Income taxes (IAS 12) - Temporary differences and deferred t...

Learning Outcomes

After reading this article, you will be able to distinguish between current tax and deferred tax, explain how temporary differences arise under IAS 12, and compute and record deferred tax assets and liabilities in the financial statements. You will also understand the effect of revaluations and tax losses on deferred tax, and apply the principles to common exam scenarios.

ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand how to account for current and deferred taxation in accordance with IAS 12. Focus your revision on:

• The definition and calculation of accounting profit, taxable profit, and current tax
• The recognition and measurement of deferred tax assets and liabilities
• The identification and treatment of temporary and permanent differences
• The impact of asset revaluation and tax losses on deferred tax
• The presentation of tax in the statement of profit or loss and statement of financial position

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is a temporary difference, and how does it affect deferred tax?
2. Under what circumstances is a deferred tax asset recognised?
3. True or false? An increase in the carrying amount of a non-current asset due to revaluation typically creates a deferred tax liability.
4. Briefly state how deferred tax is calculated and reported in the financial statements.
5. When a company has a taxable loss, under what conditions can a deferred tax asset be recognised?

Introduction

IAS 12 Income Taxes requires entities to account for both current and deferred tax. Current tax represents the tax payable for the period, based on taxable profit as computed using tax rules. Deferred tax, by contrast, arises when accounting profit and taxable profit differ due to timing differences in the recognition of income or expenses. Understanding how and why these temporary differences create deferred tax is critical for preparing accurate financial statements and tackling exam questions.

Key Term: Current tax
The amount of income tax payable (or recoverable) in respect of the taxable profit (or loss) for a reporting period.

Key Term: Deferred tax
Tax computed on temporary differences between the carrying amount of assets or liabilities in the financial statements and their tax base, resulting in future tax payable or recoverable.

Key Term: Temporary difference
A difference between the carrying amount of an asset or liability in the statement of financial position and its tax base; arises when income or expenses are recognised in different periods for accounting and tax purposes.

Current Tax vs. Deferred Tax

Current tax is calculated based on taxable profit, which may not match accounting profit because tax laws often take a different approach to recognising revenue and expenses. Current income tax is recognised as a liability (or asset if overpaid) and is charged to profit or loss for the reporting period.

Deferred tax arises from temporary differences. These are timing differences between when an item is recognised for accounting purposes and when it is recognised for tax purposes. Deferred tax adjusts for these differences to ensure the tax expense recognised in profit or loss matches the accounting profits more accurately.

Types of Differences

• Permanent Differences do not reverse in future periods. For example, fines that are not deductible for tax are expensed in accounting but will never be allowable for tax. Permanent differences do not create deferred tax.
• Temporary Differences will reverse in future periods. For instance, accelerated tax depreciation on assets results in taxable profit being lower than accounting profit in early years, but higher in later years.

Key Term: Tax base
The amount attributed to an asset or liability for tax purposes, against which future taxable amounts will be determined.

Recognising Deferred Tax

IAS 12 requires recognising deferred tax liabilities for all taxable temporary differences (where recovery or settlement of an asset or liability will lead to future taxable amounts). Deferred tax assets are recognised for deductible temporary differences only to the extent it is probable there will be sufficient taxable profit in future to use them.

Common sources of deferred tax include:

• Depreciation: Tax allowances for depreciation may be faster or slower than accounting depreciation
• Revaluation: Upward revaluations increase carrying value but are not taxable until the asset’s disposal
• Provisions: Some provisions may be recognised in accounting before they are allowable for tax

How to Calculate Deferred Tax

1. Identify the carrying amount of each asset and liability in the statement of financial position.
2. Identify their tax base (the amount allowed for tax purposes).
3. The difference is the temporary difference.
4. Multiply each temporary difference by the applicable tax rate.
5. Recognise the resulting deferred tax liability or asset in the statement of financial position.

Tax Base Examples

• For assets: Tax base is usually original cost less any tax depreciation claimed.
• For liabilities: Tax base is the amount deductible in the future for tax purposes.

Key Term: Taxable temporary difference
A temporary difference that will result in taxable amounts in future periods when the carrying amount of an asset or liability is recovered or settled.

Key Term: Deductible temporary difference
A temporary difference that will result in amounts deductible in future periods when the carrying amount is recovered or settled.

Worked Example 1.1

A company’s equipment has a carrying amount of $80,000. Cumulative tax depreciation to date totals $95,000 (tax base: $55,000 original cost less $50,000 tax depreciation = $5,000), so the tax base is $5,000. The tax rate is 25%.

What is the deferred tax liability?

Answer:
Carrying amount: $80,000
Tax base: $5,000
Temporary difference: $80,000 – $5,000 = $75,000 (taxable)
Deferred tax liability: $75,000 × 25% = $18,750

Special Cases: Revaluations and Tax Losses

When assets are revalued upwards, the carrying amount exceeds the tax base. Even if there is no intention to sell, a deferred tax liability is recognised, as future sale or recovery will create taxable amounts.

If a company makes tax losses, a deferred tax asset is recognised only if it is probable there will be sufficient taxable profits in the future (or the losses can be used within a group).

Worked Example 1.2

A property was revalued upward by $100,000. The corresponding tax base did not change. The tax rate is 20%.

Answer:
Temporary difference: $100,000 (taxable)
Deferred tax liability: $100,000 × 20% = $20,000

Exam Warning

A common mistake is to ignore deferred tax on revalued assets, assuming no tax will be payable until sale. IAS 12 requires deferred tax to be recognised on the entire taxable temporary difference.

Presentation and Disclosure

• Deferred tax liabilities and assets are shown separately in the statement of financial position, often as non-current items.
• The tax charge in profit or loss reflects current tax plus the movement in deferred tax for the period.
• Deferred tax arising on items credited or charged to other comprehensive income (such as a revaluation surplus) must be recognised in other comprehensive income and not profit or loss.

Worked Example 1.3

In the year ended 31 December 20X8, a company had:

• Current year estimated tax: $50,000
• Brought forward tax under-provision (Debit balance): $2,000
• Deferred tax brought forward: $6,000
• Deferred tax carried forward: $8,500

What is the tax expense for the year and how are tax liabilities presented?

Answer:
Statement of profit or loss tax expense:
$50,000 (current year estimate) + $2,000 (under-provision) + $2,500 (increase in deferred tax) = $54,500 Statement of financial position:
Current tax (unpaid): $50,000
Deferred tax liability: $8,500 Revision Tip Always calculate deferred tax for each reporting date, not just when assets or liabilities change. Examiners commonly test recognition, calculation, and presentation of deferred tax.

Summary

Current tax reflects the amount payable based on taxable profit for the period. Deferred tax adjusts for timing differences between accounting and taxable profits, ensuring expenses match with revenues in the correct periods. Recognising deferred tax on all taxable temporary differences and eligible deductible temporary differences ensures faithful representation of financial performance and position.

Key Point Checklist

This article has covered the following key knowledge points:

• The definition and calculation of current tax and deferred tax under IAS 12
• How temporary differences create deferred tax assets and liabilities
• The requirement to recognise deferred tax liabilities for all taxable temporary differences
• Measurement of deferred tax using the tax rate expected to apply at reversal
• Presentation and disclosure of current and deferred tax in the financial statements
• Treatment of deferred tax on revaluation and tax losses

Key Terms and Concepts

• Current tax
• Deferred tax
• Temporary difference
• Tax base
• Taxable temporary difference
• Deductible temporary difference