LECTURE TWO

ACCOUNTING FOR INCOME TAX PART II

BACHELOR OF ACCOUNTING YEAR 4

SCHOOL OF BUSINESS AND MANAGEMENT
DEPARTMENT OF ACCOUNTING

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INTRODUCTION
 The main focus in this topic is not on the determination of
Company’s taxable income or tax payable as this is already
covered in your ACC703 Taxation unit.
 Rather we concentrate on the accounting treatment of income
tax expense for the purpose of measurement and disclosure in
the Organisation’s general purpose financial statement.
 IAS 12/ AASB112 Income taxes is the accounting standard that
determines the treatment of Income taxes. It applies what is
known as the Balance sheet method.
 Recognition of assets and liabilities in Balance sheet to ensure
that correct levels of future tax benefits and of sacrifices arising
between the accounting and tax values of assets and liabilities
are recognised.

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Learning Objectives
 Understand that there is typical difference between profit and
loss for accounting purposes and profit and loss for taxation
purposes.
 Be able to identify some types of factors that will cause a
difference between profit or loss for accounting purposes and
profit and loss for taxation purposes.
 Under stand the balance sheet approach accounting for
taxation.
 Understand the difference between the carrying amount of an
asset or liability and its tax base will lead to temporary
difference
 Understand that temporary difference creates a deferred tax
asset or deferred tax liability.

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Learning Objectives
 Understand how deferred tax assets and deferred tax liabilities
arise and how they are calculated.
 Be able to critically evaluate the balance sheet approach to
accounting for taxation and the associated asset ( deferred tax
asset) and liability ( deferred tax liability).

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TAX EFFECT ACCOUNTING
 In Accounting for income tax, various events impacting the
entity and various transactions undertaken by the entity
will create two separate- effects. There will be current
liabilities for income tax payable and there will also be tax
consequences beyond the next financial period.
 The future consequences will give rise to deferred tax asset
and deferred tax liabilities.
 Deferred tax is the estimated future tax as a result of
current and past period transaction in the financial
statements. It is an accounting entry and not the actual tax
payable to or refundable to or from Inland Revenue.
 Deferred tax exists because of the difference between
accounting profit and taxable profits.

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 Deferred Tax
Something that will lead to a decrease in
taxable profit in future years (a deductible
temporary difference) creates an asset -
Deferred tax asset.

Something that will lead to increase in

taxable profit in future years (a taxable
temporary difference)- Deferred tax liability.

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THE BALANCE SHEET APPROACH TO
ACCOUNTING FOR TAXATION
 The balance sheet approach to accounting for taxation
focuses on comparing the carrying amount of an
entity’s assets and liabilities (determined in
accordance with accounting rules” with tax base for
assets and liabilities ( determined by Taxation rules)
 That is we are comparing the balance sheet (statement of
financial position) that is derived using accounting rules,
with the balance sheet that would be derived if we were to
use taxation rules.
 When considering how assets and liabilities would be
recognised for taxation purposes, we refer to the tax base of
the relevant asset or liability (tax base)
 The tax base is defined in AASB 112 as the amount that
is attributed to asset or liability for tax purposes
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 THE BALANCE SHEET APPROACH TO
ACCOUNTING FOR TAXATION
Where the carrying amount of an asset or liability is different from tax base, a
temporary different from tax base, temporary difference can arise.

Temporary difference: The difference between the carrying amount of an asset

or liability in the statement of financial position and its tax base.

 Deductible temporary differences that will results in amounts that are

deductible in determining taxable profits ( tax loss)of the future periods
when the carrying amount of the asset or liability is recovered or settled, or
 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.

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ILLUSTRATIVE EXAMPLE I
 To illustrate a taxable temporary difference that lead to
deferred tax liability, we can consider a depreciable asset-
Let’s say machine.

 Let us assume that an entity acquires a machine at cost $200

000 in 2022. For accounting Purposes the asset is expected to
have a useful life of five years, after which time it is expected
to have no salvage value; the benefits are expected to be
derived uniformly, meaning the straight line method of
depreciation is used. Let’s assume the tax rate is 30%.

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ILLUSTRATIVE EXAMPLE I
Fortax purposes the asset can be depreciated on the straight line basis over 4 years. Hence after
2 years, we determine the carrying amount and the tax base.

