Tax p2

1 Basic principles of tax

 

Taxation

 

Taxation is a major expense for business entities. IAS 12 Income Taxes notes that there are two elements to tax that an entity must deal with:

 

  • Current tax – the amount payable to the tax authorities in relation to the trading activities of the current period.

 

  • Deferred tax – an accounting measure used to match the tax effects of transactions with their accounting treatment. It is not a tax that is levied by the government that needs to be paid, but simply an application of the accruals concept.

 

In summary, the tax expense for an entity is calculated as follows:

 

Tax expense = current tax +/– movement in deferred tax

 

2 Current tax

 

Accounting for current tax

 

Current tax is the amount expected to be paid to the tax authorities by applying the tax laws and tax rates in place at the reporting date.

 

Current tax is recognised in the financial statements by posting the following entry:

 

Dr Tax expense (P/L)

 

Cr Tax payable (SFP)

 

Current tax expense and income

 

IAS 12 contains the following requirements relating to current tax.

 

  • Unpaid tax for current and prior periods should be recognised as a liability. Overpaid current tax is recognised as an asset.

 

  • Current tax should be accounted for in profit or loss unless the tax relates to an item that has been accounted for in equity.

 

  • If the item was disclosed as an item of other comprehensive income and accounted for in equity, then the tax should be disclosed as relating to other comprehensive income and allocated to equity.

 

  • Tax is measured at the amount expected to be paid. Tax rates used should be those that have been enacted or substantively enacted by the reporting date.

 

 

 

3 Basic principles of deferred tax

 

The need to provide for deferred tax

 

There are generally differences between accounting standards (such as IFRS Standards) and the tax rules of a particular jurisdiction. This means that accounting profits are normally different from taxable profits.

 

Some differences between accounting and tax treatments are permanent:

 

  • Fines, political donations and entertainment costs would be expensed to the statement of profit or loss but are normally disallowed by the tax authorities. Therefore, these costs are eliminated (‘added back’) in the company’s tax computation.

 

Some differences between accounting and tax treatments are temporary:

 

  • Capital assets might be written down at different rates for tax purposes than they are in the financial statements.

 

Temporary differences may mean that profits are reported in the financial statements before they are taxable. Conversely, it might mean that tax is payable even though profits have not yet been reported in the financial statements.

 

According to the accruals concept, the tax effect of a transaction should be reported in the same accounting period as the transaction itself. Therefore, an adjustment to the tax charge may be required. This gives rise to deferred tax.

 

Deferred tax only arises on temporary differences. It is not accounted for on permanent differences.

 

A temporary difference is the difference between the carrying amount of an asset or liability and its tax base.

 

The tax base is the ‘amount attributed to an asset or liability for tax purposes’ (IAS 12, para 5).

 

Illustration 1 – Basic principles of deferred tax

 

Prudent prepares financial statements to 31 December each year. On 1 January 20X0, the entity purchased a non-current asset for $1.6 million that had an anticipated useful life of four years. This asset qualified for immediate tax relief of 100% of the cost of the asset.

 

For the year ending 31 December 20X0, the draft accounts showed a profit before tax of $2 million. The directors anticipate that this level of profit will be maintained for the foreseeable future.

 

Prudent pays tax at a rate of 30%. Apart from the differences caused by the purchase of the non-current asset in 20X0, there are no other differences between accounting profit and taxable profit or the tax base and carrying amount of net assets.

 

Required:

 

Compute the pre, and post-tax profits for Prudent for each of the four years ending 31 December 20X0–20X3 inclusive and for the period as a whole assuming:

 

  • that no deferred tax is recognised

 

  • that deferred tax is recognised.

 

Solution

 

  • No deferred tax

 

First of all, it is necessary to compute the taxable profits of Prudent for each period and the current tax payable:

 

Year ended 31 December Total
20X0 20X1 20X2 20X3
$000 $000 $000 $000 $000
Accounting profit 2,000 2,000 2,000 2,000 8,000
Add back Depreciation 400 400 400 400 1,600
Deduct Capital
allowances (1,600) (1,600)
––––– ––––– ––––– ––––– –––––
Taxable profits 800 2,400 2,400 2,400 8,000
––––– ––––– ––––– ––––– –––––
Current tax at 30% 240 720 720 720 2,400
––––– ––––– ––––– ––––– –––––

 

The differences between the accounting profit and the taxable profit that occur from one year to another, cancel out over the four years as a whole.

