Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 19-1 Chapter 19 Accounting for income taxes

. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 19-1

Chapter 19

Accounting for income taxes


Objectives of this lecture• Understand that there is typically a difference between an

organisation’s profit or loss for accounting purposes, and its profit or loss for taxation purposes

• Be able to identify some of the factors that will cause a difference between profit or loss for accounting purposes and profit or loss for taxation purposes

• Understand how deferred tax assets and deferred tax liabilities arise

• 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


Introduction to accounting for income taxesTaxable profit• Profit for taxation purposes is known as taxable profit• Determined in accordance with Australian income tax

legislation, not according to general accounting rules• There are 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 (shown in the statement

of comprehensive income) calculated after applying relevant accounting standards

• Income tax payable to tax office (statement of financial position) based on taxable profit derived by the entity applying the rules of taxation law

• Worked Example 19.1 (p. 615) shows the difference between taxable profit and accounting profit


Some differences between accounting and tax rules

Item Generally accepted accounting rule

Tax rule

Many accrued expenses (e.g. long-service leave, warranty costs)

An expense when accrued Recognised as a tax deduction when paid

Many prepaid expenses (e.g. prepaid rent)

Initially an asset—expensed when economic benefits used

Typically a tax deduction when paid

Revenue received in advance (e.g. rental revenue)

Treated as a liability and recognised as revenue when earned

Typically taxed when received

Entertainment and goodwill impairment

Treated as an expense Not a tax deduction in current or subsequent periods

Doubtful debts Treated as an expense when recognised

Treated as a tax deduction when debtor is actually written off in subsequent period

Development expenditure Often capitalised and subsequently amortised

Typically a tax deduction when paid for


Worked Example 19.1—Calculating taxable profit and accounting profit

You are provided with the following information from the accounts of Big Kahuna Ltd for the year ending 30 June 2012. You are to calculate accounting profit and taxable profit

•Cash sales $100 000•Cost of goods sold $40 000•Amounts received in advance for services to be performed in August 2012 $5 000•Rent expense for year ended 30 June 2012 $10 000•Rent prepaid for two months to 31 August 2012 $1 000•Doubtful debts expenses $1 000•Amount provided in 2012 for employees’ long-service leave entitlements $3 000

Accounting Taxableprofit profit

Cash sales $100 000 $100 000Cost of goods sold ($40 000) (40 000)Amounts received in advance by Big Kahuna Ltd for services to be performed in August 2012 – $5 000Rent expense for year ended 30 June 2012 ($10 000) ($10 000)Rent prepaid for two months to 31 August 2012 _ ($1 000)Doubtful debts costs ($1 000) –Amount provided in 2012 for employees’ long-service leave entitlements ($3 000) –

$46 000 $54 000


Balance sheet approach to accounting for taxation

Accounting for income taxes• Governed by AASB 112• Applies the ‘balance sheet’ method—this means the recognition

of tax-related assets and liabilities in the balance sheet (statement of financial position) is 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 the balance sheet that would be derived from taxation rules


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 (statement of financial position) 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



Temporary differences can be of two types

1. A taxable 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

2. 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



• 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



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



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



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



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


Balance sheet approach to accounting for taxation (cont.)Income tax payable• The amount of tax generally expected to be paid to

the tax office, 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



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

• Calculation of income tax payable

– Tax rate multiplied by tax profit

Refer to Worked Example 19.2 on pp. 616–19—Temporary differences caused by the depreciation of a non-current asset


Worked Example 19.2—Temporary differences caused by the depreciation of a non-current asset

• Robert August Ltd commences operations on 1 July 2009 • On the same date, it purchases a fibreglassing machine at a

cost of $600 000 • The machine is expected to have a useful life of four years, with

benefits being uniform throughout its life. It will have no residual value at the end of four years

• Hence, for accounting purposes the depreciation expense would be $150 000 per year

• For taxation purposes, the ATO allows the company to depreciate the asset over three years—that is $200 000 per year

• The profit before tax of the company for each of the next four years (for years ending 30 June) is $500 000, $600 000, $700 000 and $800 000 respectively

• The tax rate is 30%


Worked Example 19.2—Solution

Year 1 (ending 30 June 2010)

Carrying Temporary

value Tax base difference

($) ($) ($)

Fibreglassing machine: cost 600 000 600 000

Accumulated depreciation 150 000 200 000

450 000 400 000 50 000


Worked Example 19.2—Solution (cont.)

