IAS 12 - How To Determine Tax Base (Part 3)

This is the third part of how to determine tax base. For the previous posts, you can refer to the following link:

Part 1 - https://tysonspeaks.blogspot.com/2019/08/ias-12-how-to-determine-tax-base-part-1.html

Part 2 - https://tysonspeaks.blogspot.com/2019/09/ias-12-how-to-determine-tax-base-part-2.html

For Part 3, I am going to discuss about how to determine the tax base for liability as well as tax base for some specific scenarios involving the accounting standards in the Financial Reporting (FR) paper of ACCA.

Tax Base of Liability

Before we go into the details, let's look again at the definition of tax base of liability according to IAS 12:

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.

In general, there are two points:

(a) Generally, the tax base of the liability will be equal to its carrying amount unless the liability represents an expense which will only be deductible in the future when it is paid. In this case, the tax base is the carrying amount minus the amount that will be deductible in the future (e.g accrued expenses in which deduction is given in the future when the liability is paid - deduction on cash basis).

(b) If the liability represents an income received in advance, then the tax base is the carrying amount minus any revenue that is not taxable in the future (e.g. an income received in advance which is taxed in this year on receipt basis. This income will not be taxable in the future).

You will understand more after going through the following illustrations:

1. Trade Payables

The entity incurs an expense of $100 on credit. The accounting double entry is:

Dr Expenses (SOPL) $100
Cr Trade payables $100

In this case, the carrying amount of the liability is $100.

Tax treatment: Assuming that the tax rule provides that such expense is deductible on an accrual basis (i.e. deduction is given even though the entity has not paid for the expense).

The imaginary tax double entry in the imaginary tax financial statements will be:

Dr Deductible expenses $100
Cr Trade payables $100

As we can see from the above, the tax base of the liability is also $100 because $100 is deductible in this year.

Since the CA and TB are the same, there will be no deferred tax because the accounting rule and tax rule are the same.

Note: Referring back to the definition, as none of the $100 liability is deductible in the future (the full $100 has already been deducted in the current year), the tax base is equal to its carrying amount of $100.

2. Accrued Expenses Which Is Deducted on Cash Basis

An entity has accrued water and electricity expenses of $100 for the month of December. Such expense has not been paid by year end. The accounting double entry is:

Dr Expenses (SOPL) $100
Cr Accrued expenses $100

In this case, the carrying amount of the liability is $100.

Tax treatment: Assuming that tax rule provides that the deduction for such expenses can only be made when the entity has paid for the expenses.

As the entity has not paid for the expenses, there will be no tax double entry. Accordingly, it follows that there is no tax base because the expense is not deductible in this year.

As such, CA = $100 and TB = $0. As CA > TB and this is a liability, this represents a DTD of $100.

Reason for DTD: The entity will pay higher tax this year because deduction is not given this year. However, the entity will pay lesser tax in the future when deduction is given (hence DTD).

Note: Referring back to the definition, as the $100 liability will only be deducted in the future, the tax base is equal to its carrying amount ($100) less the amount that will be deductible in the future ($100). This will result in tax base to be equal to zero ($100 - $100).

3. Deferred Income Which Is Taxed on Cash / Receipt Basis

An entity receives $100 advance payment for services to be rendered in the future. As the performance obligation has not been satisfied, according to IFRS 15 Revenue from Contracts with Customers, revenue cannot be recognised. Instead, a deferred revenue (liability) should be recognised as follows:

Dr Bank $100
Cr Deferred revenue (liability) $100

In this case, the carrying amount of the liability is $100.

Tax treatment: Assuming that the tax rule mentions that the income will be taxed if the entity has received the income.

As the income is subject to tax in this year (since the entity has received the income), the imaginary tax double entry in the imaginary tax financial statements will be as follows:

Dr Bank $100
Cr Taxable income $100

In other words, in the tax SOFP, there will be no liability because the income has already been taxed this year. As such, tax base is equal to zero.

As CA = $100 and TB = 0 and this is a liability, there will be a DTD of $100 since CA > TB.

Reason for DTD: The entity will pay more tax in this year because the deferred income is subject to tax in this year. However, the entity need not pay tax again in the future (hence the future tax is lesser and it is DTD).

Note: Referring back to the definition, as the $100 income received in advance has already been taxed in this year, there will be no tax to be paid in the future. As such the tax base is the carrying amount ($100) less the revenue that will not be taxable in the future ($100). This will result in the tax base to be equal to $0 ($100 - $100).

4. Deferred Income Which Is Taxed in the Future

Assuming that the scenario is the same as scenario no.3 above, except that the tax treatment is that the income will not be taxed now, but it will only be taxed in the future when services are rendered.

In this case, the imaginary tax double entry in the imaginary tax financial statements will be similar to the accounting double entry:

Dr Bank $100
Cr Deferred revenue (liability) $100

As such, tax base of the liability is equal to $100 because we have not paid the tax.

As CA = $100 and TB = $100, it follows that there is no deferred tax. This is because the accounting rule and tax rule are the same.

Note: Referring back to the definition, as the $100 income received in advance will be taxed in the future, the tax base is the carrying amount ($100) less the revenue that will not be taxable in the future ($0). This will result in the tax base to be equal to $100 ($100 - $0).

