03/02/2022 EFIMM0124 Advanced Financial Reporting Accounting for Taxation Lei Wang lei.wang@bristol.ac.uk Aims and objectives By the end of this section, you should be able to: Explain and illustrate the impact of taxation on financial statements Distinguish between accounting profit and taxable profit Understand temporary differences and how they require the operation of a deferred tax account Explain alternative approaches to accounting for deferred tax Know and apply some of the main requirements of IAS 12 Income Taxes on accounting for deferred tax 1 2 03/02/2022 Readings Alexander et al., International Financial Reporting and Analysis (8th edition) Chapter 20. Picker et al., Applying IFRS Standards (4th edition) Chapter 6. Summary of IAS 12 Income Taxes on http://www.iasplus.com Types of Taxes Direct taxes – Assessed on and collected from ‘individuals’ intended to bear it – Examples: corporation tax; income tax; capital gains tax Indirect taxes – Burden can be passed on by supplier to final consumer – Examples include VAT and excise duties Note that companies act as both: – a) Tax collecting agents – b) Tax payers themselves 3 4 03/02/2022 Acting as an Agent Employees have to pay NI and income tax on their earnings. These taxes are collected by the firm. Assume a company has to pay the following monthly costs for an employee: Net pay ￡4,000 National Insurance (NI) ￡240 Income tax (PAYE) ￡600 Gross pay ￡4,840 Statement of Financial Position T1 T2 T3 Cash 10,000 6,000 5,160 Tax and NI due -840 10,000 5,160 5,160 Ordinary shares 10,000 10,000 10,000 Retained earnings -4,840 -4,840 10,000 5,160 5,160 Revenue and Tax: IFRS 15 In most countries, indirect taxes are charged, such as: – Sales taxes – Value-added taxes – Goods or service taxes In financial reporting under IFRS, revenue does not include amounts collected on behalf of third parties. These do not represent economic benefits to the firm and do not increase equity. 5 6 03/02/2022 Revenue and Tax: IFRS 15 Example: VAT VAT Rate 20% (VAT Fraction 1/6). Assume a firm buys goods for ￡400 + VAT and sells them for ￡800 + VAT. Inputs (purchases) Outputs (sales) Transaction value ￡480 ￡960 Tax ￡80 = ￡480 x 1/6 ￡160 = ￡960 x 1/6 7 8 03/02/2022 Example: VAT Balance sheets Cash 1,000 -480 520 Inventory +400 400 VAT +80 80 1,000 1,000 Ordinary shares 1,000 1,000 Retained earnings 1,000 1,000 Example: VAT Balance sheets after sale of inventory Cash 1,000 -480 520 +960 1,480 Inventory +400 400 -400 0 VAT +80 80 -160 -80 1,000 1,000 1,400 Ordinary shares 1,000 1,000 1,000 Retained earnings -400+800 400 1,000 1,000 1,400 9 10 03/02/2022 Example: VAT Balance sheets after settlement Cash 1,000 -480 520 +960 1,480 -80 1,400 Inventory +400 400 -400 0 VAT +80 80 -160 -80 +80 0 1,000 1,000 1,400 1,400 Ordinary shares 1,000 1,000 1,000 1,000 Retained earnings -400+800 400 400 1,000 1,000 1,400 1,400 Corporation Taxation Companies are treated as separate entities for taxation purposes and are themselves liable for tax on their profits. Shareholders are treated separately and are only liable for tax on distributions of profits (i.e. dividends) – Shareholders sometimes receive concessions on dividends to avoid ‘double taxation’. Contrast this with partnerships, where each partner is liable for tax on their share of profits, whether distributed as dividends or not. 11 12 03/02/2022 Corporation Tax: The Main Issue Accounting profit Taxable profit Accounting assets/liabilities Tax assets/liabilities Corporation Tax: Differences Permanent differences: differences between accounting profit and taxable profit that arise when amounts recognised as part of accounting profit are never recognised as part of taxable profit and vice versa. Timing differences: differences between accounting profit and taxable profit that arise when the period in which revenues and expenses are recognised is different from the period in which such revenues and expenses are treated as taxable income and allowable deductions for tax purposes. Temporary differences: differences in carrying amounts of assets or liabilities in the balance sheets and their value for tax purposes (tax base). 