Assessment of the Criteria DTAs&DTLs - Research Paper Example

DTAs & DTLs – Assessment of the Criteria This article aims to critically assess the whether AASB 112 misleads the users of financial ments with regards to recognition of Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs). It has been a point of concern for the regulators, practitioners, auditors and professionals to take a closer look at whether these DTAs and DTLs under AASB 112 meet the fundamental criteria of “Assets” and “Liabilities” under SAC4. This paper is categorized into sections. In first section, the basic definitions and recognition criteria are reproduced from SAC 4 and AASB 112. Section 2 comprises of the brief explanation of DTAs and DTLs. Section 3 discusses the shift from Income Statement Approach to Balance Sheet approach with respect to Income Tax recognition. Section 4 highlights the reasons why Deferred Tax balances show a larger impact. In section 5, critical analysis will be developed to elaborate whether DTAs and DTLs are meeting the assets and liabilities criterion or not. Section 6 covers accounting and computational framework for DTA & DTL .Section 7 covers the impact of Deferred Taxes on the financial performances of two companies picked from Australian Stock Exchange. In the end of the article, appendices have been attached. Section 1: Definitions Assets "Assets are future economic benefits controlled by the entity as a result of past transactions or other past events.” Criteria for Recognition of Assets “An asset should be recognized in the statement of financial position when and only when: (a) It is probable that the future economic benefits embodied in the asset will eventuate; and (b) The asset possesses a cost or other value that can be measured reliably.” Liabilities "Liabilities are the future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events.” Criteria for Recognition of Liabilities “A liability should be recognized in the statement of financial position when and only when: (a) It is probable that the future sacrifice of economic benefits will be required; and (b) The amount of the liability can be measured reliably” Current Tax “Current tax is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period.” Deferred Tax Assets “Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of deductible temporary differences the carry forward of unused tax losses and the carry forward of unused tax credits.” Deferred Tax Liabilities “Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences.” Tax Base “Tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.” Tax Expense (Tax Income) “Tax expense (tax income) is the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax.” Temporary Differences “Temporary differences are differences between the carrying amount of an asset or liability in the balance sheet and its tax base.” “Temporary differences may be either: • taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled • deductible temporary differences, which are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.” Section 2: Deferred Tax Assets (DTAs) & Deferred Tax Liabilities (DTLs) Deferred Tax Asset “A deferred tax asset is recognized when there is a deductible temporary difference between the tax base of an asset or liability and its carrying amount in the balance sheet, but only to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized. A deductible temporary difference arises when the carrying amount of liability exceeds its tax base, as the future settlement of its carrying amount will be deductible (e.g. provision for warranty is recognized in the accounts at the point of sale but it is only recognized as a tax deduction when the expense is incurred and paid). Further, a deductible temporary difference arises when the carrying amount of an asset is less than its tax base, as its future recovery will generate a tax deduction (e.g. a depreciable asset where accumulated depreciation is greater for accounting than tax purposes, or an asset is revalued downwards but the unrealized loss is not tax deductible until the loss is crystallized by disposal.). A deferred tax asset will not be recognized if arising from the initial recognition of an asset or liability in a transaction that is not a business combination AND at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss). A deferred tax asset shall be recognized for the carry forward of unused tax losses and unused tax credits, but only to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilized.” Deferred Tax liability “A deferred tax liability shall be recognized when there is a taxable temporary difference between the tax base of an asset or liability