5. Loan Payable

An entity borrowed $100 from the bank. The accounting double entry is as follows:

Dr Bank $100
Cr Loan payable $100

As such, the carrying amount of the liability is $100.

Tax treatment: When the entity receives the borrowing from the bank, there is no tax implication. When the entity makes repayment of loan to the bank, there is also no tax implication.

The imaginary tax double entry in the imaginary tax financial statements will be similar to the accounting double entry:

Dr Bank $100
Cr Loan payable $100

As the CA and TB are the same, it follows that there is no deferred tax. This is because the accounting rule and tax rule are the same.

Note: Referring back to the definition, as the $100 liability will not be deductible in the future, the tax base is equal to its carrying amount ($100) less the amount that will be deductible in the future ($0). This will result in tax base to be equal to $100 ($100 - $0).

6. Accrued Fines and Penalties

An entity accrues fines and penalties amounting to $100. The accounting double entry is as follows:

Dr Expenses (SOPL) $100
Cr Accrued fines and penalties $100

As such, the carrying amount of the liability is $100.

Tax treatment: Assuming that fines and penalties are not deductible for tax purposes.

The imaginary tax double entry in the imaginary tax financial statements will be similar to the accounting double entry:

Dr Non-deductible expenses $100
Cr Accrued fines and penalties $100

As such, the tax base of the liability is also $100.

As the CA and TB are the same, it follows that there is no deferred tax.

Note: Referring back to the definition, as the $100 liability will not be deductible in the future, the tax base is equal to its carrying amount ($100) less the amount that will be deductible in the future ($0). This will result in tax base to be equal to $100 ($100 - $0).

Alternatively, you can also argue that as fines and penalties are not deductible, the difference represents a permanent difference and deferred tax should be ignored. Both analysis will result in no deferred tax calculation.

There you go! This is the idea of how do we determine tax base for liability.

Next, I am going to cover about some specific scenarios involving the accounting standards in the Financial Reporting (FR) paper of ACCA.

Specific Scenarios

In this part, I will cover some scenarios involving the following:

1. Unutilised tax losses or unutilised tax credits
2. Leasing (IFRS 16)
3. Convertible loan note (IAS 32)

1. Unutilised Tax Losses / Unutilised Tax Credits

Unutilised tax losses (in Malaysia, this is known as unabsorbed business losses) refer to the tax losses that can be carried forward to the future so that it can be used to offset against taxable income that an entity will earn in the future. In other words, future tax can be reduced by these unutilised tax losses.

As the entity will pay lesser tax in the future, unutilised tax losses will result in deferred tax asset (DTA).

For example, if an entity is having unutilised tax losses of $100,000 and the tax rate is 25%, there will DTA of $25,000 ($100,000 x 25%).

However, do take note that paragraph 34 of IAS 12 mentions that such deferred tax asset can be recognised "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."

In other words, using the same example as above, if the entity only expects that it can earn $70,000 taxable profit in the future, the entity can only recognise DTA of $21,000 ($50,000 x 25%) instead of the full $25,000 DTA.

The remaining DTA of $4,000 ($25,000 - $21,000) will not be recognised because the entity is not able to earn the extra $30,000. In other words, the entity will not be able to use the tax losses of $30,000 because the entity cannot earn the extra $30,000. As such, the DTA of $4,000 will only be disclosed in the notes to the financial statements.

2. Leasing

Under IFRS 16, a lessee (an entity who lease an asset) will recognise right-of-use asset as well as lease liability (the detailed accounting treatment under IFRS 16 is not covered in this post). Let's just say:

Right-of-use asset - $100
Lease liability - $90
Net CA of lease (asset) - $10

Tax treatment: Assuming that the tax rule provides that lease rental is treated as a deductible expense.

The imaginary tax double entry for the lease rental in the imaginary tax financial statements will be as follows:

Dr Deductible expenses $100
Cr Bank $100

As such, under the tax rule, there will be no asset because we just claim a deductible expense on lease rental. Tax base will be equal to zero.

As CA = 10 and TB = $0 and this is an asset, the difference of $10 represents TTD.

Reason for TTD: If there is a positive net asset of lease in the accounting SOFP, it means that there will be higher profit in the accounting SOPL (due to double entry). In other words, accounting profit is more than taxable profit for this year. As we only claim lease rental as deductible expenses for tax purpose, we will actually pay lesser income tax this year. In the future, our tax might be higher after we have claimed all the lease rental deduction (hence TTD).

Note: If the net CA of the lease is a liability, then the difference shall be DTD.

Reason for DTD: If there is a net liability of lease in the accounting SOFP, it means that there will be higher expenses (thus lower profit) in the accounting SOPL (due to double entry). In other words, accounting profit is lower than taxable profit for this year. We will pay more income tax in this year. In the future, our tax might be lower (hence DTD).

3. Convertible Loan Note (IAS 32)

Under IAS 32, convertible loan note needs to be split into loan component and equity component (the detailed accounting treatment under IAS 32 is not covered in this post). Let's just say we have a convertible loan note of $100 and upon initial recognition, the entity has determined that

Loan element - $90
Equity element - $10

The double entry upon initial recognition is

Dr Bank $100
Cr Convertible loan note $90
Cr Equity component $10

As such, the CA of the convertible loan note (liability) is $90.

