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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The Meaning of Teaching - Am I a Good Teacher?

Tonight I don't feel like writing about technical stuff. Instead, I want to write about something that is in my mind, i.e. what does teaching mean to me or to other educators.

To be frank, I always, and will continue to think that teaching is a noble profession. Since young, I always looked up to my teacher. Many told me that:

A good teacher is like a candle - it consumes itself to light the way for others.

I used to think that I understand what this quote meant. As I want to do something meaningful in life, I decided to embark on this journey to become an educator. Little did I know, I only start to really appreciate the significance of this quote after I become a teacher myself.

To illustrate my point, perhaps it is good that you watch the following video:

最難的一堂課
◤ #最難的一堂課 ◢ 　 ❓老師總是知道答案嗎 ❓站在台上，一定能解開所有問題嗎 ❓在最難的選擇中，老師該怎麼作答 　 這是一堂最難的課，日日夜夜考驗著老師們 　 ============================= 紀錄片導演沈可尚執導 X 龍騰真情鉅獻 ============================= 　 這一次，在寫下答案前 先讓我們聽聽，老師們藏在心中「最難的一堂課」吧
Posted by 閱讀紙飛機 on Sunday, March 17, 2019

The title of the video is "The Most Difficult Lesson". Basically it is a video in which some teachers share about their experience in teaching and dealing with students. The main theme revolves around "Am I a Good Teacher?". If you don't understand Mandarin, I have translated some of the statements by these teachers (in bold below). I will also talk about my thoughts about these statements that resonate with me.

"As a teacher, I want to share everything that I know with my students.".

Tyson speaks: 

Yes I do too. This was my thought when I first started teaching. However, subsequently I realised that this is impossible due to time constraints in class. Apart from that, I also need to address the majority (i.e. the average students). If I share everything that I know, most students will be confused and it will be ineffective delivery on my part.

As you can see, I am stuck between what I want to teach and teaching the knowledge required by the exam.

As such, consider this question: Should a teacher share everything that he/she knows with the students in order to qualify as a good teacher?

"For me, the student's understanding in a subject is more important than covering the entire syllabus in class. This is the main reason why I complained a lot about my career. Imagine that when it is almost time for final exam but you still have a lot more topics to cover with the students, tell me how can the students sit for exam?"

Tyson speaks: 

Exactly my feeling 😭😭 If the students walk out of the classroom thinking that they don't understand what I taught, I will feel that I am a failure. But if I can't finish the syllabus, students will not have adequate knowledge to sit for final exam. As such, I find myself always caught in this struggle. Should I speed up my teaching in class? Or should I slow down and conduct more additional classes for my students (hoping that my students don't hate me for asking them to attend more class)? If not additional class, then should I record additional videos for students so that the students can watch the video themselves at home? If I record video, will they even bother to watch them?

Although one can argue that students shouldn't complain as we are kind enough to sacrifice our extra time for the students, one cannot deny the fact that the students' opinion matter to us as well.

As such, consider this question: Should a good teacher focus on getting all their students to understand part of the syllabus or should he/she focus on covering the entire or almost all of the important areas of the syllabus?

"When I teach, some students will nod in class. When I see my students nodding in class, I know that they have absorbed the knowledge, but I start to wonder whether what I said was 100% correct or not."

Tyson speaks: 

Sometimes this happen to me also. After the class, I will spend some time to reflect about the things that I have told my students - whether or not I have covered the syllabus sufficiently in class? Have I accidentally said something that is wrong in class? When I accidentally said the wrong stuff in class (yes this can happen to us, we are not perfect, we are human too), I actually felt very bad and I will apologise to my students (I believe that when we make a mistake, we should apologise). Sometimes I hope to minimise such events from occurring, because I am afraid that my students will start to be sceptical. Will they start to doubt whether I am a good teacher or not?

As such, consider this question: If I may teach the wrong thing in class, do I still deserve to be a good teacher?

"I remember I had a student who is quite good in his studies. He told me this shocking statement, "Teacher, I think that after I studied chemistry, the biggest rewards that I get was that I become 100% sure that I will dislike chemistry forever".