 

The statements of profit or loss for each period and for the four years as a whole, are given below:

 

Year ended 31 December Total
20X0 20X1 20X2 20X3
$000 $000 $000 $000 $000
Profit before tax 2,000 2,000 2,000 2,000 8,000
Current tax (240) (720) (720) (720) (2,400)
––––– ––––– ––––– ––––– –––––
Profit after tax 1,760 1,280 1,280 1,280 5,600
––––– ––––– ––––– ––––– –––––

 

Ignoring deferred tax produces a performance profile that suggests a declining performance between 20X0 and 20X1.

 

In fact the decline in profits is caused by the timing of the current tax charge on them.

 

In 20X0, some of the accounting profit escapes tax, but the tax is only postponed until 20X1, 20X2 and 20X3, when the taxable profit is more than the accounting profit.

 

  • Deferred tax is recognised

 

The deferred tax figures that are required in the statement of financial position are given below:

 

Year ended 31 December
20X0 20X1 20X2 20X3
$000 $000 $000 $000
Carrying amount 1,200 800 400 Nil
Tax base Nil Nil Nil Nil
Temporary difference ––––– ––––– ––––– –––––
at year end 1,200 800 400 Nil
Closing deferred ––––– ––––– ––––– –––––
tax liability (30%) 360 240 120 Nil
Opening deferred tax liability Nil (360) (240) (120)
––––– ––––– ––––– –––––
So charge/(credit) to P/L 360 (120) (120) (120)
––––– ––––– ––––– –––––

 

The statements of profit or loss for the four year period including deferred tax are shown below:

 

Year ended 31 December Total
20X0 20X1 20X2 20X3
$000 $000 $000 $000 $000
Profit before tax 2,000 2,000 2,000 2,000 8,000
Current tax (240) (720) (720) (720) (2,400)
Deferred tax (360) 120 120 120 Nil
––––– ––––– ––––– ––––– –––––
Profit after tax 1,400 1,400 1,400 1,400 5,600
––––– ––––– ––––– ––––– –––––

 

A more meaningful performance profile is presented.

 

Examples of temporary differences

 

Examples of temporary differences include (but are not restricted to):

 

  • Tax deductions for the cost of non-current assets that have a different pattern to the write-off of the asset in the financial statements.

 

  • Pension liabilities that are accrued in the financial statements, but are allowed for tax only when the contributions are made to the pension fund at a later date.

 

  • Intra-group profits in inventory that are unrealised for consolidation purposes yet taxable in the computation of the group entity that made the unrealised profit.

 

  • A loss is reported in the financial statements and the related tax relief is only available by carry forward against future taxable profits.

 

  • Assets are revalued upwards in the financial statements, but no adjustment is made for tax purposes.

 

  • Development costs are capitalised and amortised to profit or loss in future periods, but were deducted for tax purposes as incurred.

 

  • The cost of granting share options to employees is recognised in profit or loss, but no tax deduction is obtained until the options are exercised.

 

Calculating temporary differences

 

Deferred tax is calculated by comparing the carrying amount of an asset or liability to its tax base. The tax base is the amount attributed to the asset or liability for tax purposes. To assist with determining the tax base, IAS 12 notes that:

 

  • ‘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’ (IAS 12, para 7).

 

  • ‘The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in future periods. In the case of revenue which is received in advance, the tax base of the liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods’ (IAS 12, para 8).

 

When looking at the difference between the carrying amount and the tax base of an asset or liability:

 

  • If the carrying amount exceeds the tax base, the temporary difference is said to be a taxable temporary difference which will give rise to a deferred tax liability.

 

  • If the tax base exceeds the carrying amount, the temporary difference is a deductible temporary difference which will give rise to a deferred tax asset.

 

Test your understanding 1 – Dive (temporary differences)

 

An entity, Dive, provides the following information regarding its assets and liabilities as at 31 December 20X1.

 

Carrying Tax base Temporary
amount difference

 

Assets

 

A machine cost

 

$100,000. Depreciation

 

of $18,000 has been

 

charged to date. Tax

 

allowances of $30,000

 

have been claimed.

