Income taxes and deferred tax

Introduction to Income Taxes

Welcome to one of the most important chapters in your F2 journey! Income tax is a topic that many students find a bit intimidating at first, but don't worry—once you understand the "why" behind the rules, it all starts to click. In this chapter, we aren't just looking at how much cash a company pays the government. We are looking at Current Tax and Deferred Tax. This ensures our financial statements follow the accruals concept, matching the tax expense to the profits earned in the same period.

Think of it like this: If you earn a bonus today but don't have to pay tax on it until next year, your accounts today should still show that you "owe" that tax. That is the essence of deferred tax!

1. Current Tax

Current tax is the amount of income tax a company expects to pay to the tax authorities for the current year. It is based on the taxable profit, which is usually different from the accounting profit because tax laws and accounting standards (IFRS) have different rules about what counts as income or an expense.

How to calculate the Current Tax charge

To find the total tax expense in the Statement of Profit or Loss (P&L), we usually need to do a small calculation involving three steps:

1. Estimate the tax for the current year.
2. Look at the prior year. Did we overestimate or underestimate our tax last year?
3. Combine these figures.

The Formula:
\( \text{Tax Expense} = \text{Current Year Estimate} + \text{Under-provision from last year} \)
OR
\( \text{Tax Expense} = \text{Current Year Estimate} - \text{Over-provision from last year} \)

Quick Review Box:
If the trial balance shows a debit balance for tax, it means we underpaid last year (Under-provision). This increases this year's expense.
If the trial balance shows a credit balance for tax, it means we overpaid last year (Over-provision). This reduces this year's expense.

2. The Concept of Deferred Tax

Deferred tax is often the "scary" part for students, but it's simply an accounting adjustment to deal with timing differences. It recognizes the future tax consequences of transactions that have happened today.

Why does it happen?
The most common reason is the difference between Depreciation (accounting) and Capital Allowances/Tax Depreciation (tax laws).
- Accounting: We spread the cost of a machine over 10 years.
- Tax Law: The government might give us a 100% tax break in Year 1 to encourage investment.

This creates a "gap." Deferred tax bridges that gap so the tax expense in the P&L looks consistent with the profit shown.

Analogy: The Credit Card
Imagine you buy a luxury dinner on a credit card. You've enjoyed the meal (the profit), but you haven't paid the cash yet (the tax). Deferred Tax is like the "pending" transaction on your banking app. You haven't paid it yet, but you know you'll have to eventually!

3. The Balance Sheet Approach (IAS 12)

IAS 12 uses the liability method. Instead of looking at the P&L, we compare the values of assets and liabilities on the Statement of Financial Position.

Key Terms to Learn:

Carrying Amount (CA): The value of an asset or liability in the accounting books.
Tax Base (TB): The value of that asset or liability for tax purposes.

Temporary Difference: The difference between the CA and the TB.

The Golden Rules for Temporary Differences:

1. If Carrying Amount of Asset > Tax Base of Asset = Taxable Temporary Difference (This creates a Deferred Tax Liability).
2. If Carrying Amount of Asset < Tax Base of Asset = Deductible Temporary Difference (This creates a Deferred Tax Asset).

Memory Aid: "AL-LO"
Asset Large = Liability Owed. (If the Asset CA is larger than the Tax Base, you owe a Deferred Tax Liability).

4. Step-by-Step: Calculating Deferred Tax

Don't worry if this seems tricky! Just follow these five steps every time:

Step 1: Identify the Carrying Amount (CA) of the asset/liability.
Step 2: Identify the Tax Base (TB).
Step 3: Find the Temporary Difference (CA minus TB).
Step 4: Multiply the difference by the Tax Rate. This gives you the Closing Balance for the Statement of Financial Position.
Step 5: Compare this Closing Balance to the Opening Balance. The movement is what goes to the P&L.

Example:
A machine has a CA of \$100,000 and a TB of \$70,000. The tax rate is 20%.
1. Difference = \( \$100,000 - \$70,000 = \$30,000 \)
\n2. Deferred Tax Liability = \( \$30,000 \times 20\% = \$6,000 \).
\nIf we had zero deferred tax last year, the P&L charge is \$6,000.

Key Takeaway:

Deferred tax isn't a "real" bill you pay today; it's a provision for tax that will be paid (liability) or saved (asset) in the future.

5. Deferred Tax and Revaluations

This is a favorite topic in CIMA F2 exams! When a company revalues an asset (upwards), the Carrying Amount increases. However, the tax authorities usually ignore this revaluation until the asset is actually sold.

Important Rule: Because the revaluation gain itself is recorded in Other Comprehensive Income (OCI) and the Revaluation Surplus, the deferred tax relating to that revaluation must also be recorded in OCI.

Common Mistake to Avoid:
Do not put the tax on a revaluation into the P&L! It must follow the item it relates to. Revaluation goes to OCI, so the tax on it goes to OCI too.

6. Deferred Tax Assets (DTA)

A Deferred Tax Asset is like a "tax voucher" for the future. It happens when you've paid too much tax now or have losses to carry forward.

Did you know?
You can only recognize a Deferred Tax Asset if it is probable that there will be future taxable profits to use it against. If the company is expected to go bust or never make a profit again, you can't record the asset because you'll never get to use that "voucher."

7. Summary and Quick Checklist

Before moving on to the next chapter, make sure you can:

• Adjust the current tax expense for under/over provisions from the prior year.
• Calculate the Tax Base of an asset (usually Cost minus Tax Depreciation/Capital Allowances).
• Determine if a difference is a Taxable Temporary Difference (Liability) or a Deductible Temporary Difference (Asset).
• Apply the tax rate to the difference to find the SFP balance.
• Remember that tax on revaluations is kept "outside" the P&L in Other Comprehensive Income.

Final Encouragement:
Tax is about logic. If the accounting value is higher than the tax value, you've essentially "delayed" your tax bill, creating a liability. If you can hold onto that one core thought, you'll master this topic in no time!