Chapter3 deferred tax2008

Gripping IFRS Deferred taxation

Chapter 3
Deferred Taxation

Reference: IAS 12 and SIC 21

Contents: Page

1. Definitions 90
2. Normal tax and deferred tax 91
2.1 Current tax versus deferred tax 91
2.1.1 A deferred tax asset 91
2.1.2 A deferred tax liability 91
2.1.3 Deferred tax balance versus the current tax payable balance 92
2.1.4 Basic examples 92
Example 1A: creating a deferred tax asset 92
Example 1B: reversing a deferred tax asset 93
Example 2A: creating a deferred tax liability 94
Example 2B: reversing a deferred tax liability 95
2.2 Calculation of Deferred tax – the two methods 97
2.2.1 The income statement approach 97
Example 3A: income received in advance (income statement approach) 98
2.2.2 The balance sheet approach 100
Example 3B: income received in advance (balance sheet approach) 101
Example 3C: income received in advance (journals) 102
Example 3D: income received in advance (disclosure) 102
2.3 Year-end accruals, provisions and deferred tax 103
2.3.1 Expenses prepaid 104
Example 4: expenses prepaid 104
2.3.2 Expenses payable 107
Example 5: expenses payable 107
2.3.3 Provisions 109
Example 6: provisions 109
2.3.4 Income receivable 112
Example 7: income receivable 113
2.4 Depreciable non-current assets and deferred tax 115
2.4.1 Depreciation versus capital allowances 115
Example 8: depreciable assets 116
2.5 Rate changes and deferred tax 119
Example 9: rate changes – date of substantive enactment 120
Example 10: rate changes 120
Example 11: rate changes 123
2.6 Tax losses and deferred tax 124
Example 12: tax losses 124

3. Disclosure of income tax 127
3.1 Overview 127
3.2 Statement of comprehensive income disclosure 127
3.2.1 Face of the statement of comprehensive income 127
3.2.2 Tax expense note 128

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Contents continued … Page

3.3 Statement of financial position disclosure 129
3.3.1 Face of the statement of financial position 129
3.3.2 Accounting policy note 129
3.3.3 Deferred tax note 129
3.3.3.1 Other information needed on deferred tax assets 130
3.3.3.2 Other information needed on deferred tax liabilities 130
3.3.3.3 Other information needed on the manner of recovery or 130
settlement
3.4 Sample disclosure involving tax 131

4. Summary 133

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1. Definitions

The following definitions are provided in IAS 12 (some of these definitions have already been
discussed under chapter 2):
• Accounting profit: is profit or loss for a period before deducting (the) tax expense.
• Taxable profit (tax loss): is the profit (or loss) for a period, determined in accordance
with the rules established by the taxation authorities, upon which income taxes are
payable (recoverable).

• 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.

• Current tax: is the amount of income tax payable (recoverable) in respect of the taxable
profit (tax loss) for a period.
• Deferred tax liabilities: are the amounts of income taxes payable in future periods in
respect of taxable temporary differences.
• 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.
• Temporary differences: are differences between the carrying amount of an asset or
liability in the statement of financial position and its tax base:
- 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; or
- 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.
• Tax base: the tax base of an asset or liability is the amount attributed to that asset or
liability for tax purposes.
• Tax base of an asset: is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount
of the asset. If those economic benefits will not be taxable, the tax base of the asset is
equal to its carrying amount.

• Tax base of a liability: is its carrying amount, less any amount that will be deductible for
tax purposes in respect of that liability in future periods. In the case of revenue that is
received in advance, the tax base of the resulting liability is its carrying amount, less any
amount of the revenue that will not be taxable in future periods.

Other definitions that are not provided in IAS 12 but which you may find useful include:
• Carrying amount: the amount at which an asset or liability is presented in the
accounting records.
• Permanent differences: are the differences between taxable profit and accounting profit
for a period that originate in the current period and will never reverse in subsequent
periods, (for example, some of the income according to the accountant might not be
treated as income by the tax authority because he doesn’t tax that type of income, or
alternatively, the tax authority might tax an item that the accountant will never treat as
income. The same type of differences may arise when dealing with expenses).

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• Comprehensive basis: is the term used to describe the method whereby the tax effects of
all temporary differences are recognised.
• Applicable or standard tax rate: is the rate of tax, as determined from time to time by
tax legislation, at which entities pay tax on taxable profits, (a rate of 30% is assumed in
this text).
• Effective tax rate: is the taxation expense charge in the statement of comprehensive
income expressed as a percentage of accounting profits .

2. Normal tax and deferred tax

2.1 Current tax versus deferred tax
As mentioned in the previous chapter, the total normal tax for disclosure purposes is broken
down into two main components:
• current tax; and
• deferred tax.
Current normal tax is the tax charged by the tax authority in the current period on the current
period’s taxable profits. The taxable profits are calculated based on tax legislation (discussed
in the previous chapter). Since this tax legislation is not based strictly on the accrual concept,
differences may arise such as income being included in taxable profits before it is earned!
The total normal tax expense recognised in the statement of comprehensive income is the tax
incurred on the accounting profits. Accounting profits are calculated in accordance with the
international financial reporting standards, which are based on the concept of accrual.
The difference between current normal tax (which is not based on the accrual concept), and
the total normal tax in the statement of comprehensive income (which is based on the accrual
concept), is an adjustment called deferred tax. The deferred tax adjustment is therefore
simply an accrual of tax.
In other words: current normal tax (i.e. the amount charged by the tax authority) is adjusted
upwards or downwards so that the total normal tax in the statement of comprehensive income
is shown at the amount of tax incurred. This results in the creation of a deferred tax asset or
liability.
2.1.1 A deferred tax asset (a debit balance)
A debit balance on the deferred tax account reflects the accountant’s belief that tax has been
charged but which has not yet been incurred. This premature tax charge must be deferred
(postponed). In some ways, this treatment is similar to that of a prepaid expense.

Debit Credit
Deferred tax asset xxx
Taxation expense xxx
Creating a deferred tax asset

2.1.2 A deferred tax liability (a credit balance)
A credit balance reflects the accountant’s belief that tax has been incurred, but which has not
yet been charged by the tax authority. It therefore shows the amount that will be charged by
the tax authority in the future. This is similar to the treatment of an expense payable.

