Getting Technical February 2001

The technical standards team comprises Keith Reilly CA, Joanne Connolly CA, Jeanette Dawes CA, Stephanie Kemp CA, Jeffrey Knapp CA, Claire Locke CA and Tim Breakspear CA Student. This month’s ‘Getting Technical’ is adapted from the forthcoming edition of Eddey, Arthur and Knapp, ‘Accounting for Corporate Combinations and Associations’.

TAX EFFECT ACCOUNTING - FROM CONCEPTS TO PRACTICE

Tax effect accounting using the ‘balance sheet approach’ is fast approaching with the new AASB 1020 applicable to financial years beginning on or after 1 July 2002. The move from an income statement approach to a balance sheet approach for tax effect accounting is a fundamental shift that will require continuing professional education. Previous editions of ‘Getting Technical’ have considered the calculation of the deferred tax balances for particular financial statement items. This month’s article extends the analysis by illustrating how tax effect accounting is likely to be performed at the end of each reporting period. It also sets out a suggested new format for the tax effect accounting worksheet.

The general principle of the balance sheet approach to tax effect accounting is that the current and future tax consequences of all transactions and other events recognised in an entity’s balance sheet give rise to current and deferred tax liabilities and assets. In effect, the balance sheet approach requires the reconciliation from an accounting balance sheet to a tax-based balance sheet. Central to the balance sheet approach of AASB 1020 are the notion of ‘temporary differences’ and the meaning of ‘tax base’. AASB 1020.15.1 defines a temporary difference as

. . . . the difference between the carrying amount of an asset or liability in the statement of financial position and its tax base

Tax base is defined in the same paragraph as:

. . . . the amount attributed to an asset or liability for tax purposes

A temporary difference may be either an ‘assessable temporary difference’ or a ‘deductible temporary difference’. The tax effect (multiplying by the tax rate) of an assessable temporary difference is a deferred tax liability whereas the tax effect of a deductible temporary difference is a deferred tax asset.

The conceptual basis of temporary differences is that future tax consequences are associated with carrying assets and liabilities in the accounting balance sheet at amounts that are different to that implied by the income tax laws. For example, if an asset has a carrying amount that exceeds its tax base, then the assessable economic benefits that flow from the asset (in use or sale) will exceed the amount allowed as a tax deduction for the asset. The resulting income taxes that are expected in future reporting periods equate to a deferred tax liability. By contrast, if a liability has a carrying amount that is greater than its tax base, then the economic benefits sacrificed to settle the liability in future reporting periods will result in future tax deductions. The resulting reduction or recovery of income tax that would otherwise be payable represents a deferred tax asset.

The following table sets out the AASB 1020 rules for measurement of the deferred tax liability and asset balances and can be used as a ‘ready reckoner’ for determining whether a balance sheet item gives rise to a deferred tax liability or asset.

Classification of temporary differences and measurement of deferred tax balances

Carrying amount of asset / greater
than / Tax base
of asset / excess
equals / Assessable
temporary difference / multiplied by tax rate equals / Deferred tax liability
Carrying amount
of asset / less
than / Tax base
of asset / deficiency
equals / Deductible
temporary difference / multiplied by tax rate equals / Deferred tax asset
Carrying amount
of liability / greater
than / Tax base
of liability / excess
equals / Deductible
temporary difference / multiplied by tax rate equals / Deferred tax asset
Carrying amount
of liability / less
than / Tax base
of liability / deficiency
equals / Assessable temporary difference / multiplied by tax rate equals / Deferred tax liability

AASB 1020 runs to some 148 pages long and provides numerous examples of the calculation of the tax base and temporary differences in respect of particular assets and liabilities recognised in the balance sheet. Temporary differences recognised using the balance sheet approach to tax effect accounting that are equivalent to the ‘timing differences’ previously recognised using the income statement approach are as follows:

(a)  Plant and equipment measured using the cost basis where depreciation rates for tax purposes are relatively higher than those used for accounting purposes. In this case, the carrying amount of the asset (i.e. its written down value) for accounting purposes is greater than for tax purposes and an assessable temporary difference and deferred tax liability result.

