DEFERRED TAX – THE COMPLICATIONS

The purpose of financial statements is to provide the users of them with information which is
both relevant and reliable in order that the users can make reasoned decisions from them.

Students studying financial reporting papers will often come across the concept of deferred
tax and undeniably it is a subject which often causes quite a lot of confusion, particularly at
the advanced stages of financial reporting studies.

This article takes a look at the subject of deferred tax in order to aid students during their
revision phase.

The statement of comprehensive income arrives at a reporting entity’s ‘accounting’ profit but
this profit is rarely the same profit used for the purposes of tax.

Accounting profit is an entity’s profit or loss for a reporting period before tax.

Taxable profit or (loss) is the profit or loss for the reporting period determined by reference
to tax principles upon which tax is payable or receivable thereon.

Students must understand that the primary intention of deferred tax is to present the estimated
actual taxes to be payable in current and future periods as the income tax liability on the
statement of financial position. Deferred tax liabilities are the amount of income taxes that
are payable in future periods because of taxable temporary differences. Deferred tax is not
paid to the tax authorities like (say) corporation tax liabilities are.

Taxable temporary differences are temporary differences that result in taxable amounts in
determining taxable profit of future periods when the carrying amount of the asset or liability
is recovered or settled.

Deferred Tax Liabilities

As we mentioned above, deferred tax liabilities are the amounts of income taxes that are
payable in future period which have arisen due to taxable temporary differences.

Illustration

Trident Manufacturing Inc has an item of plant with a carrying amount in the financial
statements amounting to $10,000. The tax written down value of the same item of plant is
$5,000. This results in a taxable temporary difference of $5,000. Trident Manufacturing Inc
pays tax at a rate of 30% so the deferred tax liability that should be recognised by Trident
Manufacturing Inc in their financial statements amounts to ($5,000 x 30%) = $1,500. To
recognise this liability, Trident Manufacturing Inc should process the following journal:

DR Income tax expense

CR Deferred tax liability

Because the tax authority is consuming the asset at a faster rate than Trident Manufacturing
Inc (net book value vs. tax written down value) then the tax effect (usually due to accelerated
capital allowances) will be felt in the financial statements in future periods. The deferred tax
liability provides for this effect.

If we assume that Trident Manufacturing already had a deferred tax balance brought forward
amounting to $500 then from the perspective of the statement of financial position, the
difference is taken to the statement of comprehensive income as follows:

Opening balance $500

Deferred tax charge in year $1,000 (Cr deferred tax liability, Dr income tax expense)
Deferred tax balance c/fwd $1,500

Types of Temporary Differences

Temporary differences can either be:

Debit balances in the financial statements compared to the tax written down values. These
give rise to deferred tax liabilities and are known as taxable temporary differences.

Credit balances in the financial statements compared to the tax written down values. These
give rise to deferred tax assets which are known as deductible temporary differences.

In financial reporting studies you will often refer to the tax written down value as an asset or
liability’s ‘tax base’. The tax base is the amount that will be deductible for tax purposes
against any taxable economic benefit that the entity will receive as it uses the asset.

Temporary differences can also arise in the following circumstances:

 Revenue recognised for financial reporting purposes before being recognised for tax
purposes. An example of this is where construction contract related revenue is
recognised on a completed-contract method for tax purposes but on a percentage-of-
completion method for financial reporting purposes. Such instances are taxable
temporary differences which give rise to deferred tax liabilities.

 Expenses that are deductible for tax purposes prior to recognition in the financial
statements. An example of this is enhanced capital allowances (first year allowances)
granted by tax authorities for qualifying assets. These are taxable temporary
differences which give rise to deferred tax liabilities.

 Expenses that are accounted for in the financial statements prior to becoming
deductible for tax purposes. An example of this are warranty costs. These are
deductible temporary differences which give rise to deferred tax assets.

 Revenue recognised for tax purposes prior to recognition in the financial statements.
A typical example would be prepaid rental income which would give rise to
deductible temporary differences and deferred tax assets.

Deferred Tax Assets

Deferred tax assets can arise usually because of unutilised tax losses. However, the
provisions in IAS 12 stipulate that deferred tax assets can only be recognised in the statement
of financial position if they are very likely to be realised in future periods. In other words,
that the entity will generate sufficient taxable profits to use the unused tax losses.
Additionally an entity should also look if there are any other temporary differences relating to
the same taxation authority to offset the deferred tax asset.