Debit Credit
Taxation expense xxx
Deferred tax liability xxx
Creating a deferred tax liability

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2.1.3 Deferred tax balance versus the current tax payable balance

The balance on the deferred tax account differs from the balance on the current tax payable
account in the following ways:
• the current tax payable account reflects the amount currently owing to or by the tax
authorities based tax legislation. This account is therefore treated as a current liability or
asset; whereas
• the deferred tax account reflects the amount that the accountant believes to still be owing
to or by the tax authorities in the long-term based on the concept of accrual. Since this
amount is not yet payable according to tax legislation, this account is treated as a non-
current liability or asset.

2.1.4 Basic examples

Consider the following examples:

Example 1A: creating a deferred tax asset (debit balance)

The current tax charged by the tax authority (using the tax legislation) in 20X1 is expected to
be C10 000.
The accountant calculates that the tax incurred for 20X1 to be C8 000.
The C2 000 excess will be deferred to future years.
There are no components of other comprehensive income.

Required:
Show the ledger accounts and disclose the tax expense and deferred tax for 20X1.

Solution to example 1A: creating a deferred tax asset (debit balance)

The tax expense that is shown in the statement of comprehensive income must always reflect
the tax that is believed to have been incurred for the year, thus C8 000 must be shown as the
expense.

Ledger accounts: 20X1

Tax: normal tax (E) Current tax payable: normal tax (L)
CTP: NT (1) 10 000 DT (2) 2 000 Tax (1) 10 000
_____ Total c/f 8 000
10 000 10 000
Total b/f 8 000

Deferred tax (A)
Tax (2) 2 000

(1) recording the current tax (the estimated amount that will be charged/ assessed by the tax
authority).

(2) deferring a portion of the current tax expense to future years so that the balance in the tax
expense account is the amount considered to have been incurred (i.e. C8 000). Notice that
the deferred tax account has a debit balance of C2 000, meaning that the C2 000 deferred
tax is an asset. This tax has been charged but will only be incurred in the future and so it
is similar to a prepaid expense.

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Disclosure for 20X1:

The disclosure will be as follows (the deferred tax asset note will be ignored at this stage):

Entity name
Statement of comprehensive income
For the year ended …20X1
Note 20X1
C
Profit before tax xxx
Taxation expense (current tax: 10 000 – deferred tax: 2 000) 3. 8 000
Profit for the period xxx
Other comprehensive income 0
Total comprehensive income xxx

Entity name
Statement of financial position
As at …20X1
20X1
ASSETS C
Non-current Assets
- Deferred tax: normal tax 2 000

Entity name
Notes to the financial statements
20X1
3. Taxation expense C
Normal taxation expense 8 000
- Current 10 000
- Deferred (2 000)

Example 1B: reversing a deferred tax asset

Use the same information as that given in 1A and the following additional information:
The current tax charged by the tax authorities (based on tax legislation) in 20X2 is expected
to be C14 000. The accountant calculates the tax incurred for 20X2 to be C16 000 (the
‘excess tax’ charged in 20X1 is now incurred).


Required:
Show the ledger accounts and disclose the tax expense and deferred tax in 20X2.
Solution to example 1B: reversing a deferred tax asset
Tax: normal tax (E) Current tax payable: normal tax
CTP: NT (1) 14 000 Tax (1) 14 000
DT (2) 2 000
16 000

Deferred tax (A)
Balance b/d 2 000 Taxation (2) 2 000

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(1) recording the current tax (estimated amount that will be charged by the tax authorities)
(2) recording the reversal of the deferred tax asset in the second year. The total tax expense in
20X2 will be the current tax charged for 20X2 plus deferred tax (the portion of the current
tax that was not recognised in 20X1, is incurred in 20X2).


Entity name
Note 20X2 20X1
C C
Profit before tax xxx xxx
Taxation expense (20X2: current tax: 14 000 + 3. 16 000 8 000
deferred tax: 2 000)
Profit after tax xxx xxx
Other comprehensive income 0 0
Total comprehensive income xxx xxx

Entity name
As at … 20X2
Note 20X2 20X1
ASSETS C C
Non-current Assets
- Deferred tax: normal tax 0 2 000

Entity name
For the year ended ……20X2
20X2 20X1
3. Taxation expense C C
Normal taxation expense 16 000 8 000
- Current 14 000 10 000
- Deferred 2 000 (2 000)
It can be seen that over the period of 2 years, the total current tax of C24 000 (10 000 + 14
000) charged by the tax authorities, is recognised as a tax expense in the accounting records:
• the tax expense in the first year is C8 000; and
• the tax expense in the second year C16 000.

Example 2A: creating a deferred tax liability (credit balance)

The current tax expected to be charged by the tax authorities (based on tax legislation) is
C10 000 in 20X1. The accountant calculates that the tax incurred for 20X1 to be C12 000.


Required:
Solution to example 2A: creating a deferred tax liability (credit balance)
The tax shown in the statement of comprehensive income must always be the amount
incurred for the year rather than the amount charged, thus C12 000 must be shown as the tax
expense.

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CTP: NT(1) 10 000 Tax (1) 10 000
DT(2) 2 000
12 000

Deferred tax (L)
Tax (2) 2 000

(1) Recording the current tax (the estimated amount that will be charged by the tax
authorities).
(2) Providing for extra tax that has been incurred but which will only be charged/assessed by
the tax authorities in future years (tax owing to the tax authorities in the long term): we
have only been charged C10 000 in the current year, but have incurred C12 000, thus
there is an amount of C2 000 that will have to be paid sometime in the future. Notice that
the deferred tax account has a credit balance of C2 000, (a deferred tax liability).

Entity name
20X1
C
Profit before tax xxx
Taxation expense (current tax: 10 000 + deferred tax: 2 000) 3. 12 000
Profit for the year xxx
Other comprehensive income 0
Total comprehensive income xxx

Entity name
As at ……..20X1
20X1
LIABILITIES C
Non-current Liabilities
- Deferred tax: 2 000

Entity name
For the year ended ……20X1
20X1
3. Taxation expense C
Normal taxation expense 12 000
- Current 10 000
- Deferred 2 000

Example 2B: reversing a deferred tax liability

Use the same information as that given in example 2A as well as the following information:
• The tax authority is expected to charge C14 000 for 20X2 but the tax incurred is
calculated to be C12 000.
• There are no components of other comprehensive income.

