ACCG224 – Semester 1 , 2013 Week 3

1. ACCG224 – Semester 1, 2013 Week 3 Accounting for Income Taxes

2. Learning objectives • Identify differences between pre-tax accounting profit and taxable profit. • Describe a temporary difference that results in future taxable amounts. • Describe a temporary difference that results in future deductible amounts. • Explain the purpose of a reporting date review of deferred tax assets. • Describe the presentation of income tax expense in the income statement. • Describe various temporary and permanent differences. • Explain the effect of various tax rates and tax rate changes on deferred income taxes.

3. Fundamentals of accounting for income taxes • Pre-tax accounting profit is • determined according to accounting standards and principles; • measured with objective of providing useful information to investors and creditors; • determined under accrual basis accounting. AASBs and the Corporations Act are key sources that determine the appropriate accounting treatment of transactions

4. Fundamentals of accounting for income taxes (cont’d) • Taxable profit is determined • according to Australian tax legislation; • principally, under cash basis accounting. The Income Tax Assessment Act determines the tax treatment of transactions

5. Accounting income vs tax treatments Recognisedas revenue, with corresponding asset (receivable) when earned Recognisedas Tax Income (TI) when cash received Rent, interest, royalties etc. Recognisedas Tax Deductible (TD) based on predetermined rates Recognisedas expense based on useful life of asset Common for assets to be depreciated over a shorter life for tax purposes than for accounting purposes Capitalised and amortised Recognisedas TD when paid Recognised as an asset and expensed as incurred Recognized as TD when paid

6. Accounting income vs tax treatments (cont’d) Recognisedas liability when received, as revenue when earned Recognised as TI when cash received Recognisedas expense based on useful life of asset Recognised as TD based on predetermined rates Possible for accounting useful life to be shorter than tax useful life Allowance and expense recognised when debt doubtful Recognised as a TD when debt physically written off Liability and expense recognised when debt owing to employee Recognisedas TD when paid Provisions (e.g. for warranties) are treated in the same way as employee benefits

7. Worked Example – Calculating taxable profit and accounting profit • You are provided with the following information from the accounts of Big Kahuna Ltd for the year ending 30 June 2012. You are to calculate accounting profit and taxable profit. • Cash sales $100 000 • Cost of goods sold $40 000 • Amounts received in advance for services to be performed in August 2012 $5 000 • Rent expense for year ended 30 June 2012 $10 000 • Rent prepaid for two months to 31 August 2012 $1 000 • Doubtful debts expenses $1 000 • Amount provided in 2012 for employees’ long-service leave entitlements $3 000

8. Worked Example – Calculating taxable profit and accounting profit (cont’d) Accounting Taxable profit profit • Cash sales $100 000 $100 000 • Cost of goods sold ($40 000) (40 000) • Amounts received in advance by Big Kahuna Ltd for services to be performed in August 2012 – $5 000 • Rent expense for year ended 30 June 2012 ($10 000) ($10 000) • Rent prepaid for two months to 31 August 2012 _ ($1 000) • Doubtful debts costs ($1 000) – • Amount earned in 2012 for employees’ long-service leave entitlements ($3 000) – • Total$46 000 $54 000

9. Two types of differences • The differences between accounting and taxable profit we discussed so far are all of a temporary nature: • temporary differences reverse over time, i.e. they will increase or decrease taxable income in the future; • therefore, they give rise to deferred taxes; • taxable amounts increase taxable income in future years: • a deferred tax liability is recognised; • deductible amounts decrease taxable income in future years: • a deferred tax asset is recognised.

10. Two types of differences (cont’d) • Some other differences are permanent: • e.g. entertainment expense must be recognised for accounting purposes, however, is not deductible for tax purposes; • they will not reverse over time; • therefore, they do not give rise to deferred taxes; • more examples and treatment of permanent differences later.

11. Balance sheet approach to accounting for taxation • Accounting for income taxes: • governed by AASB 112; • applies the ‘balance sheet’ method: • this means the recognition of deferred tax assets and liabilities is based on the differences between accounting and tax values of assets and liabilities; • focuses on comparing the carrying value of an entity’s assets and liabilities (determined by accounting rules) with the tax base for those assets and liabilities: • effectively involves comparing the balance sheet derived using accounting rules with the balance sheet that would be derived from taxation rules.

12. Balance sheet approach to accounting for taxation (cont’d) • Carrying amount vs tax base of asset or liability • Carrying amount is the amount the asset or liability is recorded at in the accounting records; • Tax base is defined as the amount that is attributed to an asset or liability for tax purposes (AASB 112): • tax base represents the amount an asset or liability would be recorded at if the balance sheet (statement of financial position) were prepared applying taxation rules; • Where the carrying amount of an asset or liability is different from the tax base a ‘temporary difference’ can arise.

13. Calculating the tax base Calculating the tax base for an asset CA– future taxable amounts + future deductible amounts = TB Calculating the tax base for a liability CA+ future taxable amounts - future deductible amounts= TB

14. Calculating the tax base (cont’d) 3,000 - 3,000 + - = - 1,000 - 1,000 + - = - 5,400 - 5,400 + 3,500 = 3,500 50,000 - - + 2,000 = 52,000 30,000 + - - - = 30,000 3,900 + - - 3,900 = -

15. Balance sheet approach to accounting for taxation (cont’d) • Taxable temporary difference → deferred tax liability: • the carrying amount of the asset exceeds the tax base; • taxation payments have effectively been deferred to future periods; • tax is reduced or ‘saved’ in early years, but additional tax will need to be paid later.

16. Balance sheet approach to accounting for taxation (cont’d) • Example of a deferred tax liability: • Carrying amount of a non-current depreciable asset exceeds the tax base in early years, as depreciation allowable as a deduction for tax purposes is greater than depreciation for accounting purposes; • this will be reversed in later years when no depreciation is allowable for tax purposes.

17. Balance sheet approach to accounting for taxation (cont’d) • Deductible temporary difference → deferred tax asset • The carrying amount of an asset is less than the tax base; • taxation payments have been made ‘in advance’; • tax is reduced or ‘saved’ in later years.

18. Balance sheet approach to accounting for taxation (cont’d) • Example of a deferred tax asset: • Tax base of a depreciable asset exceeds the carrying amount in early years, as depreciation allowable as a deduction for tax purposes is less than depreciation for accounting purposes; • this will be reversed in later years when the asset is fully depreciated for accounting purposes, but depreciation is still allowable as a deduction for tax purposes.

19. Balance sheet approach to accounting for taxation (cont.) • Calculation of income tax payable: • Income tax payable is based on taxable income, not accounting profit; • necessary to make adjustments to accounting profit to determine tax profit, e.g.: • add back accounting depreciation; • deduct depreciation for taxation purposes; • calculation of income tax payable: • tax rate multiplied by tax profit.

20. Worked Example – Temporary differences caused by the depreciation of a non-current asset • Robert August Ltd commences operations on 1 July 2009. • On the same date, it purchases a fibreglassingmachine at a cost of $600 000. • The machine is expected to have a useful life of four years, with benefits being uniform throughout its life. It will have no residual value at the end of four years. • Hence, for accounting purposes the depreciation expense would be $150 000 per year (600 000/4 years). • For taxation purposes, the ATO allows the company to depreciate the asset over three years – that is $200 000 per year. • The profit before tax of the company for each of the next four years (for years ending 30 June) is $500 000, $600 000, $700 000 and $800 000 respectively. • The tax rate is 30%.

21. Worked Example – Solution • Year 1 (ending 30 June 2010) Carrying Temporary value Tax base difference($) ($) ($) Fibre glassing machine: cost 600 000 600 000 Accumulated depreciation 150 000 200 000 450 000400 00050 000

22. Worked Example – Solution (cont’d) The tax on the taxable income would be determined as follows: Accounting profit before tax $500 000 Add back accounting depreciation $150 000 Subtract depreciation for taxation purposes ($200 000) Taxable profit $450 000 Tax at 30% $135 000 The journal entries at 30 June 2010 would be: Dr Income tax expense 15 000 (50 000 x 30%)Cr Deferred tax liability 15 000 Dr Income tax expense 135 000Cr Income tax payable 135 000

23. Worked Example – Solution (cont’d) • Year 2 (ending 30 June 2011) Carrying Temporary value Tax base difference($) ($) ($) Fibre glassing machine: cost 600 000 600 000 Accumulated depreciation 300 000 400 000 300 000200 000100 000 • The temporary difference at 30 June 2011 totals $100 000. Applying the tax rate of 30% provides a deferred tax liability of $30 000. • Because $15 000 has already been recognised in 2010, an increase (or ‘top up’) of $15 000 is required.