Tax treatment: Assuming that we do not split the loan into loan and equity component as per tax rule.

As such, TB will be $100.

As CA = $90 and TB = $100 and this is a liability, the difference of $10 represents TTD.

Notes:

1. The deferred tax liability arising on initial recognition (as explained above) is not charged to SOPL. Instead, it is charged directly to the equity component. Remember, the deferred tax treatment should follow the accounting treatment. Since in accounting we credit equity component $10, we have to charge the deferred tax to the equity component too.

2. On subsequent accounting, when we apply amortised cost method to the carrying amount of convertible loan note, the carrying amount of convertible loan note will be increased by finance cost and reduced by actual interest paid. The subsequent changes in deferred tax liability as a result of this will be charged to SOPL because the finance cost on convertible loan note is charged to SOPL.

Congratulations! You have reached the end of this post!

In my next post on IAS 12, I will talk about some specific scenarios relevant for SBR students. So stay tuned!

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IAS 12 - How To Determine Tax Base (Part 2)

This post is a continuation from Part 1. If you have not read Part 1, you can access it via the following link:

https://tysonspeaks.blogspot.com/2019/08/ias-12-how-to-determine-tax-base-part-1.html

In Part 1, we have covered the basic of deferred tax. In this post, we will cover the following:

1. Techniques that I use in determining tax base
2. Determining whether the temporary difference is taxable temporary difference (TTD) or deductible temporary difference (DTD).

For item no.1 above, the way that I use in determining tax base is by imagining the amount that would appear in the tax Statement of Financial Position (tax SOFP) if we prepare financial statements using tax rule.

To fully understand tax base, you will need to use some imagination. Normally, we adopt IAS/IFRS in preparing financial statements (we will call this accounting rule). However, let's just imagine, if we were to use income tax rule to prepare financial statements, the financial statements will become something like this:

Tax Statement of Profit or Loss (Tax SOPL)

For tax purpose, we are concerned with taxable income and deductible expenses as these two items will determine taxable profit as well as the tax expenses. Thereafter, we also have the non-taxable income as well as non-deductible expenses in our tax SOPL. The final figure is the profit for the year.

Note: In practice we don't prepare SOPL using this manner. This is just my imagination.

Tax Statement of Financial Position (Tax SOFP)

If we prepare the SOPL using tax rule, the amount recognised in SOFP will also be different (due to different double entry).

The general idea is that tax base is the amount of asset or liability that is recognised in the tax SOFP if we prepare financial statements using tax rule.

Consider the definition of tax base in IAS 12 below:

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

We can thus interpret tax base as the amount that is recognised in tax SOFP.

In a tax SOFP, we also have asset, liability and equity. As we know the basic accounting equation is:

Asset - Liability = Equity

In any case, I came across the following in Facebook:

17 Equations that changed the World..
Posted by Electronic Engineering on Thursday, August 1, 2019

I was wondering why accounting equation is not included.

Allow me to add on the #18:
Accounting Equation: Asset - Liability = Equity
Luca Pacioli, 1494 😂😂😂

Luca Pacioli, a.k.a. Thanos 😂😂😂

Anyway back to deferred tax. About the accounting equation, the idea when we calculate deferred tax is that we are going to compare all the assets and liabilities in both our accounting SOFP as well as tax SOFP (i.e. comparing carrying amount and tax base). We can ignore equity when we calculate deferred tax (since we already considered all the assets and liabilities).

Note: For this post, I will refer to the financial statements prepared using tax rule as "imaginary tax financial statements" because really, it is just my imagination ok 😂😂😂

You will understand more once you look into the different scenarios that I will illustrate below. But before we go into that, we will look into how do we determine whether a temporary difference is a taxable temporary difference or deductible temporary difference.

Taxable Temporary Difference (TTD) or Deductible Temporary Difference (DTD)?

In general, TTD means we are going to pay more tax in the future and DTD means we are going to pay lesser tax in the future. TTD will result in deferred tax liability whereas DTD will result in deferred tax asset. For the detailed explanation of what are these items, you can refer to Part 1.

There is a quick way to determine whether a temporary difference is TTD or DTD. You can use the following table in exam:

Note: CA represents carrying amount (value in accounting SOFP) whereas TB represents tax base (value in tax SOFP).

To illustrate:

1. For an asset, if the CA is larger than the TB, the difference is a TTD.
2. For an asset, if the CA is smaller than the TB, the difference is a DTD.
3. For a liability, if the CA is larger than the TB, the difference is a DTD.
4. For a liability, if the CA is smaller than the TB, the difference is a TTD.

All you need to do is to memorise the one that I highlighted in yellow (i.e. the first point above). For the rest, all you need to do is just to fill in the table by following the arrows as shown below:

Notice the arrow above? Yes, there is an animation. It is a gif. You can trust your eyes

When you fill in the table, all you need to do is to insert a reverse entry. In other words, for the column CA > TB, when you move down the arrow from TTD, you will fill in DTD. Then when you move to the right, you are going to fill in TTD. Then finally, when you move up, you will fill in DTD.