Required:

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Solution to example 2B: reversing a deferred tax liability

The deferred tax liability (a non-current liability) will have to be reversed out in 20X2 since
the amount will now form part of the current tax payable liability instead (a current liability).


CTP: NT (1) 14 000 DT (2) 2 000 Tax (1) 14 000
Total 12 000

Deferred tax (L)
Tax (2) 2 000 Balance b/f 2 000

(1) recording the current tax (charged by the tax authority)
(2) recording the reversal of the deferred tax in the second year.


Entity name
For the year ended …..20X2
20X2 20X1
C C
Profit before tax xxx xxx
Taxation expense (current tax and deferred tax) 3. 12 000 12 000
Profit for the year xxx xxx
Total comprehensive income xxx xxx

Entity name
As at ……..20X2
20X2 20X1
LIABILITIES C C
Non-current Liabilities
- Deferred Tax 0 2 000

Entity name
20X2 20X1
Normal taxation expense 12 000 12 000
- current 14 000 10 000
- deferred (2 000) 2 000
It can be seen that over the period of 2 years, the total current tax of C24 000 (10 000 + 14 000)
charged by the tax authority is recognised as a tax expense in the accounting records:
• the tax expense in the first year is C12 000 and
• the tax expense in the second year is C12 000.

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2.2 Calculation of Deferred tax – the two methods

Although IAS 12 refers to only one method of calculating deferred tax, (the balance sheet
method), there are in fact two methods:
• Balance sheet method: a comparison between the carrying amount and the tax base of
each of the entity’s assets and liabilities; and the
• Income statement method: a comparison between accounting profits and taxable profits.

The method used will not alter the journals or disclosure. You will generally be required to
calculate the Deferred tax using the balance sheet method. The income statement method is
still useful though since it serves as a tool to check your balance sheet calculations and is
useful in that it is easier to explain the concept of deferred tax. If there was deferred tax on a
gain or loss that is recognised directly in equity (i.e. not in profit or loss), then the income
statement method will need to bear this into account, since the income statement method
looks only at the deferred tax caused by items of income and expense recognised in profit or
loss.

IAS 12 expressly prohibits the discounting (present valuing) of deferred tax balances.

2.2.1 The income statement approach

The ‘accountant’ and the ‘tax authorities’ calculate profits in different ways:

International Financial Reporting Standards govern the manner in which the accountant
calculates accounting profit:
• profit or loss for a period before deducting (the) tax expense.
Tax legislation governs the manner in which the tax authorities calculate taxable profit:
• the profit (or loss) for the period, determined in accordance with the rules established by
the taxation authorities, upon which income taxes are payable or recoverable.

In order for the accountant to calculate the estimated current tax for the year, he converts his
accounting profits into taxable profits. This is done as follows:

Conversion of accounting profits into taxable profits: C

Profit before tax (accounting profits) xxx

Adjusted for permanent differences: xxx
- less exempt income (e.g. certain capital profits and dividend income) (xxx)
- add non-deductible expenses (e.g. certain donations and fines) xxx

Accounting profits that are taxable (A x 30% = tax expense incurred) A

Adjusted for movements in temporary differences: xxx
- add depreciation xxx
- less depreciation for tax purposes (e.g. wear and tear) (xxx)
- add income received in advance (closing balance): if taxed when xxx
received (xxx)
- less income received in advance (opening balance): if taxed when (xxx)
received xxx
- less expenses prepaid (closing balance): if deductible when paid xxx
- add expenses prepaid (opening balance): if deductible when paid (xxx)
- add provisions (closing balance): if deductible when paid
- less provisions (opening balance): if deductible when paid

Taxable profits (B x 30% = current tax charge) B

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As can be seen from the calculation above, the difference between accounting profits and
taxable profits may be classified into two main types:
• temporary differences; and
• permanent differences.

Accounting =
Profit before tax
profits

+/- Permanent differences

Portion of the accounting
Taxable = profits that are taxable Tax
accounting profits although not necessarily X 30% = expense
now
Deferred tax
+/- Temporary differences
X 30% = expense/ income

Taxable = Profits that are taxable now, Current tax
profits based purely on tax laws X 30% = expense

The difference between total accounting profits and the taxable accounting profits are
permanent differences. These differences include, for instance, items of income that will
never be taxed as income and yet are recognised as income in the accounting records.

The difference between taxable accounting profits (A above) and taxable profits (B above) are
caused by the movement in temporary differences. These differences relate to the issue of
timing: for instance, when the income is taxed versus when it is recognised as income in the
accounting records.

A deferred tax adjustment is made for the movement relating to temporary differences only.

Example 3A: income received in advance (income statement approach)
A company receives rent income of C10 000 in 20X1 that relates to rent earned in 20X2 and
then receives C110 000 in rent income in 20X2 (all of which was earned in 20X2). The
company has no other income. The tax authority taxes income on the earlier of receipt or
earning.
Required:
Calculate, for 20X1 and 20X2, the current tax expense, the deferred tax adjustment and the
final tax expense to appear in the statement of comprehensive income and show the related
ledger accounts.

Solution to example 3A: income received in advance (income statement approach)

Current tax calculation: 20X1 Profits Tax at
30%
Profit before tax (accounting profits) (10 000 – 10 000) (1) 0
Adjusted for permanent differences: 0
Taxable accounting profits and tax expense (3) 0 0
Adjusted for movement in temporary differences: (5) 10 000 3 000
add income received in advance (closing balance): taxed in the current 10 000
year (2)
less income received in advance (opening balance): previously taxed (0)

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Taxable profits and current normal tax (4) 10 000 3 000
Since the income is not recognised in the statement of comprehensive income in 20X1, it does
not make sense to recognise the related tax in 20X1, (it makes more sense to recognise the tax
on income when the income is recognised). Thus the recognition of this current tax is deferred
to this future year (20X2).