Accounting profit before tax $500 000

Add back accounting depreciation $150 000

Subtract depreciation for taxation purposes ($200 000)

Taxable profit $450 000

Tax at 30% $135 000

The journal entries at 30 June 2010 would be:

Dr Income tax expense 15 000

Cr Deferred tax liability 15 000


Cr Income tax payable 135 000




Carrying Temporary


($) ($) ($)



300 000 200 000 100 000

The temporary difference at 30 June 2011 totals $100 000. Applying the tax rate of 30% provides a deferred tax liability of $30 000. Because $15 000 has already been recognised in 2010, an increase (or ‘top up’) of $15 000 is required



Accounting profit before tax $600 000

Add back accounting depreciation $150 000

Subtract depreciation for taxation purposes ($200 000)

Taxable profit $550 000

Tax at 30% $165 000

The journal entries at 30 June 2011 would be:


Cr Deferred tax liability 15 000


Cr Income tax payable 165 000




Carrying Temporary


($) ($) ($)



150 000 0 150 000

The temporary difference at 30 June 2012 is $150 000. Applying the tax rate of 30% provides a deferred tax liability of $45 000. Because $30 000 has already been recognised in 2010 and 2011, an increase of $15 000 is required


Worked Example 19.2—Solution (cont.)The tax on the taxable income would be determined as follows:Accounting profit before tax $700 000Add back accounting depreciation $150 000Subtract depreciation for taxation purposes ($200 000)Taxable profit $650 000Tax at 30% $195 000

The journal entries at 30 June 2012 would be:Dr Income tax expense 15 000Cr Deferred tax liability 15 000

Dr Income tax expense 195 000Cr Income tax payable 195 000




Carrying Temporary


($) ($) ($)



0 0 0

The temporary difference at 30 June 2013 is $nil, which means that there should be no deferred tax liability or deferred tax asset recorded in relation to this asset. This means the balance accrued in the deferred tax liability must be reversed in 2013


Worked Example 19.2—Solution (cont.)The tax on the taxable income would be determined as follows:Accounting profit before tax $800 000Add back accounting depreciation $150 000Subtract depreciation for taxation purposes 0Taxable profit $950 000Tax at 30% $285 000

The journal entries at 30 June 2013 would be:Dr Deferred tax liability 45 000Cr Income tax expense

45 000

Dr Income tax expense 285 000Cr Income tax payable

285 000



A review of Worked Example 19.2 indicates that the balance sheet approach to accounting for income tax ‘smooths’ the tax expenses across the four years, as indicated below:

Year 1 Year 2 Year 3 Year 4 Total

($) ($) ($) ($) ($)

Tax expense based on taxable profit 135 000 165 000 195 000 285 000 780 000

Adjustment for ‘temporary’ difference 15 000 15 000 15 000 (45 000) –

Total taxation expense 150 000 180 000 210 000 240 000 780 000



Overview of journal entries• Journal entry if temporary differences result in

deferred tax asset– To recognise tax expense that relates to the temporary

differenceDr Deferred tax asset (temp. difference x tax rate)

Cr Tax expense

– To recognise tax expense that relates to the entity’s taxable profitDr Taxation expense

Cr Income tax payable



• 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



Reversal in future periods• In future periods, timing differences will reverse

– Deferred tax asset will be credited

– Deferred tax liability will be debited


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 the carrying amount of an asset exceeds the tax base there is a deferred tax liability

• If the carrying amount of the asset is less than the tax base there will be a deferred tax asset


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 19.3 on p. 620—Determining the tax base of assets


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


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 19.4 on pp. 669—Determining the tax base of liabilities


Deferred tax assets and deferred tax liabilities • Assets

– Deferred tax liability arises when: carrying amount > tax base

– Deferred tax asset arises when: carrying amount < tax base

• Liabilities– Deferred tax liability arises when:

carrying amount < tax base

– Deferred tax asset arises when: carrying amount > tax base


Deferred tax assets and deferred tax liabilities (cont.)Summary• Carrying amount of assets or liabilities—tax bases of assets

or liabilities = taxable or deductible temporary differences• Taxable 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 19.5 on p. 623—Temporary differences and the recognition of a deferred tax liability

Refer to Worked Example 19.6 on p. 624—A deductible temporary difference resulting in a deferred tax asset


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


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– For example, if we make a tax loss of $300 000 this year,

but next year we make a taxable profit of $300 000 then we will be able to carry forward the loss and not have to pay tax in the next year. The prior loss has created an economic benefit in the form of tax that has been saved

• 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 as assets


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 19.7 on p. 625, which illustrates the utilisation of unused tax losses