13 14 03/02/2022 IAS 12 Income Taxes IAS 12 focuses on temporary differences (an approach based on the balance sheet). Treatment: requires full provision for deferred tax based on the liability method (i.e. in the event of a change in tax rates, the balance on the deferred tax account also changes) Potential alternatives to liability method are: – Flow through: no provision for deferred tax. – Partial provision: previous UK standard SSAP15 used this method but there was much ‘creativity’. IAS 12 Income Taxes – definitions Temporary difference: a difference between the carrying amount of an asset or liability and its tax base. – Taxable temporary difference: a temporary difference that will result in taxable amounts in the future when the carrying amount of the asset is recovered or the liability is settled. – Deductible temporary difference: a temporary difference that will result in amounts that are tax deductible in the future when the carrying amount of the asset is recovered or the liability is settled. 15 16 03/02/2022 Example: accounting profit and taxable profit ￡m Profit from income statement 93 Add back: depreciation charge 10 Add back: entertainment expenses 2 105 Less: capital allowances -25 Taxable profit 80 This is a TIMING difference This is a PERMANENT difference Example: accounting values and tax bases ￡m Carrying value of asset 90 Add back: accumulated depreciation 10 Cost 100 Less: accumulated capital allowances -25 Tax base 75 Temporary difference: difference in the carrying amount for tax purposes and accounting purposes Temporary difference = 90 75 = 15 17 18 03/02/2022 Tax in Income Statement v.s. Tax to be paid Tax rate 28%; Accounting profit 93; Taxable profit 80 Question: how do we account for the difference Tax in Income Statement (based on accounting profit) 28% x 93 = 26.04 Tax to be paid 28% x 80 = 22.40 Three approaches ‘Flow through’ method: don’t account for timing differences. Timing difference method: account for the difference between accounting profit and taxable profit. Temporary difference method: account for the difference between carrying value and tax base. IAS 12 requires this 19 20 03/02/2022 Example: Capital allowances and deferred tax An asset costs ￡30,000. It has a 6 year life and zero residual value. The company buying the asset has profit before depreciation of ￡12,000. The tax rate is 35% and annual capital allowances for taxation are 25% on a reducing balance basis. All payments and receipts are in cash. The asset is still in use at the end of year 6. Method 1: Flow through – no deferred tax (NOT ALLOWED UNDER IAS 12) Depreciation charge Accounting profit Capital allowances Taxable profit Tax payable Profit after tax A B 12,000 A C D 12,000 C E D x 35% F B E Year 1 5,000 7,000 7,500 4,500 1,575 5,425 Year 2 5,000 7,000 5,625 6,375 2,231 4,769 Year 3 5,000 7,000 4,219 7,781 2,723 4,277 Year 4 5,000 7,000 3,164 8,836 3,093 3,907 Year 5 5,000 7,000 2,373 9,627 3,369 3,631 Year 6 5,000 7,000 1,780 10,220 3,577 3,423 Total 30,000 42,000 24,661 47,339 16,568 25,432 21 22 03/02/2022 Method 1: Flow through – no deferred tax (NOT ALLOWED UNDER IAS 12) End of year 1 2 3 4 5 6 Fixed assets 25,000 20,000 15,000 10,000 5,000 0 Cash 12,000 22,425 32,194 41,471 50,378 59,009 Tax due -1,575 -2,231 -2,723 -3,093 -3,369 -3,577 35,425 40,194 44,471 48,378 52,009 55,432 Share capital 30,000 30,000 30,000 30,000 30,000 30,000 Retained earnings 5,425 10,194 14,471 18,378 22,009 25,432 35,425 40,194 44,471 48,378 52,009 55,432 Statements of Financial Position Method 2: Timing differences approach (not covered by IAS 12) Year Accounting/ pre-tax profit Tax payable Deferred tax transfer Profit after tax Deferred tax a/c balance 1 7,000 1,575 875 4,550 875 2 7,000 2,231 219 4,550 1,094 3 7,000 2,723 -273 4,550 821 23 24 03/02/2022 Temporary Differences