Current tax calculation: 20X2 Profits Tax at
30%
Profit before tax (accounting profits) (110 000 + 10 000) (6) 120 000
Taxable accounting profits and tax expense (8) 120 000 36 000
Adjusted for movement in temporary differences: (9) (10 000) (3 000)
add income received in advance (closing balance): taxed in the 0
current year
less income received in advance (opening balance): previously taxed (10 000)
(7)


(1) The receipt in 20X1 is not yet earned and is therefore not recognised as income but as a
liability.
(2) The income is taxed by the tax authority on the earlier date of receipt or earning: the
amount is received in 20X1 and earned in 20X2 and is therefore taxed in 20X1 (the
earlier date).
(3) The tax that appears on the face of the statement of comprehensive income should be
zero since it should reflect the tax owing on the income earned. Since no income has
been earned, no tax should be reflected.
(4) The difference between the current tax charged (3 000) and the tax expense (0) is the
deferred tax adjustment, deferring the current tax to another period.
(5) Notice that the deferred tax account has a debit balance at the end of 20X1 and is
therefore classified as an asset: tax has been charged in 20X1 for taxes that will only be
incurred in 20X2.
(6) The income in 20X2 includes the C10 000 received in 20X1 since it is earned in 20X2.
The income received in advance liability is reversed out.
(7) Notice that the tax authority charges current tax in 20X2 on just the C110 000 received
since the balance of C10 000 was received and taxed in an earlier year.
(8) The accountant believes that the C36 000 tax should be expensed in 20X2 (together with
the related income of C120 000).
(9) This requires that the C33 000 current tax recorded in the books in 20X2 be adjusted to
include the tax of C3 000 that was charged in 20X1 but not recognised in 20X1. This
results in a reversal of the deferred tax balance of C3 000 brought forward from 20X1.


Bank Rent received in advance (L)
RRIA (1) 10 000 Bank (1) 10 000

CTP: NT (2) 3 000 DT (4) 3 000 Tax (2) 3 000
Total b/f (3) 0

Deferred tax (A)
Tax (4 & 5) 3 000

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Bank Rent received in advance (L)
Rent 110 000 Rent (6) 10 000 Balance b/f 10 000

CTP:NT (7) 33 000 Balance b/f 3 000
DT (9) 3 000 Tax (7) 33 000
Total (8) 36 000

Deferred tax Rent (I)
Balance b/f 3 000 Tax (9) 3 000 RRIA (6) 10 000
Bank 110 000
120 000

2.2.2 The balance sheet approach

When calculating deferred tax using the balance sheet approach, the carrying amount of the
assets and liabilities are compared with the tax bases of these assets and liabilities. Any
difference between the carrying amount and the tax base of an asset or liability is termed a
‘temporary difference’:
• The carrying amounts are the balances of the assets and liabilities as recognised in the
statement of financial position based on International Financial Reporting Standards.
• The tax bases are the balances of the assets and liabilities, as they would appear in a
statement of financial position drawn up based on tax law (please read these definitions
again – you will find them at the beginning of this chapter).

The total temporary differences multiplied by the tax rate will give:
• the deferred tax balance in the statement of financial position.

The difference between the opening and closing deferred tax balance in the statement of
financial position will give you:
• the deferred tax journal adjustment.

Carrying amount: Temporary difference Tax base:
X 30% =
Opening balance Deferred tax balance: beginning of year Opening balance
Movement:
Deferred tax
journal
adjustment

Carrying amount: Temporary difference Tax base:
X 30% =
Closing balance Deferred tax balance: end of year Closing balance

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A useful format for calculating deferred tax using the balance sheet approach is as follows:

Carrying Tax base Temporary Deferred Deferred tax
amount (per IAS 12) difference tax balance/
(SOFP) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)

Opening balance: Asset/
in the SOFP liability
dr FP; cr CI
Movement: deferred tax
or
charge in the SOCI
cr FP; dr CI
Closing balance Asset/
in the SOFP liability

Example 3B: income received in advance (balance sheet approach)

Use the information given in example 3A.

Required:
Calculate the Deferred tax adjustment using the balance sheet approach for both years.

Solution to example 3B: income received in advance (balance sheet approach)

Rule for liability: revenue received in advance (per IAS 12):
The tax base of revenue received in advance is the carrying amount of the liability less the
portion representing income that will not be taxable in future periods.

Applying the rule for revenue received in advance (L) to the calculation of the tax base:
20X1 tax base: C
Carrying amount 10 000
Less that which won’t be taxed in the future (because taxed in the (10 000)
current year)
This means that there will be no related current tax charge in the future. 0

20X2 tax base: C
Carrying amount 0
Less that which won’t be taxed in the future 0
0
The carrying amount is zero since the income was earned in 20X2 so the balance on
the liability account was reversed out to income (see journal 6 in the 20X2 t-accounts
above).

Calculation of Deferred tax (balance sheet approach):
Income received in advance Carrying Tax base Temporary Deferred Deferred
amount difference tax at 30% tax
(SOFP) (IAS 12) (b) – (a) (c) x 30% balance/
(a) (b) (c) (d) adjustment
Opening balance – 20X1 0 0 0 0
(3)
Deferred tax charge – 20X1 (10 000) 0 10 000 3 000 dr DT;
(balancing: movement) cr TE
Closing balance – 20X1 (1) (10 000) 0 10 000 3 000 Asset (2)
(5)
Deferred tax charge – 20X2 10 000 0 (10 000) (3 000) cr DT;
(balancing: movement) dr TE
Closing balance – 20X2 (4) 0 0 0 0

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Explanation of the above:

1) During 20X1, the C10 000 rent is received in advance. The accountant treats this as a
liability whereas the tax authority treats it as income. Thus the carrying amount of the
income received in advance account is C10 000 whereas the tax authority has no such
liability: the tax base is therefore zero. This results in a temporary difference of C10 000
and therefore a deferred tax balance of C3 000.
2) The tax base of a liability that represents income, is that portion of the liability that will
be taxed in the future. The difference between the carrying amount and the tax base
represents the portion of the liability that won’t be taxed in the future with the result that
the deferred tax balance is an asset to the company: the tax that has been ‘prepaid’.
3) The deferred tax charge in 20X1 will be a credit to the statement of comprehensive
income.
4) During 20X2, the C10 000 rent that was received in advance in 20X1 is now recognised
as income (the accountant will debit the liability and credit income) with the result that
the accountant’s liability reverses out to zero. As mentioned above, the tax authority had
no such liability since he treated the receipt as income in 20X1. The carrying amount and
the tax base are now both zero, with the result that the temporary difference is now zero
and the deferred tax is zero.
5) The deferred tax charge in 20X2 is a debit to the statement of comprehensive income.