and its corresponding carrying amount in the balance sheet. This arises when the carrying amount of an asset exceeds its tax base. Consequently, the future recovery of the carrying amount will generate taxable profit; e.g. Accumulated depreciation of an asset in the financial report is less than the cumulative depreciation allowed up to the reporting date for tax purposes, i.e. depreciation of an asset is accelerated for tax purposes; Development costs have been capitalized and will be amortized to the income statement but were deducted in calculating taxable amounts in the reporting period in which they were incurred. A taxable temporary difference also arises when the carrying amount of a liability is less than its tax base, because the future settlement of its tax base will generate taxable profit (e.g. a loan initially recognized at fair value net of borrowing costs incurred in the loan establishment but the tax deductions for the costs are amortized over the life of the loan.).” “A deferred tax liability will not be recognized if arising from the initial recognition of goodwill or goodwill for which amortization is not deductible for tax purposes the initial recognition of an asset or liability in a transaction which is not a business combination, and, at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss)”. (Kothari and Zimmerman, 1995). Bartholomew (1987) has also given the same idea as mentioned in AASB. It states that; “A deferred tax asset or liability shall be measured based on the enacted, or substantively enacted, tax rates (tax laws) expected to apply when the asset is realized or the liability is settled, and is recognized as an income or expense, and included in profit or loss for the period. (Note: UIG Interpretation 1039 Substantive Enactment of Major Tax Bills in Australia provides a consensus view of what is substantive enactment). An exception arises when the item is credited or charged directly to equity (e.g. the revaluation of property, plant and equipment, or an adjustment to the opening balance of retained earnings due to a change in accounting policy or an error correction), in which case the amount of deferred tax liability or asset is charged or credited directly to equity.” (Herbohn, Tutticci and Khor, 2008). Section 3: Approaches to Recognition of Income Taxes Balance sheet (Statement of Financial Position) approach v. the income statement (Statement of Financial Performance) approach Beaver and Dukes (1972) agree with the standards devised by AASB; “AASB 112 is based on a balance sheet approach to account for income taxes, as opposed to an income statement approach. The balance sheet approach is conceptually different to the income statement approach under the 1989 version of AASB 1020.” Income Statement Approach: “The entity will prepare reconciliation from accounting profit/loss to taxable income/loss.” “From the reconciliation items, timing differences are identified.” “The adjustments representing timing differences are used to determine the movement (and hence the balance) of the following accounts: Future income tax benefit (FITB); and Provision for deferred income tax (PDIT).” Balance Sheet Approach: Givoly and Hayn (1992) have extensively studied the deferred tax liability. They have the same opinion pertaining to calculate and balance deferred tax liability. “Tax reconciliation, is still required. However, the focus is on the balance sheet in calculating the movement and balances in the deferred tax asset account (previously referred to as FITBs) and the deferred tax liabilities account (previously referred to as PDITs).” The above means that; “The current four-column approach to accounting for income taxes is no longer appropriate. The Tax Effect Accounting Toolkit provides a suggested methodology that is both comprehensive and systematic. Generally, the deferred tax balances are larger under the balance sheet approach as compared to the income statement approach.” (Lasman and Weil, 1978). Section 4: Why are deferred tax balances likely to be larger? Sidhu (2003) in his research states that; “Under the new standard, deferred tax balances are likely to increase because certain items will be tax-effected for the first time. The following are examples of items that were not previously tax-effected, which will be now: asset revaluations — because the change in the carrying amount of the asset does not affect its tax cost/tax base; acquisitions of entities or operations — because the assets and liabilities acquired will be reflected at fair value and this is generally not the same as their tax base; investments in subsidiaries, branches, associates and joint venture activities — because the value of the assets used to determine the value of the ‘equity-accounted investment’ in the parent entity may differ to the tax base of the investment; exchange differences that arise when recognizing a foreign subsidiary/associate in consolidated accounts — because of the different exchange rates used to convert the carrying amount and tax base of assets and liabilities; and Components of convertible financial instruments classified as equity.” Section 5: Critical Assessments Wise (1986) discussed extensively on the behavior of deferred tax. His study concludes that; “In the light of above discussions, this fact can be generalized that DTAs and DTLs, both meet the criterion of assets and liabilities. Since DTAs directly do not provide any economic benefit from the front, but they are used to reduce the amount of tax payable in subsequent years, providing indirect economic benefit to the firm. On the contrary, the DTAs act in the opposite fashion. When DTAs arise, they increase the tax liability of the firm in the subsequent years resulting in an economic outflow of resources from the firm.” Chaney and Jeter (1988) in their study concluded that “AASB 112 has determined a better framework to disclose separately the amount of Current Tax, Deferred Tax Assets and Deferred Tax Liabilities clearly on the face of financial statements to avoid any confusion in the mind of users of financial statements.” Section 6: Accounting and Computational Framework for DTA & DTL The accounting and computational framework for the calculations of Deferred Tax Assets and Liabilities are shown in the following diagram. Section 7: Impact of Deferred Tax on Financial Performance of Companies In the given workings, the financial ratios have been calculated of Ten Network Holdings Limited and West Australian Newspapers Holding Limited for the years 2008, 2009 and 2010 respectively. Net Profit Margin, Current Ratio, Total Asset Turnover and Debt Ratio are used to analyze the performances of both companies in three years. The reason behind picking up these specific ratios is that, only these ratios constitute DTAs & DTLs. Here, a comparative analysis has been portrayed in respect of performance with DTAs & DTLs and without DTAs & DTLs. Significant deviations are not observed generally. Due to some non-recurring tax expenses, very few extra-ordinary items have the impact of big differences in the calculations. Section 8: Appendices Ratio Analysis of Ten Network Holdings Limited & West Australian News Papers Holding Limited With Deferred Tax Without Deferred Tax Net Profit Margin Net Income Net Income - Non-recurring Tax Sales Sales Current Ratio Current Assets Current Assets -Current Tax Current Liabilities Current Liabilities - Current Tax Total Asset Turnover Sales Sales Total Assets Total Assets - Current Tax - Deferred Tax Assets Debt Ratio Total Debt Total Debt - Current Tax - Deferred Tax Liabilities Total Assets Total Assets- Current Tax - Deferred Tax Assets 2008 Ten Networks Limited Net Profit Margin 274005 0.27 (274005-188066) 0.085 1006126 1006126 Current Ratio 363956 1.53 363956-20178 1.45 236929 236929 Total Asset Turnover 1006126 0.58 1006126 0.598 1713820 (1713820-11326-20178) Debt Ratio 947546 0.55 (947546-38745) 0.54 1713820 (1713820-11326-20178) 2009 Net Profit Margin -89354 -0.09 -89354 -0.09 903000 903000 Current Ratio 294921 1.33 294921-5001 1.316 220280 220280 Total Asset Turnover 903000 0.56 903000 0.572 1595171 1595171-12098-5001 Debt Ratio 789091 0.49 789091-36996 0.476 1595171 1595171-12098-5001 2010 Net Profit Margin 150007 0.15 150007-53156 0.097 991916 991916 Current Ratio 388154 1.7 388154-18930 1.625 227156 227156 Total Asset Turnover 991916 0.59 991916 0.607 1663842 1663842-11718-18930 Debt Ratio 761542 0.45 761542-102122 0.403 1663842 1663842-11718-18930 2008 West Australian Newspapers Holding Limited Net Profit Margin 109935 0.23 109935 0.233 471683 471683 Current Ratio 100923 2.68 100923 2.68 37599 37599 Total Asset Turnover 471683 0.97 471683 0.977 482521 482521 Debt Ratio 390141 0.80 390141-9723 0.788 482521 482521 2009 Net Profit Margin 87244 0.20 87244 0.208 418619 418619 Current Ratio 8044 0.14 8044 0.141 56799 56799-6692 Total Asset Turnover 418619 0.93 418619 0.935 447556 447556 Debt Ratio 379753 0.84 379753-3988-6692 0.824 447556 447556 2010 Net Profit Margin 96223 0.23 96223 0.235 409174 409174 Current Ratio 82893 2.22 82893 2.684 37318 37318-6434 Total Asset Turnover 409174 0.92 409174 0.927 441290 441290 Debt Ratio 310739 0.70 310739-10924-6434 0.664 441290 441290 References Australian Accounting Standards , 2007, AASB 112 Income Taxes. 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