With this, we can now look into the different scenarios for deferred tax.

Tax Base of Assets

Before we go into the details, let's look at the definition of the tax base of an asset according to IAS 12:

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.

In short, there are two main points:

(a) If an amount is deductible in the future (e.g. asset in which we can claim capital allowance), then that amount is the tax base for an asset.

(b) If we have an asset (e.g. receivable) in which we need not pay additional tax in the future when we receive the money, then tax base is equal to its carrying amount.

The various examples below would illustrate the two main points above.

1. Property, Plant and Equipment (PPE) which qualifies for capital allowance (tax depreciation)

This is the scenario that I have covered in Part 1. In this case, if we have a PPE in which we can claim capital allowance or tax depreciation, then we will have a tax base for that PPE.

Scenario: An entity purchased a machine for $100. The useful life is 5 years. For tax purpose, the entity can claim 50% tax depreciation. As such, for the first year,

CA = $100 - $100/5 = $80
TB = $100 - $100 x 50% = $50

If we were to apply tax rule in preparing financial statements, our tax SOFP will have an asset of $50 (after we charge 50% tax depreciation in our tax financial statements). As such, $50 is the tax base, indicating that we can claim $50 capital allowance in the future (an amount which is deductible in the future).

As we can see above, the CA is larger than TB. Referring to the table, as this is an asset, this represents a TTD which is equal to $30 ($80-$50).

Reason for TTD: The tax depreciation is faster than the accounting depreciation. In other words, the entity will pay lesser tax this year. In the future, the entity will have lesser or no tax depreciation if compared to accounting depreciation. This will result in higher tax payable in the future (hence TTD).

2. PPE which does not qualify for capital allowance (tax depreciation)

I have also covered this scenario in Part 1.

Scenario: An entity purchased a piece of land for $100 which does not qualify for capital allowance or tax depreciation.

If we were to prepare financial statements using tax rule, our imaginary tax double entry will be as follows (Note: this is not the real double entry. This is just my imagination of the double entry in the imaginary tax financial statements):

Dr Non-deductible expenses (Tax SOPL) $100
Cr Bank $100

In other words, since the land does not qualify for capital allowance, there is no asset in the tax SOFP. Therefore, the tax base of this land is zero because there is no amount of asset that will be deductible in the future.

As such, CA of the land is $100 and the TB is zero. This is the case when CA > TB. As this is an asset, the difference should be a TTD of $100 (but this is not true, read below).

In Part 1, I mentioned that no deferred tax is recognised for permanent difference. In this case, the difference is a permanent difference because the land will never be deductible for tax purposes (i.e. the accounting treatment will be forever different from the tax treatment). As such, we DO NOT calculate deferred tax for this scenario.

3. PPE under Revaluation Model (IAS 16)

Scenario: An entity purchased a piece of land for $100 which does not qualify for capital allowance or tax depreciation. The land is not depreciated for accounting purpose. However, the entity adopts revaluation model for land under IAS 16. As at year end, the fair value of the land has increased to $120.

Tax treatment: Assume that the land does not qualify for capital allowance. As such, the TB is zero. However, if the entity sell off the land in the future, the gain on disposal is taxable under capital gain tax (in Malaysia this is known as Real Property Gains Tax).

In this case, as explained above, the difference between CA and TB is permanent difference because the land does not qualify for capital allowance. As such, deferred tax calculation is not required.

However, deferred tax calculation will be required on the gain on revaluation as the entity will need to pay capital gain tax in the future. As the entity may need to pay extra tax in the future, this represents TTD and the TTD will be equal to the revaluation gain of $20 ($120-$100).

The accounting double entry for gain on revaluation is as follows:

Dr Land $20
Cr Other Comprehensive Income (OCI) / Revaluation Surplus $20

Notice that the gain is recognised in OCI under revaluation model. As such, it should be noted that the deferred tax on the gain on revaluation should also be recognised in the OCI (the deferred tax treatment should follow the accounting treatment of the asset).

Assuming a tax rate of 25%, the deferred tax liability will be equal to $5 ($20 x 25%). The accounting double entry for this deferred tax liability is:

Dr OCI / Revaluation Surplus $5
Cr Deferred tax liability $5

Take note of the highlighted debit entry, it is to OCI, not to Profit or Loss.

Refer to the following for the extract of the SOPL:

As you can see from the above, the debit entry of the deferred tax is recognised is recognised in OCI (not profit or loss). You can choose to show the deferred tax as a separate line in the OCI or to show the gain on revaluation net of tax (as shown in the extract above).

Note: If the land is an investment property under IAS 40 and it is held under fair value model (i.e. the change in fair value is recognised in SOPL), then the deferred tax will also be recognised in the SOPL. Again, the deferred tax treatment should follow the accounting treatment of the asset.

4. Development Cost (IAS 38)

An entity incurs development cost of $100 and the entire $100 meets the criteria for capitalisation under IAS 38 Intangible Asset.

Tax treatment: Assume that development cost is deductible when it is incurred.