Approach Based on the SOFP 1. Value asset for accounting (net book or carrying value) 2. Value asset for tax (tax base) 3. Find the difference 4. Difference x tax rate = deferred tax balance 5. Adjust balance via the income statement Carrying values and tax base Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Carrying value 30,000 25,000 20,000 15,000 10,000 5,000 0 Tax base 30,000 22,500 16,875 12,656 9,492 7,119 5,339 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 Carrying value Tax base 25 26 03/02/2022 Temporary differences: balance in year 3 Carrying value for accounting: 30,000 (3 x 5,000) 15,000 Carrying value for tax (tax base): 30,000 7,500 5,625 4,219 12,656 Difference: 15,000 12,656 2,344 Difference @ 35% 820 Temporary differences: year 1 and 2 Year 1 Year 2 Accounting value 25,000 20,000 Tax value 22,500 16,875 Difference 2,500 3,125 Difference @ 35% 875 1,094 Opening value -0 -875 Charge 875 219 27 28 03/02/2022 Full deferral Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Fixed assets 25,000 20,000 15,000 10,000 5,000 0 Cash 12,000 22,425 32,194 41,471 50,378 59,009 Tax due -1,575 -2,231 -2,723 -3,093 -3,369 -3,577 35,425 40,194 44,471 48,378 52,009 55,432 Share capital 30,000 30,000 30,000 30,000 30,000 30,000 Retained earning b/f 0 4,550 9,100 13,650 18,200 22,750 for year 5,425 4,769 4,277 3,907 3,631 3,423 transfer to deferred tax -875 -219 273 643 919 1,127 c/f 4,550 9,100 13,650 18,200 22,750 27,300 Deferred tax 875 1,094 821 178 -741 -1,868 35,425 40,194 44,471 48,378 52,009 55,432 Deferred tax balance Year 1 Year 2 Year 3 Tax based on accounting profit: 7,000 x 35% 2,450 2,450 2,450 Actual tax charge -1,575 -2,231 -2,723 Balance b/f 0 875 1,094 Deferred tax balance 875 1,094 821 29 30 03/02/2022 Differences between the three methods Flow through: profit declines gradually even though the firm has the same operating profits every year and the tax rate is unchanged. Timing differences method and temporary differences methods give the same result. Why is IAS12 based on temporary differences method – If tax rates change, timing differences method will give incorrect liability. – If asset is revalued, timing differences method will give incorrect liability. Example: Change in the tax rate A company has a deferred tax liability of ￡900,000 at 31st March 20X0 and in September 20X0 the tax rate is reduced from 40% to 30%, effective from 1st April 20X0. Balance is now overstated so it must be reduced: Double entry: Dr deferred tax liability; Cr corporation tax expense Opening balance ￡900,000 Adjustment for change in rate: (40 30) ÷ 40 -￡225,000 Restated balance ￡675,000 31 32 03/02/2022 Example: Revaluation In 20X0, a company buys land costing ￡10m. In 20X5, it is re-valued to ￡15m. In 20X9 it is sold for ￡18m. Assume that the tax rate is 35% and there is no inflation. Example: Revaluation 20X0 20X5 With DT 20X9 Land 10.00 15.00 15.00 0.00 Cash 18.00 10.00 15.00 15.00 18.00 Ordinary shares 10.00 10.00 10.00 10.00 Revaluation reserve 5.00 3.25 0.00 Retained earnings 5.20 Deferred tax 1.75 Tax due 2.80 10.00 15.00 15.00 18.00 33 34 03/02/2022 Recap 1. Compute carrying value of asset/liability for financial reporting (FRV) 2. Compute value (the tax base) for taxation (TB) 3. Take the difference (FRV TB) = Temporary difference (TD) (see next slide) 4. Take the temporary difference at the tax rate = balance on DT account 5. Compare with opening balance and adjust balance through I/S: To increase deferred tax liability, Dr I/S tax expense, Cr DTL To reduce deferred tax liability, Cr I/S tax expense, Dr DTL To increase deferred tax asset, Cr I/S tax expense, Dr DTA To reduce deferred tax asset, Dr I/S tax expense, Cr DTA Summary table (EY, 2014) Asset / Liability Carrying amount higher / lower than tax base Nature of temporary difference Resulting deferred tax (if recognised) Asset Higher Taxable Liability Asset Lowe Deductible Asset Liability Higher Deductible Asset Liability Lower Taxable Liability 35 36
