ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

Nature of Taxation: Taxation has certain characteristics that set it apart from other expenses moreover, it sets a different treatment, in particular, a. Tax payments are not made in exchange for goods or services specific to the business b. The business has no say in whether or not the payments are to be made In essence, the government is a stakeholder in the success of any business within its territory that is why it takes taxes as a participation o the results of the business operations. Technically, it is the stakeholder given first the priority. Thus, a tax in substance is not an expense but a distribution of wealth. Although it is viewed this way, accounting for taxes does not take this Accounting for income tax is accounting for it as an expense. distribution view .

Deferred Taxation is the reconciliation mechanism adapted by International Financial reporting standards and FASB to recognize the tax effects of transaction between periods. Philippine Setting Accounting for income tax is governed by PAS 12. Deferred tax accounting is applicable to All ENTERPRISE- whether public or non public. a. Public enterprises whose debt and equity securities are traded in a public market, including those traded on a stock exchange or in the over-the-counter market whose debt and equity securities are registered with SEC in preparation for sale of the securities. b. Non-public enterprises whose liabilities are more than P50 million. For less than P50 million, they are encouraged to apply SFAS 23. c. Non-public enterprises regardless of the amount of its liabilities if it follows different policies for financial and tax purposes.

OBJECTIVES: a. to recognize the amount of taxes payable or refundable for the current year. (INTERPERIOD TAX ALLOCATION) b. to recognize deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in an enterprise financial statements or tax returns. (INTERPERIOD TAX ALLOCATION) c. to allocate the income tax expense or benefit for the year among the various components of income or losses. (INTRAPERIOD TAX ALLOCATION)

Page | 1

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

DIFFERENCE BETWEEN TAXABLE AND FINANCIAL INCOME Accounting Income- is the net income for the period before deducting income tax expense. Is the Income appearing in the traditional income statement. Taxable Income income for the period determined according to the rules st by taxing authorities. Is the income appearing in the income tax return. Notable differences a. Revenues and expense which affect financial income in one period and taxable income in another period. b. Adjustments to taxable income carried forward (3 years). c. Prior-period adjustments. TYPES OF DIFFERENCES: a. Permanent differences items of revenue which are included in either accounting income or taxable income but will never be included in the other. - Pertains to non taxable income and non deductible expenses - Do not give rise to deferred taxes Examples: a. Interest Income on deposits that are subject to final tax b. dividends received c. Life insurance premiums when the company is the beneficiary of life insurance policy of an officer or employees. d. the proceeds received from c e. tax penalties, surcharges and fines are not deductible. Examples of nontaxable or tax-exempt revenues are: gain from settlement life insurance of officers and employees where the corporation is the named beneficiary, dividends received by a domestic corporation or non-resident corporation from a domestic corporation, and interest on government securities (municipal bonds, treasury bills) and deposits. Examples of non-deductible expenses are: fines and penalties for violation of law, charitable contributions in excess of tax limitation, premiums on life insurance for officers and employees, and amortization of goodwill.

b. Temporary or Timing differences Timing Differences - Represent items of income or expenditure which are taxable or tax deductible , but in periods different from those in which they are dealt with in the financial statements. They therefore arise when items of income and expenditure enter into measurement of profit for both accounting and taxation purposes, but in different accounting periods. They are said to ORIGANATE in the first of these periods and REVERSES in one or more subsequent periods. ( FOCUS ON INCOME STATEMENT) Temporary Difference- is the difference between the carrying amount of an asset or liability and its tax base.

Page | 2

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

According to VALIX ( 2009), temporary difference encompasses timing differences. Temporary difference 1. TAXABLE TEMPORARY DIFFERENCE 2. DEDUCTIBLE TEMPORARY DIFFERENCE results in FUTURE TAXABLE AMOUNT results in FUTURE DEDUCTIBLE AMOUNT

DEFERRED TAX LIABILITY Is the amount of income taxes payable in the future periods in respect of taxable temporary differences It generally arises from a. AHT- Accounting income is higher than the taxable income b. AHT- Accounting base( carrying amount) is greater that the Tax base c. Accounting Base ( carrying amount) of liability is lower than the Tax base

Note: Tax base of an asset or liability is the amount attributable to the asset or liability for tax purposes 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 entity when it recovers the carrying amount of the asset. E.g. an entity may have a receivable of P 5,000 nevertheless this is NIL for tax purposes because it is viewed by taxing authorities as nothing until collected. Tax base of a liability - is its carrying amount, less any amount that will be deductible for tax purposes in respect of liability in the future periods. FORMAT: Financial income per book(based on GAAP appearing on FS) Add(deduct): Permanent differences: Non deductible expenses (Nontaxable or tax exempt revenues) Financial income subject to income tax Add (deduct): Temporary differences: (2) Deductible temporary differences a. b. c. d. e. (3)

Bad debts Estimated expenses Recognition of impairment Organizational costs Retirement benefits

