Company Accounting 11th Edition - ( Chapter 17 Accounting for company income tax ) PDF

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CHAPTER 17

Accounting for company income tax CHA PT ER A IM This chapter explains how to account for company income tax in accordance with AASB 112 Income Taxes, which is based on the current and future tax consequences of transactions and events of the period and the future recovery of assets and settlement of liabilities.

LEA RNING OBJECT IVES After studying this chapter, you should be able to: 17.1 explain the benefit of having information regarding current and deferred tax in the financial statements 17.2 describe how income tax is included in the financial statements 17.3 explain the general principles of current and deferred tax set out in AASB 112 17.4 describe how taxable profit is generally determined according to Australian income tax legislation and explain how it differs from accounting profit 17.5 prepare a current tax worksheet that reconciles from accounting profit to taxable profit and then use the worksheet to record the entries for current tax 17.6 prepare a deferred tax worksheet to determine the differences between the accounting and tax values for assets and liabilities and use the worksheet to record the entries for deferred tax 17.7 determine the tax bases of various assets and liabilities included in the statement of financial position 17.8 calculate the taxable and deductible temporary differences of various assets and liabilities included in the statement of financial position and identify items that are excluded from the calculation of deferred tax liabilities and assets 17.9 describe the criteria for the recognition of deferred tax liabilities and assets and how these balances may reverse over time

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17.10 describe the other disclosures relating to income tax in the financial statements 17.11 explain some of the additional issues that arise in accounting for income tax.

BEF ORE YOU BEGIN Before studying this chapter, you should: • reflect on how the accrual basis of accounting differs from the cash basis of accounting • find a recent annual financial report of a top 50 company listed on the Australian Securities Exchange (ASX) and briefly review the accounting policy note for income tax and the disclosures for income tax in the financial statements and notes to the financial statements.

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Introduction This chapter explains how to account for a company’s income tax commitments. In 1946, the Institute of Chartered Accountants in Australia (ICAA) issued D4 Treatment of Taxation in Accounts, the first official Australian pronouncement on accounting for income tax. D4 stated that a charge should be made against the profits of each year for the amount of estimated income tax required to be paid on those profits (Recommendation 1). This recommendation highlights three important points as follows: 1. income tax is recognised as an expense rather than as an appropriation or distribution of profits to the government. 2. accounting for income tax involves the recognition of items in both the statement of profit or loss and other comprehensive income (e.g. income tax expense) and the statement of financial position (e.g. current tax liability). 3. income tax laws are relevant when accounting for company income tax because these laws determine the amount of income tax paid. During the period, 1946 to 1970 most Australian companies accounted for income tax using the ‘tax payable’ method where the income tax expense for the current reporting period is based on income tax laws and the company’s income tax obligations to the Australian Taxation Office (ATO) for the period. The tax payable method only recognises the current tax consequences of transactions and events. It is easy to apply because the information prepared by the company in its income tax return for the ATO is the basis for determining the amount of income tax expense. The method is conceptually weak, however, because the amount of income tax expense does not necessarily reflect the transactions included in accounting profit. During the period 1971 to 2004 the ‘liability method of tax-effect accounting’ was applied in Australia. The premise of this method is that income tax expense should be attributable to the transactions included in the accounting profit irrespective of whether the income tax is currently payable, has been paid in prior years, or will become payable in future years. In the liability method of tax-effect accounting, the income tax consequences of transactions are recognised irrespective of when the income tax is paid. In this way, current and future tax consequences are recognised. Income tax expense is, in effect, based on the matching principle. Income tax could be prepaid giving rise to a deferred tax asset or the payment of income tax could be postponed giving rise to a deferred tax liability. In 2005, Australian Accounting Standard AASB 112 Income Taxes became effective pursuant to a program of convergence with international accounting standards. AASB 112 replaced the liability method of tax-effect accounting and introduced ‘the statement of financial position approach’ to accounting for income tax. AASB 112 accounts for income tax by recognising current and future tax consequences as follows: 1. the recognition of current tax is based on the income tax payable to the ATO for the current period. 2. the recognition of future or deferred tax is based on future tax consequences of the assets and liabilities shown in the statement of financial position at the end of the reporting period. The AASB 112 recognition of current tax is equivalent to what was previously done in the tax payable method and liability method of tax-effect accounting. In contrast, the AASB 112 recognition of deferred tax based on the assets and liabilities of the statement of financial position differs to the prior methods of accounting for income tax. This chapter demonstrates the AASB 112 approach to the recognition of current and deferred tax.

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17.1 The benefit of information on current and deferred tax LEARNING OBJECTIVE 17.1 Explain the benefit of having information regarding current and deferred tax in the financial statements.