Example 3C: income received in advance (journals)
Use the current tax calculation done in example 3A and the deferred tax calculation done in
3B.
Required:
Show the related tax journal entries.

Solution to example 3C: income received in advance (journals)

20X1 Debit Credit
Taxation expense: normal tax (SOCI) 3 000
Current tax payable: normal tax (SOFP) 3 000
Current tax payable per tax law (see calculation in
3A)
Deferred tax: normal tax (SOFP) 3 000
Deferred tax adjustment (see calculation in 3B)

20X2
Current tax payable: normal tax (SOFP) 33 000
Current tax payable per tax law (see calculation in
3A)
Deferred tax: normal tax (SOFP) 3 000
Deferred tax adjustment (see calculation in 3B)

Example 3D: income received in advance (disclosure)
Use the information given in example 3A, 3B or 3C.
The current tax for 20X1 is paid in 20X2 and that the current tax for 20X2 is paid in 20X3.
Required:
Disclose all information in the financial statements.

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Solution to example 3D: income received in advance (disclosure)

Company name
As at 31 December 20X2
ASSETS Note 20X2 20X1
Non-Current Assets C C
Deferred tax: normal tax 6 0 3 000
LIABILITIES
Current Liabilities
Current tax payable: normal tax 33 000 3 000
Income received in advance 0 10 000

Company name
Statement of comprehensive income (extracts)
For the year ended 31 December 20X2
Note 20X2 20X1
C C
Profit before taxation 120 000 0
Taxation expense 5 36 000 0
Profit for the year 84 000 0
Total comprehensive income 84 000 0

Company name
Notes to the financial statements (extracts)
20X2 20X1
C C
5. Taxation expense
Normal taxation 36 000 0
• Current 33 000 3 000
• Deferred 3 000 (3 000)

Total tax expense per the statement of comprehensive 36 000 0
income

6. Deferred tax asset
The closing balance is constituted by the effects of:
• Year-end accruals 0 3 000
It can be seen that the deferred tax effect on profits is nil over the period of the two years.

2.3 Year-end accruals, provisions and deferred tax

Five statement of financial position accounts resulting directly from the use of the accrual
system include:
• income received in advance;
• expenses prepaid;
• expenses payable;
• provisions; and
• income receivable.
Income received in advance has already been covered in example 3 above. The deferred tax
effect of each of the remaining four examples will now be discussed. Since IAS 12 refers only
to the use of the balance sheet approach, this is the only approach shown in this text.

103 Chapter 3


2.3.1 Expenses prepaid

Remember that, although the tax authority normally allows a deduction of expenses when the
expenses are incurred, he may, however, allow a deduction of a prepaid expense depending
on criteria in the tax legislation. If this happens, deferred tax will result.

Example 4: expenses prepaid

Profit before tax is C20 000 in 20X1 and in 20X2, according to the accountant and the tax
authority, before taking into account the following information:
• An amount of C8 000 in respect of electricity for January 20X2 is paid in December 20X1.
• The Receiver allows the payment of C8 000 as a deduction against taxable profits in 20X1.
• The company paid the current tax owing to the tax authorities for 20X1, in 20X2.
• There are no permanent differences, no other temporary differences and no taxes other
than normal tax at 30%.

Required:
A. Calculate the Deferred tax for 20X1 and 20X2 using the balance sheet approach.
B. Calculate the current normal tax for 20X1 and 20X2.
C. Show the related journal entries in ledger account format.
D. Disclose the tax adjustments for the 20X2 financial year.

Solution to example 4A: expenses prepaid (deferred tax)

Rule for assets: expenses prepaid (IAS 12):

The tax base of an asset (that represents an expense) is the amount that will be deducted for
tax purposes against any taxable economic benefits that will flow to an entity when it recovers
the carrying amount of the asset. If those economic benefits will not be taxable, the tax base
of the asset is equal to its carrying amount (e.g. an investment that renders dividend income).

Applying the rule to the calculation of the tax base (expenses prepaid):

20X1 tax base: C
Less amount already deducted from taxable profits (deducted in current year: 20X1) (8 000)
Deduction from taxable profits in the future 0

20X2 tax base:
Carrying amount 0
Less that which won’t be deducted for tax purposes in the future 0
0
The carrying amount will now be zero since the expense was incurred in 20X2 with the asset
balance transferred to an expense account (see journal 1 in the 20X2 t-accounts).


Expenses prepaid Carrying Tax Temporary Deferred Deferred tax
amount base difference tax at 30% balance/
(per SOFP) (IAS 12) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Opening balance: 20X1 0 0 0 0
Movement (balancing) 8 000 0 (8 000) (2 400) cr FP; dr CI (3)
Closing balance: 20X1 (1) 8 000 0 (8 000) (2 400) Liability (2)

104 Chapter 3


Solution to example 4B: expenses prepaid (current tax)

Calculation of current normal tax: 20X1
The prepayment of C8 000 is allowed as a deduction by the tax authority in 20X1 but the accountant
recognises the C8 000 as a prepaid expense, (an asset), thus causing a temporary difference.
Profits Tax at 30%
Profit before tax (accounting profits) (1) 20 000
Adjusted for movement in temporary differences: (3) (8 000) (3)
(2 400)
Less expense prepaid (closing balance): deductible in current year 20X1 (8 000)


The accountant recognises (deducts) the C8 000 as an expense in 20X2 since this is the period in which
the expense is incurred but the tax authority, having already allowed the deduction of the expense in
20X1, will not deduct it again in 20X2. The difference in 20X2 reverses the difference in 20X1.

