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Deferred Taxation - Part 1

In line with our tradition of not just catching fishes for our subscribers but also teaching
them how to fish, i Capital Education is conducting a seminar on 17 Jan 2005 titled
�Understanding Financial Statements, Invest Wisely.� The aim of the seminar is to
explain the importance of financial statements and the benefits in understanding them.
Understanding financial statements can be done at various levels. To take this subject to a
deeper level, starting this week, i Capital is featuring a special series on deferred taxation,
a topic that has bugged many listed companies.

[1]. Is Tax a Distribution of Earnings or a Business Expense?

Is tax considered a distribution of earnings to government, or is it a form of expense paid
by a company? Though this may seem simple, this is one question that has sparked many
arguments in the accounting profession. It is also the question that gave birth to the
subject of deferred taxation. Those who say tax is a form of distribution to government,
just like distribution of dividend to shareholders, argue that [a]. Tax cannot be an expense
because there is no exchange of goods involved, and [b]. Paying tax is not a matter of
choice. At the other end, those who say that tax is in fact an expense are of the opinion
that [a]. As a government does not contribute funds to companies, it cannot be a
distribution of income, and [b]. Since a government provides services to a company in the
form of providing business platform, tax is an expense paid to the government.

If tax is a form of distribution, then the tax a company needs to pay will only be the tax
expense for that financial year. On the other hand, if one were to hold the view that tax is
an expense, then tax expenses should be �matched� to its respective financial year, just
like other expenses.

[2]. Accounting Profit versus Taxable Profit, Tax Paid versus Tax Expense
Before proceeding further, it is essential to differentiate between accounting profit (or
profit before tax) and taxable profit. Accounting profit is the profit for a period before
deducting tax expense as reported in the Profit & Loss (P&L) statement whereas taxable
profit is the amount that will be taxed for income tax purposes. In certain instances, both
accounting profit and taxable profits can be the same, although the chances of this
happening are minute. Why are there two profits? The reason behind this is because in
Malaysia, the calculation of profit for accounting purposes is based on the Malaysian
Accounting Standard Board�s (MASB) rules whereas for tax purposes, it is based on the
Inland Revenue Board�s (IRB) rules. Both have different income and expense
recognition criteria. For instance, accounting rules recognised income on an accrual basis
but tax rules recognise income on a receipt basis. Profit calculated based on the
accounting method is called �accounting profit� whereas profit calculated based on tax
rules is called �taxable profit�.

Another difference that needs to be clarified is the difference between �tax paid� and
�tax expense�. Tax paid is the actual amount of tax that is paid by a company based on
the �taxable profit� as calculated according to tax rules. However, tax expense is the
total tax attributable to an accounting period, which consists of the tax paid and deferred
taxes.

[3]. What is Deferred Tax?

As the trend is towards regarding tax as an expense, deferred taxation was created to
�allocate� tax expenses to the respective financial period. In layman�s term, the
purpose of deferred tax is to make sure that the tax expenses presented in the financial
statements represent the amount attributable to the accounting profit for that particular
financial year, regardless of the actual amount of tax paid. Other than that, deferred tax
also serves as an estimation of future tax that a company needs to pay based on the
current financial standing. The question asked here may be, how can a tax be
�deferred� or how can a tax expense for a financial year be different from the tax paid?
As stated earlier, because there are differences between the way activities are included in
accounting profit and taxable profit, it is possible for a company to incur a tax liability in
one financial period and pay the tax liability in a much later period, or vice versa.
Example {A} below will highlight this.

Example {A} :
Company ABC (ABC) receives its only income, which is interest income, of RM2,000
for financial year 2004. However, another interest income of RM3,000 for 2004 will only
be received in 2005. For financial year 2005, ABC receives 2004�s accrued interest and
another RM4,000 interest for that year. Since accounting policy allocates income to the
years the income is attributed to, assuming ABC has no other transactions for both years,
ABC will record RM5, 000 (RM2,000 + RM3,000) as interest income in fiscal year 2004.
Interest income in ABC�s P&L for financial year 2005 would be RM4,000.