 

Interest receivable in the

 

statement of financial

 

position is $1,000. The

 

interest will be taxed when

 

received.

 

Trade receivables have a

 

carrying amount of

 

$10,000. The revenue has

 

already been included in

 

taxable profit.

 

Inventory has been written

 

down by $500 to $4,500

 

in the financial

 

statements. The reduction

 

is ignored for tax

 

purposes until the

 

inventory is sold.

 

Liabilities

 

Current liabilities include

 

accrued expenses of

 

$1,000. This is deductible

 

for tax on a cash paid

 

basis.

 

Accrued expenses have a

 

carrying amount of

 

$5,000. The related

 

expense has been

 

deducted for tax

 

purposes.

 

Required:

 

Complete the table with carrying amount, tax base and temporary difference for each of the assets and liabilities.

 

 

 

4 Deferred tax liabilities and assets

 

Recognition

 

IAS 12 Income Taxes states that deferred tax should be provided for on all taxable temporary differences, unless the deferred tax liability arises from:

 

  • goodwill, for which amortisation is not tax deductible

 

  • the initial recognition of an item that affects neither accounting profit nor taxable profit, and which does not result from a business combination.

 

Deferred tax assets should be recognised on all deductible temporary differences unless:

 

  • the exceptions above apply

 

  • insufficient taxable profits are expected to be available in the future against which the deductible temporary difference can be utilised.

 

Measurement

 

The tax rate in force (or expected to be in force) when the asset is realised or the liability is settled, should be applied to the temporary difference to calculate the deferred tax balance. IAS 12 specifies that this rate must be based on legislation enacted or substantively enacted by the reporting date.

 

Deferred tax assets and liabilities are not discounted to present value.

 

The entry to profit or loss and other comprehensive income in respect of deferred tax is the difference between the net liability (or asset) at the beginning of the year and the net liability (or asset) at the end of the year. It is important to note that:

 

  • If the item giving rise to the deferred tax is dealt with in profit or loss, the related deferred tax should also be presented in profit or loss.

 

  • If the item giving rise to the deferred tax is dealt with in other comprehensive income, the related deferred tax should also be recorded in other comprehensive income and held within equity.

 

Offsetting

 

IAS 12 notes that it is appropriate to offset deferred tax assets and liabilities in the statement of financial position as long as:

 

  • the entity has a legally enforceable right to set off current tax assets and current tax liabilities

 

  • the deferred tax assets and liabilities relate to tax levied by the same tax authority.

 

Test your understanding 2 – Dive (deferred tax calculation)

 

Required:

 

Using the information in ‘test your understanding 1’, calculate Dive’s deferred tax balance as at 31 December 20X1. The applicable tax rate is 30%.

 

Test your understanding 3 – Brick

 

Brick is a company with a reporting date of 30 April 20X4. The company obtains tax relief for research and development expenditure on a cash paid basis. The recognition of a material development asset during the year, in accordance with IAS 38, created a significant taxable temporary difference as at 30 April 20X4.

 

The tax rate for companies as at the reporting period was 22%. On 6 June 20X4, the government passed legislation to lower the company tax rate to 20% from 1 January 20X5.

 

Required:

 

Explain which tax rate should have been used to calculate the deferred tax liability for inclusion in the financial statements for the year ended 30 April 20X4.

 

5 Specific situations

 

Revaluations

 

Deferred tax should be recognised on the revaluation of property, plant and equipment even if:

 

  • there is no intention to sell the asset

 

  • any tax due on the gain made on any sale of the asset can be deferred by being ‘rolled over’ against the cost of a replacement asset.

 

Revaluation gains are recorded in other comprehensive income and so any deferred tax arising on the revaluation must also be recorded in other comprehensive income.

 

Test your understanding 4 – Dodge

 

An entity, Dodge, owns property, plant and equipment that cost $100,000 when purchased. Depreciation of $40,000 has been charged up to the reporting date of 31 March 20X1. The entity has claimed total tax allowances on the asset of $50,000. On 31 March 20X1, the asset is revalued to $90,000. The tax rate is 30%.

 

Required:

 

Explain the deferred tax implications of this situation.

