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Accounting for Income Taxes

LO: Identify the major differences between tax and


accounting treatments

Taxable income usually differs from accounting profit before


tax.
- Assessable income is similar (but not identical) to
accounting income
- Allowable deductions are similar (but not identical) to
accounting expenses

Many expenses payable:


- Accounting treatment: recognised as an expense when
accrued
- Tax treatment: recognised as a tax deduction when paid
For some revenue received in advance:
- Accounting treatment: recognised as revenue when
earned
- Tax treatment: typically assessed for tax when received

Property, plant and equipment:


- Accounting treatment: depreciation is allocated over the
estimated economic life of the asset
- Tax treatment: depreciation recognised as a tax
deduction in the schedule of depreciation rates issued
by the ATO
Doubtful debts:
- Accounting treatment: recognised as an expense when
identified as doubtful
- Tax treatment: treated as a tax deduction when the
receivables are written off as bad
Refer Table 9.1 textbook page 235

LO: Identify and explain alternative ways of accounting for


company income tax

Income tax payable is:


- The amount that must be paid to the government
- Calculated by applying the company income tax rate to
taxable income
Income tax expense is:
- The amount of income tax shown as an expense on the
statement of comprehensive income
- Not necessarily the same as income tax payable
Tax payable method
Assumes tax expense in a period is the tax payable to the
government

In Example 9.1 (textbook page 235) :


Year 1 journal entry:
Income tax expense
Dr $18,000
Income tax payable
Cr $18,000

Advantages
Simple to apply
Reasonable to assume that tax expense for a period is
the tax that must be paid for the period
LO: Understand the perceived problems with the taxpayable method

Criticisms:
- It was believed it resulted in misleading financial
statements
- Changes in profit after tax may not be caused by
changes in performance but by vagaries of the income
tax legislation
Counter argument:
- Tax payable method reflects reality
LO: Apply the statement of financial position approach
to tax allocation
Introduces the idea of a tax base of an asset or liability
- The amount at which an asset or liability would be
shown in a statement of financial position derived from
accounts prepared for tax purposes
In Example 9.1, Captain Ltd had a depreciable asset costing
$100,000 with a zero residual value:
- For accounting purposes:
- The asset was depreciated over four years on a
straight-line basis
- For taxation purposes:
- The asset was depreciated over four years on a
reducing-balance basis

Temporary differences:
In year 1, the depreciation expense recognised for accounting
purposes is $15,000 less than the amount claimed for tax
($25,000 vs $40,000).
As a result, the CA of asset > TB by $15,000 ($75,000$60,000).
This difference between the carrying amount and tax base of
the asset is defined as temporary difference.
The difference is temporary because it will reverse in future
periods. E.g. see the differences between Income tax
expense and Income tax payable over the 4 year periods in
Example 9.1.
The use of reducing-balance depreciation for tax purposes
means that less tax is paid now but more will be paid later.

Deferred tax liabilities (DTLs) and deferred tax assets (DTAs):


- Arise because of temporary differences between the
carrying amount and tax base of an asset or liability
- They are reversed from the accounts as the temporary
differences reverse

Assets:
- DTL = Carrying amount > Tax base
- DTA = Tax base > Carrying amount
Liabilities:
- DTA = Carrying amount > Tax base
- DTL = Tax base > Carrying amount
General journal entries to record DTA/DTL:
Dr Deferred Tax Asset
Cr Deferred Income Tax Expense
Dr Deferred Income Tax Expense
Cr Deferred Tax Liability

The income tax expense reported in the statement of


comprehensive income has two components:
- The amount of income tax payable (current income tax
expense paid to ATO); plus
- The amount necessary to restate the deferred tax
liability or asset to its current amount (deferred income
tax expense)
General journal entries for Year 1 (Example 9.1):
Current income tax expense Dr $18,000*
Income tax payable
Cr
$18,000
(*18,000 = taxable income 60,000 x 30%)
Deferred income tax expense Dr $4,500
Deferred tax liability
Cr
$4,500**
(** 4,500 = taxable temporary difference 15,000 x 30%)