However, when tax rules recognise interest income on a cash basis, the taxable profit for
2004 would be RM2,000 and RM7,000 for 2005. Assuming tax rate maintains at 28% for
2004 and 2005, ABC�s tax paid for the financial year 2004 and 2005 would be RM560
and RM1,960, respectively. The summarized Profit and Loss statement for ABC would
be as follows:

Table 1 : Summary of ABC�s P&L for 2004 (without deferred tax)

As can be seen, the tax expense shown does not reflect the actual amount of tax attributed
for each year. ABC paid less tax relative to its reported profits in 2004 (11.2%) and
conversely, paid higher tax compared to its reported profits in 2005 (49%). Therefore,
there are 2 direct implications here: [i]. The tax paid in 2004 is less than the actual
amount that is attributed to 2004�s income, and [ii]. The estimated tax that is to be paid
in 2005 (the RM3, 000 to be received) should be provided in 2004 as a future liability.
Therefore, deferred tax accounting serves to answer these two issues.

Since the taxable profit for 2004 is lower than accounting profit by RM3,000, the tax paid
for 2004 (RM560) is less than the tax attributable to 2004, which should be RM1,400
(28% X RM5, 000). Based on the matching principle, the current financial year's tax
expense must be matched against the current year's financial results. Therefore, an
�additional� tax expense of RM840 (RM1,400 � RM560) must be provided for in
fiscal year 2004 to �increase� the tax expense to RM1,400. Since this RM840
�additional� tax expense will only be paid in future periods when the interest income is
received, it is credited into the Balance Sheet, representing a future tax liability. The
journal entry is as follows:
Dr: Tax expense (2004) RM840
Cr: Liability (Balance Sheet) RM840
In 2005, the taxable profit is higher than accounting profit by RM3,000, which is the
interest income not recognized by the tax rules in 2004 but when it is actually received in
2005. This translates into tax paid in 2005 being higher than the tax attributable to 2005's
results by RM840 (RM3,000 X 28%). To match 2005's tax expense with its results, the
tax expense in the P&L is �reduced� by the RM840 tax liability that is already
provided in financial year 2004.
Dr: Liability (Balance Sheet) RM840
Cr: Tax expense (2005) RM840
In short, the "additional" tax expense that is created in 2004 is known as "deferred tax".
Table 2 below shows the calculation of deferred tax whereas table 3 shows the Deferred
Tax Liability account as will appear in the Balance Sheet.

Table 2 : Deferred tax calculation

Table 3 : Deferred tax liability account as in Balance Sheet

The summarized Profit and loss statement for ABC after taking deferred tax into
consideration is shown in table 4.
 Table 4 : Summary of ABC's P&L (with deferred tax)
Example {A} above provides a basic understanding of the basis for deferred tax. From
here, we can make 2 conclusions about deferred tax. [1]. Deferred tax is included in
financial statements so that the total tax expense is reflective of the amount of accounting
profit recorded for that financial period. [2]. When the amount of tax paid is less than the
total tax expenses for the period, a deferred tax liability will be recognised in the Balance
Sheet to prepare for future tax obligations. Similarly, when the amount of tax paid is
greater than the total tax expense for the period, a deferred tax asset will be recognised in
the Balance Sheet. However, in practice, deferred tax involves a number of technical
issues, which is sometimes not so straightforward.

Part 1 looked at [1]. Is Tax a Distribution of Earnings or a Business Expense? [2]. Accounting
Profit versus Taxable Profit, Tax Paid versus Tax Expense and [3]. What is Deferred Tax?

