Welcome to Income Taxes (IAS 12)!
Hello there! If the thought of tax makes your head spin, don't worry—you aren't alone. In Strategic Business Reporting (SBR), we focus on IAS 12 Income Taxes. The goal isn't to turn you into a tax accountant; it's to ensure you understand how tax impacts the financial performance of a business.
In this chapter, we explore why the tax bill we pay the government often doesn't match the "tax expense" in our profit or loss statement. We will look at Current Tax and the more famous (and sometimes tricky) Deferred Tax. Let's break it down step-by-step!
1. The Basics: Current Tax
Current Tax is the amount of income tax actually payable (or recoverable) for the current year. It's based on the taxable profit, which is calculated using the rules set by the tax authorities (not the accounting rules!).
How to record it:
Dr Tax Expense (Profit or Loss)
Cr Tax Payable (Current Liability)
Quick Review: Sometimes we over-estimate or under-estimate last year's tax. When we get the final bill, we adjust for that "over/under provision" in the current year's profit or loss. It’s just like getting a refund or a surprise bill from your utility company for last year’s usage!
2. Understanding Deferred Tax: The "Why"
Did you know? Accounting rules (IFRS) and Tax rules (Government) often disagree on when a profit or expense should be recognized. This creates a "timing" problem.
The Concept: Deferred tax is the tax that will be paid or saved in the future because of something that happened now. It follows the Matching Principle: if we report a profit today, we should also report the tax expense related to that profit today, even if we don't pay the cash until next year.
Analogy: Imagine you buy a coffee today on your credit card. You've "consumed" the coffee now (Accounting Profit), but you haven't paid the cash yet (Taxable Profit). You have a "deferred liability" to pay the credit card company later. Deferred tax works exactly the same way!
3. Step-by-Step: The Asset/Liability Method
In SBR, we calculate deferred tax using the Balance Sheet approach. We compare what a "thing" is worth in our accounts versus what the taxman thinks it's worth.
Step 1: Carrying Amount (CA)
This is the value of the asset or liability in your financial statements (e.g., Cost minus Accumulated Depreciation).
Step 2: Tax Base (TB)
This is the value of that asset or liability for tax purposes.
Example: The taxman might allow "Capital Allowances" instead of depreciation, so the tax value of a machine will differ from its accounting value.
Step 3: Temporary Difference
Calculate the difference: \( CA - TB = Temporary Difference \).
Step 4: Calculate the Deferred Tax Balance
Apply the tax rate (the one expected to apply when the asset is realized or the liability settled):
\( Temporary Difference \times Tax Rate = Deferred Tax Balance \).
4. Taxable vs. Deductible Differences
This is where students often get confused. Here is a simple trick to remember which is which:
For Assets:
If Carrying Amount > Tax Base = Taxable Temporary Difference. This leads to a Deferred Tax Liability (DTL).
Memory Aid: "Asset Higher? Tax is Nigher" (meaning you'll have a bill coming soon).
If Carrying Amount < Tax Base = Deductible Temporary Difference. This leads to a Deferred Tax Asset (DTA).
For Liabilities:
If Carrying Amount > Tax Base = Deductible Temporary Difference. This leads to a Deferred Tax Asset (DTA).
If Carrying Amount < Tax Base = Taxable Temporary Difference. This leads to a Deferred Tax Liability (DTL).
Summary Key Takeaway: If the accounting rules make an asset look "bigger" than the tax rules do, you are likely creating a future tax bill (Liability). If they make it look "smaller," you are likely creating a future tax saving (Asset).
5. Special Items in SBR
Strategic Business Reporting requires you to handle more complex scenarios. Here are the big ones:
A. Revaluations
When an asset is revalued upwards (Dr Asset, Cr OCI), its Carrying Amount increases, but its Tax Base usually stays the same. This creates a Deferred Tax Liability.
Crucial Rule: Because the gain went to Other Comprehensive Income (OCI), the related tax expense must also go to OCI. Don't put it in the Profit or Loss!
B. Unused Tax Losses
If a company makes a loss, it can often use that loss to reduce future tax bills. This is a Deferred Tax Asset.
The Catch: You can only recognize this asset if it is probable that there will be future taxable profits to use the loss against. If the company is struggling and likely to keep losing money, you cannot record the asset.
C. Business Combinations (Groups)
When a parent buys a subsidiary, assets are often "stepped up" to Fair Value. This increases the Carrying Amount but not the Tax Base. Therefore, you must recognize a Deferred Tax Liability on the consolidation worksheets. This DTL will actually increase the amount of Goodwill calculated!
6. Common Mistakes to Avoid
1. Discounting: NEVER discount deferred tax assets or liabilities. Even if the tax won't be paid for 20 years, IAS 12 says we use the undiscounted amount.
2. The Tax Rate: Do not use the rate from the start of the year. Use the rate that has been enacted or substantively enacted by the end of the reporting period.
3. Offsetting: You can only offset a Tax Asset against a Tax Liability if you have a legal right to do so (usually meaning they are with the same tax authority).
7. Quick Review: Final Summary
Current Tax: Based on this year's tax return. Record it as an expense and a liability.
Deferred Tax: Accounts for future tax consequences. Use the formula: \( (CA - TB) \times Tax Rate \).
P&L vs. OCI: Tax follows the item. If the gain is in P&L, tax is in P&L. If the gain is in OCI (like a revaluation), tax is in OCI.
DTA Recognition: Only recognize a Deferred Tax Asset for losses if future profits are "probable."
Don't worry if this seems tricky at first! The more you practice comparing the "Book Value" (CA) to the "Tax Value" (TB), the more natural it will become. You've got this!