Tyson speaks: 

The truth is, this statement can be really hurtful to a teacher who is very passionate in teaching.

I never had a student who talked to me like this before. However, I do have a similar experience when I was conducting training on "Financial Management for NGOs" recently. After the training, one of the participants approached me and told me the following:

"I think you delivered a good training. Actually, I am good in speaking, I am also good with writing, but I am never good with numbers. That is why I am quite slow when it comes to financial management. When you explained the steps by steps of accounting for NGO, you managed to explain and illustrate the concepts clearly to us. I can follow what you are delivering just now. However, after this training, I finally understand that being a club's treasurer is something that is too difficult for me. I can now confirm that this is not something that I want to do in my club."

You want to know the truth? The truth is that I am not sure how am I supposed to feel after listening to it. I always hoped to make accounting easier for someone (even secretly hoping that I can change someone's mind - from disliking accounting to having an interest in accounting). But here I am, someone telling me that after they attended my training, they now confirm that they will never like accounting. Should I be sad or...?

As such, consider this question: If I can't make all my students to be interested in the subjects that I am teaching, am I still a good teacher?

Luckily, I meet a good soul (a psychologist) who gave me some words of wisdom. If you faced such issue, perhaps such words of wisdom may help you too. He said,

"I don't think you should think in that way. See, you made her realised that she don't like accounting, and I think that this is a very important thing. The worst thing that can happen to her is that she didn't know that she dislikes accounting. Imagine that if she didn't know about this and she accepts a treasurer's role, she will definitely have a bad time herself. So I think that you did the right thing. Making someone realise that something is not their interest is also an important role that an educator should do. Remember that each individual is unique and they should have an autonomy to choose what they like to do in life."

Seriously, I am really touched by such words. Thank you for giving me another perspective to ponder upon. I felt way better after listing to what you say.

"A student once said this to me, "I want to tell you something. Do you know that you are a terrible teacher? Your teaching is really terrible. You are also very bad in leading the class." After I listened to this, I felt so sad that I have this really awful feeling - the feeling that it is a shame for me to be standing together with my students on this land. I felt so bad that I don't deserve to be standing together with my students in Taipei".

Tyson speaks: 

Oh my god!

This statement is so damn hurtful!

I consider myself very blessed - I never had a student that told me such statement before.

But do consider this - I believe most teacher actually feared this. We fear that our students don't like us. We fear that our students find our class to be so terrible that they rather to be elsewhere in this world but not inside our class.

As such, consider this question: If certain students give us such a bad comments, are we still a good teacher?

However, trust me on this. Despite feeling hurt, we will still need to calm ourselves down and continue our teaching life. No matter how shameful you felt when you face your student, we will still want to force ourselves to finish the semester with them.

As you can see, this is a balance that we need to strike - a balance between our emotion and what we are supposed to do. Even though we feel hurt, we can't really say we quit, because we feel that it is our responsibility to teach no matter what happened to us.

In the video, the teacher who received this bad comments still decided go back to class the next day, after gathering all her courage. I think I can relate to this feeling because it will be a difficult thing for me to do if I were her. This is what she said in the video:

"When I entered the class the next day, I felt shocked that my students actually took the liberty to list down the things that I have done for them for the past three years. At that moment, I felt that my heart was healed by these bunch of students."

Tyson speaks:

I am also very blessed to meet some students who are really close to me after I started teaching. At the time when I was sad, it was them who gave me the supports I needed. Sometimes, we really have to realise that it is impossible to get everyone to agree with us. All we need is just some supportive students. They are the one that will restore our faith in humanity.

Someone in Facebook summarised the challenges faced by a teacher nicely in the following post.

老师您辛苦了
Posted by 教师公会 on Wednesday, May 15, 2019

It is said that the teaching process is just like bring the students to swim in the ocean of knowledge.

After a while, you realised that you are only the one who reached the shore. Then you have to swim back to the ocean and pick the students up one by one.

Sometimes you may even realise that the students that you have picked up yesterday have gone back to be ocean. You need to pick them up again today.

