Deegan FA 8e SM Ch18 PDF

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Chapter 18 Accounting for income taxes Review questions 18.1

Where the carrying amount of an asset or liability (the carrying amount is determined using accounting rules) is different to the tax base (which is determined by applying taxation rules) then a ‘temporary difference’ can arise. Paragraph 5 of AASB 112 defines a temporary difference as: The difference between the carrying amount of an asset or a liability in the statement of financial position and its tax base. AASB 112 explains that temporary differences may be either: (a) deductible temporary differences, which are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled; or (b) taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Something that will lead to an increase in taxable income in future years (a taxable temporary difference) creates a liability—a deferred tax liability. Something that will lead to a decrease in taxable income in future years (a deductible temporary difference) creates an asset—a deferred tax asset.

18.2

The tax base of an asset is determined by calculating what the value of the asset would be from a taxation perspective: that is, it is the value that would be calculated if we applied taxation rules. As paragraph 5 of AASB 112 states: The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. According to paragraph 7 of AASB 112: The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount.

18.3

The tax base of a liability is the amount that is attributed to a liability for tax purposes. According to paragraph 8 of AASB 112: The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.

18.4

Income tax expense represents the sum of the tax attributable to the taxable profit (where taxable profit is calculated by applying tax rules) plus or minus any adjustments relating to Solutions Manual t/a Financial Accounting 8e by Craig Deegan Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd 18–1

temporary differences. (Temporary differences arise because of differences between accounting rules and taxation rules.) This is consistent with the definition of income tax expense provided in AASB 112, which is: Tax expense (tax income) is the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax. Paragraph 6 of AASB 112 further states: Tax expense (tax income) comprises current tax expense (current tax income) and deferred tax expense (deferred tax income). Effectively, tax expense is determined by multiplying accounting profit, adjusted for any permanent differences, by the relevant tax rate. 18.5

The tax assessed by the tax office, and reflected in the current liability of income tax payable (which appears in an entity’s statement of financial position), will be based on the taxable profit derived by the entity, and this will be determined by applying the rules stipulated in taxation law, rather than the rules incorporated within accounting standards.

18.6

The rationale for recognising a deferred tax asset or a deferred tax liability is that failure to do so will misstate the assets and liabilities of an entity. The argument is that the entity’s current activities will create some future taxation obligations (deferred tax liabilities) or taxation benefits (deferred tax assets) which would otherwise be ignored.

18.7

If an entity has generated taxable income then it will be required to pay tax. For example, assume that a company has taxable income of $1 million and that the tax rate is 30 per cent. In this case the entity will have an obligation to the tax office of $300 000 (which will be recorded as income tax payable). However, if the entity has unused tax losses then it can use these amounts to offset the amount that would otherwise be payable. That is, the unused tax losses will provide future economic benefits (a requirement of an asset) because they will reduce the amount that would otherwise have to be paid by the entity. For example, if the company has unused tax losses of $600 000 then it can use these losses to reduce the amount of tax payable in the current year to $120 000, which equals ($1 000 000 – $600 000) x 30%. The unused tax losses provided an economic benefit of $180 000 (the absolute amount of the loss multiplied by the tax rate). However, there are some restrictions on recognising deferred tax assets that arise as a result of tax losses. For example, paragraphs 34 to 36 of AASB 112 state: 34. A deferred tax asset shall be recognised for the carryforward 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. 35. The criteria for recognising deferred tax assets arising from the carryforward of unused tax losses and tax credits are the same as the criteria for recognising deferred tax assets arising from deductible temporary differences. However, the existence of unused tax losses is strong evidence that future taxable profit may not be available. Therefore, when an entity has a history of recent losses, the entity recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit will be available against which the unused tax losses or unused tax credits can be utilised by the entity. In such circumstances, paragraph 82 requires Solutions Manual t/a Financial Accounting 8e by Craig Deegan Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd 18–2

disclosure of the amount of the deferred tax asset and the nature of the evidence supporting its recognition. 36. An entity considers the following criteria in assessing the probability that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised: (a) whether the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which the unused tax losses or unused tax credits can be utilised before they expire; (b) whether it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire; (c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and (d) whether tax planning opportunities (see paragraph 30) are available to the entity that will create taxable profit in the period in which the unused tax losses or unused tax credits can be utilised. To the extent that it is not probable that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised. 18.8

