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Income Taxes

Dr. Derek K. Chan


HKU

1
Outline
1. Overview
2. Permanent vs. Temporary Differences
3. Two Common Sources of Temporary Differences
4. Deferred Tax Recognition Comprehensive Recognition
Approach
5. Deferred Tax Measurement Asset/Liability Method
6. Disclosure Rules for Temporary Differences

This chapter discusses issues regarding the recognition


and measurement of deferred taxes rather than the
computation of income tax per se. Details about
computation of income tax are dealt with in ACCT3107:
Hong Kong Taxation.
Income Taxes 2
1. Overview
Some items reported on the financial statements are treated differently
for tax and accounting purposes.
Taxable income:
Income based upon tax rules that determine taxes due.
The primary objective in levying taxes is to provide cash for the
government's operations. The government also designs tax laws to
encourage some and discourage other activities.
Taxes payable:
The taxes due to the government are determined by taxable income
and the tax rate.
This is also referred to as current tax expense. It is an existing
legal liability.
Income tax paid:
Actual cash flow for income taxes, including payments or refunds
for other years.

Income Taxes 3
Pre-tax financial income/Accounting profit:
Income before income tax expense based on generally
accepted accounting principles and standards (e.g., IFRS and
HKFRS).
The role of HKFRS is to provide users of financial
statements with information to help them in decision
making.

Income tax expense:


The expense recognized on financial statements that includes
taxes payable and deferred income tax expense/benefit.

The taxable income IS NOT necessarily the SAME as the pre-


tax financial income.

The taxes payable IS NOT necessarily the SAME as the tax


expense. Income Taxes 4
The Inland Revenue
HKFRS is the set of
Code is the set of rules
rules for preparing
for preparing tax
financial statements.
returns.

Results in . . . Usually. . . Results in . . .


Financial statement Income taxes
income tax expense payable

The difference between tax expense and tax


payable is recorded in an account called deferred
taxes.
Income Taxes 5
Example 1:
Examine the December 31, 2005, information for ABC Inc.

Revenues $ 1,000,000
Depreciation Expense:
Straight-line 200,000
Accelerated 320,000
Other Expenses 650,000

ABC uses straight-line depreciation for financial reporting and


accelerated depreciation for income tax reporting. ABCs tax
rate is 30%.

Income Taxes 6
Example 1 (Contd):
Compute ABCs income tax expense and income tax
payable.

Income Tax
The income tax
Statement Return Difference
amount computed
Revenues $ 1,000,000
Less:
based on financial
Depreciation 200,000 statement income
Other expenses 650,000 is income tax
Income before taxes $ 150,000 expense for the
Tax rate 30%
period.
Income taxes $ 45,000

Income Taxes 7
Example 1 (Contd):
Compute ABCs income tax expense and income tax
payable.

Income Tax
Statement Return Difference
Income taxes
Revenues $ 1,000,000 $ 1,000,000
based on tax
Less:
Depreciation 200,000 320,000 return
Other expenses 650,000 650,000 income are
Income before taxes $ 150,000 $ 30,000 the taxes
payable for
Tax rate 30% 30%
Income taxes $ 45,000 $ 9,000
the period.

Income Taxes 8
Example 1 (Contd):
The deferred tax for the period of $36,000 is the difference
between income tax expense of $45,000 and income tax payable
of $9,000.
Income Tax
Statement Return Difference
Revenues $ 1,000,000 $ 1,000,000 $ -
Less:
Depreciation 200,000 320,000 (120,000)
Other expenses 650,000 650,000 -
Income before taxes $ 150,000 $ 30,000 $ 120,000

Tax rate 30% 30% 30%


Income taxes $ 45,000 $ 9,000 $ 36,000

Income Taxes 9
2. Permanent vs. Temporary Differences

Differences in pretax financial income (based on HKFRS)


and taxable income (based on tax rules) are due to time
differences, which results from a transaction being treated
differently (timing or amount) on the financial statements
and tax return.

Timing differences can be


Permanent, or
Temporary

Income Taxes 10
Permanent differences:
Arise when there are items included in the accounting
profit that will NEVER be taxed or allowed as tax
deductibles.
For example, in HK, dividend income is included in pre-
tax financial income but excluded from taxable income.
Permanent differences that occurred in a year do not give
rise to any further differences in future years. Therefore,
they have no impact on either current or future (deferred)
tax obligations.
If the only difference between taxable and pretax
incomes were a permanent one, then taxable income
(determines taxes payable) is equal to financial income
subject to tax (determines tax expense), which is pretax
financial income adjusted for the permanent differences,
and taxes payable equals tax expense.
Income Taxes 11
Temporary differences:
Arise when there are items included in the accounting
profit that will be taxed or allowed as tax deductibles in
different accounting periods.
Depreciation methods using accelerated depreciation
for the tax return and SL depreciation for the financial
statements.
Subscription revenue received in advance.
Bad debts.
Warranty expense.
Unrealized gains/losses on trading securities.
Temporary differences that originated in a year are capable
of reversal in later years. Eventually all items will be
treated the same for both tax and accounting purposes.

Income Taxes 12
Example 2 (The Effect of Permanent and Temporary
Differences on the Computation of Income Taxes):
A firm has reported income before taxes of $420,000,
which includes $20,000 of nontaxable revenues and $5,000
of nondeductible expenses, both permanent differences.
The firm also has two temporary differences: (1) the
depreciation (cost recovery) deduction on the tax return
exceeds depreciation expense on the income statement by
$30,000, and (2) subscription revenue included on the tax
return is $14,000 more than the amount recognized on the
income statement. The latter difference arises because
income tax laws require recognition of subscription revenue
when the payment is received, not when the subscription is
earned.
The tax rate is 35%.