[4]. Deferred Tax Under International Accounting Standards (IAS) 12

Before the Malaysian Accounting Standards Board (MASB) was created, the International
Accounting Standards was used as a guiding rule in the local accounting industry. The
International Accounting Standards is a dominant standard considering it inspired the financial
reporting framework in most parts of the world. The International Accounting Standard that
touches on income taxes is IAS 12. The original IAS 12 was issued in 1979, named IAS 12 :
Accounting for Taxes on Income. It was later replaced by IAS 12 (reformatted 1994), IAS 12
(revised 1996) and the latest being IAS 12 (revised 2000). IAS 12 (revised 2000) is known as
�Income Taxes�. The original IAS 12 issued in 1979 uses the concept of timing difference in
determining deferred tax.

[5]. IAS 12 (1979): Timing Difference Method

Based on the original IAS 12 issued in 1979, the items that caused accounting profits to defer
from taxable profits can be categorised as those that are permanent (known as permanent
differences) and those that are temporary (known as temporary differences).

[a]. Permanent differences

Permanent differences arise in two instances: [1]. When an income item in the P&L is not tax
chargeable, such as tax-free interest, proceeds from life insurance policies and capital gain, and
[2]. When an expense item in the P&L is not tax deductible, such as unapproved donations, fines
for violations of law and disallowed entertainment expenses.

For an income that is not tax chargeable, it will only be included in computing accounting profit
and will be deducted when calculating taxable profit, thus making accounting profit higher than
taxable profit. On the other hand, non-tax deductible expenses are deducted when calculating
accounting profit but added back when calculating taxable profit, thus making taxable profit
higher than accounting profit. As an example showing the difference in accounting profit and
taxable profit due to permanent differences, assume Company ABC (ABC) has an accounting
profit calculated based on Table 1.

Table 1 : ABC's summarized P&L and taxable profit computation

As seen from the table above, tax-free interest and gain on disposal of investment (capital gain)
are non-taxable items whereas unapproved donations are non-tax deductible items under the tax
rules. Therefore, to derive taxable profit, tax-free interest and gain on disposal of investment
have to be deducted from accounting profit whereas donations to unapproved organisations have
to be added back to accounting profit. Based on the current tax rate of 28%, the amount of tax
that Company ABC is liable for is RM14,000 (RM50,000 X 28%). Table 2 shows the simplified
income statement for ABC.

Table 2 : Summarized P&L for ABC (RM)

Permanent differences only create a difference between accounting profit and taxable profit in
the year these items arose, and do not cause the differences to be carried to the following period/s
because they are either wholly included or excluded when calculating one of the profits.
Therefore, as can be seen from Table 2, although the effective tax rate differs from the actual tax
rate, this difference is only caused by items attributable to that particular period and has no tax
effect on subsequent periods. Thus, it can be concluded that permanent differences do not give
rise to deferred tax.

[b]. Timing differences

As explicitly stated in its name, timing differences are caused by items that are included in
calculating both accounting profit and taxable profit, but differ in the periods that the items are
being recognised. For example, Company ABC (ABC) receives an income of RM1,200. Assume
that the RM1,200 interest has different recognition periods for accounting and tax rules, as
shown in Table 3 below.

Table 3: Calculation of timing differences (RM)

Based on the example above, the whole RM1,200 income is recognised by both accounting profit
and taxable profit. The only difference lies with the period the income is recognized. The
difference between the amounts being recognised based on tax rule and amount being recognized
based on accounting rule is known as timing difference. From the table above, it can also be seen
that there is a trend where for the first two periods, the timing difference are caused by tax profit
recognition being more than accounting profit recognition and the timing difference for the
subsequent periods (period 3 to 5) are the result of accounting profit recognition being more than
tax profit recognition. Such a reversal of trend is one of the characteristic of timing differences:
whatever timing differences that initially arise (known as timing difference originating) will be
reversed out in the subsequent period/s by timing differences that is known as �timing
difference reversing�.