24. Worked Example – Solution (cont’d) The tax on the taxable income would be determined as follows: Accounting profit before tax $600 000 Add back accounting depreciation $150 000 Subtract depreciation for taxation purposes ($200 000) Taxable profit $550 000 Tax at 30% $165 000 The journal entries at 30 June 2011 would be: Dr Income tax expense 15 000Cr Deferred tax liability 15 000 Dr Income tax expense 165 000Cr Income tax payable 165 000

25. Worked Example – Solution (cont’d) • Year 3 (ending 30 June 2012) Carrying Temporary value Tax base difference($) ($) ($) Fibre glassing machine: cost 600 000 600 000 Accumulated depreciation 450 000 600 000 150 0000150 000 • The temporary difference at 30 June 2012 totals $150 000. Applying the tax rate of 30% provides a deferred tax liability of $45 000. • Because $30 000 has already been recognised in 2010 and 2011, an increase (or ‘top up’) of $15 000 is required.

26. Worked Example – Solution (cont’d) The tax on the taxable income would be determined as follows: Accounting profit before tax $700 000 Add back accounting depreciation $150 000 Subtract depreciation for taxation purposes ($200 000) Taxable profit $650 000 Tax at 30% $195 000 The journal entries at 30 June 2012 would be: Dr Income tax expense 15 000Cr Deferred tax liability 15 000 Dr Income tax expense 195 000Cr Income tax payable 195 000

27. Worked Example – Solution (cont’d) • Year 4 (ending 30 June 2013) Carrying Temporary value Tax base difference($) ($) ($) Fibre glassing machine: cost 600 000 600 000 Accumulated depreciation 600 000 600 000 000 • The temporary difference at 30 June 2013 is $nil, which means that there should be no deferred tax liability or deferred tax asset recorded in relation to this asset. • This means the balance accrued in the deferred tax liability must be reversed in 2013.

28. Worked Example – Solution (cont’d) The tax on the taxable income would be determined as follows: Accounting profit before tax $800 000 Add back accounting depreciation $150 000 Subtract depreciation for taxation purposes 0 Taxable profit $950 000 Tax at 30% $285 000 The journal entries at 30 June 2013 would be: Dr Deferred tax liability 45 000Cr Income tax expense 45 000 Dr Income tax expense 285 000Cr Income tax payable 285 000

29. Worked Example – Solution (cont’d) • A review of the Worked Example indicates that the balance sheet approach to accounting for income tax ‘smoothes’ the tax expenses across the four years, as indicated below: Year 1 Year 2 Year 3 Year 4 Total($) ($) ($) ($) ($) Tax expense based on taxable profit 135 000 165 000 195 000 285 000 780 000 Adjustment for ‘temporary’ difference 15 000 15 000 15 000 (45 000) – Total tax expense 150 000 180 000 210 000 240 000 780 000

30. Worked Example – Current tax liability Additional information: • $60 allowed as a tax deduction for plant. • Interest has not yet been received. • Bad debts of $20 were written off during the year. • Payments of $30 were made to employees in relation to annual leave taken during the year. • The tax rate is 30% Required: • Calculate the current tax liability of ABC Ltd for 2012.

31. Worked Example – Solution Accounting profit before tax 300 Government grant (80) exempt income Goodwill impairment 20 not deductible Interest not yet received(40) Adjustment for plant depreciation (10) Adjustment for bad debt write-offs 10 Adjustment for annual leave paid (20) Taxable profit 180 Current tax liability (CTL) (30%) 54 Acctgdepn 50 Tax depn (60) Adjreq(10) B/debts expense-acctg 30 B/debts w/off- tax (20) Adjreq10 A/L expense- acctg 10 Paid- tax (30) Adjreq(20)

32. Total incometax expenseor benefit Incometaxpayable Change indeferred income tax + – = Income statement presentation • An increase in a deferred tax liability is added to tax payable • An increase in a deferred tax asset is subtracted from tax payable • Formula to calculate income tax expense (benefit):

33. Income statement presentation • Income statement presentation of income tax expense: CHELSEA LTDStatement of Comprehensive Income for the year ending 30 June 2008 Revenues $130 000 Expenses 60 000 Profit before income tax 70 000 Income tax expense 21 000 Profit for the period $ 49 000 • see textbook for details.

34. Permanent differences • These are caused by items that: • Enter into pre-tax accounting profit but never into taxable profit, or • enter into taxable profit but never into pre-tax accounting profit.

35. Permanent differences (cont’d) • Since permanent differences affect only period in which they occur, they do not give rise to future taxable or deductible amounts. • Details of permanent differences must be disclosed in a note.

