 PAS 12

INCOME TAXES

Introduction

PAS 12 prescribes the accounting for income taxes. For purposes of PAS 12, income taxes refer
to taxes that are based on taxable profits.

The income tax expense reported in the statement of comprehensive income may be different
from the amount of income tax required to be paid to the Bureau of Internal Revenue (BIR).
This is because the income tax expense in the statement of comprehensive income is computed
using PFRSs while the current tax expense in the income tax return (ITR) is computed using
Philippine tax laws, and the PFRSs and tax laws have different accounting treatments for some
economic activities.

Some items are appropriately recognized as income (expense) under financial reporting but are
either (a) non-taxable (non-deductible) or (b) taxable (deductible) only at some other periods
under Philippine tax laws. These varying treatments result to permanent and temporary
differences. PAS 12 addresses the accounting, presentation and reconciliation of these
differences.

For example, assume Entity A accrues bad debts expense of P100 under financial reporting.
However, under taxation, this amount is tax deductible only when it is deemed worthless. The
difference is analyzed in the next slide:

Financial reporting Taxation Difference

Profit before bad debts 1,000 1,000 -

Bad debts (100) -_______________

Accounting / Taxable profit 900 1,000 (100)

Tax rate 30% 30%______________

Income / Current tax expense 270 300 (30)___

Accounting profit and Taxable profit

 Accounting profit is “profit or loss for a period before deducting tax expense”.
  Taxable profit (tax loss) is “profit (loss) for a period, determined in accordance with the
rules established by the taxation authorities, upon which income taxes are payable
(recoverable)”. (PAS 12.5)

Income tax expense and Current tax expense

 Tax expense or income tax expense (tax income) – is the total amount included in the
determination of profit or loss for the period. It “comprises current tax expense (current
tax income) and deferred tax expense (deferred tax income)”. (PAS 12.6)

 Current tax or current tax expense – is “the amount of income taxes payable
(recoverable) in respect of the taxable profit (tax loss) for a period”. (PAS 12.5)

 Deferred tax expense (income or benefit) – is the sum of the net changes in deferred tax
assets and deferred tax liabilities during the period.

 If the increase in deferred tax liability exceeds the increase in deferred tax asset,
the difference is deferred tax expense.

 If the increase in deferred tax asset exceeds the increase in deferred tax liability,
the difference is deferred tax income or benefit.

Let’s continue the example from the previous slide (i.e., Entity A):

Accounting profit 900 Income tax expense 270

Temporary difference 100 Deferred tax (expense) benefit 30

Taxable profit 1,000 Current tax expense 300

Using the definition above, we can reconcile the income tax expense as follows:

Income tax expense = Current tax expense + Deferred tax expense / - Deferred tax benefit

Income tax expense = 300 computed using tax laws – 30 determined using PFRSs = 270 amount
presented in the statement of comprehensive income

or

Income tax expense 270

Deferred tax (expense) benefit 30

Current tax expense 300

The varying treatments of economic activities between the PFRSs and the tax laws results to
following differences:

a. Permanent differences

b. Temporary differences

Permanent differences

Permanent differences arise when income and expenses enter in the computation of either
accounting profit or taxable profit but not both. If an item is included in the computation of
one, it will never enter in the computation of the other.

Permanent differences usually arise from non-taxable and non-deductible expenses and those
that have already been subjected to final taxes. In other words, these are items excluded from
the income tax return.

Since permanent differences are non-taxable, nontax-deductible or have already been taxed
under final taxation, they do not have future tax consequences, and hence do not give rise to
deferred tax assets and liabilities.

Examples of permanent differences:

a. Interest income on government bonds and treasury bills

b. Interest income or bank deposits

c. Dividend income

d. Fines, surcharges, and penalties arising from violation of law

e. Life insurance premium on employees where the entity is the irrevocable beneficiary

Temporary differences

Temporary differences are “differences between the carrying amount of an asset or liability in
the statement of financial position and its tax base”. (PAS 12.5) Temporary differences may be
either:

a. Taxable temporary differences – those that result to future taxable amounts when the
carrying amount of the asset or liability is recovered or settled; or

b. Deductible temporary differences – those that result to future deductible amounts

when the carrying amount of the asset or liability is recovered or settled.
Temporary differences have future tax consequences; hence they give rise to either deferred
tax assets or deferred tax liabilities.

Taxable temporary differences give rise to deferred tax liabilities while Deductible temporary
differences give rise to deferred tax assets.

Temporary differences include timing differences. Timing differences arise when income and
expenses are recognized for financial reporting purposes in one period but are recognized for
taxation purposes in another period (or vice versa). They are called “timing differences”
because only the timing or period of their recognition differs between financial reporting and
taxation. They are temporary differences because their effect reverses in one or more
subsequent periods.

Taxable temporary differences

Taxable temporary differences arises when:

a. Financial income (accounting profit) is greater than the Taxable income (taxable profit);

b. The carrying amount of an asset is greater than its tax base; or

c. The carrying amount of a liability is less than its tax base.