In short, since timing difference causes accounting profit and taxable profit to differ for more
than a period before finally reversing out, it creates the need to allocate the tax expense to the
respective periods. Thus, the deferred taxation that is based on the original IAS 12 (1979) is
actually to take into account the tax effect of these timing differences.
[5]. IAS 12 (1979): Timing Difference Method

[c]. Deferred Tax Based on Timing Difference (IAS 12 1979)

Deferred Tax Asset

In Part 2, it looked at [a]. Permanent differences and [b]. Timing differences. This week, it looks
at deferred tax asset (DTA). DTA occurs when the taxable profit is higher than accounting profit.
A simple example would be, say Company ABC (ABC) recorded a taxable profit of RM500 and
an accounting profit of RM300 in 2004. With the tax rate of 28%, the tax expense for ABC
would be RM140. However, the tax expense attributable to financial year 2004 would be RM84
(RM300 X 28%), creating a deferred tax of RM56 (RM84 � RM140). Therefore, a deferred tax
adjustment will arise to �match� the total tax expense with the current year�s performance.
Table 1 shows modified financial statements for ABC to cater for this example.
 Table 1: ABC's financial statements for 2004
Based on the table above, the deferred tax of RM56 is a reduction to the current tax expense,
making the total tax expense attributable to 2004 to be RM84 (RM140 � RM56). The journal
entry would be:
Dr: Deferred Tax Assets (in Balance Sheet) RM56
Cr: Tax expense (in P&L) RM56
In non-accounting language, the company has paid more tax in 2004 than it actually should by
RM56. Since the excess tax will reverse out in the subsequent period/s (due to the nature of
timing differences), the excess tax is considered as �prepaid�, and thus is categorized under
the �Asset� column in the balance sheet.

There are 2 instances when DTA is created: [i]. When revenues/gains are recognized in
calculating taxable profits before the revenues/gains are recognized in calculating accounting
profits, and [ii]. When expenses are recognized in calculating accounting profits before the
expenses are recognized in calculating taxable profits.

An example for [i] would be assuming company ABC (ABC) received interest of RM300 in
fiscal year 2004, where RM100 is attributable to that fiscal year and RM200 is attributable
equally to fiscal years 2005 and 2006. The accounting profit for 2004, 2005 and 2006 would be
RM100 each. However, the whole RM300 will be included in calculating taxable profits in 2004,
as the whole amount was received in 2004. Assuming no other transactions, the timing
differences would be calculated as follows:

Table 2: Calculation of timing differences

The deferred tax asset account in the balance sheet would be:
 Table 3: Deferred tax asset account
As for [ii], the example would be assuming ABC recognized a warranty expense of RM600 in its
P&L in 2004 due to a sale in that year. However, the actual warranty claim only occurs in 2005.
Therefore, accounting profit will recognize the warranty expense in 2004 but taxable profit will
only recognise the warranty expense when it is actually incurred (i.e. 2005). Assuming no other
transactions:

Table 4: Calculation of timing differences

The deferred tax asset account in the balance sheet would look like:

Table 5: Deferred tax asset account

Deferred Tax Liability

In Part 4, it looked at deferred tax asset which occurs when taxable profit is higher than
accounting profit. Deferred tax liability (DTL), which i Capital will look at this week, occurs
when taxable profit is lower than accounting profit.

A simple example would be, say Company ABC (ABC) recorded a taxable profit of RM300 and
an accounting profit of RM500 in 2004. With the tax rate of 28%, the tax expense for ABC
would be RM84. However, the tax expense attributable to financial year 2004 would be RM140
(RM500 X 28%), creating a deferred tax of RM56 (RM140 � RM84). Therefore, a deferred tax
adjustment will arise to �match� the total tax expense with the current year�s performance.
Table 1 shows the modified financial statements for ABC.
 Table 1: ABC�s Financial Statements for 2004
Based on the table above, the deferred tax of RM56 is an increment to the current tax expense.
The journal entry would be:
Dr: Tax expense (in P&L) RM56
Cr: Deferred Tax Liability (in Balance Sheet) RM56
In non-accounting language, the company has paid less tax in 2004 than it actually should. Since
the tax shortfall will be reversed in the subsequent period/s (due to timing differences), the tax
shortfall is considered as �accrued�, and thus is categorized under the �Liabilities� column
in the Balance Sheet.

