BUSN2015 S2 2018 Topic 5 Tutorial Solutions PDF

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Tutorial Solutions: Topic 5 Chapter 12: Income Taxes Comprehension questions 1. What is the main principle of tax-effect accounting as outlined in AASB 112/IAS 12? As the objective paragraph of AASB 112/IAS 12 points out, the principal issue in accounting for income taxes is how to account for the current and future tax consequences of: (a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in a company’s statement of financial position; and (b) transactions and other events of the current period that are recognised in a company’s financial statements. AASB 112/IAS 12 adopts the philosophy that, as a general rule, the tax consequences of transactions that occur during a period should be ‘recognised as income or an expense in the net profit or loss for the period’ irrespective of when those tax effects will occur. A transaction may have two tax ‘effects’: 1. Tax payable on the current profit earned for the year may be reduced or increased because the transaction is not taxable or deductible in the current year. 2. Future tax payable may be increased or reduced when that transaction becomes taxable or deductible. If only current tax payable is recorded as an expense, the accounting profit after tax for the current year is overstated (understated) by the amount of tax (benefit) to be paid (received) in future years. Similarly, in the years that the tax (benefit) on these transactions is paid (received), income tax expense will include amounts relating to prior periods and therefore be overstated (understated). To illustrate, consider an entity with accrued interest of $12 000 at end of reporting period. Assuming accrued interest is deductible only when paid, taxable profit will be $12 000 greater than accounting profit, resulting in $3 600 extra tax being paid (assuming a 30% tax rate). In the next accounting period, the tax deduction for interest paid results in a taxable profit that is $12 000 lower than the accounting profit. This tax benefit reduces the current tax expense by $3 600 although the transaction occurred in the prior year. If only current tax payable calculated based on the taxable profit is recorded as an expense, the accounting profit after tax for the current year is overstated by the amount of benefit to be received in future years. Similarly, in the years that the benefit on this transaction is received, income tax expense will include benefits relating to prior periods and therefore be understated. To ensure that the tax effect (expense or benefit) of a transaction is recorded in the appropriate period, AASB 112/IAS 12 requires income tax expense to reflect all tax effects of transactions entered into during the year regardless of when the effects occur.

2. Explain how accounting profit and taxable profit differ and how each is treated when accounting for income taxes. Accounting profit is defined in AASB 112/IAS 12, paragraph 5, as ‘net profit or loss for a period before deducting tax expense’, with net profit or loss being the excess (or deficiency) of revenues over expenses for that period. The revenues and expenses would be determined and recognised in accordance with accounting standards and the conceptual Framework, normally based on accrual accounting rules:  revenues are recognised when earned, not when received in cash  expenses are recognised when incurred, not when paid in cash. Taxable profit is defined in the same paragraph AASB 112/IAS 12 as ‘the profit for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable’. Taxable profit is the excess of taxable income over taxation deductions allowable against that income, normally based on cash accounting rules:  income is taxed received in cash  deductions are claimed when paid in cash. Thus, accounting profit and taxable profit, as they are determined by different principles and rules, are unlikely to be equal in any one period. Income tax expense cannot be determined by simply multiplying the accounting profit by the applicable tax rate. Instead, accounting for income taxes involves identifying and accounting for the differences between accounting profit and taxable profit. These differences arise from a number of common transactions and may be either permanent or temporary in nature. Normally:  the income tax expense is calculated as the accounting profit adjusted for permanent differences and then multiplied by the tax rate  the current tax liability is calculated as the taxable profit multiplied by the tax rate  the difference between the income tax expense recognised based on the adjusted accounting profit and the current tax liability is the deferred tax.

3. How are the current and future tax consequences of transactions accounted for? Accounting for income tax takes into account both current and future tax consequences of transactions. In essence, AASB 112/IAS 12:  Prescribes the accounting treatment of the current tax consequences of transactions. This will give rise to current tax liabilities or current tax assets. The task is to determine an entity’s liability for taxation in the current period based on an assessment of the entity’s current taxable profit or tax loss determined in accordance with the tax legislation. The liability for taxation in the current period is recognised by a journal entry of the following form. Income tax expense (current) Dr xxx Current tax liability Cr xxx (Recognition of the current tax liability) Accounting for current tax is covered in section 12.4. 