Page | 3

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

f. Unrealized losses g. Excess of financial over tax depreciation h. Cash received in advance

Taxable temporary differences

(4)

a. those because they result to having higher accounting income than taxable one - Revenues and gains included in accounting income of the current period but are taxable in future periods. A. Cost recovery method for tax and percentage of completion for financial B. Unrealized gains C. Installment Sales Expenses and loses are deductible for tax purposes in the current period but deductible for accounting purposes in the future period. Examples are a. Prepayments - deducted already on tax because cash basis b. Excess of tax over financial depreciation. -Depicted when accelerated depreciation for tax purposes and straight line for accounting. Be reminded: Accelerated depreciation results to higher depreciation in the first years. c. Development costs have been capitalized and will be amortized to the income statement but were to be deducted in full in determining the taxable income for the current period. -above mentioned are al timing differences Other taxable temporary difference (a) subsidiaries, associates or joint ventures that have not distributed all its profits to the parent or the investor; (b) assets which are accounted revaluation, without making a similar adjustment for tax purposes, and (c) the cost of a business combination will be distributed among the identifiable assets acquired and liabilities assumed identifiable, based on their fair values but without an equivalent adjustment for tax purposes.

Taxable income

(based on applicable tax laws appearing on income tax returns)

Recognition of Deferred Tax Liability is not recognized when the taxable temporary difference arises from: 1. Goodwill resulting from a business combination and which is non deductible for tax purposes. Exemption: If the goodwill does not arise from initial recognition and if the goodwill is tax deductible for tax purposes in some jurisdiction. 2. Initial recognition of an asset or liability in a transaction that is not a business combination and affects neither the accounting income nor taxable income. 3. The company must recognize a deferred tax liability in all cases of taxable temporary differences associated with investments in subsidiaries, branches and associated companies, or in joint ventures, except it's making together the following two conditions: (a) the dominant investor is able to control the timing of the reversal of temporary difference and Page | 4 (b) it is probable that the temporary difference not reverse in the foreseeable future.

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

(1)

(2) (3)

(4)

Revenues and expenses which are included either in financial income or taxable income but will never be included in the other. They do not give rise to deferred tax asset and liability because of no future tax consequences. Revenues and expenses which are included both in financial income or taxable income but at different time periods. Taxable income > Financial income. These are future deductible amounts. These result in DEFERRED TAX ASSETS which are attributable to deductible temporary differences and operating loss carryforward. Financial income > Taxable income. These are future taxable amounts. These result in DEFERRED TAX LIABILITIES which are attributable to taxable temporary differences.

IMPORTANT Recognition of deferred tax liability is recognized for ALL taxable temporary differences. Nevertheless, exemption to the rule applies when the taxable temporary differences arise out of the following: According to IAS 12 (a) The non-monetary assets and liabilities of an entity that is valued in its functional currency but the taxable gain or loss (and therefore the tax base of these non-monetary assets and liabilities) is determined in a different currency; (b) The non-monetary assets and liabilities of the company are restated to follow the provisions of IAS 29, financial reporting in hyperinflationary economies, or (c) The carrying amount of an asset or liability is different, at the time of his initial recognition of its tax base accordingly.

According to VALIX ( 2009), 1. GOODWILL resulting from business combinations which is NOT DEDUCTIBLE FOR TAX 2. INITIAL RECOGNITION OF AN ASSET OR LIABILITY in a transaction not a business combination and affects neither accounting nor taxable income. 3. Undistributed profit of Subsidiary, associate or Joint Venture when a. the parent or investor is able to control the timing of the reversal of the temporary difference b. It is probable that the temporary difference will not reverse in the foreseeable future. JOURNAL ENTRIES (INTERPERIOD ALLOCATION): a. Income tax expense (current tax expense) Income tax payable (Taxable income x Income tax rate) xx xx

Page | 5

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

b. Income tax expense xx Deferred tax liability xx (Taxable temporary difference x Income tax rate) c. Deferred tax asset xx Income tax benefit (offset to current tax expense) xx (Deductible temporary difference x Income tax rate) d. Income tax expense xx Allowance to reduce deferred tax asset to expected realizable value xx (Percentage of doubtful x Deferred tax asset) When computing deferred taxes, use the tax rate that will be in effect when the temporary difference reverses itself. Income tax expense (benefit): Current tax expense (benefit) xx OR Financial income Income subject to tax x tax rate

Deferred income tax expense (benefit) (xx) Total xx

Income tax rates for domestic corporations and resident foreign corporations: Prior to 1998 1998 1999 2000 and thereafter PRESENTATION: Income tax expense is shown in the income statement as a deduction from income before income taxes as presented below: Income before income taxes Income tax expense: Current Deferred (Benefit) Net income TERMS: a. Income tax (benefit) is the sum of current tax expense (benefit) and deferred tax expense (benefit). b. Current tax expense (benefit) is the amount of income taxes paid or payable (or refundable) for a year determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year. c. Deferred tax expense (benefit) is the change during the year in an enterprise s deferred tax liabilities and assets. d. Tax consequences are the effects on income taxes current or deferred of an event. e. Deferred tax consequences are future effects on income taxes as measured by the applicable enacted tax rates and provisions of the enacted tax law resulting from temporary differences and operating loss carryforward at the end of the current year. xx xx xx 35% 34% 33% 32%

xx xx

Page | 6

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

f.