 

Investment properties and deferred tax

 

The deferred tax calculation must take into consideration how the asset is measured together with how the entity expects to recover its value. In some jurisdictions, trading profits are taxed at different rates than capital gains.

 

IAS 12 presumes that the carrying amount of investment properties measured at fair value will be recovered from a sales transaction, unless there is evidence to the contrary.

 

IAS 40 illustration

 

Melbourne has an investment property, which is measured using the fair value model in accordance with IAS 40, comprising the following elements:

 

Cost Fair value
$000 $000
Land 800 1,200
Building 1,200 1,800
––––– –––––
2,000 3,000
––––– –––––

 

Further information is as follows:

 

  • Accumulated tax allowances claimed on the building to date are $600,000.

 

  • Unrealised changes in the carrying value of investment property do not affect taxable profit.

 

  • If an investment property is sold for more than cost, the reversal of accumulated tax allowances will be included in taxable profit and taxed at the standard rate.

 

  • The standard rate of tax is 30%, but for asset disposals in excess of cost, the tax rate is 20%, unless the asset has been held for less than two years, when the tax rate is 25%.

 

Required:

 

Calculate the deferred tax liability required if:

 

  • Melbourne expects to hold the investment property for more than two years.

 

  • Melbourne expects to sell the investment property within two years.

 

Solution

 

A summary of cost, fair value, and accumulated allowances claimed to date, together with tax base and temporary difference is as follows:

 

(a) (b) (c) (a) – (c) = (d) (b) – (d) =
(e)
Cost Fair Tax allowances Tax base Temp.
value claimed diff
$000 $000 $000 $000 $000
Land 800 1,200 800 400
Building 1,200 1,800 (600) 600 1,200
–––– ––––– ––––– ––––– –––––
2,000 3,000 (600) 1,400 1,600
–––– ––––– ––––– ––––– –––––

 

Note that the tax rate to apply in each situation will be the tax rate expected to apply when the investment property is sold.

 

  • If Melbourne expects to hold the investment property for more than two years:

 

The reversal of the accumulated tax allowances claimed on the building element will be charged at the standard rate of 30%, whilst the proceeds in excess of cost will be charged at 20% as follows:

 

$000
Accumulated tax allowances (600 × 30%) 180
Proceeds in excess of cost (1,000 × 20%) 200
––––
Deferred tax liability 380
––––

 

  • If Melbourne expects to sell the investment property within two years:

 

The reversal of the accumulated tax allowances claimed on the building element will be charged at the standard rate of 30%, whilst the proceeds in excess of cost will be charged at 25% as follows:

 

$000
Accumulated tax allowances (600 × 30%) 180
Proceeds in excess of cost (1,000 × 25%) 250
––––
Deferred tax liability 430
––––

 

Share option schemes

 

Accounting for share option schemes involves recognising an annual remuneration expense in profit or loss throughout the vesting period. Tax relief is not normally granted until the share options are exercised. The amount of tax relief granted is based on the intrinsic value of the options (the difference between the market price of the shares and the exercise price of the option).

 

This delayed tax relief means that equity-settled share-based payment schemes give rise to a deferred tax asset.

 

The following pro-forma can be used to calculate the deferred tax asset arising on an equity-settled share-based payment scheme:

 

$ $
Carrying amount of share-based payment Nil
Less:
Tax base of the share-based payment* (X)
× Tax rate % ––––
X
–––– ––––
Deferred tax asset X
––––

 

  • The tax base is the expected future tax relief (based on the intrinsic value of the options) that has accrued by the reporting date.

 

Where the amount of the estimated future tax deduction exceeds the accumulated remuneration expense, this indicates that the tax deduction relates partly to the remuneration expense and partly to equity. Therefore, the deferred tax must be recognised partly in profit or loss and partly in equity.

 

Test your understanding 5 – Splash

 

An entity, Splash, established a share option scheme for its four directors. This scheme commenced on 1 July 20X8. Each director will be entitled to 25,000 share options on condition that they remain with Splash for four years, from the date the scheme was introduced.

 

Information regarding the share options is provided below:
Fair value of option at grant date $10
Exercise price of option $5

 

The fair value of the shares at 30 June 20X9 was $17 per share.

 

A tax deduction is only given for the share options when they are exercised. The allowable deduction will be based on the intrinsic value of the options. Assume a tax rate of 30%.

