Comparison of a Deferred Taxation - Essay Example

A) Compare and Contrast Timing differences, Temporary differences and Permanent differences Timing differences, focus on profit and loss movements, and pertain to the difference between the taxable amount and the pre-tax accounting profit that originate in one reporting period and reverses in one or more subsequent periods. Temporary differences focus on balance sheet movements and pertain to the differences between the carrying amount of an asset or liability in the balance sheet and its tax base. Permanent differences are one-off differences between results for accounting purposes and taxable income, caused by certain items not being taxable / allowable. Such differences only impact on the taxation computation of one period. 2. Deferral Method and Liability Method Deferral method is where the tax effects of current timing differences are deferred and allocated to future periods when the timing differences reverse. Since deferred tax balances in the balance sheet are not considered to represent rights to receive or obligations to pay money, they are not adjusted to reflect changes in the tax rate or the imposition of new taxes. Under the deferral method, the tax expense for a period comprises of provision for taxes payable and the tax effects of timing differences deferred to or from other periods. Liability Method is where the expected tax effects of current timing differences are determined and reported either as liabilities for taxes payable in the future or as assets representing advance payment of future taxes. Deferred tax balances are adjusted for changes in the tax rate or for new taxes imposed. The balances may also be adjusted for expected future changes in tax rates. Under the liability method, the tax expense for a period comprises of the provision for taxes payable, the amount of taxes expected to be payable or considered to be prepaid in respect of timing differences originating or reversing in the current period and the adjustments to deferred tax balances in the balance sheet necessary to reflect either a change in the tax rate or the imposition of new taxes. 3. Nil provision, partial provision and full provision Nil provision is where no provisions are made for deferred tax whatever the circumstances. This is based on the principal that only the tax that is deemed to be payable in respect of a period should be accounted for in the financial statements. Full provision is where the tax effects of all timing differences are recognized as and when they arise. Although this method is arithmetically accurate it can lead to the building up of large meaningless provisions in the balance sheet. Partial provision lies between the two extremes stated above. Deferred tax should be accounted for in respect of the net amount by which it is probable that any payment of tax will be temporarily deferred by the operation of timing differenced, which will reverse in the foreseeable future without being replaced. 4. Discounting Discounting deferred tax assets and liabilities enables to reflect the time value of money. IAS 12 does not permit discounting due to the difficulty in ascertaining the timing of reversal of each temporary difference B) Critically assess the current IAS 12 requirements for accounting for deferred tax Deferred tax is an accounting term, meaning future tax liability or asset, resulting from temporary differences between book (accounting) value of assets and liabilities, and their tax value. This arises due to differences between accounting for shareholders and tax accounting. Deferred tax arises when the actual tax as a result of a particular transaction (tax payable or recoverable) arises in a different period from the period in which the transaction is included in the financial statements. The provision for taxes payable is calculated in accordance with rules for determining taxable income established by taxation authorities. In many circumstances these rules differ from the accounting policies applied to determine accounting income. The effect of this difference is that the relationship between the provision for taxes payable and accounting income reported in the financial statements may not be representative of the current level of tax rates. One reason for a difference between taxable income and accounting income is that certain items are considered to be appropriately included in one calculation but are required to be excluded from the other. For example, some donations are not an allowable deduction in determining taxable income; however, such amounts would be deducted in determining accounting income. These differences are referred to as "permanent differences". Another reason for a difference between taxable income and accounting income is that certain items, considered in determining both amounts, are included in the calculation for different periods. For example, accounting policies may specify that certain revenues are included in accounting income at the time goods or services are delivered but tax rules may require or allow their inclusion at the time cash is collected. The total of these revenues included in accounting income and taxable income will ultimately be the same, but the periods of inclusion will differ. Another example is when the depreciation rate used in determining taxable income differs from that used in determining accounting income. These differences are referred to as "timing differences". Temporary differences focus on balance sheet movements and pertain to the differences between the carrying amount of an asset or liability in the balance sheet and its tax base. As mentioned above, since the profit chargeable