When you felt very tired, you realised that there are some students who swim further and further from the shore😲

Well, I guess we should appreciate the fact that the students are willing to swim. What can you do if the students are too scared of the water? Or what should you do if the students just prefer sunbathing on the beach?

So to my students who supported me all these while and if you are reading the blog, thank you very much! You have no idea how your support meant to me when I was really down.

Question of the Day - Am I a Good Teacher?

According to the video, this question of "am I a good teacher" is "the most difficult lesson" for educators. It is also mentioned that this lesson is "the most difficult to be experienced in our life". It is also said in the video that "the most important lesson for an educator begins with their own reflection about themselves."

Let's see how the teachers in this video answer this question:

"I must tell all of you (my students) that I can't answer this question as at this moment. This is because I still have a lot of things to work on in order to be a better teacher. I can only answer this question as I progress through my entire teaching career."

"If there was a "good teacher" graduation certificate, frankly I don't know if I deserve that certificate or not. I don't know if I can achieve the passing mark in order to receive such certificate from all of you (my students)".

Tyson speaks:

On whether am I a good teacher, I can't really answer this question. I can't give a definite answer to the questions that I wrote above (the questions in purple). I think these questions should not be answered by me, but it should be answered by my students.

In any case, regardless of I am a good teacher or not, I just want to tell you that I am always learning and thinking about how to be better every day. No matter what is the answer, regardless of whether I felt hurt or otherwise, I want to tell my students that I am trying my best to impart my knowledge to all of you. I know that I am not perfect, and I think I will never be perfect. But what I know is that I will constantly improve myself in all aspects of my teaching career. I will always be willing to help you if you need help from me.

I also believe that you have the potential to achieve great things in life. As the saying goes,

青出于蓝，而胜于蓝

Literally translate to: green is born of blue, but beats blue.

It means that the student can become superior to the master.

I wish you all the best and thank you for reading this post! To my students, my wish is that one day you will greet me on the street and tell me the stories of how you transform yourself to be a better person in your life.😃

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Foreign Exchange - Which Exchange Rate to Use?

Foreign exchange could appear in a few ACCA papers. For example, it could appear in accounting papers (FR and SBR), when IAS 21 The Effects of Changes in Foreign Exchange Rates is examined. It could also appear in SBR if hedge accounting is examined under IFRS 9. Apart from accounting papers, it could also appear in finance papers (both FM and AFM), especially on the topic of hedging or international investment appraisal.

I remember the time when I first encounter the topics of foreign exchange, I got really confused when it comes to the conversion of foreign currency to home currency. For example, in the Financial Management (FM) papers, they could give you two exchange rate as follows:

Spot exchange rate: 4.1780 – 4.2080 euros per $

Exactly my reaction. Which one to choose?

As such, this post intends to introduce to you the basic of foreign exchange as well as guiding you on the exchange rate that you are supposed to choose in your exam. Hopefully after reading through this post, you can tackle foreign exchange questions with more confidence.

To understand which rate to use, we need to understand how foreign exchange works. I will use Malaysia as a home country (Reason: I am from Malaysia and Malaysia is my home).

P.S. Jalur Gemilang (Stripes of Glory) is the name of Malaysia's flag. 

This is the US flag. It looks quite the same as our Jalur Gemilang eh? Maybe some day someone can enlighten me with the reason behind the similarity.

In Malaysia, the currency that we use is Ringgit Malaysia (RM).

No, this is not my money. (P.S. our currency is very colourful, just like monopoly money 😍😍😍)

Since our Jalur Gemilang is so similar with the US flag, I will use US dollar as the foreign currency in my illustration. Let's say I want to exchange RM100 to United States Dollar (USD).

Is USD more handsome than RM? 😂😂😂

To determine how much USD we can get, we will need to refer to the exchange rate. According to our Bank Negara Malaysia (central bank of Malaysia) website, the middle exchange rate as of today (4 September 2019, for session 1200) is:

RM4.2125/USD

This means that if you have 1 USD, you are going to get RM4.2125.

Illustration 1

So if I have RM100, to convert this into USD, I will need to perform the following calculations:

RM100 / (RM4.2125/USD) = USD 23.74

In other words, with RM100, I can only get USD 23.74 if the exchange rate is RM4.2125/USD.