Operating loss carryforward is the excess of tax deductions over gross income in a year that may be carried forward to reduce taxable income in a future year. Accordingly, the expected future tax benefit of an operating loss carryforward is recognized as a DEFERRED TAX ASSET. Certain enterprises registered with the Board of Investments (BOI) are permitted to carryover net operating losses for tax purposes subject to limitations of the relevant law and implementing regulations of the BOI. g. Taxable income is the excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the BIR. h. Valuation allowance is the portion of a deferred tax asset for which it is more likely than not (more than 50%) that a tax benefit will not be realized.

According to IAS 12, An enterprise should offset the tax assets and tax liabilities if, and only if, the entity: (a) Have a legally recognized right to offset against the tax authority the amounts recognized in these items, and (b) Intends to liquidate the debts resulting net, or perform simultaneously liquidate assets and debts that has compensated for them. According to Valix (2010) it was mentioned in PAS 12 that a deferred tax liability and asset can be compensated with each other if; a. The deferred tax asset and deferred tax liability relate to income taxes levied by the same tax authority. b. The entity has a legal enforceable right to set off a current tax asset against a current tax liability.

Page | 7

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

REVIEW QUESTIONS Accounting for income tax Problem 1. Venus Company had no prior deferred tax balances. The worksheet for calculating current and deferred taxes for 2011 is as follows: 2011 1,400 (800) 400 1,000 30% 105 140 2012 2013

Pretax Financial Income Temporary Differences: Depreciation Warranty Costs Taxable Income Enacted Rate Deferred tax asset Deferred tax expense

(1200) (100) 30%

2000 (300) 25%

1. What is the current tax expense? a. 420 b. 350 2. What is the deferred tax expense? a. 350 b. 300 Answer Key: 1. C.

c. 300

d. 0

c. 120

d. 35

(30% x 1,000) 300 2. D. Deferred tax liability Deferred tax ASSET Deferred expense

140 105 35

On January 1, 2008, Easy Company Acquired an equipment for P 8,000,000. The equipment is depreciated using straight line method based on a useful life of 8 years with no residual value. On January 1, 2011, after 3 years, the equipment was revalued at a replacement cost of P 12,000,000 with no change in the useful life. The pre tax accounting income before depreciation for 2011 is P 10,000,000. The income tax rate is 30% and there are no other temporary differences at the beginning of the year. 1. What is the revaluation surplus? 1,750,000 2. What is the deferred tax liability on January 1, 2011 arising from the revaluation? a. 1,200,000 b. 450,000 c. 750,000 d. 0 3. What is the current tax expense for 2011? a. 2,700,000 b. 3,000,000 c. 3,450,000 d. 3,300,000 4. What is the deferred tax liability on December 31, 2011 arising from revaluation?

Page | 8

ACCOUNTING FOR INCOME TAX

JOHN ALLEN MARILLA COMPILED

a. 750,000

b. 450,000

c. 600,000

d. 0

5.What amount should surplus on December 31, 2011? c. 1,400,000 d. 2,000,000 a. 2,500,000 b. 1,750,000 6. What amount should be reported as total income tax expense for 2011? a. 2.550,000 b. 3,000,000 c. 2,700,000 d. 2,000,000 Theories 1. Deferred income tax does not need to be recorded when: (a) temporary differences will reverse within 5 years. (b) the company does not know when the temporary difference will reverse. (c) the future repayment of taxes is sufficiently far off that the present value of the payment approaches zero. (d) accelerated depreciation is used for both financial reporting and tax purposes. 2. A temporary difference which would result in a deferred tax asset is: (a) tax, penalty or surcharge (b) dividend received on stock investment (c) excess tax depreciation over financial depreciation (d) rent received in advance included in taxable income at the time of receipt but deferred for financial accounting purposes 3. A temporary difference which would result in a deferred tax liability is: (a) interest revenue on municipal bonds. (b) accrual of warranty expense. (c) excess of tax depreciation which over financial depreciation. (d) subscription received in advance. 4. The amount of income tax applicable to transactions that are not reported in the continuing operations section of the income statement is computed: (a) by multiplying the item by the effective income tax rate. (b) as the difference between the tax computed based on taxable income without including the item and the tax computed based on taxable income including the item. (c) as the difference between the tax computed on the item based on the amount used for financial reporting and the amount used in computing taxable income. by multiplying the item by the difference between the effective income tax rate and the statutory income tax rate.

Page | 9