6.3 IAS 12 Income Taxes — Current and Deferred Tax

6.3 IAS 12 Income Taxes — Current and Deferred Tax

Core Principle: Corporate income tax represents one of the largest cash outflows for commercial enterprises. In financial reporting, accounting for income taxes is governed by IAS 12 Income Taxes, which addresses two interconnected pillars:

1. Current Tax: The statutory tax payable to (or refundable by) the tax authorities on taxable profits for the current operating period.
2. Deferred Tax: The future tax consequences of past transactions, accounting for timing differences between financial reporting standards (IFRS) and statutory tax legislation.

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1. The Objectives and Dual Components of IAS 12

Why Income Tax Accounting is Complex

Accounting profit (computed under IFRS) rarely equals taxable profit (computed under statutory tax legislation):

Accounting Profit (IFRS) != Taxable Profit (Tax Authority)

Tax rules frequently permit accelerated depreciation (capital allowances) to incentivize capital investment, disallow certain expenses (entertaining, fines), or tax income only when received in cash. If an entity simply recorded tax based on its statutory tax return, the tax charge in profit or loss would fluctuate erratically relative to accounting profit, violating the fundamental accruals concept.

                                  Total Income Tax Expense (P&L)
                                                │
               ┌────────────────────────────────┴────────────────────────────────┐
               ▼                                                                 ▼
          CURRENT TAX                                                       DEFERRED TAX
  • Estimated tax payable for the year                              • Movement in SFP temporary
  • Plus/Minus prior year under/over                                  differences
    provisions                                                      • Matching future tax
  • Settled with tax authorities                                      consequences to current
                                                                      reporting periods

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2. Current Tax Accounting & Prior Year Adjustments

Current Year Tax Estimate

At each financial year-end, the entity estimates its taxable profit and applies the enacted corporate tax rate:

• Current Tax Liability = Estimated Taxable Profit x Enacted Tax Rate
• Journal Entry:

  Debit:  Income Tax Expense (Profit or Loss)       $X
  Credit: Current Tax Liability (Current Liability)   $X
  

Accounting for Prior Year Under/Over Provisions

Because the current tax recognized at year-end is an accounting estimate, the final tax assessment agreed with the tax authority in the subsequent year will often differ from the accrued amount. Under IAS 8 Basis of Preparation of Financial Statements, this difference is treated as a change in estimate and adjusted in the current year's profit or loss:

                               Prior Year Tax Adjustments
                                           │
                   ┌───────────────────────┴───────────────────────┐
                   ▼                                               ▼
            UNDER-PROVISION                                 OVER-PROVISION
  (Actual Tax Paid > Accrued Provision)           (Actual Tax Paid < Accrued Provision)
  • Entity under-estimated prior tax              • Entity over-estimated prior tax
  • Current year P&L suffers an EXTRA charge      • Current year P&L receives a CREDIT
  • DEBIT: Tax Expense (P&L)                      • CREDIT: Tax Expense (P&L)

Total Current Tax Formula for P&L

Total Current Tax Expense = Current Year Estimate + Prior Year Under-Provision - Prior Year Over-Provision

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3. The Rationale for Deferred Tax: Matching & Accruals

Permanent Differences vs. Temporary Differences

To understand deferred tax, one must distinguish between two fundamental types of differences:

1. Permanent Differences:
   • Items that enter into the determination of accounting profit but never into taxable profit (e.g., non-deductible entertaining expenses, statutory fines), or items exempt from tax (tax-free dividends).
   • These differences do not reverse in future periods.
   • Treatment: Permanent differences affect the current tax calculation, but never give rise to deferred tax!
2. Temporary Differences:
   • Differences between the carrying amount of an asset or liability in the statement of financial position and its tax base.
   • These differences arise in one period and reverse in one or more subsequent periods.
   • Treatment: Temporary differences are the exclusive foundation of deferred tax.

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4. The Balance Sheet Liability Method: Carrying Amount vs. Tax Base

IAS 12 adopts the balance sheet liability method, comparing balance sheet carrying amounts to their statutory tax bases.

Definition of Tax Base (IAS 12.5)

• Tax Base of an Asset: The amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset. (If those economic benefits will not be taxable, the tax base equals the carrying amount).
• Tax Base of a Liability: The carrying amount of the liability, less any amount that will be deductible for tax purposes in respect of that liability in future periods.