Profits Tax at 30%
Profit before tax (accounting profits) (20 000 – 8 000) (4) 12 000
Adjusted for movement in temporary differences: (5) 8 000 (5)
2 400
Add expense prepaid (opening balance): deducted in prior year 20X1 8 000


Solution to example 4C: expenses prepaid (ledger accounts)

Bank Expenses prepaid (A)
Exp Prepaid(1) 8 000 Bank (1) 8 000

CTP: NT(6) 3 600 Tax (6) 3 600
DT (3) 2 400
Total 6 000
Deferred tax (L)
Tax (3) 2 400

T-accounts: 20X2
Electricity and water Expenses prepaid (A)
EP(4) 8 000 Balance b/f 8 000 E&W (4) 8 000

CTP: NT(7) 6 000 DT (5) 2 400 Bank (8) 3 600 Balance 3 600
_____ Total c/f 3 600 Tax (7) 6 000
6 000 6 000
Total b/f 3 600
Deferred tax (L) Bank
Tax (5) 2 400 Balance b/d 2 400 CTP: NT (8) 3 600

105 Chapter 3


Comments on example 4 A, B and C
1) The accountant treats the payment as an asset since the expense has not yet been incurred
whereas the tax authority treats the payment as an expense and therefore has no asset
account.
2) This represents a deferred tax liability since it represents a premature tax saving (received
before the related expense is incurred).
3) In order to create a deferred tax credit balance, the deferred tax liability must be credited
and the tax expense debited.
4) The expense is incurred in 20X2, so the expense prepaid (asset) is reversed out to
electricity expense (reducing profits). Now both accountant and tax authority have zero
balances on the expense prepaid (asset) account and so there is no longer a temporary
difference and thus a zero deferred tax balance.
5) In order to adjust a deferred tax credit balance to a zero balance, the liability must be
debited and the tax expense credited.
6) Current tax charged by the tax authority in 20X1.
8) Payment of the balance owing to the tax authority for 20X1 (the prior year).
It can be seen that over 2 years:
• the accountant recognises tax expense of C9 600 (6 000 + 3 600) as incurred; and this equals
• the actual tax charged by the tax authority over 2 years is C9 600 (3 600 + 6 000).
The difference relates purely to when the tax is incurred versus when the tax is charged, thus the
difference reverses out once the tax has both been charged and incurred.

Solution to example 4D: expenses prepaid (disclosure)
Company name
Note 20X2 20X1
ASSETS C C
Current assets
Expense prepaid 0 8 000
LIABILITIES
Non-current liabilities
Current liabilities
Company name
Note 20X2 20X1
C C
Profit before taxation 20X2: 20 000 – 8 000 12 000 20 000
Taxation expense 5 3 600 6 000
Profit for the year 8 400 14 000
Total comprehensive income 8 400 14 000
Company name
20X2 20X1
Normal taxation 3 600 6 000
• current 6 000 3 600
• deferred (2 400) 2 400
Total tax expense per the statement of comprehensive income 3 600 6 000

106 Chapter 3


6. Deferred tax asset/ (liability)
• Year-end accruals 0 (2 400)

2.3.2 Expenses payable

The tax authority generally allows expenses to be deducted when they have been incurred
irrespective of whether or not the amount incurred has been paid. This is the accrual system
and therefore there will be no deferred tax on an expense payable balance.

Example 5: expenses payable
• A telephone expense of C4 000, incurred in 20X1, is paid in 20X2.
• The Receiver will allow the expense of C4 000 to be deducted from the 20X1 taxable
profits.
• The current tax owing to the tax authorities is paid in the year after it is charged.
• There are no permanent or other temporary differences and no taxes other than normal tax
at 30%.
• There are no components of other comprehensive income

Required:
A. Calculate the Deferred tax for 20X1 and 20X2 using the balance sheet approach.
C. Show the related journal entries in ledger account format.
D. Disclose the tax adjustments for the 20X2 financial year.

Solution to example 5A: expenses payable (deferred tax)

Rule for liabilities: expenses payable (IAS 12 adapted):
The tax base of a liability (representing expenses) is its carrying amount less any amount that
will be deductible for tax purposes in respect of that liability in future periods.

Applying the rule to the example (expenses payable):
20X1 tax base: C
Less deductible in the future (all deducted in the current year) 0
4 000
20X2 tax base:
Carrying amount 0
Less deductible in the future (already deducted in 20X1) 0
0
The carrying amount will now be zero since the expense was paid in 20X2 with the balance on
the liability account being reversed.

Carrying Tax Temporary Deferred Deferred
amount base difference tax at 30% tax balance/
Expenses payable
(per SOFP) (IAS 12) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Opening balance: 20X1 0 0 0 0 N/A
Movement (balancing) (4 000) (4 000) 0 0 N/A
Closing balance:20X1 (3) (4 000) (4 000) 0 0 N/A
Movement (balancing) 4 000 4 000 0 0 N/A
Closing balance: 20X2(5) 0 0 0 0 N/A

107 Chapter 3


Solution to example 5B: expenses payable (current tax)
Since the telephone expense is recognised as an expense and is also deducted for tax purposes in 20X1,
the effect on accounting profits and taxable profits is identical. There is, therefore, no deferred tax.
Profits Tax at
30%
(1)
Taxable accounting profits and tax expense 16 000 4 800
Adjusted for temporary differences: (3) 0 0
Since the telephone expense is recognised as an expense in the statement of comprehensive income in
20X1, it will have no impact on the statement of comprehensive income in 20X2. Similarly, since the
telephone expense is deducted for tax purposes in 20X1, it will not be deducted for tax purposes in
20X2. Since the effect on accounting profits and taxable profit is the same, there is no deferred tax.

Profits Tax at 30%
Adjusted for movement in temporary differences: (6) 0 0
Solution to example 5C: expenses payable (ledger accounts)
Ledger accounts - 20X1
Telephone Expenses payable (L)
EP(1) 4 000 Tel (1) 4 000

CTP: NT(2) 4 800 Tax (2) 4 800

Ledger accounts – 20X2
Bank Expenses payable (L)
EP(4) 4 000 Bank (4)
4 000 Balance b/f 4 000
CTP: NT (7) 4 800
CTP: NT(5) 6 000 Bank (7) 4 800 Balance 4 800
Tax (5) 6 000
Comments on example 5A, B and C
(1) The telephone expense is incurred but not paid in 20X1 and is therefore recognised as an expense
and expense payable in 20X1.
(2) Current tax charged by the tax authority in 20X1.
(3) Since the accountant and tax authority both treat the expense payable as an expense in the
calculation of profits, there is no temporary difference and therefore no deferred tax adjustment.
(4) Notice that although the telephone expense is paid in 20X2, the payment is not taken into account
in the calculation of the profits for 20X2. The payment of the expense in 20X2 simply results in
the reversal of the expense payable account.
(5) Current tax charged by the tax authority in 20X2.
(6) Since the tax authority has treated the expense in the same manner as the accountant, there is no
temporary difference and therefore no deferred tax adjustment.
(7) The balance owing to the tax authority at the end of 20X1 is paid in 20X2.