Carrying amount Tax base

Cost $200 000 $200 000

Less accumulated Depreciation $ 80 000 $100 000
$120 000 $100 000

In the above situation, what has effectively happened is that the Inland Revenue has been given
the entity greater deduction relative to consumption of the economic benefits. While the entity
is given tax deductions for the first 4 years, and has effectively reduced the tax payable in
those years, no deductions will be given in year 5 as cost of the asset will have been fully
claimed with Inland revenue by the end of year 4.Because no deduction for tax purposes in
year 5, the entity has deferred the tax to the fifth year- that is the entity has a deferred tax
liability. A deferred tax liability is defined in AASB 112 as the income tax payable in future
reporting periods in respect of temporary differences.

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 ILLUSTRATIV EXAMPLE 2
 For example if it is assumed that the entity in
Illustrative example 1 is going to generate accounting
profits of $500 000, $600, 000, $650 000, $700 000
and, $800 000 respectively in each of the next 5 years
(before tax). And that tax rate is 30%, taxable income
can be determined as follows

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 ILLUSTRATIV EXAMPLE 2
2015 2016 2017 2018 2019
$ $ $ $ $
Accounting Profit
500 000 600 000 650 000 700 000 800 000
Add back accounting
Depreciation 40 000 40 000 40 000 40 000 40 000
Less tax depreciation (50 000) (50 000) (50 000) (50 000) -
Taxable Profit 490 000 590 000 640 000 690 000 640 000
Tax payable ( at 30%) 147 000 177 000 192 000 207 000 252 000

As we can see from the above workings, the excess of the tax depreciation over
accounting depreciation in the first 4 years reduces taxable profit. However, no
depreciation is deductible in year 5. The company is given extra deductions in year 1 to
year 4 in which it will give back in in year 5. There is in effect a timing difference. A
deferred tax liability is considered throughout life of the asset. Thus, year 5 a further
$12 000 in taxes will be payable. Any difference in total depreciation throughout 5 years
is temporary. Once additional taxation of $12 000 is paid in year 5, the deferred tax
liability will no longer exist.

10 000 x 4= 40 000 x 30%

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FORMULA IN DETERMINING DEFERRED TAX
LIABILITIES AND ASSETS
 Carrying Amount of assets or liabilities
minus tax bases of assets and liabilities
equals taxable or deductible temporary
differences.

 Taxable or deductible temporary differences

multiply Tax rate equals Deferred tax
liabilities or deferred tax assets.

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 ILLUSTRATIVE EXAMPLE 3
Temporary differences caused by the depreciation of a non-current Asset

KK Mart Commence operations on 1st July 2012. On the same date, it

purchases a fire glassing machine at cost of $600 000. The machine is
expected to have a useful life of 4 years, with benefits being uniform
throughout its life. It will have no residual value at the end of 4 years.
Hence, for accounting purposes the depreciation expense would be$150
000 per year. For taxation purpose, the Tax act allows the company to
depreciate the asset over 3 years- that is $200 000 per year. The profit
before tax of the Company for each of the next 4 years (years ending 30
the June is $500, 000, $600, 000, $700, 000 and $800, 000. The Tax rate
is 30%.

 Required
Determine the tax expense and taxes payable for the years 2013 to 2016,
and provide the necessary accounting Journal entries.

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Solution year 1
 Year ending 30th June 2013
Carrying Tax base $ Temporary
Value $ difference
Fibre glassing 600 000 600 000 $
Machine cost
Accumulated 150 000 200 000
Dep 450 000 400 000 50 000
If we look at the calculations for year 1, we see that, in essence, the entity
has claimed a $50 000 deduction from Tax in excess of the asset’s
recoverable amount. If the asset is sold for its anticipated recoverable
amount, this $50, 000 would be assessable and $15 000 would be payable
( $50 000 x 30%).

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However accepting that the asset has not been sold, the total tax on the
Company’s taxable income would be determined as follows:

Accounting profit before tax $500 000

Add back accounting Depreciation $150 000
Subtract depreciation for taxation purposes ($200 000)
Taxable profit $450 000
Tax at 30% $135 000

The Journal entries at 30th June 2013 would be:

Dr Income tax expense $15 000
Cr Deferred tax liability $15 000
(To recognise the tax expense that relates to the temporary difference which equals $50
000 x 0.30%)

Dr Income tax Expense 135 000

Cr Income tax payable 135 000

 (To recognise the tax expense that relates to the entity’s taxable income which equals
$450 000 x 0.30%)

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 Year 2 Ending 30th June 2014

Carrying Tax base $ Temporary

Value $ difference
Fibre glassing 600 000 600 000 $
Machine cost
Accumulated Dep 300 000 400 000
300 000 200 000 100 000

The temporary difference at 30th June 2014 totals $100 000.