In this case, because the entity has incurred the development cost, the entity will be able to claim a tax deduction this year. The imaginary tax double entry for the imaginary tax financial statements shall be as follows:

Dr Deductible expenses $100
Cr Bank $100

In other words, since the entity has already claimed a deduction for development cost in the current year, there will be no asset in the tax SOFP (because there is no more deduction available in the future). Hence, the tax base is zero.

Therefore, CA = 100 and TB = 0 and as this is an asset, the difference of $100 will be TTD.

Reason for TTD: As the entity has already claimed deduction in this year, the entity will pay lesser tax this year. However, as the entity will have no more deduction in the future. the entity is going to pay more tax in the future. Hence, this is a TTD.

5. Inventory Written Down to Net Realisable Value (NRV)

Purchases of Inventory

When an entity purchases inventory for $100, they will include the inventory in their current asset by

Dr Inventory $100
Cr Bank $100

As such, the carrying amount of inventory is $100.

When the inventory is sold in the future, the entity will:

Dr Cost of sales $100
Cr Inventory $100

Tax treatment: Assuming that when the entity makes a purchase of inventory, a deduction cannot be given now. However, a deduction can be given when the inventory is sold in the future.

As such, the imaginary tax double entry that we have when we prepare the imaginary tax financial statements when we purchase inventory are as follows:

Dr Inventory $100
Cr Bank $100

In this case, we have a tax base of $100 because we can claim a deduction in the future when the inventory is sold.

When the inventory is sold in the future, the imaginary tax double entry will be:

Dr Deductible expenses $100
Cr Bank $100

As the CA = $100 and TB = $100 when the entity purchases the inventory, there will be no temporary difference and no deferred tax. This is because the accounting rule and tax rule are the same (as we can see, the accounting double entry and tax double entry is similar).

Write Down of Inventory

Damaged goods

An entity purchased inventory for $100. The tax rule on purchase of inventory is similar to the previous illustration (i.e. deductible when inventory is sold in the future).

According to IAS 2, if the NRV of the inventory drop to $80 (e.g. due to damaged goods), by applying the lower of cost and NRV rule, the entity will write down the inventory to its NRV by:

Dr Cost of sales (SOPL) $20
Cr Inventory $20

As such, the carrying amount of the inventory is $80 ($100 - $20).

Tax treatment: Assuming that the write down of inventory is a non-allowable expense. However, such write down will only be permitted when the inventory is sold in future.

Because of the write down of inventory is not allowable in the current year, accordingly there is no tax double entry in the imaginary tax financial statements. The tax base of the inventory will remain at $100 as there is no adjustment for tax purpose.

In this case, the CA = $80 and TB = $100. As this is an asset and CA < TB, there will be a DTD of $20.

Reason for DTD: The entity cannot claim deduction for write down of NRV now. As such, the tax will be higher this year. In the future, when the inventory is sold, the entity can pay lesser tax as deduction will be given by then (hence DTD).

6. Impairment of Trade Receivables 

Recognise Credit Sales

When an entity makes a credit sales of $100, the accounting double entry is:

Dr Trade receivables $100
Cr Revenue $100

The carrying amount of the asset (trade receivables) is $100.

Tax treatment: Assuming that credit sales is taxable even though the entity has not received the money from customer.

As such, the tax double entry in the imaginary tax financial statements will be similar to accounting double entry:

Dr Trade receivables $100
Cr Taxable income $100

The tax base of the asset (trade receivables) is $100.

In this case, as the CA = $100 and TB = $100, there will be no temporary difference and no deferred tax. This is because the accounting rule and tax rule are the same.

Impairment of Trade Receivables

Impairment of trade receivables is covered under IFRS 9 Financial Instrument. For example, if we have trade receivables of $100 and we have determined that the trade receivables has been impaired by $20, the accounting double entry is:

Dr Impairment of Trade Receivables (SOPL) $20
Cr Allowance for Impairment of Trade Receivables $20

The carrying amount of the trade receivables is $80 ($100 - $80).

Tax treatment: Similar to the previous illustration, credit sales of $100 is taxable. However, assume that impairment of trade receivables is not an allowable expense. Deduction can only be given in the future if the entity confirms that the trade receivables has already gone bankrupt.

Because of the impairment of trade receivables is not allowable in the current year, accordingly there is no tax double entry in the imaginary tax financial statements. The tax base of the trade receivables will remain at $100 as there is no adjustment for tax purpose.

In this case, the CA = $80 and TB = $100. As this is an asset and CA < TB, there will be a DTD of $20.

Reason for DTD: The entity cannot claim deduction for impairment of trade receivables now. As such, the tax will be higher this year. If the trade receivables really become bankrupt in the future, the entity will be able pay lesser tax in the future (hence DTD) when deduction for impairment of trade receivables is given.

7. Prepaid Expenses

An entity made an advance payment for electricity expenses for the next financial year (prepaid expenses) amounting to $100. The double entry will be:

Dr Prepaid expenses $100
Cr Bank $100

As such, carrying amount of the asset (prepaid expenses) is $100.

Tax treatment: Assuming that the tax law mentions that an entity can only make a deduction for an expense if the expense is paid (i.e. deduction is on cash basis)

In this case, as the entity has already made the payment of $100, the entity will be able to claim a deduction. The imaginary tax double entry in the imaginary tax financial statements will be as follows:

Dr Deductible expenses $100
Cr Bank $100

In other words, since the entity has already claimed a deduction for electricity expenses in this year,  there will no asset in the tax SOFP because there is no more deduction available in the future. As such, the tax base is zero.