The income tax expense of Year 1 reported in the statement of


comprehensive income is:
Current income tax expense:
$18,000
Deferred income tax expense: $ 4,500
----------Income tax expense:
$22,500

Permanent differences:
- In addition to the temporary differences, there are also
permanent differences, which are assets or liabilities
that are recognised in either an accounting statement of
financial position or a tax statement of financial position
but are never recognised in the other
- Examples
- Tax exempt income
- Expenses payable with a zero tax base
- Allowable tax deductions that are not recognised
for accounting purposes
- They do not result in DTAs or DTLs
LO: Understand and apply the requirements of AASB
112

The tax base of an asset is


either:
- 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; or
- The carrying amount where the economic benefits
will not be taxable.
(AASB 112: 7)

Example:
- A non-current asset cost $100,000 and accumulated
depreciation for accounting purposes is $40,000:
- The carrying amount = $60,000
- An amount of $55,000 has been claimed as a
depreciation deduction for tax purposes:
- The tax base = $45,000 (100,000-55,000)
- Temporary difference: Carrying amount - Tax base
= $60,000- $45,000
= 15,000
If the tax rate is 30%: DTL is $15,000 X 30% = $4,500
The general journal entry
(assuming a $3,000 carried-forward DTL balance):
Deferred income tax expense Dr $1,500

Deferred tax liability

Cr

$1,500

Again, starting from the DTL calculation of $4,500 (see


slide number 27)
- General journal entry
(assuming a $5,500 carried-forward DTL balance):
Deferred tax liability
Dr
$1,000
Deferred income tax expense Cr
$1,000
With your neighbour, do a T account to show how this
works
-

The tax base of a liability:


- Is the carrying amount less any amount that will be
deductible for tax purposes in respect of that liability
- In the case of revenue received in advance, its tax base
is its carrying amount less any amount of the revenue
that will not be taxable in future periods
(AASB 112: 8)

Example:
Provision for long-service leave of $100,000
Carrying Amount = $100,000
Tax Base = $nil
Temporary difference = $100,000
DTA = $100,000 X 0.30 = $30,000
Step 1: Calculate taxable income to determine income tax payable
and current income tax expense
Income Tax Payable = Taxable income x Tax Rate*
*Using the tax rates enacted or substantively enacted by the end of
the reporting period (AASB112:46)
Step 2: Identify temporary differences resulting in deferred tax
assets (DTA) and deferred tax liabilities (DTL) to determine the
changes in the DTA and DTL
Step 3: Record the journal entries for income tax payable and
current income tax expense and changes in DTA, DTL and deferred
income tax expense accounts.
Dr Current Income Tax Expense
Cr Income Tax Payable
Dr Deferred Income Tax Expense
Cr Deferred Tax Liability*
(*increase in taxable temporary differences x tax rate)
Dr Deferred Tax Asset**
Cr Deferred Income Tax Expense
(**increase in deductible temporary differences x tax rate)
Revalued assets

Revaluation of property, plant and equipment gives rise to a


taxable/deductible temporary difference
Example:
- A depreciable asset was acquired for $100,000 with a
useful life of 10 years
- The asset was depreciated straight-line over the same
useful life for accounting and tax purposes
- After 5 years the asset is revalued to $75,000

Before revaluation:
- Carrying amount $_____
- Tax Base $_____
- Temporary difference $________
- Journal entries for the revaluation:
After revaluation:
- Carrying amount $______
- Tax Base $_______
- Temporary difference $________
- DTA or DTL $________
- Journal entry to record DTA or DTL:
In this case, current tax and deferred tax must be charged or
credited directly to equity (AASB 112.61A, note in particular 61A(a)
and (b)
Refer Example 9.5 (textbook page 257)

After criticism of the tax payable method of accounting for


income tax, a new and more complicated method emerged
that sought to smooth reported profits.
With the emergence of the conceptual framework, which pays
more attention to balance sheet items, this method was
adjusted to what we see today.
The method is controversial and requires thought:
- Questions arise whether a deferred tax liability really is
a liability as defined by the framework, and whether a
deferred tax asset really is an asset as defined by the
framework.
- Questions also arise about the meaning of the amount
reported in the income statement as income tax
expense.