Worked Example – Deferred Taxes

The following financial statement extracts relate to the Colerob Corporation for the year
ended 31 December 2008:

Per Financial Statements Tax Base

$ $
Non current assets
Plant and machinery 300,000 296,000

Current assets

Receivables (see note) 70,000

Other receivables 2,000

Current liabilities

Damages 15,000

Loan interest 3,000

Note the receivables balance is made up as follows:

Per listing 80,000

Provisions (10,000)
70,000

 The deferred tax balance at the start of the year was $1,500

 Other receivables relate to interest receivable which is taxed on a cash basis

 Non-specific bad debt provisions are not allowable for tax purposes

 The damages relate to compensation payable for an illegal activity which is not tax
deductible

 Colerob Corporation pays tax at 30%

Required

Calculate the deferred tax provision to be included in the financial statements of Colerob for
the year ended 31 December 2008.
Solution
Per Financial Statements Tax Base Temporary
Difference
$ $ $
Non current assets
Plant and machinery 300,000 280,000 20,000

Current assets

Receivables (see note) 70,000 80,000 (10,000)

Other receivables 2,000 - 2,000

Current liabilities

Damages 15,000 15,000 -

Loan interest 3,000 - (3,000)

Temporary Differences Deferred tax @ 30%

Deferred tax liabilities 22,000 6,600

Deferred tax assets (13,000) (3,900)
2,700

Accounting for Business Combinations – Deferred Tax Aspects

IAS 12 requires the tax effects of the tax-book basis differences of all assets and liabilities
generally be presented as deferred tax assets and liabilities as at the date of acquisition.

Illustration

Colerob Corporation Inc is involved in the acquisition of a business. Relevant data is as

follows:

1. The income tax rate of Colerob Corporation is 40%

2. The cost of the acquisition was $500,000
3. The fair value of the net assets acquired are $750,000
4. The tax bases of the assets acquired are $600,000
5. The tax bases of the liabilities acquired are $250,000
6. The difference between the tax and fair values of the assets acquired are $150,000
which consists of taxable temporary differences of $200,000 and deductible
temporary differences of $50,000
7. The directors are confident about the recoverability of the deductible temporary
differences.
Required

Show how the purchase price will be allocated in the above acquisition.

Solution

Gross purchase price 500,000

Allocation to identifiable assets and

(liabilities):
Assets (excluding goodwill and deferred tax assets) 750,000
Deferred tax assets (50,000 x 40%) 20,000
Liabilities (excluding deferred tax liabilities) (250,000)
Deferred tax liabilities (200,000 x 40%) (80,000)
440,000
Balance allocated to goodwill 60,000 (500,000)

Goodwill may be tax deductible depending on the tax jurisdictions or it may be non-
deductible. If it is deductible, the amortisation period will cause the carrying amount for tax
purposes to differ from that of the financial statements. Under IFRS goodwill is not
amortised over its expected useful life and as a result a temporary difference will develop
with book values being greater than tax written down values. If impairment charges are taken
into account then carrying amounts may be lower than the corresponding tax basis.

Where you encounter negative goodwill then IAS 12 states that the acquirer should reassess
the values placed on the net assets and liabilities. If this does not lead to the elimination of
the negative goodwill that amount is to be reported in income in the current period. This will
likely result in a difference between tax and carrying values for the negative goodwill and this
also is a timing difference to be considered in computing the deferred tax balance for the
reporting entity.

In our above illustration the directors were confident that deferred tax assets were deemed
probable of being realised. However, there are circumstances where there is substantial
doubt about the ability to realise deferred tax assets. In other words, it is not probable that the
asset will be realised. Under IAS 12, the deferred tax asset would not be recognised at the
acquisition date. If this applied to our illustration above, the allocation of the purchase price
would have to reflect that fact and more of the purchase cost would be allocated to goodwill
than would have otherwise been the case.

Illustration

Let us assume that Colerob Corporation were involved in a business acquisition on 1 January
2005. At the date of acquisition the deferred tax assets were calculated at $100,000. On 1
January 2005, the directors considered that realisation of the deferred tax assets were NOT
probable.

The unrecognised deferred tax asset is allocated to goodwill during the purchase price
assignment process.
However, on 1 January 2009 the likelihood of realising the deferred tax assets is reassessed as
being probable in future years. On 1 January 2009 the entries are:

DR deferred tax asset $100,000

CR goodwill $100,000

Disclosures Required

IFRS requires the following to be disclosed separately in an entity’s financial statements:

 The major components of tax expense, including:

- current tax expense
- adjustments relating to previous periods
- deferred tax expense/income
- deferred tax expense/income arising because of changes to tax rates
- deferred tax implications of a change in accounting policy or correction of an
error
 The aggregate current and deferred tax relating to items that are charged or credited
directly to equity and the amount charged/credited to other comprehensive income
 A reconciliation between the income tax expense and the accounting profit multiplied
by the applicable tax rate(s) disclosing also the basis on which the applicable tax
rate(s) have been computed
 A reconciliation between the average effective tax rate and the applicable tax rate
together with the basis on which the applicable tax rate has been computed.

Conclusion

Accounting for deferred taxes can become problematic. However in order to fully understand
how deferred tax impacts on a set of financial statements then it is important that you
understand what gives rise to a ‘taxable temporary difference’ and a ‘deductible temporary
difference’.

Steve Collings FMAAT ACCA DipIFRS is Audit Manager at Leavitt Walmsley

Associates Limited and also a partner in AccountancyStudents.co.uk. He is also the
author of ‘A Summary of IFRS and IAS’ which can be purchased direct from
www.accountancystudents.co.uk