of unused tax loss and unused tax credit:

 The amount of the deferred tax assets and liabilities recognised

in the balance sheet for each period presented

 The amount of the deferred tax income or expense recognised

in the income statement, if this is not apparent from the changes
in the amounts recognised in the balance sheet

 In respect of discontinued operations, the tax expense relating to

 The gain or loss on discontinuance

 The profit or loss from the ordinary activities of the

discontinued operation for the period, together with the
corresponding amounts for each prior period presented

42. In addition to the above, an enterprise should disclose the amount of a

deferred tax asset and the nature of the evidence supporting its recognition,
when:

(a) The utilization of the deferred tax asset is dependent on future taxable
profits in excess of the profits arising from the reversal of existing
taxable temporary differences,

(b) The enterprise has suffered a loss in either the current or preceding
period in the tax jurisdiction to which the deferred tax asset relates.

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E. Exercises

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