Therefore, CA = 100 and TB = 0 and as this is an asset, the difference of $100 will be TTD.

Reason for TTD: As the entity has already claimed deduction in this year, the entity will pay lesser tax this year. However, the entity will have no more deduction in the future. This will result in the entity to pay more tax (in relation to its accounting profit) in the future. Hence, this is a TTD.

Exam shortcut: This scenario is similar to development cost as explained above (the fourth scenario). Just remember that if the tax treatment provides that deduction is on a cash basis, then tax base will be equal to zero.

8. Income Receivable Which Is Taxed on Cash / Receipt Basis

An entity recognises interest income of $100 on accrual basis even though the entity has not received the interest income. The accounting double entry is:

Dr Interest receivable $100
Cr Interest income (SOPL) $100

As such, the carrying amount of interest receivable (asset) is $100.

Tax treatment: Assuming that the tax law mentions that interest income is only taxed when the entity receives the income (i.e. taxed on receipt or cash basis).

As the entity have not receive the income this year, the entity need not pay any tax on the interest income. Accordingly, the entity will not have any imaginary tax double entry.

In other words, because the interest income is not taxable this year, there will be no asset in the tax SOFP. The tax base of the asset will be zero.

Therefore, CA = $100 and TB = $0. As interest receivable is an asset, this represents TTD of $100.

Reason for TTD: The entity will not pay tax this year. However, the entity will pay more tax in the future when they receive the interest income. As such, it is a TTD.

Exam shortcut: As the tax treatment provides that the income will be taxed on receipt or cash basis, the tax base will be equal to zero.

9. Receivables for Non-Taxable Income

An entity has a dividend receivables of $100. The accounting double entry is

Dr Dividend receivables $100
Cr Dividend income $100

As such, carrying amount of the asset is $100.

Tax treatment: Assuming that dividend income is a non-taxable income.

The imaginary tax double entry in the imaginary tax financial statement is

Dr Dividend receivables $100
Cr Non-taxable income $100

Tax base is also equal to $100.

As the CA and TB are the same, there will be no deferred tax.

Note: As mentioned previously in the definition of tax base for asset, "if those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount."As dividend income is not taxable, the TB shall be equal to its CA.

Alternatively, you can also argue that as the income is not taxable, the difference represents a permanent difference and deferred tax should be ignored. Both analysis will result in no deferred tax calculation.

10. Loan Receivable

A loan receivable has a carrying amount of $100. The accounting double entry is:

Dr Loan Receivable $100
Cr Bank $100

As such, carrying amount of the asset is $100.

Tax treatment: When loan is given out, there is no tax consequence. When the loan is being repaid back to the entity, there is also no tax consequence.

In this case, the imaginary tax double entry in the imaginary tax financial statement is the same as the accounting double entry, i.e.

Dr Loan Receivable $100
Cr Bank $100

Tax base is also equal to $100.

As the CA and TB are the same, there will be no deferred tax.

Note: As mentioned previously in the definition of tax base for asset, "if those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount." As the repayment of loan has no tax implication (i.e.not taxable), the TB shall be equal to the CA.

That's all for this post! I believe you will have a lot to digest for now.

In my next post, I will discuss about how do we determine tax base for liability. Stay tuned!

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IAS 12 - How To Determine Tax Base (Part 1)

When it comes to IAS 12 Income Taxes, especially on deferred tax, I believe a lot of students (including me, when I was a student) would feel a surge of stress.

Exactly how I felt when I first encounter deferred tax. #truestory

The reason is because it is quite difficult to grasp the concept of deferred tax. For me, when I was a student, I know the rough idea on how to calculate deferred tax but I always couldn't grasp the concept and meaning of tax base. I tried to read the definition of tax base in the standards (refer below):

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

Apa maksud oui? (Translate to what do you mean?)

Let's dig further for more definition from IAS 12.

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.

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. 

Normally by this point, my mind will shut down. Don't worry, you are not alone if your mind shut down at this point.

As such, I intend to write some blog posts (in a few parts) to share with you about the methods that I used in determining tax base. I will give you a few scenarios to consider together with the detailed explanations behind the logic of determining tax base.

This post is relevant to you if you are taking the Financial Reporting (FR) paper or Strategic Business Reporting (SBR) papers in ACCA.

But before we delve into the details of how to determine tax base, it is important that we understand the basic concept of deferred tax. This shall be our focus for Part 1.

Concept of Deferred Tax

The main idea of why we recognise deferred tax in the financial statement is basically due to the difference between accounting rules (i.e. IAS / IFRS) and tax rules (e.g. in Malaysia, we need to follow Income Tax Act 1967).

我们不一样 每个人都有不同的境遇 (Sorry, suddenly I feel like singing this song 😂)

Seriously, the difference between accounting rules and tax rules are the root cause of why deferred tax exist in the first place. It is my dream that one day, accounting rules and tax rules will converge.