When a provision is created in relation to long-service leave, or is increased, there is no actual cash flow. There is a debit to employee benefits expense and a credit to provision for long-service leave. Typically, tax deductions are only allowed by the Australian Taxation Office (ATO) when there are actual cash flows involved. Hence, no tax deduction would be allowed at the time the provision is created or increased. The company will, therefore, pay a greater amount of tax than would be payable if it was assessed purely on the basis of its accounting profit. In a sense the company is prepaying the tax, which creates a deferred tax asset. When cash flows associated with the long-service leave obligation occur in a subsequent period, the ATO will allow a deduction. In a sense the company will be receiving a tax deduction for an expense that was incurred in a previous period: it will receive the benefits (in the form of lower required tax payments) in this subsequent period as a result of the previously recorded deferred tax asset. When the cash flow occurs, the company will debit the provision for long-service leave and credit cash. No expense is recognised at this point by the company. Where a provision for long-service leave is created, a liability will be created for accounting purposes. However, for taxation purposes the liability is not recognised (a tax base of $0). Where the carrying amount of a liability is greater than the tax base of a liability, this will give rise to a deductible temporary difference, which will in turn give rise to a deferred tax asset.

18.9

No, unused tax losses will not always lead to the recognition of a deferred tax asset. Before a deferred tax asset is recognised it must be ‘probable’ that the benefits associated with the unused tax losses will ultimately be received. Specifically, paragraph 34 of AASB 112 states:

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A deferred tax asset shall be recognised for the carryforward 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. Paragraphs 35 to 36 of AASB 112 provide further guidance in relation to unused tax losses. They state: 35. The criteria for recognising deferred tax assets arising from the carryforward of unused tax losses and tax credits are the same as the criteria for recognising deferred tax assets arising from deductible temporary differences. However, the existence of unused tax losses is strong evidence that future taxable profit may not be available. Therefore, when an entity has a history of recent losses, the entity recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit will be available against which the unused tax losses or unused tax credits can be utilised by the entity. In such circumstances, paragraph 82 requires disclosure of the amount of the deferred tax asset and the nature of the evidence supporting its recognition. 36. An entity considers the following criteria in assessing the probability that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised: (a) whether the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which the unused tax losses or unused tax credits can be utilised before they expire; (b) whether it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire; (c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and (d) whether tax planning opportunities (see paragraph 30) are available to the entity that will create taxable profit in the period in which the unused tax losses or unused tax credits can be utilised. To the extent that it is not probable that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised. 18.10 Changed tax rates will have implications for the value attributed to pre-existing deferred tax assets and deferred tax liabilities. For example, if an organisation has recognised a deferred tax asset relating to a previous loss for tax purposes and that previous carried-forward tax loss was $1 million, and the tax rate is increased from 30 per cent to 35 per cent, the amount of the deferred tax asset will need to be increased from $300 000 to $350 000. This is because when the organisation subsequently earns a taxable profit of, say, $1 000 000 it will be able to offset the loss against the $350 000 in tax that would otherwise be payable under the revised tax rate. The $50 000 increase in the value of the deferred tax asset (which is calculated as $1 000 000 x [0.35 – 0.30]) would be treated as income, given that the carrying amount of the asset has been increased. Conversely, if the tax rate had been decreased, the value of the asset would be decreased and this would be recognised as an expense. Solutions Manual t/a Financial Accounting 8e by Craig Deegan Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd 18–4

An increase in tax rates will create an expense where an organisation has deferred tax liabilities, whereas a decrease in tax rates will create income in the presence of deferred tax liabilities. Where there are both deferred tax assets and deferred tax liabilities at the time of a change in tax rate, there will be both gains and losses (there will be a gain on the asset and a loss on the liability, or vice versa) and the net amount would be treated as either income or an expense. The impact of changing tax rates is discussed at paragraph 60 of AASB 112: The carrying amount of deferred tax assets and liabilities may change even though there is no change in the amount of the related temporary differences. This can result, for example, from: (a) a change in tax rates or tax laws; (b) a re-assessment of the recoverability of deferred tax assets; or (c) a change in the expected manner of recovery of an asset. The resulting deferred tax is recognised in profit or loss, except to the extent that it relates to items previously recognised outside profit or loss. 18.11 Yes, deferred tax assets can be offset against deferred tax liabilities. Paragraph 75 of AASB 112 requires, subject to limited exceptions, that the entity must set-off deferred tax liabilities and deferred tax assets and recognise the net amount in the statement of financial position. Paragraph 75 states: To avoid the need for detailed scheduling of the timing of the reversal of each temporary difference, this Standard requires an entity to set-off a deferred tax asset against a deferred tax liability of the same taxable entity if, and only if, they relate to income taxes levied by the same taxation authority and the entity has a legally enforceable right to set-off current tax assets against current tax liabilities. 18.12 (a)