 

Required:

 

Calculate and explain the amounts to be included in the financial statements of Splash for the year ended 30 June 20X9, including explanation and calculation of any deferred tax implications.

 

 

 

Unused tax losses

 

Where an entity has unused tax losses, IAS 12 allows a deferred tax asset to be recognised only to the extent that it is probable that future taxable profits will be available against which the unused tax losses can be utilised.

 

IAS 12 advises that the deferred tax asset should only be recognised after considering:

 

  • whether an entity has sufficient taxable temporary differences against which the unused tax losses can be offset.

 

  • whether it is probable the entity will make taxable profits before the tax losses expire.

 

  • whether the cause of the tax losses can be identified and whether it is likely to recur (otherwise, the existence of unused tax losses is strong evidence that future taxable profits may not be available).

 

  • whether tax planning opportunities are available.

 

Test you understanding 6 – Red

 

As at 31 December 20X1, Red has tax adjusted losses of $4m which arose from a one-off restructuring exercise. Under tax law, these losses may be carried forward to relieve taxable profits in the future. Red has produced forecasts that predict total future taxable profits over the next three years of $2.5m. However, the accountant of Red is not able to reliably forecast profits beyond that date.

 

The tax rate for profits earned during the year ended 31 December 20X1 is 30%. However, the government passed legislation during the reporting period that lowered the tax rate to 28% from 1 January 20X2.

 

Required:

 

Explain the deferred tax implications of the above.

 

6 Business combinations and deferred tax

 

Accounting for a business combination, such as the consolidation of a subsidiary, can have several deferred tax implications.

 

Fair value adjustments

 

The identifiable assets and liabilities of the acquired subsidiary are consolidated at fair value but the tax base derives from the values in the subsidiary’s individual financial statements. A temporary difference is created, giving rise to deferred tax in the consolidated financial statements.

 

The deferred tax recognised on this difference is treated as part of the net assets acquired and, as a result, impacts upon the amount of goodwill recognised on the acquisition of the subsidiary.

 

The goodwill itself does not give rise to deferred tax because IAS 12 specifically excludes it.

 

Test your understanding 7 – Tom

 

On 30 June 20X1 Tom acquired 100% of the shares of Jones for $300,000. At this date, the carrying amount of the net assets of Jones were $250,000. Included in this net asset figure is inventory which cost $50,000 but which had a replacement cost of $55,000. The applicable tax rate is 30%.

 

Required:

 

Explain the deferred tax implications of the above in the consolidated financial statements of the Tom group.

 

Provisions for unrealised profit

 

When one company within a group sells inventory to another group company, unrealised profits remaining within the group at the reporting date must be eliminated. The following adjustment is required in the consolidated financial statements:

 

Dr Cost of sales (P/L)

 

Cr Inventory (SFP)

 

This adjustment reduces the carrying amount of inventory in the consolidated financial statements but the tax base of the inventory remains as its cost in the individual financial statements of the purchasing company.

 

This creates a deductible temporary difference, giving rise to a deferred tax asset in the consolidated financial statements.

 

Note: you may find it easier to think of this adjustment in terms of profits. The unrealised profit on the intra-group transaction is removed from the consolidated financial statements and therefore the tax charge on this profit must also be removed.

 

Test your understanding 8 – Mug

 

Mug has owned 80% of the ordinary shares of Glass for many years. During the current year, Mug sold inventory to Glass for $250,000 making a gross profit margin of 40%. One quarter of this inventory remains unsold by Glass at the reporting date.

 

The tax rate is 20%.

 

Required:

 

Discuss the deferred tax implications of the above transaction.

 

Unremitted earnings

 

A temporary difference arises when the carrying amount of investments in subsidiaries, associates or joint ventures is different from the tax base.

 

  • The carrying amount in consolidated financial statements is the investor’s share of the net assets of the investee, plus purchased goodwill. The tax base is usually the cost of the investment. The difference is the unremitted earnings (i.e. undistributed profits) of the subsidiary, associate or joint venture.

 

  • IAS 12 says that deferred tax should be recognised on this temporary differences except when:

 

– the investor controls the timing of the reversal of the temporary difference and

 

– it is probable that the profits will not be distributed in the foreseeable future.