The difference between accounting rule and tax rule will result in the difference between accounting profit and taxable profit (in Income Tax Act 1967, taxable profit is known as chargeable income). Some examples of such differences are listed below:

• Some expenses are not deductible in arriving at taxable profit. For example, entertainment expenses to potential customer, penalty and fines, purchase of land are non-allowable expenses under Income Tax Act 1967.
• In accounting, we charge depreciation if we have property, plant and equipment (PPE). However, in Income Tax Act 1967, depreciation is non-allowable expenses. Instead, capital allowance (also known as tax depreciation) is given if the asset is a qualifying asset. Normally, depreciation expense and capital allowance will be different. 
• Some expenses are accrued in the financial statements if it is incurred. However, for income tax purpose, it can only be deducted if the payment is made (i.e. deduction is on cash basis). For example, in Malaysia, secretarial fee and tax filing fee is deductible only if it is incurred and paid (refer to Income Tax (Deduction for Expenses in Relation to Secretarial Fee and Tax Filing Fee) Rules [P.U. (A) 336/2014] for more information).
• Some income are deferred in financial statements (e.g. when a company receives advance payment for service to be rendered in the future, the income is not recognised as revenue in the Profit or Loss. Instead, it is recognised as deferred income in liability), but according to the income tax rule, it might be taxed when the entity receive the income (e.g. according to Section 24(1A) of Income Tax Act 1967, advance payment in relation to services to be rendered in the future will be taxable when it is received).

To understand the difference better, let's consider the following scenario:

Scenario

Assuming that an entity has profit before tax of $100 from year 1 to year 5. 

The entity has an asset which costs $100 and the expected useful life of this asset is 5 years. The depreciation is $20 per year ($100 / 5 years) and this depreciation is already included in the profit before tax of $100.

For income tax purpose, depreciation is non-deductible expense. However, this asset is a qualifying asset. In year 1, the entity can claim an initial allowance of 20% on cost as well as annual allowance of 20% on cost (i.e. a total of 40% in year 1). Subsequently, the entity can claim 20% annual allowance for year 2, 3 and 4 (i.e. until 100% of the cost is claimed).

The applicable income tax rate is 25%.

Let's look at the income tax calculation for this case:

As we can see above, there is a difference between profit before tax (accounting profit) and taxable profit for year 1 and year 5. Even though we pay income tax at 25%, the effective tax rate for year 1 and year 5 is not 25%. This is because:

1. In the first year, we get to claim a total of 40% capital allowance and this is higher than the depreciation of $20. As such, the tax expense in year 1 is lower.

2. In year 5, after we have claimed all the capital allowance in year 4, we will have a higher tax expense because there is no more capital allowance for us to claim in year 5.

Such variation in tax expense and effective tax rate can be very misleading to the users of financial statements as it doesn't give the true picture of the income tax expenses that the entity needs to pay.

Le face of the users of financial statements, if we managed to successfully confuse them.

As such, deferred tax aims to minimise such distortion. The general idea of how deferred tax works is like this:

Refer to the explanations below:

Year 1

In year 1, we will recognise additional tax expense of $5 as well as a deferred tax liability of $5. Refer to the double entry below:

Dr Tax expense $5

Cr Deferred tax liability $5

The reason for such entry is because we will be paying extra $5 income tax on top of $25 tax expense in year 5.

Years 2 to 4

No adjustment is made to the tax expense in year 2 to 4.

Year 5

In year 5, we will reduce the tax expense by $5 (reduce from $30 to $25) as well as reduce the deferred tax liability recognised in year 1 by $5 (reduce from $5 to $0). Refer to the double entry below:

Dr Deferred tax liability $5

Cr Tax expense $5

As we have already paid for the extra $5 income tax in year 5, the deferred tax liability will no longer be needed. As such, the deferred tax liability is reversed to tax expense in year 5. 

Conclusion of Scenario

As we can see, after the adjustment for deferred tax, the effective tax rate is now consistently at 25% from year 1 to year 5. This is a better presentation as it gives a better picture of the tax expense to the investor. As shown below:

Now your financial statements look more handsome. Congratulations! 😂😂😂

Note: The above is just an illustration of how deferred tax works. You are not allowed to use the above method in the exam.

Methods to be Used in Exam

The correct method to calculate deferred tax is by comparing the carrying amount (CA) and the tax base (TB) of the asset.

CA means the net book value of the asset, whereas TB means the tax written down value of the asset (i.e. cost minus capital allowance). Refer to the following table for the comparison between the CA and TB of the asset for year 1 to year 5.

1. The CA of the asset is calculated by taking the cost of the asset ($100) minus the depreciation. For example, in year 1, the CA of $80 is equal to $100 minus depreciation of $20.

2. The TB of the asset is calculated by taking the cost of the asset ($100) minus the capital allowance. For example, in year 1, the TB of $60 is equal to $100 minus capital allowance of $40.

3. The difference between CA and TB is known as temporary difference. The difference is temporary because the difference of $20 only exist from year 1 to year 4. By year 5, there is no more difference between CA and TB (as both are equal to zero).

4. The difference of $20 as shown above is known as taxable temporary difference (TTD) because more tax is payable in the future (i.e. as shown previously, we will be paying extra $5 income tax on top of $25 tax expense in year 5).