108 Chapter 3


Solution to example 5D: expenses payable (disclosure)

Company name
Note 20X2 20X1
LIABILITIES C C
Current liabilities
Expense payable 0 4 000

Company name
Note 20X2 20X1
C C
Profit before taxation 20X1: 20 000 – 4 000 20 000 16 000
Other comprehensive 0 0
income
Total comprehensive 14 000 11 200
income

Company name
20X2 20X1
• Current 6 000 4 800
• Deferred 0 0
Total tax expense per the statement of comprehensive 6 000 4 800
income
2.3.3 Provisions
Although the tax authority generally allows expenses to be deducted when they have been
incurred, he often treats the deduction of provisions with more ‘suspicion’. In cases such as
this, the tax authority generally allows the provision to be deducted only when it is paid.

Example 6: provisions

• A provision for warranty costs of C4 000 is journalised in 20X1 and paid in 20X2.
• The tax authority will allow the warranty costs to be deducted only once paid.
• The current tax owing to the tax authority is paid in the year after it is charged.
• There are no permanent differences, no other temporary differences and no taxes other
than normal tax at 30%.
Required:
A. Calculate the Deferred tax using the balance sheet approach.
C. Show the related ledger accounts.
D. Disclose the above information.

109 Chapter 3


Solution to example 6A provisions (deferred tax)
Rule for liabilities: provisions (IAS 12 adapted)
The tax base of a liability (representing expenses) is its carrying amount less any amount that
will be deductible for tax purposes in respect of that liability in future periods.
Applying the rule to the calculation of the tax base (provisions)
20X1 tax base: C
Less deductible in the future (all will be deducted in the future: 20X2) 4 000
0
20X2 tax base:
Carrying amount 0
Less deductible in the future (all deducted in 20X2 since now paid) 0
0
The carrying amount will now be zero since the expense was paid in 20X2 with the
balance on the liability account being reversed.
Calculation of Deferred tax (balance sheet approach)
Provision for warranty amount base difference tax at 30% tax
costs (per SOFP) (IAS 12) (b) – (a) (c) x 30% balance/
Opening balance – 20X1 0 0 0 0
Movement (balancing) (4 000) 0 4 000 1 200 dr FP; cr CI (3)
Closing balance – 20X1 (1) (4 000) 0 4 000 1 200 Asset (2)
Movement (balancing) 4 000 0 (4 000) (1 200) cr FP; dr CI (7)
Closing balance – 20X2 (5) 0 0 0 0

Solution to example 6B: provisions (current tax)
Since in 20X1 the tax authority disallows the provision and the accountant recognises the provision,
the accounting profits will be less than the taxable profits in 20X1.
Profits Tax at
30%
Adjusted for movement in temporary differences: (3) 4 000 1 200
• Add back provision for an expense disallowed in 20X1 4 000

The difference that arose in 20X1 will reverse in 20X2 when the tax authority allows the deduction of
the provision since the taxable profits will now be less than the accounting profits (the provision will
not affect the statement of comprehensive income again in 20X2).
20X2 Profits Tax at 30%
Profit before tax (accounting profits) 20 000
Adjusted for movement in temporary differences: (7) (4 000) (1 200)
- provision for warranty cost allowed in 20X2 (4 000)

110 Chapter 3


Solution to example 6C: provisions (ledger accounts)


Warranty costs (E) Provision for warranty costs (L)
Provision(1) 4 000 WC (1) 4 000

CTP: NT(4) 6 000 DT (3) 1 200 Tax (4) 6 000
Total c/f 4 800
6 000 6 000
Total b/f 4 800

Deferred tax (A) (2)
(3)
Taxation 1 200


Bank Provision for warranty costs (L)
Provision(5) 4 000 Bank(5) 4 000 Balance b/f 4 000
CTP: NT (8) 6 000

CTP: NT(6) 4 800 Bank (8) 6 000 Balance b/f 6 000
DT (7) 1 200 Tax (6) 4 800
Total b/f 6 000

Deferred tax (A)
Balance b/f 1 200 Tax (7) 1 200

1) Warranty costs of C4 000 are incurred but not paid in 20X1 and therefore an expense and expense
payable are recognised in 20X1 (reducing 20X1 profits). Although the accountant believes these
costs to be incurred, the tax authority does not believe this to be the case (therefore the tax
authority does not recognise the expense and expense payable).
2) This represents a deferred tax asset since the expense (already incurred) will result in a future
reduction in taxable profits (a future tax saving).
3) In order to create a deferred tax asset, the statement of financial position deferred tax account must
be debited and the tax expense must be credited. Since the tax authority disallowed the deduction
of the warranty costs in 20X1, the current tax was greater than the tax expense incurred, thus
requiring a deferral of tax to future years.
5) The payment of C4 000 reverses the provision and thus both the accountant and the tax authority
now have balances of zero in the liability account. When the balances are the same, there are no
temporary differences meaning that the deferred tax balance must be zero.
7) In order to reverse a deferred tax asset, it is necessary to credit deferred tax and debit tax expense.
8) Payment of the current tax for 20X1 in 20X2.

111 Chapter 3


Solution to example 6D: provisions (disclosure)

Company name
Note 20X2 20X1
ASSETS C C
Non-current assets
LIABILITIES
Current liabilities
Provision for warranty costs 0 4 000

Company name
Note 20X2 20X1
C C
Profit before taxation (20X1: 20 000 – 4 000) 20 000 16 000

Company name
20X2 20X1

• Current 4 800 6 000
• Deferred 1 200 (1 200)

income

6. Deferred tax asset/ (liability)
• Year-end accruals 0 1 200


2.3.4 Income receivable

The tax authority generally taxes income on the earlier of the date the income is earned or the
date it is received. Therefore the taxable income will equal the accounting income if the
income is received on time or is receivable (as opposed to received in advance) and therefore
there will be no deferred tax on an income receivable balance.