Worked Example 19.7—Utilisation of unused tax losses• Grommit Ltd commenced operations in 2012 • In the year ending 30 June 2012 it incurred a loss of $1 million • It is expected that the company will not incur losses again and will

generate taxable profit in subsequent years• The profits before tax in the following years are as follows:

Year Profit before tax2013 $300 0002014 $400 0002015 $600 000

• It is assumed that there are no temporary differences between the carrying values of Grommit Ltd’s assets and liabilities and the respective tax bases

• The tax rate is 30%

REQUIREDProvide the journal entries to show the recognition of the asset associated with the tax loss, as well as the journal entries to recognise the use of the loss


Worked Example 19.7—Solution2012Accepting that it is probable that the entity will be able to recoup the benefits associated with the tax loss, the entry in 2012 would be:

Dr Deferred tax asset 300 000Cr Income tax revenue 300 000

2013In 2013 the entity generates a profit of $300 000. In the absence of a tax loss, $90 000 would be payable. We still recognise tax expense, but rather than crediting income tax payable, we credit the deferred tax asset. This will reduce the balance of the deferred tax asset account to $210 000, and no amount will be payable to the ATO

Dr Income tax expense 90 000Cr Deferred tax asset 90 000


Worked Example 19.7—Solution (cont.)2014In 2014 the entity generates a profit of $400 000. In the absence of a tax loss, $120 000 would be payable. As noted above, we still recognise tax expense, but rather than crediting income tax payable, we credit the deferred tax asset. This will reduce the balance of the deferred tax asset account to $90 000.

Dr Income tax expense 120 000Cr Deferred tax asset 120 000

2015In 2015 the entity generates a profit of $600 000. In the absence of a tax loss, $180 000 would be payable. We can use the balance of the previously unused tax loss ($90 000) and the remaining amount will then be treated as income tax payable—a current liability

Dr Income tax expense 180 000Cr Deferred tax asset 90 000Cr Income tax payable 90 000


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


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)


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


Revaluation of non-current assets (cont.)• As the revaluation is adjusted against equity

(revaluation surplus account), the accounting entry to record the recognition of the deferred tax liability is

Dr Revaluation surplus

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 surplus account

• Entry assumes that the revalued amount of the asset will be recovered by the entity’s continued use of the asset


Revaluation of non-current assets (cont.)

As an example, assume the following:• Tax Ltd acquired land two years ago for $450 000• Its fair value is now $600 000• The tax rate is 30%

The entries to recognise a revaluation would be:Dr Land 150 000Cr Revaluation surplus 150 000

Dr Revaluation surplus 45 000Cr Deferred tax liability 45 000


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 the entity operates in a country with capital gains tax indexation

– 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 Examples 19.8 and 19.9 on pp. 629–631—Accounting for a revaluation


Change of tax rates• Tax rates will change across time• Will have implications for value to be attributed to pre-existing

deferred tax assets and deferred tax liabilities• An increase in tax rates will create an expense (which will be of

the nature of income tax expense) when an entity has deferred tax liabilities, and will create income in the presence of deferred tax assets

• Conversely, a decrease in tax rates will create income when an entity has deferred tax liabilities, whereas a decrease will create an expense in the presence of deferred tax assets

Consider Worked Examples 19.11—Change in tax rates—and 19.12—Impact of changing tax rates (pp. 634–35)


Worked Example 19.12—Impact of changing tax rates

Taxi Ltd has the following deferred tax balances as at 30 June 2012:

Deferred tax asset $500 000

Deferred tax liability $300 000

The above balances were calculated when the tax rate was 30%. On 1 August 2012 the government reduced the corporate tax rate to 25%.

REQUIRED

Provide the journal entries to adjust the carry-forward balances of the deferred tax asset and deferred tax liability


Worked Example 19.2—SolutionBalance at Balance at Change

30 June 2012 1 August 2012Deferred tax asset $500 000 $500 000 × 25/30 = $416 667 ($83 333)

Deferred tax liability $300 000 $300 000 × 25/30 = $250 000 ($50 000)

The accounting entry at 1 August 2012 would be:

Dr Deferred tax liability 50 000


Cr Deferred tax asset 83 333


Evaluation of the assets and liabilities created by AASB 112Deferred tax assets vs the AASB ‘Framework for the Preparation and Presentation of Financial Statements’

– Deferred tax asset might not meet AASB Framework definition of asset—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 reporting 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


Evaluation of the assets and liabilities created by AASB 112 (cont.)

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


Summary• Main purpose of the lecture 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


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

Documents

Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 19-1 Chapter 19 Accounting for income taxes