Prescribes the accounting treatment of the future tax consequences of transactions. This involves an analysis of whether more tax or less tax will need to be paid in the future as a result of those transactions. From this analysis, the future tax consequences are accounted for by the recognition of deferred tax assets and deferred tax liabilities. The deferred or future tax assets and liabilities are recognised by a journal entry of the following form.

Income tax expense (deferred) Dr xxx Deferred tax asset Dr xxx Deferred tax liability Cr xxx (Recognition of movement in deferred tax accounts)

4. What is a ‘tax loss’ and how is it accounted for? Tax losses occur when allowable deductions exceed taxable revenues. In Australia, tax losses can be carried forward and deducted against future taxable profits. This means that an entity that incurs a tax loss has a future tax benefit: provided it earns taxable profit in the future, it will be able to use the carried forward balances of tax losses to reduce the tax it needs to pay on that taxable profit. This tax benefit will be recognised as an asset referred to as ‘a deferred tax asset’. In dealing with tax losses it is necessary to distinguish between two events occurring at two different points of time. 1. The creation of carry forward tax losses.  In the year in which a tax loss occurs, there is no liability to pay tax as there is no taxable profit. Instead a deferred tax asset is recorded to recognise the future deductibility of the tax loss. The form of the journal entry is: Deferred tax asset Dr Income tax revenue Cr (Recognition of current period tax loss)

xxx xxx

2. Recoupment of carry forward tax loss.  In a period subsequent to that in which the tax loss was incurred, an entity may earn taxable profit. The amount of tax to be paid on that period’s taxable profit may then be reduced by claiming a deduction for past tax losses. In this period, the form of the journal entry for the current period tax liability is: Income tax expense (current) Deferred tax asset Current tax liability (Recognition of current tax)

Dr Cr Cr

xxx xxx xxx

5. What is an ‘exempt income’ and how does it affect the calculation or recovery of carry‐forward tax losses? Exempt income is recognised as accounting income by the company but not recognised as taxable by the tax authorities; for example, certain government grants are tax exempt. The existence of exempt income has an effect both on the creation of a tax loss and the recoupment of a tax loss. 1. Exempt income and the creation of tax loss. 

If a tax loss occurs in a period, prior to determining any deferred tax asset arising from it, exempt income must be added back to the tax loss to calculate the tax loss after exempt income. It is this number on which the deferred tax asset is calculated. Exempt income loses its exempt status under these circumstances.

2. Exempt income and the recoupment of a tax loss. 

If a company has earned exempt income in the current period, the deduction for past tax losses must be made firstly from the exempt income, and only after that from the taxable profit for the current period. In other words, a tax loss must first be set off against the entity’s exempt income before any reduction can be made in relation to the current period’s liability for tax.

Application and Analysis Exercise 1. Current and deferred tax with prior year losses The accounting profit before tax of Collingwood Ltd for the year ended 30 June 2020 was $175 900. It included the following revenue and expense items:

The draft statement of financial position as at 30 June 2020 included the following assets and liabilities.

Additional information  The tax depreciation rate for plant is 10% p.a., straight-line.  The tax rate is 30%.  The company has $15 000 in tax losses carried forward from the previous year. A deferred tax asset was recognised for these losses. Taxation legislation allows such losses to be offset against future taxable profit. Required 1. Prepare the worksheets and journal entries to calculate and record the current tax liability and the movements in deferred tax accounts for the year ended 30 June 2020. 2. Justify your treatment of the interest revenue in the current tax worksheet. Explain how and why this leads to the deferred tax consequence shown in the deferred tax worksheet.

1.