The importance of accounting for both current tax and deferred tax as required by AASB 112 is demonstrated using a simplified example. Figure 17.1 shows an extract from the statement of financial position of Coopers Ltd. In this statement, only a current tax liability is recognised based on the income tax due and payable to the ATO for the year ended 30 June 2017. 898 Company accounting

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FIGURE 17.1

Extract from a statement of financial position with current tax only COOPERS LTD Statement of Financial Position (Extract) as at 30 June 2017

Assets Cash at bank Licence for television station

$ 20 000 900 000 $920 000

Total assets Liabilities Current tax liability

$ 10 000 10 000

Total liabilities Net assets

$ 910 000

Assume that around 30 June 2017, the managing director of Coopers Ltd, Mr X, approaches a bank to request a loan of $700 000 to fund growth opportunities. Mr X states that the bank need not worry about being repaid because the company has no existing debt, minimal other liabilities and the existing television licence has been independently valued to be worth $900 000. The problem with Mr X’s analysis is that there is no mention of the future tax consequences that may arise if the television licence was sold for $900 000. There is no information in the statement of financial position about future or deferred tax that would become due to the ATO after the asset was sold for its carrying amount. If the company were to sell the television licence for $900 000 and make a capital gain of $800 000, then it would have a tax obligation to the ATO of $240 000 based on a corporate tax rate of 30% (i.e. $800 000 × 30%). Once it has paid that capital gains tax, the company would have only $660 000 left from the sale proceeds (i.e. $900 000 − $240 000) and would no longer be in a position to repay the bank loan of $700 000. Therefore, the statement of financial position should recognise both current and deferred tax in order to provide more complete or relevant information for the economic decision making of the users of the financial statements (e.g. creditors). In the Coopers Ltd example, the liability section of the statement of financial position should also recognise a deferred tax liability of $240 000, which is the future tax that would become due and payable if the television licence was sold for $900 000. LEARNING CHECK

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■ The recognition of current tax and deferred tax provides more complete or relevant information for economic decision making than current tax alone. ■ The recognition of deferred tax in AASB 112 is based on the likely future tax consequences that would arise for the assets and liabilities shown in the statement of financial position.

17.2 Income tax in the financial statements LEARNING OBJECTIVE 17.2 Describe how income tax is included in the financial statements.

Figure 17.2 uses the example of Lybrand Ltd to illustrate the financial statement outcomes from accounting for current and deferred tax based on the requirements of AASB 112. The Lybrand Ltd example shows that income tax disclosures are made in the statement of financial position, the statement of profit or loss and other comprehensive income, and the notes to the financial statements. CHAPT ER 17 Accounting for company income tax

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899

FIGURE 17.2

Income tax disclosures in financial statements and notes to financial statements LYBRAND LTD Statement of Financial Position (Extract) as at 30 June

Non-current assets Deferred tax asset

2017

2016

$ 51 000

$ 45 000

78 000

36 000

120 000

30 000

Current liabilities Current tax liability Non-current liabilities Deferred tax liability

LYBRAND LTD Statement of Profit or Loss and Other Comprehensive Income (Extract) for the year ended 30 June 2017 Profit before tax Less: Income tax expense

$400 000 132 000

Profit for the year Revaluation increase on land Less: Tax effect

$ 268 000 100 000 30 000

Other comprehensive income net of tax Total comprehensive income

70 000 $ 338 000

LYBRAND LTD Notes to the financial statements (Extract) for the year ended 30 June 2017 The components of income taxation expense are as follows: Current tax expense Deferred tax expense from origination and reversal of temporary differences Total income tax expense

$ 78 000 54 000 $132 000

Reconciliation between income tax expense and before tax accounting profit Profit before tax

400 000

Prima facie income tax expense at 30% Non-assessable and non-deductible items included in profit

120 000 12 000

Total income tax expense

$132 000

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Deferred tax charged directly to equity Revaluation increase on land

$ 30 000

Deferred tax asset Deferred tax assets are attributable to the following: Provision for employee benefits

$ 51 000

Deferred tax liability Deferred tax liabilities are attributable to the following: Land Plant and equipment

30 000 $ 90 000 $120 000

900 Company accounting

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The disclosures shown in figure 17.2 reveal a number of important insights into accounting for income tax in accordance with AASB 112 as follows. • The current tax due and payable to the ATO is disclosed as a current liability in the statement of financial position. Current tax liability is based on the taxable profit according to tax laws otherwise known as taxable income. • Deferred tax disclosed in the statement of financial position may be in the form of a deferred tax liability shown in non-current liabilities or deferred tax asset shown in non-current assets. • The source of the deferred tax balances disclosed in the statement of financial position is the future tax consequences from recovering assets and settling liabilities, which are based on the notion of ‘temporary differences’. The deferred tax asset is usually attributable to liabilities (e.g. provisions), whereas the deferred tax liability is usually attributable to assets (e.g. revalued or depreciable assets). • Income tax expense related to the profit or loss of the period is presented as part of the profit or loss in the statement of profit or loss and other comprehensive income. • Income tax expense is comprised of both current tax and deferred tax and is attributable to amounts recognised in the statement of financial position for current and deferred tax liabilities and assets. • Income tax expense is not equal to the prima facie income tax on accounting profit; that is, the corporate tax rate multiplied by profit before tax. Income tax expense differs from this prima facie amount because income tax laws use different concepts to accrual accounting in the measurement of the profit that is subject to tax (i.e. non-assessable and non-deductible items are excluded from the calculation of profit for income tax purposes). • Separate disclosure is required in the statement of profit or loss and comprehensive income or in the notes to the financial statements for any current or deferred tax recognised directly against equity (e.g. deferred tax on the revaluation of land). • The corporate tax rate is currently 30% and has been at this level since 2001. Income tax disclosures may also be included in the statement of cash flows and the statement of changes in equity. LEARNING CHECK