112 Chapter 3


Example 7: income receivable

• Interest income of C6 000 is earned in 20X1 but only received in 20X2.
• The tax authority will tax the interest income when earned.
• The current tax owing to the tax authorities is paid in the year after it is charged.
• There are no permanent or other temporary differences and no taxes other than normal tax
at 30%.

Required:
D. Disclose the above information.

Solution to example 7A: income receivable (deferred tax)

Rule for assets: income receivable:
The tax base of an asset (that represents an income) is the carrying amount less that portion
that will be taxed in the future.

Applying the rule to the calculation of the tax base (income receivable):

20X1 tax base: C
Less portion that will be taxed in the future (all taxed in current year: 20X1) 0
6 000
20X2 tax base:
Carrying amount 0
Less portion that will be taxed in the future (all taxed in 20X1) 0
0
The carrying amount will now be zero since the income receivable was received in 20X2 (see
journal 1 in the 20X2 ledger accounts).

Income receivable amount base difference tax at 30% tax
(per SOFP) (IAS 12) (b) – (a) (c) x 30% balance/
Opening balance – 20X1 0 0 0 0 N/A
Movement (balancing) 6 000 6 000 0 0 N/A
Closing balance – 20X1 (1) 6 000 6 000 0 0 N/A
Movement (balancing) (6 000) (6 000) 0 0 N/A
Closing balance – 20X2 (3) 0 0 0 0 N/A

Solution to example 7B: income receivable (current tax)

Since the tax authority taxes income either on the date it is received or on the date it is earned,
whichever is earlier, the interest income will be taxable in 20X1. The accountant records income when
it is earned and since the interest income is earned in 20X1, the accountant will record the income in
20X1. The accountant and tax authority therefore treat the interest income in the same way with the
result that there are no deferred tax consequences.

113 Chapter 3



Profits Tax at 30%
Profit before tax (accounting profits) (20 000 + 6 000) (1) 26 000


Profits Tax at
30%

Solution to example 7C: income receivable (ledger accounts)

20X1

Income receivable (A) Interest income (I)
Int income(1) 6 000 Inc receivable(1) 6 000

CTP: NT(2) 7 800 Tax (2) 7 800

20X2

Income receivable (A) Bank
Balance b/d 6 000 Bank (3) 6 000 Int receivable (3) 6 000 CTP (5) 7 800

CTP: NT(4) 6 000 Bank (5) 7 800 Balance b/d 7 800
Tax (4) 6 000

1) Since the income is treated as income by both the accountant and the tax authority in
20X1 and yet it hasn’t been received, both the accountant and the tax authority have the
same income receivable account. There are therefore no temporary differences or deferred
tax.
2) Current tax for 20X1.
3) Since the income is received, the receipt reverses the income receivable account to zero
(in both the accountant’s and tax authority’s books). There are therefore still no
temporary differences or deferred tax.
4) Current tax for 20X2.
5) Payment of current tax for 20X1 in 20X2.

114 Chapter 3


Solution to example 7D: income receivable (disclosure)

Company name
Note 20X2 20X1
ASSETS C C
Current assets
Income receivable 0 6 000
LIABILITIES
Current liabilities

Company name
Note 20X2 20X1
C C
Profit before taxation (20X1: 20 000 + 6 000) 20 000 26 000

Company name
20X2 20X1
• Current 6 000 7 800
• Deferred 0 0
income

2.4 Depreciable non-current assets and deferred tax

2.4.1 Depreciation versus capital allowances

The accountant expenses (deducts from income) the cost of non-current assets through the use
of depreciation and the tax authority allows (deducts from income) the cost of non-current
assets through the use of depreciation for tax purposes. Depreciation in the tax records may be
referred to in many different ways, for example it may be referred to as wear and tear, capital
allowances or depreciation for tax purposes. For ease of reference, this text will generally
refer to the depreciation for tax purposes as capital allowances.

The difference between depreciation in the accounting records and capital allowances
(depreciation in the tax records) is generally a result of the differences in the rate or method of
depreciation. For example, the rate of depreciation in the accounting records may be 15%
using the reducing balance method, whereas the rate of capital allowance may be 10% using
the straight-line method. Another difference may arise when depreciation is apportioned for a
period that is less than one year, if the capital allowance in the tax records is not apportioned
for part of the year. Over a period of time, however, the accountant and the tax authority will
generally expense the cost of the asset, meaning that any difference arising between the
depreciation and capital allowance in any one year is just a temporary difference.

115 Chapter 3


Example 8: depreciable assets
Profit before tax is C20 000, according to both the accountant and the tax authority, in each of
the years 20X1, 20X2 and 20X3, before taking into account the following information:
• A plant was purchased on 1 January 20X1 for C30 000
• The plant is depreciated by the accountant at 50% p.a. straight-line.
• The tax authority allows a capital allowance thereon at 33 1/3 % straight-line.
• This company paid the tax authority the current tax owing in the year after it was charged.
• The normal income tax rate is 30%.
Required:
B. Calculate the current normal tax for 20X1, 20X2 and 20X3.
D. Disclose the above in as much detail as is possible for all three years.

Solution to example 8A: depreciable assets (deferred tax)
Rule for assets: depreciable assets (per IAS 12):
The tax base of an asset is the amount that will be deducted for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of
the asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its
carrying amount (e.g. an investment that renders dividend income).
Applying the rule to the calculation of the tax base (depreciable assets):

20X1:
Tax base: C
Original cost 30 000
Less accumulated capital allowances (30 000 x 33 1/3 % x 1year) 10 000
Deductions still to be made (decrease in taxable profits in the future) 20 000

Carrying amount: C
Less accumulated depreciation (30 000 x 50%) 15 000
Expenses still to be incurred (decrease in accounting profits in the future) 15 000

20X2:
Tax base: C
Less accumulated capital allowances (10 000 x 2 years) 20 000
Deductions still to be made 10 000

Carrying amount: C
Less accumulated depreciation (15 000 x 2 years) 30 000
Expenses still to be incurred 0

20X3:
Tax base: C
Less accumulated capital allowances (10 000 x 3 years) 30 000
Deductions still to be made 0

Carrying amount: C
Less accumulated depreciation (15 000 x 2yrs) (fully depreciated at 30 000
31/12/20X2)
Expenses still to be incurred 0

116 Chapter 3

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