(b)  Provisions for employee entitlements that are not recognised as a liability for tax purposes. In this case, the carrying amount of the liability for accounting purposes is greater than the carrying amount for tax purposes and a deductible temporary difference and deferred tax asset result.

(c)  Capitalised research and development costs that are not recognised as an asset for tax purposes. In this case, the carrying amount of the asset for accounting purposes is greater than for tax purposes and an assessable temporary difference and deferred tax liability result.

(d)  Unrealised exchange gains and losses recognised in the carrying amounts of foreign currency monetary assets and liabilities. For example, an unrealised exchange loss on foreign currency borrowings results in the carrying amount of the liability being greater for accounting purposes than tax purposes and a deductible temporary difference and deferred tax asset result.

Importantly, the balance sheet approach to tax effect accounting has also created a number of temporary differences that were not previously recognised using the income statement approach. Two main categories are as follows:

(a)  Non-current assets measured using the fair value basis that have been revalued upwards from original cost. In this case, the carrying amount of the asset for accounting purposes is greater than for tax purposes and an assessable temporary difference and deferred tax liability result.

(b)  Hybrid securities such as convertible notes that are apportioned between debt and equity components for accounting purposes but treated as wholly debt for tax purposes. In this case, the carrying amount of the liability for accounting purposes is less than for tax purposes and an assessable temporary difference and deferred tax liability result.

While differences between the carrying amounts and tax bases of assets and liabilities give rise to assessable or deductible temporary differences not all such differences are recognised as deferred tax liabilities or assets. In accordance with AASB 1020.6.1, the following temporary differences must not be tax effected.

(a)  goodwill if the amortisation is not deductible for tax purposes;

(b)  the initial recognition of an identifiable asset or liability with some exceptions; and

(c)  investments in subsidiaries and certain other entities where the investor is able to control the distributions and it is probable that the temporary difference will not reverse in the foreseeable future.

Another special category of deferred tax asset not shown in the table above concerns unused tax losses that the income tax law allows to be carried forward and offset against future taxable income. The deferred tax asset for unused tax losses is calculated as follows:

Unused tax losses / multiplied by tax rate equals / Deferred tax asset

It should also be noted that the recognition of a deferred tax asset in the balance sheet is subject to a recognition test. A deferred tax asset can only be recognised to the extent that it is probable that future taxable amounts will be available within the entity against which the deductible temporary differences can be utilised. This test applies whether the deferred tax asset results from deductible temporary differences or unused tax losses (AASB 1020.4.3 and 4.4)

The following example illustrates the mechanics of applying the balance sheet approach of tax effect accounting to a company.

On 1 January 20X0, AAA Ltd is incorporated and begins operations. Set out below is a tax-effect worksheet incorporating the accounting and tax-based balance sheets of AAA Ltd one year later at 31 December 20X0. The tax accountant of AAA Ltd has estimated that in accordance with income tax laws the company has a taxable income for the 20X0 year of $250,000. The company tax rate is 30%. AAA Ltd uses the fair value basis of measurement for land but the cost basis for all depreciable non-current assets.

Accounting / Tax-based / Deferred tax balances / Tax / Asset rev. / Current tax
Balance / Balance / Asset / Liability / expense / reserve / payable
Sheet / Sheet / dr (cr) / dr (cr) / dr (cr) / dr (cr) / dr (cr)
$ / $ / $ / $ / $ / $ / $
Assets
Cash / 20,000 / 20,000
Inventory / 35,000 / 40,000 / 5,000 / (5,000)
Plant - net / 155,000 / 130,000 / (25,000) / 25,000
R&D - net / 80,000 / - / (80,000) / 80,000
Land / 250,000 / 200,000 / (50,000) / 50,000
540,000 / 390,000
Liabilities
Provisions / 60,000 / - / 60,000 / (60,000)
Borrowings / 350,000 / 300,000 / 50,000 / (50,000)
410,000 / 300,000
Net assets / 150,000 / 90,000
Temporary differences at period end / 115,000 / (155,000) / (10,000) / 50,000
Less: Prior period amounts / - / - / - / -
Movement for the period / 115,000 / (155,000) / (10,000) / 50,000
Tax effected at 30% / 34,500 / (46,500) / (3,000) / 15,000
Tax on taxable income, 30% x $250,000 / 75,000 / (75,000)
Income tax adjustments / 34,500 / (46,500) / 72,000 / 15,000 / (75,000)

Tax effect accounting using the balance sheet approach proceeds by determining the assessable and deductible temporary differences at the end of the reporting period. The movements in the temporary differences are calculated (nil in the first year of operations) and then tax effected to establish what are adjustments are needed to the deferred tax liability and asset balances for the period.