36. Examples of permanent differences Permanent differences (cont’d) • Items recognised for financial reporting purposes but not for tax purposes: • Goodwill impairment expense • Non-taxable (exempt) revenue • Entertainment expense • Items recognised for tax purposes but not for financial reporting purposes • Research and development allowance (currently 125% of eligible expenditure is deductible)

37. Example – Permanent and temporary differences, one rate The accounting records of Anderson Ltd show the following data for the financial year ended 30 June 2012. • Equipment was acquired in early July 2011 for $200 000. Straight-line depreciation over a 5-year life is used, with no residual value. For tax purposes, Anderson used a 30% rate to calculate depreciation. • Exempt revenue totalled $4000. • Product warranties were estimated to be $60 000. Actual repair and labour costs relating to the warranties in the financial year ended 30 June 2012 were $10 000. The remainder is estimated to be incurred evenly in the 2013 and 2014 financial years. • Sales on an accrual basis were $100 000. For tax purposes, $75 000 was recorded using the instalment method. • Entertainment expenses paid were $4200. • Pre-tax accounting profit was $850 000. The tax rate is 30%. Required: (a) Prepare a schedule starting with pre-tax accounting profit and ending with taxable profit. (b) Prepare the journal entry for 30 June 2012 income tax payable and expense.

38. Example – Solution a) Schedule Pre-tax Accounting profit and Taxable Income for 2012Pre-tax accounting profit $850 000 Permanent differences Entertainment expense 4 200 Exempt revenue (4 000) Adjusted accounting profit 850 200 Temporary differences Depreciation expense ($40 000 - $60 000)* (20 000) DTL Instalment sales ($75 000 - $100 000) (25 000) DTL Warranty expense ($60 000 - $10 000) 50 000 DTA Taxable profit $855 200 × 30% = Income Taxes Payable $256 560 * Depreciation acctg ($200 000 / 5) = $40 000Depreciation tax ($200 000 × 30%) = 60 000Difference $20 000

39. Example – Solution (cont’d) b) Journal entry for 30 June 2012 DR Income Tax Expense 255 060 DR Deferred Tax Asset 15 000(50 000 x 30%) CR Deferred Tax Liability 13 500(20 000 + 25 000) x 30% CR Income Taxes Payable 256 560

40. Tax rate considerations • If tax rates are different in future years, the enacted tax rate expected to apply should be used • When different tax rates apply to different levels of taxable income, companies are required to use average tax rates expected to apply in periods in which temporary differences reverse

41. Tax rate considerations (cont’d) • When a change in tax rate is enacted, its effect should be recorded immediately. • The effect is reported as an adjustment to tax expense in the period of change.

42. Financial statement presentation • Statement of Financial Position • Deferred tax accounts reported as assets and liabilities • Offset and presented as net amount only if entity • has legal right of set-off, and • intends to settle asset and liability simultaneously or on a net basis.

43. Financial statement presentation (cont’d) • Steps in process of classifying deferred taxes on balance sheet • Classify amount as current or non-current; • Determine net current amount by adding various tax assets and liabilities classified as current: • if net result is an asset, report as current asset; • if net result is a liability, report as current liability.

44. Financial statement presentation (cont’d) • Determine non-current amount by adding various deferred tax assets and liabilities classified as non-current: • if net result is an asset, report as non-current asset; • if net result is a liability, report as non-current liability.

45. Financial statement presentation (cont’d) • Income tax disclosures (Notes): • Current tax expense or benefit; • Adjustments from prior periods; • Deferred tax expense or benefit relating to temporary differences; • Adjustments of deferred tax expense or benefit relating to changes in rates; • Deferred tax expense from write-down; • Current tax expense relating to changes in accounting policies or errors.

46. Financial statement presentation (cont’d) • Reasons for disclosures relating to income tax include: • Assessing quality of earnings; • Making better predictions of future cash flows; • Predicting future cash flows from tax loss carry-forwards.

47. In your study and tute preparation ask yourselves – Can I • Identify differences between pre-tax accounting profit and taxable profit? • Describe a temporary difference that results in future taxable amounts? • Describe a temporary difference that results in future deductible amounts? • Explain the purpose of a reporting date review of deferred tax assets? • Describe the presentation of income tax expense in the income statement? • Describe various temporary and permanent differences? • Explain the effect of various tax rates and tax rate changes on deferred income taxes?