Applying the tax rate at 30% percent provides a deferred
tax liability of $30, 000. Because $15 000 has been
recognised on 2013, an increase or top up of $15 000 is
required.

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The tax on the taxable income would be determined as follows:
Accounting profit before tax 600 000
Add back accounting Depreciation 150 000
Subtract depreciation for taxation purposes (200 000)
Taxable profit 550 000
Tax at 30% 165 000

The Journal entries at 30th June 2014 would be:

Dr Income tax expense $15 000
Cr Deferred tax liability $15 000
(To recognise the tax expense that relates to the temporary difference)

Dr Income tax Expense 165 000

Cr Income tax payable 165 000
(To recognise the tax expense that relates to the entity’s taxable income
which equals $550 000 x 0.30%)

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 Year 3 (Ending- 30 June 2015)

Carrying Tax base $ Temporary

Value $ difference
Fibre glassing 600 000 600 000 $
Machine cost
Accumulated Dep 450 000 600 000
150 000 0 150 000

The temporary difference at 30th June 2015 totals $150 000.

Applying the tax rate at 30% percent provides a deferred
tax liability of $45, 000. Because $30 000 has been
recognised on 2013 and 2014, an increase or top up of $15
000 is required.

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 The tax on the taxable income would be determined as follows:
Accounting profit before tax 700 000
Add back accounting Depreciation 150 000
Subtract depreciation for taxation purposes (200 000)
Taxable profit 650 000
Tax at 30% 195 000

The Journal entries at 30th June 2015 would be:

Dr Income tax expense $15 000
Cr Deferred tax liability $15 000
(To recognise the tax expense that relates to the temporary difference)

Dr Income tax Expense 195 000

Cr Income tax payable 195 000

(To recognise the tax expense that relates to the entity’s taxable income
which equals $650 000 x 0.30%)

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  Year 4 (Ending- 30 June 2016)
Carrying Tax base $ Temporary
Value $ difference
Fibre glassing Machine cost 600 000 600 000 $
Accumulated Dep

600 000 600 000

0 0 0

The temporary difference at 30th June 2016 is nil, which

means there should be no deferred tax liability or
deferred tax asset recorded in relation to this asset. This
means the balance accrued in the deferred tax liability
must be reversed in 2016.

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The tax on the taxable income would be determined as follows:
Accounting profit before tax 800 000
Add back accounting Depreciation 150 000
Subtract depreciation for taxation purposes (0)
Taxable profit 950 000
Tax at 30% 285 000

The Journal entries at 30th June 2015 would be:

Dr Deferred tax liability $45 000
Cr Income tax expense $45 000

(We credit tax expense because this $45 000 has already been recognised in previous
years)

Dr Income tax Expense 285 000

Cr Income tax payable 285 000

(To recognise the tax expense that relates to the entity’s taxable income which equals
$950 000 x 0.30%)

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 A review of the worked example indicates that the balance
sheet approach to accounting for income tax smooth the tax
expense across the 4 years, as indicated below.

Year 1 Year 2 Year 3 Year 4 Total

Tax expense based on taxable
profit 135 000 165 000 195 000 285 000 780 000

Adjustment for temporary 15 000 15 000 15 000 (45 000)

difference
Total taxation expense as 150 000 180 000 210 000 240 000 780 000
reported in the statement of
comprehensive income

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 SUMMARY
 In this topic we have explored how to account for taxes. It
was established that taxable profit and accounting profit will
often be different because expense and recognition rules
used in accounting are frequently different from those
applied for taxation purposes.
 AASB 112/ IAS 12 applies the balance sheet approach method
for accounting for taxes. This required a comparison of the
carrying amounts and tax bases of the entity’s assets and
liabilities. The comparison of these values is the key to
applying the balance sheet method.
 The difference between carrying amounts and tax bases leads
to deductible temporary differences or taxable temporary
differences. Multiplying these differences by the tax rate
gives the deferred tax assets and deferred tax liabilities.

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 SUMMARY
 If the carrying amount of an asset is greater than its tax base
then there will be a deferred tax liability. If the carrying
amount of an asset is less than its tax base then there will be
a deferred tax asset. If the carrying amount of a liability is
greater than its tax base then there will be a deferred tax
asset, and if the carrying amount of liability is less than its
tax base then there will be a tax deferred tax liability.

Deferred tax liability Deferred tax asset

Asset Carrying amount > tax base Carrying amount < than
tax base
Liability Carrying amount < tax base Carrying amount > Tax
base

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 Thank you for Listening

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