 

  • An investor can control the dividend policy of a subsidiary, but not always that of other types of investment. This means that deferred tax does not arise on investments in subsidiaries, but may arise on investments in associates and joint ventures.

 

Financial assets may give rise to deferred tax if they are revalued.

 

7 Other issues

 

 

Arguments for recognising deferred tax

 

If a deferred tax liability is ignored, profits are inflated and the obligation to pay an increased amount of tax in the future is also ignored. The arguments for recognising deferred tax are summarised below.

 

  • The accruals concept requires tax to be matched to profits as they are earned.

 

  • The deferred tax will eventually become an actual tax liability.

 

  • Ignoring deferred tax overstates profits, which may result in:

 

–   over-optimistic dividend payments based on inflated profits

 

– distortion of earnings per share and of the price/earnings ratio, both important indicators of an entity’s performance

 

–   shareholders being misled.

 

Arguments for not recognising deferred tax

 

Some people believe that the ‘temporary difference’ approach is conceptually wrong. The framework for the preparation and presentation of financial statements defines a liability as an obligation to transfer economic benefits, as the result of a past event. In practice, a liability for deferred tax is often recognised before the entity actually has an obligation to pay the tax.

 

For example, suppose that an entity revalues a non-current asset and recognises a gain. It will not be liable for tax on the gain until the asset is sold. However, IAS 12 requires that deferred tax is recognised immediately on the revaluation gain, even if the entity has no intention of selling the asset (and realising the gain) for several years.

 

As a result, the IAS 12 approach could lead to the build-up of liabilities that may only crystallise in the distant future, if ever.

Test your understanding answers

 

Test your understanding 1 – Dive (temporary differences)

 

Carrying Tax base Temp.
amount difference
$ $ $
Non-current asset 82,000 70,000 12,000
Interest receivable 1,000 Nil 1,000
Receivables 10,000 10,000 Nil
Inventory 4,500 5,000 (500)
Accrual (cash basis for tax) (1,000) Nil (1,000)
Accrual (already had tax relief) (5,000) (5,000) Nil

 

 

Test your understanding 2 – Dive (deferred tax calculation)

 

The net temporary difference as at the reporting date is as follows:

 

Non-current assets $
12,000
Interest receivable 1,000
Receivables
Inventory (500)
Accrual (cash basis for tax) (1,000)
Accrual (already had tax relief)
–––––––
11,500
–––––––

 

There will be a deferred tax liability because the carrying value of the net assets and liabilities exceeds their net tax base. The deferred tax liability is calculated by applying the relevant tax rate to the temporary difference.

 

The deferred tax liability is therefore $3,450 ($11,500 × 30%).

 

Assuming that there is no opening deferred tax liability, the following accounting entry is required:

 

Dr Tax expense (P/L) $3,450
Cr Deferred tax liability (SFP) $3,450

 

Test your understanding 3 – Brick

 

Deferred tax liabilities and assets should be measured using the tax rates expected to apply when the asset is realised. This tax rate must have been enacted or substantively enacted by the end of the reporting period.

 

The government enacted the 20% tax rate after the period end. Therefore, it should not be used when calculating the deferred tax liability for the year ended 30 April 20X4. The current 22% rate should be used instead.

 

Per IAS 10, changes in tax rates after the end of the reporting period are a non-adjusting event. However, if the change in the tax rate is deemed to be material then Brick should disclose this rate change and an estimate of the financial impact.

 

 

 

Test your understanding 4 – Dodge

 

The carrying value of the asset is $90,000 and the tax base is $50,000 ($100,000 – $50,000). The carrying value exceeds the tax base by $40,000 ($90,000 – $50,000).

 

This temporary difference will give rise to a deferred tax liability of $12,000 ($40,000 × 30%).

 

Prior to the revaluation, the carrying amount of the asset was $60,000. The asset was then revalued to $90,000. Therefore, $30,000 ($90,000 – $60,000) of the temporary difference relates to the revaluation. Revaluation gains are recorded in other comprehensive income and so the deferred tax charge relating to this gain should also be recorded in other comprehensive income. This means that the tax charged to other comprehensive income is $9,000 ($30,000 × 30%).

