Financial Reporting

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Deferred Tax - the Complications

The purpose of financial statements is to provide the users of them with information which is both relevant and reliable in order that the users can make reasoned decisions from them.

Students studying financial reporting papers will often come across the concept of deferred tax and undeniably it is a subject which often causes quite a lot of confusion, particularly at the advanced stages of financial reporting studies.

This article takes a look at the subject of deferred tax in order to aid students during their revision phase.

The statement of comprehensive income arrives at a reporting entity’s ‘accounting’ profit but this profit is rarely the same profit used for the purposes of tax.

Accounting profit is an entity’s profit or loss for a reporting period before tax.

Taxable profit or (loss) is the profit or loss for the reporting period determined by reference to tax principles upon which tax is payable or receivable thereon.

Students must understand that the primary intention of deferred tax is to present the estimated actual taxes to be payable in current and future periods as the income tax liability on the statement of financial position.  Deferred tax liabilities are the amount of income taxes that are payable in future periods because of taxable temporary differences.  Deferred tax is not paid to the tax authorities like (say) corporation tax liabilities are.

Taxable temporary differences are temporary differences that result in taxable amounts in determining taxable profit of future periods when the carrying amount of the asset or liability is recovered or settled.

Deferred Tax Liabilities

As we mentioned above, deferred tax liabilities are the amounts of income taxes that are payable in future period which have arisen due to taxable temporary differences.

Illustration

Trident Manufacturing Inc has an item of plant with a carrying amount in the financial statements amounting to $10,000.  The tax written down value of the same item of plant is $5,000.  This results in a taxable temporary difference of $5,000.  Trident Manufacturing Inc pays tax at a rate of 30% so the deferred tax liability that should be recognised by Trident Manufacturing Inc in their financial statements amounts to ($5,000 x 30%) = $1,500.  To recognise this liability, Trident Manufacturing Inc should process the following journal:

DR Income tax expense
CR Deferred tax liability

Because the tax authority is consuming the asset at a faster rate than Trident Manufacturing Inc (net book value vs. tax written down value) then the tax effect (usually due to accelerated capital allowances) will be felt in the financial statements in future periods. The deferred tax liability provides for this effect.

If we assume that Trident Manufacturing already had a deferred tax balance brought forward amounting to $500 then from the perspective of the statement of financial position, the difference is taken to the statement of comprehensive income as follows:

Opening balance $500
Deferred tax charge in year $1,000 (Cr deferred tax liability, Dr income tax expense)
Deferred tax balance c/fwd $1,500

Types of Temporary Differences

Temporary differences can either be:

Debit balances  in the financial statements compared to the tax written down values.  These give rise to deferred tax liabilities and are known as taxable temporary differences.

Credit balances in the financial statements compared to the tax written down values.  These give rise to deferred tax assets which are known as deductible temporary differences.

In financial reporting studies you will often refer to the tax written down value as an asset or liability’s ‘tax base’.  The tax base is the amount that will be deductible for tax purposes against any taxable economic benefit that the entity will receive as it uses the asset.

Temporary differences can also arise in the following circumstances:

• Revenue recognised for financial reporting purposes before being recognised for tax purposes.  An example of this is where construction contract related revenue is recognised on a completed-contract method for tax purposes but on a percentage-of-completion method for financial reporting purposes. Such instances are taxable temporary differences which give rise to deferred tax liabilities.

• Expenses that are deductible for tax purposes prior to recognition in the financial statements.  An example of this is enhanced capital allowances (first year allowances) granted by tax authorities for qualifying assets.  These are taxable temporary differences which give rise to deferred tax liabilities.

• Expenses that are accounted for in the financial statements prior to becoming deductible for tax purposes.  An example of this are warranty costs.  These are deductible temporary differences which give rise to deferred tax assets.

• Revenue recognised for tax purposes prior to recognition in the financial statements.  A typical example would be prepaid rental income which would give rise to deductible temporary differences and deferred tax assets.

Deferred Tax Assets

Deferred tax assets can arise usually because of unutilised tax losses.  However, the provisions in IAS 12 stipulate that deferred tax assets can only be recognised in the statement of financial position if they are very likely to be realised in future periods.  In other words, that the entity will generate sufficient taxable profits to use the unused tax losses.  Additionally an entity should also look if there are any other temporary differences relating to the same taxation authority to offset the deferred tax asset.