5. TTD will result in deferred tax liability (DTL). As more tax is payable in the future, we will need to recognise liability.

6. The DTL of $5 as calculated above represents closing balance of the liability. This is because the TTD is calculated by comparing the closing balance of the CA and the TB for years 1 to 5. As DTL is calculated based on TTD, it follows that DTL must be the closing balance of the liability.

Refer to the following table for the movement of DTL balance:

Year 1

In year 1, we will recognise additional tax expense of $5 and DTL of $5. The double entry is:

Dr Tax expense $5

Cr Deferred tax liability $5

Years 2 to 4

As shown above, there is no difference between the opening balance and closing balance of DTL. As such, no adjustment is required for these years.

Year 5

In year 5, as the closing balance of DTL has become $0, the following double entry is required: 

Dr Deferred tax liability $5

Cr SOPL $5

In other words, the tax expense will be reduced by $5 and DTL will no longer be needed.

Conclusion of Methods

Refer to the following table for the tax expense in the profit or loss:

Important Pointers From the Above Calculations

To sum up, let me repeat the important points that we have covered so far:

1. Because of the difference in accounting rule and tax rule, there will be difference in accounting profit and taxable profit.
2. Such difference will cause the tax expense to be distorted (i.e. effective tax rate will be different, which can misleading).
3. To solve this issue, we need to make deferred tax adjustment (the general idea is to make the effective tax rate the same / almost the same for all the years).
4. To calculate deferred tax, we need to compare CA and TB. The difference between CA and TB is known as temporary difference. If the difference is TTD, then if we take TTD and multiply it with a tax rate, we will get the closing balance of DTL.
5. In general, the difference between the closing balance and opening balance of DTL will be charged to the profit or loss. Note that under certain circumstances, the deferred tax can be charged to the other comprehensive income (this is covered in Part 2).

Points no.4 and 5 above are very important, so make sure you read them properly. Remember, when we multiply temporary difference with tax rate, we will get the CLOSING BALANCE of deferred tax. 

Allow me to continue my explanation a little bit further before I conclude Part 1.

When we talk about the difference between accounting profit and taxable profit, the difference can be either:

1. Temporary difference; or
2. Permanent difference.

Let's look at the two items in more details below:

Temporary Difference

As illustrated above, the difference between the CA and the TB of the asset are temporary differences. Generally, the difference will be temporary if it is due to timing difference (i.e. as shown previously, the temporary difference between CA and TB in year 1 to year 4 is due to the difference between depreciation and capital allowance, which is essentially the difference in the timing of the deduction). 

Let's look at what IAS 12 has to says about temporary difference:

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 may be either: 

(a) 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; or 

(b) 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.

If the temporary difference will result in more taxes to be paid in the future, it is known as taxable temporary difference (TTD). TTD will result in deferred tax liability (DTL).

If the temporary difference will result in lesser taxes to be paid in the future, it is known as deductible temporary difference (DTD). DTD will result in deferred tax asset (DTA).

Consider the following definition from IAS 12 in relation to deferred tax liability and deferred tax asset:

Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences.

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:  

(a) deductible temporary differences;
(b) the carryforward of unused tax losses; and
(c) the carryforward of unused tax credits. 

Permanent Difference

To understand permanent difference, let's consider the case when an entity purchases a land for $1 million.

Assuming the land is a freehold land which is not depreciated. As such, the land will have CA of $1 million.

However, for income tax purpose, land is not a qualifying asset (i.e. no capital allowance can be claimed). As such, there is no asset for tax purpose (i.e. tax base of this asset is zero).

The difference between the CA and the TB is therefore $1 million ($1 million CA minus $0 TB).

However, as there will be no deduction given for land for income tax purpose (i.e. no capital allowance is given), the difference between CA and TB is a permanent difference (the difference will be forever $1 million starting from day 1 until the land is disposed off). 

Forever alone or forever permanent?

Imagine if we calculate deferred tax based on this $1 million, we will have a DTL of $250,000 which will remain permanently in the liability until the land is disposed of. There is actually no point for us to recognise this DTL because the recognition of $250,000 DTL doesn't really benefit the user of the financial statements (i.e. what is the point of recognising such DTL since it will just forever remain as liability since day 1? It seems like such liability is redundant.).

Accordingly, no deferred tax is recognised for permanent difference (i.e. we can ignore permanent difference in calculating deferred tax).

One of the happy things in FR exam - ignore deferred tax. Yay! 😂😂😂

Some other examples of permanent difference includes items that are not deductible for tax purposes (e.g. entertainment expenses to potential customer, penalty and fines). The differences are permanent because such expenses are forever not deductible for income tax purpose. Accordingly, we can ignore them for deferred tax purpose.

Conclusion

After reading through this post, you will have a rough idea on what is deferred tax as well as the rough ides on how it is calculated.

In the next post(s), we will talk about different types of assets and liabilities in the Statement of Financial Statements together with how do we determine the tax bases for these items. We will also talk about how do we determine whether the difference between CA and TB is TTD or DTD.

Stay tuned for more post! 😉

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Part 2 Link: https://tysonspeaks.blogspot.com/2019/09/ias-12-how-to-determine-tax-base-part-2.html

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