 

The following accounting entry is required:
Dr Other comprehensive income $9,000
Dr Profit or loss (bal. fig.) $3,000
Cr Deferred tax liability $12,000

 

The balance on the revaluation reserve within other components of equity will be $21,000 ($30,000 revaluation gain – $9,000 deferred tax).

 

Test your understanding 5 – Splash

 

The expense recognised for an equity-settled share-based payment scheme is calculated based on the fair value of the options at the grant date. This expense is spread over the vesting period. At each reporting date, the entity should reassess the number of options expected to vest.

 

The expense for the scheme in the year ended 30 June 20X9 is $250,000 (4 × 25,000 × $10 × 1/4).

 

For tax purposes, tax relief is allowed based on the intrinsic value of the options at the date they are exercised.

 

At the reporting date, the shares have a market value of $17 but the options allow the holders to purchase these shares for $5. The options therefore have an intrinsic value of $12 ($17 – $5).

 

The deferred tax asset is calculated as follows:
$ $
Carrying value of share-based payment Nil
Tax base of the share-based payment (300,000)
(4 × 25,000 × ($17 – $5) × 1/4) ––––––––
× Tax rate 30%
(300,000) –––––––
Deferred tax asset 90,000
–––––––

 

Where the amount of the estimated future tax deduction exceeds the accumulated remuneration expense, this indicates that the tax deduction relates partly to the remuneration expense and partly to equity.

 

In this case, the estimated future tax deduction is $300,000 whereas the accumulated remuneration expense is $250,000. Therefore, $50,000 of the temporary difference is deemed to relate to an equity item, and the deferred tax relating to this should be credited to equity.

 

The following entry is required:
Dr Deferred tax asset $90,000
Cr Equity ($50,000 × 30%) $15,000
Cr Profit or loss ($250,000 × 30%) $75,000

 

If the deferred tax asset is to be recognised, it must be capable of reliable measurement and also be regarded as recoverable.

 

Test you understanding 6 – Red

 

A deferred tax asset can be recognised if it is deemed probable that future taxable profits will be available against which the unused losses can be utilised.

 

The tax losses have arisen from an exceptional event, suggesting that the entity will return to profitability. Forecasts produced by the accountant confirm this.

 

Red is only able to reliably forecast future profits of $2.5m. This limits the deferred tax asset that can be recognised.

 

Deferred tax should be calculated using the tax rate that is expected to be in force when the temporary difference reverses based on the rates enacted by the reporting date. This means that the 28% rate should be used.

 

The deferred tax asset that can be recognised is therefore $700,000

 

($2.5m × 28%). There will be a corresponding credit to the tax expense in the statement of profit or loss.

 

Test your understanding 7 – Tom

 

According to IFRS 3, the net assets of the subsidiary at the acquisition date must be consolidated at fair value. The carrying amount of the inventory in the group financial statements will be $55,000. The tax base of the inventory is based on its carrying amount of $50,000 in the individual financial statements. Therefore, there is a temporary difference of $5,000 that arises on consolidation.

 

A deferred tax liability must be recognised in the consolidated financial statements for $1,500 ($5,000 × 30%). This is treated as a reduction in the subsidiary’s net assets at the acquisition date, which will increase the goodwill arising on acquisition.

 

$ $
Consideration 300,000
Net assets:
Carrying amount 250,000
Fair value uplift 5,000
Deferred tax liability (1,500)
––––––– (253,500)
Goodwill at acquisition –––––––
46,500
–––––––

Test your understanding 8 – Mug

 

There has been an intra-group sale and some of the inventory remains within the group at the reporting date. The profits held within this unsold inventory must therefore be removed from the consolidated statements.

 

The profit on the sale was $100,000 ($250,000 × 40%). Of this, $25,000 ($100,000 × 25%) remains within the inventory of the group.

 

The adjustment required to eliminate the unrealised profits is:
Dr Cost of sales $25,000
Cr Inventory $25,000

 

The carrying amount of inventory in the consolidated financial statements is now $25,000 lower than its tax base, creating a deductible temporary difference of $25,000. This gives rise to a deferred tax asset of $5,000 ($25,000 × 20%) in the consolidated statement of financial position as well as a corresponding reduction to the tax expense in the consolidated statement of profit or loss.

 

The adjustment required to account for the deferred tax is:
Dr Deferred tax asset $5,000
Cr Tax expense $5,000

 

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