In general, deferred tax that arises in a reporting period must be recognised as an expense or revenue for the period. However, to the extent that the deferred tax relates to amounts that were previously recognised as direct debits or credits in equity it must also be directly debited or credited to equity. These rules are illustrated in the worksheet above. The deferred tax entries for all but the land have been allocated to the column for income tax expense and result in a revenue adjustment of $3,000. In the case of the land, a debit entry is made to the asset revaluation reserve in order to follow the revaluation increment credited to the asset revaluation reserve resulting in a net revaluation increment of $35,000 (i.e. $50,000 less $15,000).

The current tax for the period is calculated as the tax on taxable income, which is 30% x $250,000 equal to $75,000. This current tax together with the deferred tax allocated to the net profit or loss (revenue of $3,000) equals the income tax expense for the period, i.e. $75,000 less $3,000 equal to $72,000. Using the information from the tax worksheet above, the tax journal entry of AAA Ltd to record the current and future tax arising during the period is as follows:

General journal of AAA Ltd – 31.12.X0

$ / $
Dr. / Income tax expense / 72,000
Dr. / Deferred tax asset / 34,500
Dr. / Asset revaluation reserve / 15,000
Cr. / Deferred tax liability / 46,500
Cr. / Income tax payable / 75,000

AASB 1020.12.4 will usually require a company to ‘set off’ deferred tax liabilities and deferred tax assets and recognise the net amount in the statement of financial position. The set off in this example is achieved as follows:

General journal of AAA Ltd – 31.12.X0

$ / $
Dr. / Deferred tax liability / 34,500
Cr. / Deferred tax asset / 34,500

It should be noted that the resulting deferred tax liability of $12,000 (i.e. $46,500 - $34,500) equals 30% of the net assessable temporary differences from the worksheet of $40,000 (155,000 assessable less $115,000 deductible).

Continuing with the example of AAA Ltd, a tax-effect worksheet incorporating the accounting and tax-based balance sheets of AAA Ltd for the subsequent reporting period, the year to 31 December 20X1, is shown below. The tax accountant estimates that the company has a taxable income for the 20X1 year of $300,000. The company income tax rate remains at 30%.

Accounting / Tax-based / Deferred tax balances / Tax / Asset rev. / Current tax
Balance / Balance / Asset / Liability / expense / reserve / payable
Sheet / Sheet / dr (cr) / dr (cr) / dr (cr) / dr (cr) / dr (cr)
$ / $ / $ / $ / $ / $ / $
Assets
Cash / 60,000 / 60,000
Inventory / 30,000 / 40,000 / 10,000 / (10,000)
Plant – net / 160,000 / 110,000 / (50,000) / 50,000
R&D – net / 60,000 / - / (60,000) / 60,000
Land / 270,000 / 200,000 / (70,000) / 70,000
580,000 / 410,000
Liabilities
Provisions / 100,000 / - / 100,000 / (100,000)
Borrowings / 350,000 / 300,000 / 50,000 / (50,000)
450,000 / 300,000
Net assets / 130,000 / 110,000
Temporary differences at period end / 160,000 / (180,000) / (50,000) / 70,000
Less: Prior period amounts / (115,000) / 155,000 / 10,000 / (50,000)
Movement for the period / 45,000 / (25,000) / (40,000) / 20,000
Tax effected at 30% / 13,500 / (7,500) / (12,000) / 6,000
Tax on taxable income, 30% x $300,000 / 90,000 / (90,000)
Income tax adjustments / 13,500 / (7,500) / 78,000 / 6,000 / (90,000)

Based on the taxable income for the 20X1 year, the current tax is 30% x $300,000 equal to $90,000. Therefore, the tax journal entry for the year to 31 December 20X1 is as follows: