Income taxes basics (ias 12) - Temporary differences and def...

Learning Outcomes

By the end of this article, you will understand the core principles of accounting for income taxes under IAS 12. You will be able to distinguish between current tax and deferred tax, explain the origin and effects of temporary differences, calculate deferred tax assets and liabilities, and apply these rules to common SBR exam scenarios.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand both the theoretical and practical aspects of income tax accounting under IFRS. When revising this article, focus on:

• The principles for calculating and recognising current and deferred tax
• Identification and calculation of temporary differences in financial statements
• Recognition criteria for deferred tax assets and liabilities
• Exceptions to deferred tax recognition, including initial recognition exemptions
• Measurement and presentation of deferred tax balances, including disclosures
• Calculation of deferred tax for specific situations (revaluations, business combinations, share-based payment schemes)

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 taxable temporary difference?
   1. Carrying amount of an asset is less than its tax base
   2. Tax base of a liability exceeds its carrying amount
   3. Carrying amount of an asset is greater than its tax base
   4. Taxable profit is less than accounting profit
2. When is a deferred tax asset recognised for unused tax losses?
   1. Always
   2. Only when it is probable that future taxable profits will be available
   3. Never
   4. Only in the year incurred

3. Explain the recognition exception for deferred tax on the initial recognition of an asset.

4. How should deferred tax be accounted for on the upward revaluation of a non-current asset?

Introduction

IAS 12 Income Taxes sets out the accounting rules for both current and deferred tax. The distinction between these two lies at the core of understanding tax in financial reporting. While current tax reflects obligations to tax authorities based on taxable profit for the period, deferred tax arises due to timing differences between accounting recognition and tax treatment of transactions. Comprehending temporary differences and applying the measurement, recognition, and presentation rules for deferred tax are essential SBR exam skills.

Current Tax vs Deferred Tax

Current tax is the amount expected to be paid or recovered based on taxable profit, applying prevailing tax rates and laws. It is recognised as a liability (or asset) until settled.

Deferred tax arises from temporary differences—differences between the carrying amount of assets and liabilities in the financial statements and their corresponding tax bases.

Key Term: Temporary Difference
The difference between the carrying amount of an asset or liability in the statement of financial position and its tax base.

Key Term: Tax Base
The amount attributed to an asset or liability for tax purposes.

Key Term: Deferred Tax
Tax that is recognised on temporary differences and represents future tax consequences of current transactions and events.

Types of Temporary Differences

There are two types of temporary differences:

• Taxable temporary differences: Result in taxable amounts in future periods; create deferred tax liabilities.
• Deductible temporary differences: Result in amounts deductible in future periods; create deferred tax assets.

Key Term: Deferred Tax Liability
The amount of income taxes payable in future periods in respect of taxable temporary differences.

Key Term: Deferred Tax Asset
The amount of income taxes recoverable in future periods due to deductible temporary differences, unused tax losses, or credits.

Recognition of Deferred Tax

IAS 12 requires recognition of deferred tax liabilities for all taxable temporary differences—with a few exceptions. Deferred tax assets are only recognised if it is probable that future taxable profits will allow the benefit to be realised.

Exceptions: Initial Recognition Exemption

No deferred tax is recognised for temporary differences arising on:

• Initial recognition of goodwill
• Initial recognition of an asset or liability in a transaction that is not a business combination and affects neither accounting profit nor taxable profit at the time of the transaction

Worked Example 1.1

A company purchases machinery for $20,000. At year-end, cumulative accounting depreciation is $4,000, but for tax purposes, $8,000 of capital allowances have been claimed. The tax rate is 25%.

Question:
Calculate the temporary difference and deferred tax balance at year-end.

Answer:
Carrying amount: $16,000 ($20,000 – $4,000)
Tax base: $12,000 ($20,000 – $8,000)
Temporary difference: $4,000 ($16,000 – $12,000), which is taxable
Deferred tax liability: $4,000 × 25% = $1,000

Worked Example 1.2

A company has written down inventory by $2,000 in its financial statements, but the tax deduction is only available on actual sale. The carrying amount is $18,000, the tax base is $20,000, and the tax rate is 20%.

Question:
What deferred tax asset should be recognised?

Answer:
Temporary difference: $18,000 – $20,000 = ($2,000) (deductible)
Deferred tax asset: $2,000 × 20% = $400

Measuring Deferred Tax

Deferred tax is measured using tax rates and laws enacted or substantively enacted at the reporting date, considering how the relevant asset or liability will be recovered or settled (e.g., use or sale).

Deferred tax is not discounted to present value.

Deferred tax arising from items recognised in other comprehensive income (e.g., revaluations) or directly in equity is also recognised in OCI or equity, not in profit or loss.

Key Term: Taxable Temporary Difference
A temporary difference that will result in taxable amounts in determining taxable profit of future periods.

Key Term: Deductible Temporary Difference
A temporary difference that will result in amounts deductible in determining taxable profit of future periods.

Common Sources of Temporary Differences

• Accelerated depreciation or capital allowances
• Provisions or accruals allowed for tax only when paid
• Revaluation of assets (without similar tax revaluation)
• Unutilised tax losses (potential deferred tax assets)
• Fair value adjustments (e.g., investment property, financial instruments)
• Consolidation adjustments (e.g., unrealised intra-group profit)

Worked Example 1.3

A machine is revalued upward by $10,000. The tax base remains unchanged. The tax rate is 30%.

Question:
Explain the deferred tax implications for the revaluation.

Answer:
Temporary difference: $10,000 (carrying amount exceeds tax base)
Deferred tax liability: $10,000 × 30% = $3,000
This deferred tax is recognised in OCI, as the revaluation gain was taken to OCI.

Exam Warning

Deferred tax must be recognised on all taxable temporary differences, even if there is no intention to sell an asset. The most common mistake is ignoring deferred tax on revaluations or failing to match the recognition of deferred tax with the treatment (profit or loss, OCI, equity) of the originating item.

Recognition and Presentation of Deferred Tax

Deferred tax assets and liabilities are presented as non-current in the statement of financial position, and may be offset only if they relate to taxes levied by the same tax authority.

Disclosure: Entities must disclose major components of tax expense, an explanation of the relationship between tax expense and accounting profit, and unrecognised deferred tax assets.

Specific Situations

Unused Tax Losses and Credits

A deferred tax asset is recognised for unused tax losses and credits only if it is probable that future taxable profits will allow their use.

Business Combinations

On acquisition, deferred tax is recognised for differences between the carrying amount (fair value) of acquired assets and liabilities and their tax bases. Goodwill is not adjusted for deferred tax recognised on acquisition.

Share-Based Payments

Tax deductions on share-based payments may differ from the amount charged to profit or loss, requiring calculation of a deferred tax asset based on the expected future tax deduction (often the inherent value of the option), allocated between profit or loss and equity as appropriate.

Summary

IAS 12 requires a full provision approach to recognising deferred tax on all temporary differences, with specific recognition and measurement criteria. Accuracy in identifying temporary differences and applying the correct recognition exceptions is essential for exam success.

Key Point Checklist

This article has covered the following key knowledge points:

• Define current tax, deferred tax, temporary differences, tax base, and related terms
• Identify and calculate temporary differences for assets and liabilities
• Distinguish taxable and deductible temporary differences
• Recognise and measure deferred tax assets and liabilities under IAS 12
• Apply initial recognition exemptions and other exceptions correctly
• Recognise deferred tax arising from revaluations and other comprehensive income
• Account for deferred tax in situations such as business combinations and share-based payments

Key Terms and Concepts

• Temporary Difference
• Tax Base
• Deferred Tax
• Deferred Tax Liability
• Deferred Tax Asset
• Taxable Temporary Difference
• Deductible Temporary Difference