Worked Example – Deferred Taxes

The following financial statement extracts relate to the Colerob Corporation for the year ended 31 December 2008:

• The deferred tax balance at the start of the year was $1,500

• Other receivables relate to interest receivable which is taxed on a cash basis

• Non-specific bad debt provisions are not allowable for tax purposes

• The damages relate to compensation payable for an illegal activity which is not tax deductible

• Colerob Corporation pays tax at 30%

Required

Calculate the deferred tax provision to be included in the financial statements of Colerob for the year ended 31 December 2008.

Solution

Accounting for Business Combinations – Deferred Tax Aspects

IAS 12 requires the tax effects of the tax-book basis differences of all assets and liabilities generally be presented as deferred tax assets and liabilities as at the date of acquisition. 

Illustration

Colerob Corporation Inc is involved in the acquisition of a business.  Relevant data is as follows:

1. The income tax rate of Colerob Corporation is 40%
2. The cost of the acquisition was $500,000
3. The fair value of the net assets acquired are $750,000
4. The tax bases of the assets acquired are $600,000
5. The tax bases of the liabilities acquired are $250,000
6. The difference between the tax and fair values of the assets acquired are $150,000 which consists of taxable temporary differences of $200,000 and deductible temporary differences of $50,000
7. The directors are confident about the recoverability of the deductible temporary differences.

Required

Show how the purchase price will be allocated in the above acquisition.

Solution

Goodwill may be tax deductible depending on the tax jurisdictions or it may be non-deductible.  If it is deductible, the amortisation period will cause the carrying amount for tax purposes to differ from that of the financial statements.  Under IFRS goodwill is not amortised over its expected useful life and as a result a temporary difference will develop with book values being greater than tax written down values.  If impairment charges are taken into account then carrying amounts may be lower than the corresponding tax basis.

Where you encounter negative goodwill then IAS 12 states that the acquirer should reassess the values placed on the net assets and liabilities.  If this does not lead to the elimination of the negative goodwill that amount is to be reported in income in the current period.  This will likely result in a difference between tax and carrying values for the negative goodwill and this also is a timing difference to be considered in computing the deferred tax balance for the reporting entity.

In our above illustration the directors were confident that deferred tax assets were deemed probable of being realised.  However, there are circumstances where there is substantial doubt about the ability to realise deferred tax assets.  In other words, it is not probable that the asset will be realised.  Under IAS 12, the deferred tax asset would not be recognised at the acquisition date.  If this applied to our illustration above, the allocation of the purchase price would have to reflect that fact and more of the purchase cost would be allocated to goodwill than would have otherwise been the case.

Illustration

Let us assume that Colerob Corporation were involved in a business acquisition on 1 January 2005.  At the date of acquisition the deferred tax assets were calculated at $100,000.  On 1 January 2005, the directors considered that realisation of the deferred tax assets were NOT probable.

The unrecognised deferred tax asset is allocated to goodwill during the purchase price assignment process. 

However, on 1 January 2009 the likelihood of realising the deferred tax assets is reassessed as being probable in future years.  On 1 January 2009 the entries are:

DR deferred tax asset $100,000
CR goodwill $100,000

Disclosures Required

IFRS requires the following to be disclosed separately in an entity’s financial statements:

• The major components of tax expense, including:
• current tax expense
• adjustments relating to previous periods
• deferred tax expense/income
• deferred tax expense/income arising because of changes to tax rates
• deferred tax implications of a change in accounting policy or correction of an error
• The aggregate current and deferred tax relating to items that are charged or credited directly to equity and the amount charged/credited to other comprehensive income
• A reconciliation between the income tax expense and the accounting profit multiplied by the applicable tax rate(s) disclosing also the basis on which the applicable tax rate(s) have been computed
• A reconciliation between the average effective tax rate and the applicable tax rate together with the basis on which the applicable tax rate has been computed.

Conclusion

Accounting for deferred taxes can become problematic.  However in order to fully understand how deferred tax impacts on a set of financial statements then it is important that you understand what gives rise to a ‘taxable temporary difference’ and a ‘deductible temporary difference’.

Steve Collings FMAAT ACCA DipIFRS is Audit Manager at Leavitt Walmsley Associates Limited and also a partner in AccountancyStudents.co.uk.  He is also the author of ‘A Summary of IFRS and IAS’ which can be purchased direct from http://www.accountancystudents.co.uk