Examples of Taxable temporary differences:

a. Revenue is recognized in full under financial reporting but is taxable only when
collected.

b. A prepayment is capitalized and amortized to expense under financial reporting but is

tax deductible in full upon payment.

c. An asset is revalued upward and no equivalent adjustment is made for tax purposes.

d. Depreciation recognized under financial reporting is lower than the depreciation

recognized for taxation purposes.

Taxable temporary difference multiplied by the tax rate results to deferred tax liability.

 Deferred tax liabilities are “the amounts of income taxes payable in future periods in
respect of taxable temporary differences.” (PAS 12.5)

Deductible temporary differences

Deductible temporary differences arise when:

 a. Financial income (accounting profit) is less than the Taxable income (taxable profit);

b. The carrying amount of an asset is less than its tax base; or

c. The carrying amount of a liability is greater than its tax base.

Examples of Deductible temporary differences:

a. Rent received in advance is treated as unearned income (liability) under financial

reporting but is taxable in full upon receipt of cash.

b. Bad debts expense is recognized for financial reporting when the collectability of
accounts receivable becomes doubtful while it is tax deductible only when the accounts
receivable is deemed worthless.

c. Warranty obligation is recognized as expense when a product is sold under financial

reporting but is tax deductible only when actually paid.

d. Depreciation recognized under financial reporting is higher than the depreciation

recognized for taxation purposes.

e. Losses and tax credits that can be carried forward and deducted from future taxable
profits.

Deductible temporary difference multiplied by the tax rate results to deferred tax asset.

 Deferred tax assets are “the amounts of income taxes recoverable in future periods in
respect of: (a) deductible temporary differences; (b) the carry forward of unused tax
losses; and (c) the carry forward of unused tax credits.

The recognition of deferred tax assets and liabilities does not alter the amount of tax to be paid
to the BIR in the current period. However, when they reverse in a future period:

a. Deferred tax liability results to a higher amount of tax to be paid to the BIR.

b. Deferred tax asset results to a lower amount of tax to be paid to the BIR.

Summary of concepts:

Accounting for Deferred Taxes

PAS 12 requires the use of the asset-liability method (also called ‘balance sheet liability
method’) in accounting for deferred taxes. This method is a comprehensive approach in
accounting for deferred taxes in that it accounts both (a) timing differences and (b) differences
between the carrying amounts and tax bases of assets and liabilities.
Timing differences are differences between accounting profit and taxable profit that originate in
one period and reverse in one or more subsequent periods. Temporary differences are
differences between the carrying amount of an asset or liability in the statement of financial
position and its tax base. Temporary differences include all timing differences; however, not all
temporary differences are timing differences.

 “The tax base of an asset or liability is the amount attributed to that asset or liability for
tax purposes”. (PAS 12.5)

 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”. (PAS 12.8)

 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”. (PAS 12.8)

Examples:

1. An asset has a carrying amount of P1,000 and a tax base of P400.

Analysis:

The difference of P600 (1,000 – 400) is a taxable temporary difference, i.e., carrying amount of
an asset is greater than its tax base. If the tax rate is 30%, the deferred tax liability is P180 (600
x 30%).

2. Entity A has dividends receivable with carrying amount of P1,000. The dividends are not
taxable.

Analysis:

Since the dividends are not taxable, the tax base is equal to the carrying amount of P1,000. No
temporary difference or deferred tax arises from the dividends, i.e., 1,000 carrying amount –
1,000 tax base = 0 difference.

3. Entity A has accounts receivable with carrying amount of P1,000. The receivable is
taxable only when collected.

Analysis:
Since the carrying amount is taxable in full when collected, the tax base is zero. The difference
of P1,000 (1,000 carrying amount – 0 tax base) is a taxable temporary difference. If the tax rate
is 30%, the deferred tax liability is P300 (1,000 x 30%).

Recognition

The fundamental principle under PAS 12 is that “an entity shall, with certain limited exceptions,
recognize a deferred tax liability (asset) whenever recovery or settlement of the carrying
amount of an asset or liability would make future tax payments larger (smaller) than they
would be if such recovery or settlement were to have no tax consequences”. (PAS 12.10)

Measurement

Deferred tax assets and liabilities are measured at the tax rates that are expected to apply to
the period of their reversal, based on tax rates that have been substantively enacted by the end
of the reporting period. PAS 12 prohibits the discounting of deferred tax assets and liabilities.

Illustration:

Entity A has a taxable temporary difference of P2,000 in Year 1. The difference is expected to
reverse as follows: P1,000 in Year 2 and P1,000 in Year 3. The tax rate in Year 1 is 30%.
However, by the end of Year 1, a tax law is enacted which requires tax rates of 32% in Year 2
and 35% in Year 3 and in succeeding years.

 Entity A recognizes a deferred tax liability of P670 at the end of Year 1, computed as
follows: [(1,000 x 32%) + (1,000 x 35%)].

Presentation in the Statement of financial position

Deferred tax assets and deferred tax liabilities are presented separately as noncurrent assets
and noncurrent liabilities, respectively, in a classified statement of financial position.

PAS 12 permits offsetting of deferred tax assets and deferred tax liabilities only if:

a. The entity has a legally enforceable right to offset current tax assets against current tax
liabilities; and

b. The deferred tax assets and the deferred tax liabilities relate to income taxes levied by
the same taxation authority.

Accounting for Current Taxes