■ Current tax and deferred tax balances are disclosed in the statement of financial position. ■ Deferred tax balances are disclosed in the non-current section of assets and liabilities. ■ Income tax expense is recognised in the statement of profit or loss and comprehensive income and is comprised of current and deferred tax. ■ Current or deferred tax recognised directly against equity instead of being charged against profit must be separately disclosed in the statement of profit or loss and comprehensive income or in the notes.

17.3 General principles of accounting for income tax

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LEARNING OBJECTIVE 17.3 Explain the general principles of current and deferred tax set out in AASB 112.

AASB 112 recognises the current and future tax consequences of the following: • the transactions and events of the current period included in the financial statements. • the recovery of assets and settlement of liabilities based on the carrying amounts shown in the statement of financial position. Current tax is the amount of income tax payable (recoverable) in respect of the taxable income (tax loss) for a period (paragraph 5). Current tax for income tax payable to the ATO is recognised as a liability; however, if current tax is recoverable from the ATO it is recognised as an asset (paragraph 12). Current tax would be recoverable if the amount of income tax already paid to the ATO exceeds the amount due for the period. Figure 17.3 summarises how current tax is included in the profit or loss for the period through income tax expense. CHAPT ER 17 Accounting for company income tax

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901

FIGURE 17.3

Accounting for current tax included in profit or loss for the period

Current tax liability (Payable to ATO) Current tax asset (Refund due from ATO)

Recognition of position at year end

Payments to ATO during the year

Income tax expense (debit) Current tax liability (credit) Current tax asset (debit) Income tax expense (credit)

Income tax expense (debit) Cash (credit) Income tax expense (debit) Cash (credit)

In accordance with AASB 112, deferred tax is the amount of income tax estimated to be payable (recoverable) in respect of the future tax consequences from the recovery of assets and settlement of liabilities in the statement of financial position. A deferred tax asset is the amount of income tax recoverable in future periods when the carrying amount of an asset or liability is recovered or settled (paragraph 5). A deferred tax liability is the amount of income tax payable in future periods when the carrying amount of an asset or liability is recovered or settled (paragraph 5). Income tax expense is the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax (paragraph 5). Figure 17.4 summarises how deferred tax is included in the profit or loss for the period through income tax expense. FIGURE 17.4

Accounting for deferred tax included in profit or loss for the period

Deferred tax liability Deferred tax asset

Origination or increase

Reversal or decrease

Income tax expense (debit) Deferred tax liability (credit) Deferred tax asset (debit) Income tax expense (credit)

Deferred tax liability (debit) Income tax expense (credit) Income tax expense (debit) Deferred tax asset (credit)

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The origination or increase in a deferred tax liability results in an increase in income tax expense whereas the origination or increase of a deferred tax asset leads to a reduction in income tax expense. Conversely, the reversal or decrease of a deferred tax liability results in a decrease in income tax expense and the reversal or decrease of a deferred tax asset leads to an increase in income tax expense. Income tax expense excludes any tax that relates to a transaction or event recognised outside of profit or loss; for example, an item recognised in other comprehensive income (paragraph 58). Current tax and deferred tax that relates to items included in other comprehensive income is recorded with those items in other comprehensive income (paragraph 61A). The general principles of accounting for income tax are demonstrated next using the disclosures in the Lybrand Ltd example at figure 17.2 and three steps to record the tax balances as follows: 1. entries to recognise the current tax for the period 2. entries to recognise the deferred tax included in the profit or loss for the period 3. entries to recognise the deferred tax included in other comprehensive income for the period. In the first step, the accounting entries for current tax are recorded based on the tax payable on taxable income as determined in accordance with Australia’s income tax legislation. In the Lybrand Ltd example, the disclosures at figure 17.2 show that the current tax included in the profit of the period is $78 000. The entries to recognise the current tax for the year are as follows: 30/6/17

Income Tax Expense Current Tax Liability (Step 1: The journal entries to recognise the current tax for the year based on taxable income)

Dr Cr

78 000 78 000

In the second step, the accounting entries fo...