Current Tax Worksheet for year ended 30 June 2020

Accounting profit Add: Interest received (assessable for tax) Long service leave expense Doubtful debts expense Depreciation expense – plant Rent expense Entertainment expense (non-deductible) Deduct: Government grant (exempt) Interest revenue Long service leave paid Bad debts written off Tax depreciation – plant Rent paid Taxable profit Add back exempt income Less recoupment of tax loss Taxable profit Current tax liability @ 30%

$175 900 10 000 7 000 4 200 33 000 22 800 $3 900

3 600 11 000 4 000 2 400 22 000 23 200

80 900 256 800

(66 200) 190 600 3 600 194 200 (15 000) 179 200 $53 760

Workings: Interest received: opening balance of interest receivable ($0) + interest revenue ($11 000) – ending balance of interest receivable ($1 000) = $10 000. Long service leave paid: opening balance of provision for long service leave ($61 000) + long service leave expense ($7 000) – ending balance of provision for long service leave ($64 000) = $4 000. Bad debts written off: opening balance of allowance for doubtful debts ($3 200) + doubtful debts expense ($4 200) – ending balance of allowance for doubtful debts ($5 000) = $2 400. Depreciation of plant for tax purposes: depreciation expense for plant ($33 000) / 15% x 10% = $22 000 Rent paid: ending balance of prepaid rent ($2 800) + rent expense ($22 800) – opening balance of prepaid rent ($2 400) = $23 200.

Those amounts (excluding the depreciation of plant for tax purposes) can also be calculated by recreating the ledgers for the affected accounts as follows:

Interest Receivable $ 01/07/19 Opening balance

0

30/06/20 Interest revenue

11 000

$ 30/06/20 Ending balance 30/06/20 Interest received

11 000

1 000 10 000 11 000

Provision for Long Service Leave $ 30/06/20 Leave paid

4 000

30/06/20 Ending balance

64 000

$ 01/07/19 Opening balance 30/06/20 Expense

68 000

61 000 7 000 68 000

Allowance for Doubtful Debts $

$

30/06/20 Ending balance

5 000

01/07/19 Opening balance

3 200

30/06/20 Debts written off

2 400

30/06/20 Expense

4 200

7 400

7 400

Prepaid Rent $ 01/07/19 Opening balance 30/06/20 Rent paid

2 400 23 200 25 600

$ 30/06/19 Rent expense 30/06/20 Ending balance

22 800 2 800 25 600

COLLINGWOOD LTD Deferred Tax Worksheet as at 30 June 2020 Carrying Amount

Assets Cash Accounts receivable Inventories Interest receivable Prepaid rent Plant

Liabilities Accounts payable Provision for long service leave Temporary differences Deferred tax liability Deferred tax asset Beginning balances Movement during year Adjustment

$

Future Taxable Amount $

Future Deductible Amount $

9 000 78 000

0 0

67 100 1 000

$

Taxable Deductible Temporary Temporary Differences Differences $ $

0 5 000

9 000 83 000

5 000

67 100 1 000

67 100 0

67 100 0

2 800 121 000

2 800 121 000

0 154 000

0 154 000

71 200

0

0

71 200

64 000

0

64 000

0

* the tax loss of $4500 recouped via current worksheet

Tax Base

1 000 2 800 33 000

64 000

3 800 1 140

102 000

30 600 720

30 360 *(4 500)

420 Cr

4 740 Dr

The future deductible amount for plant is calculated as follows: Cost Accumulated tax depreciation Future deductible amount

$220 000 66 000* $154 000

*The accumulated depreciation for accounting purposes is $99 000 which at $33 000 per annum (15% x $220 000) is 3 years’ worth of depreciation and therefore the accumulated depreciation for tax purposes is 3 x $200 000 x 10%. The entries for income tax, current and deferred, are: Income tax expense (current) Current tax liability Deferred tax asset (tax losses)

Dr Cr Cr

58 260

Deferred tax asset Deferred tax liability Income tax expense (deferred)

Dr Cr Cr

4 740

53 760 4 500

420 4 320

2. Interest is recorded as revenue for accounting purposes as it is earned but is only taxable when the cash is received. In this situation $1000 of interest revenue has not been received and has been recognised as a receivable at end of reporting period. In calculating the current tax liability this $1000 was deducted from accounting profit as not taxable by deducting the whole interest revenue recognised for accounting purposes of $11 000 and only adding to taxable profit the interest received of $10 000. Accordingly, the current tax liability for the year does not include tax of $300 with respect to this interest receivable. This tax will be paid in the next financial year when the cash is received. A deferred tax liability of $300 has been raised to reflect this future tax payment....