There are two instances when DTLs are created: [i]. When revenues/gains are recognized in
calculating accounting profit before the revenues/gains are recognized in calculating taxable
profit, and [ii]. When expenses are recognized in calculating taxable profit before the expenses
are recognized in calculating accounting profit.

An example of instance [i] would be assuming ABC was supposed to receive rental income for
2004 amounting to RM2,000. However, the tenant will be paying the rental owed in 2 equal
installments in 2005 and 2006. Accounting profit will recognize the whole RM2,000 whereas
taxable profit will only recognized the income in 2005 and 2006. Assuming no other
transactions, the deferred tax will be calculated as follows:

Table 2 : Calculation of Timing Differences

The deferred tax liability in the balance sheet is shown in table 3.
 Table 3 : Deferred Tax Liability Account (RM)
A good example of instance [ii] would be timing difference when capital allowances claimed for
tax purposes is more than the depreciation charged in a financial year. In accounting,
depreciation is charged as an expense in the P&L statement. However, depreciation is a non-
allowable expense based on tax rules. However, tax rules allow assets to be claimed for capital
allowances, which are tax-deductible items. Nevertheless, not all assets qualify for capital
allowances. Assets qualified are known as �qualifying assets�. The expenditure for qualifying
assets is known as �qualifying expenditure�. Usually, the amount of depreciation charged is
different from capital allowances given, thus generating timing differences. There are two types
of capital allowances given, namely initial allowances and annual allowances. Initial allowances
are allowances given to qualifying expenditures of the qualifying assets on the year of purchase
whereas annual allowances are given to qualifying assets for each year that the assets are owned
by a company.

To cite an example. ABC purchases its only machinery worth RM6,000 in 2004. ABC uses a
depreciation rate of RM1,000 per annum. Assuming that the machinery qualifies for 20% initial
allowance and 20% annual allowance. The calculation for timing difference in this instance
would be shown in Table 4.

Table 4: Calculation of Timing Differences

Table 5 shows the deferred tax liability account from 2004 to 2009.
 Table 5 : Deferred tax liability account (RM)
he deferred tax accounting method used by the original IAS 12 (1979), or the timing difference
approach, is also known as the Income Statement Liability method. The reason behind this is that
the timing difference method focuses on the timing difference between accounting profits and
taxable profit to derive deferred tax. In short, it focuses on the income statement to calculate
deferred tax. However, with the introduction of IAS 12 (1996), deferred tax accounting has
totally shifted from Income Statement Liability method to Balance Sheet Liability Method,
which caters for the usage of temporary difference in determining deferred tax.
[6]. IAS 12 (1996): Temporary Difference Method
In technical terms, temporary differences are �differences between the tax base of
an asset or liability and its carrying amount in the Balance Sheet�. Definitions
aside, the fact is that timing differences are a subset of temporary differences,
meaning to say all timing differences are in fact temporary differences. However,
temporary differences cover a wider definition to include items that do not give rise
to timing differences, such as asset revaluation with no tax adjustments. The
question now is: since both timing differences and temporary differences are
basically the same, what differentiates the two methods? As presented in the earlier
part, the timing difference method calculates deferred tax by focusing on the
difference between accounting profit and taxable profit. However, the temporary
difference method calculates deferred tax by focusing on the difference between
the carrying amount of assets and liabilities as stated in the balance sheet and their
respective tax base.

Tax Bases in Temporary Differences Method

[a]. Tax Base of Assets

In a layman's term, the tax base of an asset is the amount of an asset that will be
tax deductible in future period/s as at the balance sheet date. If the amount of the
asset had been wholly claimed for tax purposes, its tax base will be nil for no
amount will be tax deductible in future period/s. Such condition arises when [i].
Expenses are claimed for tax purposes when incurred but recognized as an asset in
the balance sheet (e.g. Provision for retirement benefits, development costs, etc),
[ii]. Assets that are accrued on balance sheet but will be taxable only upon actual
receipt (e.g. accrued incomes). On the other hand, if the asset will not be taxed in
the future period/s, the tax base will equal the carrying amount (e.g. sales debtors
where the attributable sales had already been included in calculating taxable
income).

[b]. Tax Base of Liabilities

The tax base of a liability is the amount of the liability shown in the balance sheet
(ie carrying amount) less the amount of the liability that will be tax deductible in
future period/s. If the whole amount of the liability will be tax deductible (eg
accrued expenses that is taxed on cash payment basis, prepaid income that has
already been taxed on receipt basis, etc), the tax base for the liability is nil. If the
settlement of a liability does not give rise to tax liabilities (eg principal loan
repayment) or not subject to tax deductibility (eg accrued tax-disallowed expenses
such as donations to unapproved organizations), the tax base of the liability would
equal the carrying amount of the liability.

[c]. Tax Base of Items not recognized in the balance sheet

Some items have tax bases but are not recognized as assets or liabilities. For these
items, the deferred tax also needs to be calculated. One of the examples would be
research cost, where it is recognized as an expense in calculating accounting profit
when incurred but will only be deducted for tax purposes in a later period.

6]. IAS 12 (1996): Temporary Difference Method

In last week�s issue, i Capital looked at �Tax Bases in Temporary Differences Method�
under [6]. IAS 12 (1996): Temporary Difference Method. This issue will continue with item [6].
IAS 12 (1996): Temporary Difference Method.

Taxable Temporary Differences & Deductible Temporary Differences

Simply put, Taxable Temporary Differences are temporary differences that give rise to Deferred
Tax Liabilities (increase the current tax expense) whereas Deductible Temporary Differences are
temporary differences that give rise to Deferred Tax Assets (reduce the current year's tax
expense).

Deferred Tax Calculation Based on Timing Differences & Temporary Differences

The example below will show the difference between deferred tax calculation based on the
timing difference method (Income Statement Liability method) and temporary difference method
(Balance Sheet Liability method).

Company ABC (ABC) started operations in 2004 with a machine worth RM100,000. ABC
depreciated the machine at 10% per annum. In 2004, ABC recognized a provision for warranty
expense of RM3,000 attributable to a sale. Warranty expenses are only tax-deductible when the
actual claim is incurred. In 2005 and 2008, RM1,000 and RM2,000 respectively were claimed
for warranties by customers. Assuming that ABC�s taxable income maintains at RM20,000
from 2004 to 2008. Initial and annual allowances for the machine are 20% and the tax rate stays
at 28% throughout the years.

[a]. Deferred Tax calculation Based on Timing Differences Method

Table 1 shows the deferred tax calculation worksheet, Table 2 and 3 shows the Deferred Tax
Liability and Deferred Tax Asset account in the balance sheet respectively, and Table 4 shows
the calculation of the total tax expense incurred by ABC from 2004 to 2008, although the actual
deferred tax timing will be until 2014 (due to the 10% depreciation policy).

Table 1: Deferred Tax Calculation (RM)

Table 2: Deferred Tax Liability (DTL) account (RM)

 Table 3: Deferred Tax Asset (DTA) account (RM)

Table 4: Calculation of Total Tax Expense (RM)

[b]. Deferred Tax calculation Based on Temporary Differences Method
The carrying amount of the machine is equal to its net book value (cost less accumulated
depreciation), for that is the value shown in the balance sheet. As for its tax base, it is
represented by its amount allowed for tax deduction (which is known as Qualifying Expenditure
and equals to the whole RM100,000 in this instance) less initial and annual allowances claimed.
This is based on the definition of a tax base for an asset : The machine is allowed for tax
deductible up to RM10,000. As at the balance sheet date, ABC had already claimed RM40,000
worth of capital allowances. Therefore, the company still can claim RM60,000 for tax-deduction
in future periods, thus forming the tax base. The calculation of the assets carrying amount and
tax base is shown in the following table.