I am so sad, my money has shrunken 😭😭😭

Let's say if we have USD 100 and if we want to convert it to RM, then we will need to perform the following calculation:

USD100 x RM4.2125/USD = RM421.25

I get more RM if I convert from USD to RM. Therefore, I am rich (only in my imagination) 😂

There you go! That's the basic in converting foreign currency to a home currency.

For the purpose of this post, I will use some terms in relation to the exchange rate. Let's refer to the same exchange rate that I used above: RM4.2125/USD

In this case, 

1. I will call RM as our quote currency.

2. I will call USD as our base currency.

In other words, whenever we refer to the base currency, we always refer to it as just 1 unit. As such, in the above exchange rate, it means that 1 USD (base currency) is equal to RM4.2125 (the quote currency).

It is possible for us to change the quote and base currency by the following calculation:

1 / 4.2125 = USD0.2374/RM

This is just another way for us to express our foreign exchange rate. In other words, RM1 is equal to USD0.2374.

Note that in ACCA exam, the quote currency and base currency can be used interchangeably. This means that sometimes you will see USD as base currency, sometimes you will see USD as the quote currency. Make sure you read the questions carefully before attempting any calculation.

I will now illustrate the calculation to you using this rate.

Illustration 2

Let's say I have RM100 and I want to convert it to USD, the calculation will be as follows:

RM100 x USD0.2374/RM = USD23.74

Now let's say I have USD 100 and I want to convert it to MYR. The calculation will be as follows:

USD100 / (USD0.2374/RM) = RM421.23

You should see that the answer for Illustration 1 is the same as Illustration 2 (the small difference is due to rounding adjustment).

Sorry, only the rounding adjustment is immaterial. Not everything is immaterial ok!

Important Lessons From The Above Illustrations

From illustration 1 and 2, you should have noticed that sometimes we multiply and sometimes we divide. The questions that I believe a lot of students will ask is, when are we supposed to multiply and when are we supposed to divide?

Mind blown 😂😂😂 Please ignore this - this is irrelevant for foreign exchange 🙈🙊

Anyway back to the question of when we should multiply or divide. This is actually a mathematics question - and it is a valid one. Because if you do it wrongly, your answer will be wrong all the way. As such, let's find a way to determine when do we multiply or when do we divide.

The idea is this:

1. If the currency that you want to convert is the same as the quote currency, then you will use division.

2. If the currency that you want to convert is NOT the same as the quote currency, then you will use multiplication.

For example, let's look at Illustration 1 and 2 above. The scenarios in which we use division are as follows (notice the currency in red colour below):

RM100 / (RM4.2125/USD) = USD 23.74

USD100 / (USD0.2374/RM) = RM421.23

As you can see, the currency that you want to convert and the quote currency are the same. As such, we use division.

Let's now look at the scenarios in which we use multiplication:

USD100 x RM4.2125/USD = RM421.25

RM100 x USD0.2374/RM = USD 23.74

As you can see, the currency that you want to convert and the quote currency are NOT the same. As such, we use multiplication.

That's the whole idea of whether we use multiplication or division. Use this techniques and I believe you will get the right answer in your exam.

Concerning Two Exchange Rates

Let's come back to the exchange rate that I introduced to you at the beginning of this post:

Spot exchange rate: 4.1780 – 4.2080 euros per $

The question is, why is there two exchange rates? Which one should I use in my calculations?!

To understand the reasons for two rates, we need to stand in the shoes of a bank or foreign currency exchange counter. 

Let's me repeat this again as this is important. We must look at the issue from the point of view of the bank!

Basically, the bank is doing a business when they help you to convert foreign currency (i.e. they want to earn some profit by helping you to exchange foreign currency). The very basic idea of how you earn profit in business is to buy something at a cheaper price and sell it at a higher price. 

The same principle is applied for foreign exchange. However, depending on how you quote the currency, it can be very confusing. I will try to clear your confusion here.