to corporation tax is rarely the same as accounting profit for the year, on the application of the concept of true and fair accounts, there is a need to account for deferred tax. This means that the tax charge in the accounts may be increased or decreased accordingly and this distortion needs to be adjusted. The general principle in IAS 12 is that deferred tax liabilities should be recognised for all taxable temporary differences. There are 3 exceptions to the requirement to recognise a deferred tax: from goodwill from the initial recognition of certain assets and liabilities, and from investments when certain conditions apply will not occur in the foreseeable future. IAS 12 also adopts a full provision balance sheet approach to accounting for tax. It assumes 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. This approach is different to nil provision basis, where no provisions are made for deferred tax whatever the circumstances. This is based on the principal that only the tax that is deemed to be payable in respect of a period should be accounted for in the financial statements. IAS 12 adopts the liability method to account for deferred tax. It assumes that deferred tax assets and liabilities should be measured at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled, based on tax rates/laws that have been enacted or substantively enacted by the end of the reporting period. Deferred tax balances are adjusted for changes in the tax rate or for new taxes imposed. The balances may also be adjusted for expected future changes in tax rates. Under the liability method, the tax expense for a period comprises of the provision for taxes payable, the amount of taxes expected to be payable or considered to be prepaid in respect of timing differences originating or reversing in the current period and the adjustments to deferred tax balances in the balance sheet necessary to reflect either a change in the tax rate or the imposition of new taxes. IAS 12 recognizes deferred tax on all differences between the carrying values of assets and liabilities in the financial statements and their values for tax purposes. Example A fixed asset cost 200,000 when purchased and depreciation totalling 80,000 has been charged up to the balance sheet date - 31 March 2002. The company has claimed total tax allowances on the asset of 100,000. The carrying value of the asset is 120,000 (200,000 - 80,000) and its tax base is 100,000 (200,000 - 100,000). The difference between the carrying value of an asset and its tax base is 20,000 (referred to in IAS 12 as a temporary difference). Under IAS 12 deferred tax is recognised on most temporary differences so the liability will be 6,000 (20,000 x 30%). FRS 19 forwards an alternative approach to calculating deferred tax. The general principle underpinning FRS 19 is that deferred tax should be provided in full on all timing differences - in other words the full provision basis. The deferred tax calculation for the above example as per FRS 19 is as follows: The timing difference on the asset prior to revaluation is 20,000 (100,000 - 80,000). The tax payable on this timing difference (30% x 20,000 = 6,000) is an unavoidable liability of the entity. If the asset is retained then future tax allowances will be 100,000 and future depreciation charges 120,000 (200,000 - 80,000). The tax payable on the net reversing timing difference is 6,000. If the asset is sold then the written down value for tax purposes (200,000 - 100,000 = 100,000) is 20,000 larger than the written down value for accounts purposes (200,000 - 80,000 = 120,000). Once again, an unavoidable liability to tax on the reversing timing difference arises of 6,000. Finally on the debate of discounting, IAS 12 prohibits discounting. This simplifies the accounting model, but creates other issues because the long term items are recorded at nominal value. This is because of the difficulty in accurately predicting the timing of the reversal of each temporary difference. If discounting is adopted then: Certain timing differences, that are already based on discounted cash-flows (such as provisions for future pension liabilities) should not be discounted further. The discount rates used should be the post-tax yields to maturity that could be obtained on government bonds with maturity dates, and in currencies similar to those of the deferred tax assets or liabilities. The 'full reversal' approach should be adopted, taking to account the incidence of potential future timing differences that will replace those reversing. Therefore there is a balance to be drawn between the additional costs of discounting and the potential benefits that the approach could bring. ACCA. 'Deferred Tax.' Paul Robins. 26 July 2002. 31 March 2008. http://www.accaglobal.com/students/publications/student_accountant/archive/2002/28/570079 ACCA. 'IAS 12 Income Tax.' By Graham Holt. 31 March 2008. http://www.accaglobal.com/members/publications/accounting_business/cpd/3070632 Finance Week. "Technical Update: IAS 12 Accounting for corporate taxes on income. Graeme Reid. 1 June 2005. 31 March 2008. http://www.financeweek.co.uk/cgi-bin/item.cgiid=1565 Google Search. 'International Finance and Accounting Handbook.' 2003. Fredrick D.S.Choi. Page 315-317. 31 March 2008. http://books.google.lk/booksid=5z2pGMGE8mYC&printsec=frontcover&dq=International+finance+and+accounting+handbook&sig=L-KR4vVNccARi8gGjy8MaaLLt4Y#PPR18,M1 Sri Lanka Accounting Standard SLAS 14. Accounting for income taxes. 1 April 2008. http://www.icasrilanka.com/slas/slas14.pdf Technical Summary. 'IAS 12 Income Taxes'. 1 April 2008. http://www.iasb.org/NR/rdonlyres/8EB2D1D7-47D7-45F9-A6BC-05981DE8B71E/0/IAS12.pdf Read More