Table 5: Calculation of Tax Base for ABC�s Machine (RM)

As for the provision for warranty expense, the carrying amount in the balance sheet will reduce
with the actual claim incurred. Table 6 shows the calculation of tax base for the provision for
warranty expense.
 Table 6: Calculation of Tax Base for Provision of Warranty Expense (RM)
Table 7 will show the deferred tax calculation based on the temporary differences method.

Table 7: Deferred Tax Calculation (RM)

Unlike the timing difference method, the deferred tax calculated based on the temporary
difference method represents the ending balance of the deferred tax as at the balance sheet date.
The deferred tax to be charged to the tax expense account in the profit and loss statement is the
difference between the ending balance of the deferred tax account and the opening balance of the
deferred tax account. Tables 8 and 9 shows the calculation of deferred tax to be charged to the
tax expense account.

Table 8: Deferred Tax Liability Calculation (RM)

Table 9: Deferred Tax Asset Calculation (RM)

The DTL and DTA account based on this temporary difference method is exactly the same as the
DTL and DTA account using the timing difference method, which are shown in tables 2 and 3.
Table 10 shows the calculation of the total tax expense for each respective year. As can be
noticed, it is the same as table 4, which calculates the deferred tax using the timing difference
method.

Table 10: Calculation of Total Tax Expense (RM)

From the example above, it can be seen that both the timing difference and temporary difference
methods show the same result. However, this may not be always true. As stated earlier, the
definition of temporary differences cover a wider scope than timing differences. The main
difference between these 2 methods is that the timing difference approach calculates the amount
of deferred tax to be recognized in the current year and the deferred tax account in the balance
sheet is the accumulation deferred tax recognized over the years. On the other hand, the
temporary difference method calculates the ending balance of deferred taxes in each year. The
amount of deferred tax to be recognized in the profit and loss is the difference between the
opening deferred tax and the closing deferred tax amount. This clearly illustrates why the timing
difference method is known as the Income Statement Liability method whereas temporary
difference method is known as the Balance Sheet Liability method.d

[7]. Malaysian Accounting Standard Board's MASB 25: Income Taxes

In Malaysia, the International Accounting Standard (IAS) 12 was superseded with the
adoption of Malaysian Accounting Standard Board (MASB) 25 : Income Taxes, which
became operative for annual financial statements covering periods beginning on or after
1st Jul 2002. Similar to IAS 12 (1996), MASB 25 requires deferred tax to be calculated
using Balance Sheet Liability Method (temporary difference method). The table below
shows the main difference between MASB 25 and IAS 12 (1979).
 Table 1: Differences between IAS 12 (1979) and MASB 25
[8]. Issues on MASB 25: Income Taxes
One of the issues regarding MASB 25 that i Capital would like to highlight is the
recognition of deferred tax liabilities and assets, which as shown in the table above,
differs in treatment between the IAS 12 (1979) and MASB 25.

The IAS 12 (1979) permits an enterprise not to recognise any deferred taxes when there is
reasonable evidence that the timing differences will not reverse for some considerable
period whereas MASB 25 requires all deferred taxes to be recognized (except for some
that are subject to certain conditions). If this MASB 25 requirement is to be followed, the
resulting financial reporting would not favour companies that continuously invest in
tangible assets. Why?

This is because when a company continuously invest in new assets, it is not likely that the
temporary differences will reverse out. This obliges the company to continuously provide
deferred tax liability, thus continuously show lower net profit than it really should. To
clarify this, assuming Company ABC, invests RM20 mln in 2004, RM20 mln in 2006,
RM40 mln in 2007, RM20 mln in 2009, RM30 mln in 2011 and RM20 mln in 2012 in
�Qualifying assets� in the beginning of each year.