Let's refer to the Bank Negara Malaysia website again. You would have realised that there is an option for you to choose (whether you want buying rate or selling rate):

In the exam, if you are given two rates, they are essentially buying rate and selling rate. Buying rate is also known as the ask rate / offer rate; whereas selling rate is also known as the bid rate. For the purpose of the illustration in this post, I will just use the terms buying rate and selling rate.

I will use the buying rate and selling rate as shown in Bank Negara Malaysia website today (4 September 2019, for session 1200) to illustrate the difference:

Buying rate - RM4.2100/USD

Selling rate - RM4.2150/USD

The difference between the buying rate and selling rate (RM0.005) is known as the spread.

Let's consider the following scenarios.

Scenario 1

Let's say we receive USD100 and we want to exchange it to RM. We can actually rephrase this scenario in the following manner:

We sell USD100 to the bank. Bank will buy USD100 from us by paying us in RM.

To determine which rate to use, we must look at the case from the point of view of the bank. The bank is buying USD from us. As such, bank will use the buying rate.

In other words, we will receive RM421 by selling USD100 to the bank (refer to the following calculation). Alternatively, we can also say that bank buys USD100 from us and give us RM421. 

USD100 x RM4.2100/USD = RM421

Scenario 2

Let's say we need to pay a foreign supplier USD100. We need to determine how much RM we need to pay in order to get USD. Similar to Scenario 1 above, we can rephrase this scenario in the following manner:

We want to buy USD100 from the bank so that we can pay our supplier in USD. Bank will sell USD100 to us.

To determine which rate to use, we must look at the case from the point of view of the bank. The bank is selling USD to us. As such, bank will use the selling rate.

In other words, we will need to pay RM421.50 to the bank in order to buy USD100 (refer to the following calculation). Alternatively, we can also say that the bank sells USD100 for RM421.50.

USD 100 x RM4.2150 = RM421.50

Analysis of Scenario 1 and 2

Let's now think from the perspective of the bank.

When the bank buy USD100 from us, bank will give us RM421. But when the bank sell USD100 to us, they are going to charge us RM421.50. 

In this transaction, bank will earn a profit of RM0.50.

In other words, bank will definitely want to earn money from you.

P.S. We can't blame the bank because they are doing a business. They need to make a profit to survive.

But What if We Switch the Quote Currency and Base Currency?

VERY IMPORTANT

Buying rate is not necessary the lower rate and the selling rate is not necessary the higher rate!!

Buying rate is not necessary the lower rate and the selling rate is not necessary the higher rate!!

Buying rate is not necessary the lower rate and the selling rate is not necessary the higher rate!!

Very important, that's why I repeat this three times.

This is because if we switch the quote currency and base currency, the buying and selling rate will be expressed in a different manner as illustrated below:

Buying rate 

RM4.2100/USD can be expressed as USD0.2375/RM.

1 / (RM4.2100) = USD0.2375/RM

Selling rate

RM4.2150/USD can be expressed as USD0.2372/RM.

1 / (RM4.2150) = USD0.2372/RM

You will notice that once I switch the quote currency with the base currency, the buying rate is now higher than the selling rate. 

This is the part which confuses me when I was a student. The reason is because in ACCA exam, most of the time they quote the currency in such a manner (in which buying rate is higher than the selling rate). As such,

Buying rate is not necessary the lower rate and the selling rate is not necessary the higher rate!!

Buying rate is not necessary the lower rate and the selling rate is not necessary the higher rate!!

Buying rate is not necessary the lower rate and the selling rate is not necessary the higher rate!!

Very important, that's why I repeat this three more times. 😂😂😂

Let's try to see what does these rates mean.

Buying rate is RM4.2100/USD and the selling rate is RM4.2150/USD

Analysis: The bank will buy 1 USD at RM4.2100 and sell 1 USD at RM4.2150, thereby making a profit of RM0.005 for every 1 USD.

Buying rate is USD0.2375/RM and the selling rate is USD0.2372/RM

Analysis: The bank will buy USD0.2375 for RM1. When the bank sells USD, they will give away USD0.2372 for RM1. In other words, initially they receive USD0.2375, then they give out USD0.2372, thereby making a profit of USD0.0003 for every RM1.