For taxation purposes, the depreciation in the first two years would be: $250 000  2 = $125 000 per year. For accounting purposes, the depreciation across five years would be: $250 000  5 = $50 000 per year. The company will claim a tax deduction of $125 000 per year for the first two years. No deduction will be available in years three, four and five. For accounting purposes, the depreciation expense in each of the first five years will be $50 000 per year. The carrying amount of the asset will be more than its tax base such that the difference will lead to a deferred tax liability (there is a taxable temporary difference). If we multiply this taxable temporary difference by the tax rate then we arrive at the balance of the deferred tax liability.

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(b) The deferred tax liability at 30 June 2018 can be calculated as follows: Carrying amount

Tax base

Temporary difference

$

$

$

Machinery—cost

250 000

250 000

Accumulated depreciation

150 000

250 000

100 000

0

100 000

As the carrying amount of the asset exceeds the tax base, a deferred tax liability exists. The balance of the deferred tax liability is $100 000 x 0.30 = $30 000. 18.13 (a)

(b)

Carrying amount $

Tax base $

Asset—cost

300

300

Accumulated depreciation

100

180

200

120

Temporary difference $

80

As the carrying amount of the asset exceeds the tax base, a deferred tax liability exists. The balance of the deferred tax liability is $80 x 0.30 = $24.

18.14 (a) Carrying amount Accrued product warranty costs (b)

Tax base

$300

$0

Temporary difference $300

As the carrying amount of the liability exceeds the tax base, a deferred tax asset exists. The balance of the deferred tax asset is $300 x 0.30 = $90. While the Tax Office has not given the company a tax deduction now, it will provide a tax deduction in future periods when the actual cash flow occurs. The deduction will provide economic benefits to the company.

18.15 (a) Carrying amount Accounts receivable (net)

$240 000

Tax base $300 000

Temporary difference $60 000

The amount of the tax base can be confirmed as follows: Carrying amount

+ Future deductible amount –

$240 000 + $60 000

–

Future taxable amount = Tax base $0

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= $300 000

(b)

As the carrying amount of the asset is less than the tax base, a deferred tax asset exists. The balance of the deferred tax asset is $60 000 x 0.30 = $18 000. While the Tax Office has not currently given the company a tax deduction for the doubtful debts, it will provide a tax deduction in future periods when the doubtful debts are written off against accounts receivable. The deduction will provide economic benefits to the company.

18.16 (a) Carrying amount Interest receivable

Tax base

$400 000

Temporary difference

$0

$400 000

The amount of the tax base can be confirmed as follows: Carrying amount

+ Future deductible amount –

$400 000 + $0 (b)

–

Future taxable amount

=

Tax base

$400 000

=

$0

As the carrying amount of the asset is greater than the tax base, a deferred tax liability exists. The balance of the deferred tax liability is $400 000 x 0.30 = $120 000. The deferred tax liability exists because while the Tax Office has not considered the interest to be assessable in the current year, it will tax the interest revenue in a subsequent period when it is actually received by the company.

18.17 (a) Carrying amount Prepaid rent (b)

Tax base

$400 000

Temporary difference $0

$400 000

As the carrying amount of the asset is greater than the tax base, a deferred tax liability exists. The balance of the deferred tax liability is $400 000 x 0.30 = $120 000. The deferred tax liability exists because the tax office has given the company a deduction ‘up front’ when the rent was paid, even though the rent was prepaid. However, when the company actually treats the rent as an expense (across time as the benefits are derived), no deduction will be available to the company. In a sense, the company has received a deduction ‘in advance’.

18.18 (a) Carrying amount