Tax Base Calculation for Standard Balance Sheet Items

The Two Types of Temporary Differences

                                Temporary Difference Rules
  ┌──────────────────────────────────────────────────────────┬─────────────────────────────┐
  │ Situation                                                │ Classification & Impact     │
  ├──────────────────────────────────────────────────────────┼─────────────────────────────┤
  │ ASSET Carrying Amount  >  Asset Tax Base                 │ Taxable Temporary Diff      │
  │ (e.g., accelerated capital allowances, revaluation gain) │ -> DEFERRED TAX LIABILITY   │
  ├──────────────────────────────────────────────────────────┼─────────────────────────────┤
  │ ASSET Carrying Amount  <  Asset Tax Base                 │ Deductible Temporary Diff   │
  │ (e.g., impairment losses not yet tax-deductible)         │ -> DEFERRED TAX ASSET       │
  ├──────────────────────────────────────────────────────────┼─────────────────────────────┤
  │ LIABILITY Carrying Amount  >  Liability Tax Base         │ Deductible Temporary Diff   │
  │ (e.g., accrued expenses/provisions deductible on cash)   │ -> DEFERRED TAX ASSET       │
  ├──────────────────────────────────────────────────────────┼─────────────────────────────┤
  │ LIABILITY Carrying Amount  <  Liability Tax Base         │ Taxable Temporary Diff      │
  │ (e.g., untaxed future liabilities)                       │ -> DEFERRED TAX LIABILITY   │
  └──────────────────────────────────────────────────────────┴─────────────────────────────┘

Deferred Tax Liabilities (DTL) vs. Deferred Tax Assets (DTA)

• Deferred Tax Liability (DTL): Represents income taxes payable in future periods in respect of taxable temporary differences. Under IAS 12, a DTL must be recognized in full.
• Deferred Tax Asset (DTA): Represents income taxes recoverable in future periods in respect of deductible temporary differences and unused tax losses carried forward. Under IAS 12.24, a DTA is recognized only to the extent that it is probable that future taxable profits will be available against which the deductible temporary difference can be utilized.

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5. Common Sources of Temporary Differences in ACCA FR

1. Accelerated Tax Depreciation (Capital Allowances)

Governments frequently permit businesses to claim tax deductions (capital allowances) faster than accounting depreciation:

• Year 1: Capital allowances exceed accounting depreciation -> Carrying amount of asset > Tax base -> Deferred Tax Liability.
• Later Years: Accounting depreciation exceeds capital allowances -> The temporary difference reverses, and the deferred tax liability is drawn down.

2. Revaluation of Non-Current Assets (IAS 16)

When an entity revalues land or buildings upward to fair value under IAS 16, the asset's carrying amount increases immediately. However, tax authorities do not adjust the tax base for accounting revaluations:

• Result: Carrying amount > Tax base -> Taxable Temporary Difference -> Deferred Tax Liability.
• Critical Accounting Rule: Because the revaluation gain is recognized in Other Comprehensive Income (OCI), the associated deferred tax must also be recognized in OCI and debited against the Revaluation Surplus in Equity!

3. Provisions and Accrued Expenses

Under IFRS, expenses are accrued when incurred (e.g., warranty provisions, restructuring costs). In many tax jurisdictions, expenses are deductible only when paid in cash:

• Result: Carrying amount of liability > Tax base ($0) -> Deductible Temporary Difference -> Deferred Tax Asset.

4. Unused Tax Losses Carried Forward

Tax legislation often permits trading losses to be carried forward to offset future taxable income. IAS 12 permits a Deferred Tax Asset to be recognized for unused tax losses to the extent that it is probable future taxable profits will be generated.

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6. Calculating the Movement in Deferred Tax: P&L vs. OCI

Measurement Rate and Prohibition of Discounting

Deferred tax assets and liabilities are measured at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting period.

• Absolute Ban on Discounting (IAS 12.53): Deferred tax assets and liabilities shall not be discounted, regardless of how far in the future they are expected to reverse!

The Standard Working for Deferred Tax

  Step 1: Compute Closing SFP Temporary Differences x Enacted Tax Rate
          = Closing Deferred Tax Liability / Asset Required on SFP

  Step 2: Compare Closing Balance to Opening Balance
          = TOTAL MOVEMENT FOR THE YEAR

  Step 3: Allocate Movement:
          • Movement relating to OCI items (e.g., Revaluation Surplus) -> CHARGE TO OCI
          • Balancing Movement -> CHARGE / CREDIT TO PROFIT OR LOSS

                                Movement Allocation Equation
  ┌─────────────────────────────────────────────────────────────────────────────────┐
  │ Total Movement in SFP Deferred Tax                                             │
  │   = (Deferred Tax Charged/Credited to P&L) + (Deferred Tax Charged to OCI)      │
  ├─────────────────────────────────────────────────────────────────────────────────┤
  │ Therefore:                                                                      │
  │ Deferred Tax Expense in P&L = Total SFP Movement - Deferred Tax Charged to OCI   │
  └─────────────────────────────────────────────────────────────────────────────────┘