Basically, when the bank buys USD, they will receive more USD (hence a higher rate). When they sells USD, they will give away lesser USD (hence a lower rate).

Let's apply this rate to Scenario 1 and 2 above (the case is reproduced below again for your easy reference, the only difference is the calculation).

Scenario 1

Let's say we receive USD100 and we want to exchange it to RM. We can actually rephrase this scenario in the following manner:

We sell USD100 to the bank. Bank will buy USD100 from us by paying us in RM.

To determine which rate to use, we must look at the case from the point of view of the bank. The bank is buying USD from us. As such, bank will use the buying rate.

In other words, we will receive RM421.05 by selling USD100 to the bank (refer to the following calculation). Alternatively, we can also say that bank buys USD100 from us and give us RM421.05. 

USD100 / (USD0.2375/RM) = RM421.05

Scenario 2

Let's say we need to pay a foreign supplier USD100. We need to determine how much RM we need to pay in order to get USD. Similar to Scenario 1 above, we can rephrase this scenario in the following manner:

We want to buy USD100 from the bank so that we can pay our supplier in USD. Bank will sell USD100 to us.

To determine which rate to use, we must look at the case from the point of view of the bank. The bank is selling USD to us. As such, bank will use the selling rate.

In other words, we will need to pay RM421.59 to the bank in order to buy USD100 (refer to the following calculation). Alternatively, we can also say that the bank sells USD100 for RM421.59.

USD 100 / (USD0.2372/RM) = RM421.59

Analysis of Scenario 1 and 2

You would have realised that the answer is the same as per the previous scenarios (the small difference is again due to rounding adjustment).

When the bank buy USD100 from us, bank will give us RM421.05. But when the bank sell USD100 to us, they are going to charge us RM421.59. 

In this transaction, bank will earn a profit of RM0.54.

Again, no matter what happen, bank will definitely want to earn money from you.

Shortcut in Exam

In exam, going through this thought process can be very tedious and tiring. As such, I will not recommend you to use the above thought process in exam. My explanation above are to make you understand how foreign exchange works in real life only. There is a shortcut that you can apply in exam.

Shortcut in exam is always fantastic!

I will use the same scenarios as per above.

Buying rate = RM4.2100/USD or USD0.2375/RM

Selling rate = RM4.2150/USD or USD0.2372/RM

The good news is that you do not need to be concerned with the quote currency and base currency in exam. You also need not worry whether is it buying rate or selling rate. All you need to determine are:

1. Is the transaction receipt or payment?

2. Are you going to multiply or divide?

To answer question no.1, remember this:

Because the bank is going to earn profit from you, you will always receive less from the bank and you will always pay more to the bank.

To answer question no.2, I have already explained it previously. I will reproduce my explanation for you here again:

1. If the currency that you want to convert is the same as the quote currency, then you will use division. 

2. If the currency that you want to convert is NOT the same as the quote currency, then you will use multiplication.

For example, if you have USD 100, you will first convert it using both buying and selling rates:

Buying Rate	USD 100 x RM4.2100  = RM421.00	USD 100 / (USD0.2375/RM)  = RM421.05
Selling Rate	USD 100 x RM4.2150  = RM421.50	USD 100 / (USD0.2372/RM)  = RM421.59

If the question in your exam mentions that you receive USD100 and you wish to convert it to RM, just choose the lower figure (RM421 or RM421.05).

If the question in your exam mentions that you need to pay USD100 and you wish to convert it to RM, just choose the higher figure (RM421.50 or RM421.59).

There you go! It is not difficult if you use this shortcut in exam. Just remember we receive less and we pay more.

Conclusion

Foreign exchange can be confusing, but there is an easy way you can use to tackle such questions in exam. Do not simply memorise the calculation. Instead, remember the very important three rules as follows and apply them in exam:

1. You will always receive lesser and will always pay more.

2. If the currency that you want to convert is the same as the quote currency, then you will use division.

3. If the currency that you want to convert is NOT the same as the quote currency, then you will use multiplication.

With this, you can now try to attempt some past year questions by applying the three important rules above. Try to see if you can select the right exchange rate or not.😉

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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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