By Graham Holt

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IAS 12 uses a liability method and adopts a balance sheet approach to accounting for taxation. It accounts for the temporary differences between the accounting and tax bases of assets and liabilities rather than accounting for the timing differences between the accounting and tax consequences of revenue and expenses. IAS 12 adopts a full provision balance sheet approach to accounting for tax. It is assumed that the recovery of all assets and the settlement of all liabilities have tax consequences and that these consequences can be estimated reliably and cannot be avoided. As the IFRS recognition criteria are different from those which are normally set out in tax law, certain income and expenditure in financial statements will not be allowed for taxation purposes, thus causing 'temporary differences'. A deferred tax liability or asset is recognised for the future tax consequences of past transactions with certain exemptions. The standard assumes that each asset and liability has a value for tax purposes and this is called a tax base. Differences between the carrying amount of an asset and liability and its tax base are called temporary differences. The principle utilised in IAS 12 is that an entity will settle its liabilities and recover its assets eventually over time and, at that point, the tax consequences will crystallise. There are two kinds of temporary differences: a taxable temporary difference and a deductible temporary difference. A taxable temporary difference results in the payment of tax when the carrying amount of the asset or liability is settled.This means that a deferred tax liability will arise when the carrying value of the asset is greater than its tax base, or the carrying value of the liability is less than its tax base. Deductible temporary differences are differences that result in amounts being deductible in determining taxable profit or loss in future periods when the carrying value of the asset or liability is recovered or settled. When the carrying value of the liability is greater than its tax base or the carrying value of the asset is less than its tax base, then a deferred tax asset may arise.

Example 1
An entity has the following assets and liabilities recorded in its balance sheet at 31 December 20X8: Carrying value $m Tax base (value for tax purposes)

Property Plant and equipment Inventory Trade receivables Trade payables Cash

20 10 8 6 12 4

$m 14 8 12 8 12 4

The entity had made a provision for inventory obsolescence of $4m that is not allowable for tax purposes until the inventory is sold and an impairment charge against trade receivables of $2m that will not be allowed in the current year for tax purposes but will be in the future. Income tax paid is at 30%. Required: Calculate the deferred tax provision at 31 December 20X8. Solution: Carrying value $m Property Plant and equipment Inventory Trade receivables Trade payables Cash 20 10 8 6 12 4 Tax base (value for tax purposes) $m 14 8 12 8 12 4 Temporary difference $m 6 2 (4) (2) 2

The deferred tax provision will be $2m x 30%, i.e. $600,000. The provision against inventory and the impairment charge for trade receivables will cause the tax base to be higher than the carrying value by the respective amounts. Every asset or liability is assumed to have a tax base. Normally this will be the amount that is allowed for tax purposes. However, some items of income and expenditure may not be taxable or tax deductible and they will never enter into the computation of taxable profit. These have sometimes been called permanent differences. Generally speaking, these items will have the same tax base as their carrying amount and no temporary difference will arise. For example, if an entity has in its balance sheet interest receivable of $2m, which is not taxable then its tax base will be the same as its carrying value, i.e. $2m. There is no temporary difference in this case and, therefore, no deferred taxation will arise.

There are some temporary differences that are not recognised for deferred tax purposes. These arise:

from goodwill from the initial recognition of certain assets and liabilities, and from investments when certain conditions apply.

IAS 12 does not allow a deferred tax liability for goodwill on initial recognition or where any reduction in the value of goodwill is not allowed for tax purposes. Because goodwill is the residual amount after recognising assets and liabilities at fair value, recognising a deferred tax liability in respect of goodwill would simply increase the value of goodwill and, therefore, the recognition of a deferred tax liability in this regard is not allowed.