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7. Comprehensive Worked Example: Comprehensive Current & Deferred Tax

Scenario Details

Vanguard Industries presents the following tax-related information for the year ended 31 December 20X4:

1. Current Tax Data:
   • Estimated current tax liability on 20X4 taxable profit: $340,000.
   • Review of prior year (20X3): The 20X3 tax liability was estimated at $290,000 in the 20X3 financial statements. In July 20X4, the tax authority agreed and settled the final 20X3 tax liability at $315,000.
2. Non-Current Assets & Revaluation:
   • On 31 December 20X4, Vanguard revalued its administrative headquarters from its carrying amount of $2,000,000 to a fair value of $2,500,000, recording a revaluation surplus of $500,000 in OCI.
   • Total carrying amount of all Property, Plant and Equipment at 31 December 20X4 (including the revaluation) is $4,800,000.
   • The tax written down value (tax base) of PPE at 31 December 20X4 is $3,200,000.
3. Provisions:
   • Vanguard carries a product warranty provision of $200,000 at 31 December 20X4. Warranty expenses are deductible for tax only when claims are settled in cash.
4. Deferred Tax Balance:
   • The opening deferred tax liability at 1 January 20X4 was $250,000.
   • The substantively enacted corporate tax rate is 25% for all relevant years.

Step 1: Calculate Current Tax Expense in Profit or Loss

• Current year tax estimate: $340,000
• Prior year adjustment: Actual settled ($315,000) less accrued ($290,000) = $25,000 Under-Provision (additional charge).

Total Current Tax Expense (P&L) = $340,000 + $25,000 = $365,000

Step 2: Calculate Closing Deferred Tax Balance at 31 December 20X4

Closing Deferred Tax Liability Required (SFP) = $1,400,000 x 25% = $350,000

Step 3: Calculate Total Movement in Deferred Tax

Total Movement = Closing DTL $350,000 - Opening DTL $250,000 = $100,000 (Increase in Liability)

Step 4: Allocate Movement between OCI and P&L

• Deferred Tax on Revaluation Surplus (OCI):
  • Revaluation Uplift Deferred Tax = $500,000 x 25% = $125,000 This $125,000 is charged directly to Other Comprehensive Income and debited against the Revaluation Surplus in equity:

  Debit:  Other Comprehensive Income (Revaluation Surplus)  $125,000
  Credit: Deferred Tax Liability (SFP)                        $125,000
  

• Deferred Tax Charge / (Credit) to Profit or Loss:
  • P&L Movement = Total Movement (+$100,000) - OCI Charge (+$125,000) = -$25,000 (Credit to P&L!)

  Debit:  Deferred Tax Liability (SFP)                     $25,000
  Credit: Income Tax Expense (Profit or Loss)                 $25,000
  

Step 5: Financial Statement Extracts for 20X4

Statement of Profit or Loss Extract:

Income Tax Expense:
  Current tax expense ($340k estimate + $25k under-provision):     ($365,000)
  Deferred tax credit:                                                $25,000
                                                                  ────────────
Total Tax Expense in Profit or Loss:                               ($340,000)

Statement of Other Comprehensive Income Extract:

Other Comprehensive Income:
  Gains on property revaluation:                                     $500,000
  Income tax relating to components of OCI (Deferred Tax):          ($125,000)
                                                                  ────────────
Other Comprehensive Income for the year, net of tax:                 $375,000

Statement of Financial Position Extract as at 31 December 20X4:

Non-Current Liabilities:
  Deferred Tax Liability:                                            $350,000
Current Liabilities:
  Current Tax Liability:                                             $340,000
Equity:
  Revaluation Surplus ($500,000 gross - $125,000 deferred tax):      $375,000

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8. Exam Traps & ACCA Examiner Tips

[!WARNING] ACCA Examiner Trap 1: Forgetting Deferred Tax on Asset Revaluations When an asset is revalued in Section C financial statement preparation questions, candidates frequently record the full revaluation gain in equity but forget to deduct deferred tax! Under IAS 12 and IAS 16, the revaluation surplus recognized in equity must be net of deferred tax.

[!WARNING] ACCA Examiner Trap 2: Under-Provision vs. Over-Provision Signs

• Under-provision: Previous year was under-accrued -> Add to current year tax expense.
• Over-provision: Previous year was over-accrued -> Deduct from current year tax expense.

[!TIP] ACCA Examiner Tip: Discounting Deferred Tax is Prohibited Even if management argues that a deferred tax liability will not reverse for 20 years, IAS 12.53 strictly prohibits discounting. Full undiscounted amounts must always be presented.