All ABC's assets qualify for initial allowances of 20% and annual allowances of 20%.
ABC has a policy of depreciating its assets at a rate of 10% per annum. Table 2 shows the
calculation of the assets' carrying amounts, table 3 shows the calculation of the tax bases
of the assets, and table 4 shows the deferred taxes calculation, from 2004 to 2012. The tax
rate is assumed to maintain at 28%.

Table 2 : Carrying Amount of ABC�s Assets (RM mln)

Table 3 : Tax Base of ABC�s Assets (RM mln)

 Table 4 : ABC�s Deferred Tax Liabilities� Calculation (RM mln)
From this example, as long as ABC is incurring capital expenditures, it is not likely that
the deferred tax liabilities will reverse out. Therefore, ABC will be burdened to provide
deferred tax expenses and thus will continuously report a lower net profit figure as long
as the deferred tax liabilities do not reverse out.

Conclusion
In Part 7, i Capital showed that if a company continuously invest or incur capital
expenditure, it is likely that the deferred tax liability will only reverse out after a
considerable period of time. Therefore, the requirement imposed by MASB 25 to
recognize all deferred taxes regardless of whether the deferred tax will be reversed in the
near future is discriminating against companies where its nature of business involves
continuous capital expenditure. Companies of such nature will have to keep recognizing
deferred tax liability every year, thus will continuously report lower profit. One of the
arguments for the rigid deferred tax recognition requirement is that such future tax
consequence (or future tax liability) arises from transactions or events that have occurred
in the past. If the tax liability is not taken into consideration in the current year�s
account, future shareholders will be penalized when the tax liability subsequently arises.
On the other hand, if the chances of the deferred tax liability being reversed are remote, is
it not tantamount to penalizing current shareholders by insisting on recognizing a future
expense that is not likely to materialise?

Instead of going on and on lambasting the rigidity of MASB 25, allow i Capital to discuss
the fundamentals of deferred tax. What is the actual substance of deferred tax? Is deferred
tax liability the same as accrued expenses, considering that both form part of a
company�s liability? Unknown or disregarded by many, there is a huge difference
between the two. Accrued expenses represent amount owed to parties that have rendered
their service/s to the company, but have not been paid. Common examples of accrued
expenses include accrued rental expenses, accrued salary, accrued commission, etc. In
short, accrued expenses represent future liability due to services received but not yet paid.
Deferred tax liability, on the other hand, represents future obligation payable not because
of past services received. It neither involves flow of services nor flow of cash. It is simply
an allocation of �anticipated� future expense in the current year, which is deemed
�fair� by the accounting �intellects�.

Following on, does it really matter if a company provides or does not provide for deferred
tax liability? A future �anticipated� condition might never materialize due to constant
changes in business dynamics (ie purchase of new assets). From a business standpoint, it
does not matter whether deferred tax is provided or not. As explained, this is because it
does not involve cash flow or service obligations. If that is the case, then, why is there
such an obsession in the accounting industry to make such a business-irrelevant issue a
must? Will mandating a provision for deferred tax make the annual report more reflective
of a company�s underlying performance? If fairness of representation is the main
consideration behind the new MASB rulings, it should start with mandating more
disclosure in the annual reports, considering the current disclosure is skimpier than G-
strings. To quote our managing director, accounting standards are created by non-
businessmen to be used by businessmen.

In short, i Capital is of the opinion that companies should be given more leeway in the
recognition of deferred tax. If there is reasonable assurance on the company�s part that
the deferred tax would not reverse out in the considerable period ahead, then the company
should not be �forced� to provide for deferred tax. This is because other than making a
company�s reported earnings continuously lower than it actually is, it makes no
difference to the fundamentals of a company. With this, i Capital hopes for a review of
MASB 25 so as to make it more �adoptable� by the business community. And with
this justifiable suggestion, i Capital concludes its exclusive series on deferred tax.