Group financial statements

Temporary differences can also arise from adjustments on consolidation. The tax base of an item is often determined by the value in the entity accounts - that is, for example, the financial statements of a subsidiary. Deferred tax is determined on the basis of the consolidated financial statements and not the individual entity accounts.Therefore, the carrying value of an item in the consolidated accounts can be different from that in the individual entity accounts, thus giving rise to a temporary difference. An example of this is the consolidation adjustment that is required to eliminate unrealised profits and losses on the inter group transfer of inventory. Such an adjustment will give rise to a temporary difference which will reverse when the inventory is sold outside the group. IAS 12 does not specifically address how inter-group profits and losses should be measured for tax purposes. It says that the expected manner of recovery or settlement of tax should be taken into account. This would generally mean that the receiving company's tax rate should be used when calculating the provision for deferred tax as the receiving company would be taxed when the asset or liability is realised.

Example 2
A wholly subsidiary sold goods costing $30m to its holding company for $33m and all of these goods are still held in inventory at the year end. The unrealised profit of $3m will have to be eliminated from the consolidated income statement and from the consolidated balance sheet in group inventory. The sale of the inventory is a taxable event and it causes a change in the tax base of the inventory. The carrying amount in the consolidated financial statements of the inventory will be $30m but the tax base is $33m. This gives rise to a deferred tax asset of $3m at the tax rate of 30%, which is $900,000 (this is assuming that both the holding company and subsidiary are resident in the same tax jurisdiction).

Summary of accounting for deferred tax

In summary, the process of accounting for deferred tax is as follows:

determine the tax base of the assets and liabilities in the balance sheet compare the carrying amounts in the balance sheet with the tax base. Any differences will normally affect the deferred taxation calculation identify the temporary differences that have not been recognised due to exceptions in IAS 12 apply the tax rates to the temporary differences determine the movement between opening and closing deferred tax balances decide whether the offset of deferred tax assets and liabilities between different companies is acceptable in the consolidated financial statements recognise the net change in deferred taxation.

Deferred tax assets

Deductible temporary differences give rise to deferred tax assets. Examples include tax losses carried forward or temporary differences arising on provisions that are not allowable for taxation until the future. These deferred tax assets can be recognised if it is probable that the deferred tax asset will be realised. Its realisation will depend on whether or not there are sufficient taxable profits available in future. Sufficient taxable profits can arise from three different sources:

existing taxable temporary differences. In principle these differences should reverse in the same accounting period as the reversal of the deductible temporary difference, or in the period in which a tax loss is expected to be used if there are insufficient taxable temporary differences, the entity may recognise the deferred tax asset where it feels that there will be future taxable profits, other than that arising from taxable temporary differences. These profits should relate to the same taxable authority and entity the entity may be able to prove that it can create tax planning opportunities whereby the deductible temporary differences can be utilised. Wherever tax planning opportunities are considered, management must have the capability and ability to implement them.

Similarly, an entity can recognise a deferred tax asset arising from unused tax losses or credits when it is probable that future taxable profits will be available against which these can be offset. However, the existence of current tax losses is probably evidence that future taxable profit will not be available.

Sundry points
The tax rates that should be used to calculate deferred tax are the ones that are expected to apply in the period when the asset is realised or the liability settled. The best estimate of this tax rate is the rate which has been enacted or substantially enacted. Deferred tax assets and liabilities should not be discounted because it is difficult to accurately predict the timing of the reversal of each temporary difference.

The standard also deals with current tax liabilities and current tax assets. An entity should recognise a liability in the balance sheet in respect of its current tax expense, both for the current and prior years to the extent that it is not yet paid. Current and deferred tax should both be recognised as income or expense and included in the net profit or loss for the period. To the extent that the tax arises from a transaction or event that is recognised directly in equity, then the tax that relates to these items that are credited or charged to equity should also be charged or credited directly to equity. Any tax arising from a business combination should be recognised as an identifiable asset or liability at the date of acquisition. There are certain tax consequences of dividends. In some countries income taxes are payable at different rates if part of the net profit is paid out as dividend. Possible dividend distributions or tax refunds have got to be taken into account in measuring deferred tax assets and liabilities. IAS 12, however, requires disclosure of the tax consequences of dividends proposed or declared at the balance sheet date, as well as disclosure of the nature and amounts of potential tax consequences. Graham Holt is principal lecturer in accounting and finance at the Manchester Metropolitan University Business School, and an ACCA examiner.