1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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)
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26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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