Income Taxes 13
Example 2 (Contd):
Income taxes payable for the year would be computed as follows:
Pretax financial income (from income statement) $420,000
Add (deduct) permanent differences:
Nontaxable revenues $(20,000)
Nondeductible expenses 5,000 (15,000)
-------- ----------
Pretax financial income subject to tax $405,000
Add (deduct) temporary differences:
Excess of tax depreciation over book depreciation (30,000)
Excess of tax subscription revenue over book
subscription revenue 14,000
Taxable income $389,000
Tax on taxable income (income taxes payable):
$389,000 .35 $136,150
=======
Income tax expense: $405,000 .35 $141,750
=======
Income Taxes 14
Deferred tax accounts: arise if, and only if, there are
temporary differences. In this case, tax expense is not
equal to tax paid or payable, and a deferred tax account
is created. There are two kinds of deferred tax accounts:

1) Income taxes expected to be paid on future taxable


amounts (FTA, i.e., result in more future cash outflow)
are reported in the balance sheet as a deferred tax
liability (DTL).

DTL represents the expected income tax on income


earned but is not yet taxed.

Thus, it is NOT an existing legal liability.


Income Taxes 15
2) Income tax benefits (savings) expected to be realized
from future deductible amounts (FDA, i.e., result in less
future cash outflow) are reported in the balance sheet as
a deferred tax asset (DTA).

DTA represents the expected benefit of a future tax


deduction for an expense item that has already been
incurred but is not yet deductible for tax purposes.

E.g., pretax income includes an accrual for warranty


expense but warranty cost is not deductible for
taxable income until the firm has made actual
expenditures to meet warranty claims.

Income Taxes 16
Deferred Tax Assets and the Valuation Allowance:
For deferred tax assets to be beneficial, the firm must have
future taxable income.
If a firm is more likely than not that a portion of deferred
tax asset will not be realized (insufficient future taxable
income to take advantage of the tax asset), then the
deferred tax asset must be reduced by a valuation
allowance, which reduces income from continuing
operations.
Income tax expense XXX
Valuation allowance XXX

Valuation allowance: Reserve against deferred tax assets


based on the likelihood that those assets will be realized.
Income Taxes 17
The following is a simple example that illustrates why
temporary difference gives rise to deferred tax.

Year tax-reporting financial-reporting


income: income:
2014 $2 $3
2015 $2 $2
2016 $2 $1

Pretax financial income is bigger than taxable income by $1


in 2014, same in 2015 and smaller by $1 in 2016.

Income Taxes 18
If tax rate is 20% for all three years, how do we account for
the tax associated with the $2 of taxable income in 2014?
Income tax expense 0.4
Tax payable 0.4

Now, how do we account for the tax associated with the extra
$1 of pretax financial income in 2014?

Since we do NOT have to pay yet (not taxable income), it is


considered a non-current liability (paid back in 2016).
Income tax expense 0.2
Deferred tax liability 0.2

In the sequel, we will focus on the issues of recognizing,


measuring, and reporting temporary differences.
Income Taxes 19
Deferred Taxes
Rules of thumb for expenses and revenues (assuming
differences are temporary and therefore will reverse out in
the future)
o If book income > tax income FTA DTL
o If book income < tax income FDA DTA

If revenues recognized faster for tax FDA DTA


If revenues recognized slower for tax FTA DTL

If expenses recognized faster for tax FTA DTL


If expenses recognized slower for tax FDA DTA
Income Taxes 20
3. Two Common Sources of Temporary Differences
(1) Short-Term Timing Differences:
These are related to the concept of accrual vs. cash basis of
accounting; (modified) cash-basis accounting is used for
tax purposes and accrual-basis is used for financial
reporting purposes.
Examples are accounting provisions, such as provision for
warranty expense, in this case the warranty expense is
included in the accounting profit on an accrual basis whilst
the tax deduction is only allowed when the firm has made
actual expenditures to meet warranty claims.

Income Taxes 21
Example 3:
Miller Co. had a pre-tax financial income in 2014 of $10,000
which includes a gain on trading securities of $6,000 that is
unrealized in 2014 and realized in future years. Therefore for
tax purposes the unrealized gain is not included in 2014 but in
future years when it is realized.
A timing difference arises in this example because
i. taxable income in 2014 = $4,000 < pre-tax financial income
in 2014 = $10,000;
ii. when Miller collects the $6,000 in the future, he has to pay
tax for that amount.

Income Taxes 22
(2) Fixed Asset Timing Differences:
These are the most common and important form of timing
difference where there is an excess of depreciation (capital)
allowances available in the profit tax computation over the
related book depreciation charges.
The reverse occurs in the future, when the depreciation
charges in financial statements exceed the depreciation
allowance available in the profits tax computation.
Over the life of the asset, the total depreciation charge will be
the same for both accounting and tax purposes.

Income Taxes 23
Example 4:
At the beginning of 2014, its first year of operations, Philip Co.
purchased a machine having an estimated 4-year life and no
residual value for $100,000. The depreciation schedules for
book purposes and for tax purposes were as follows:
Year Book Capital Current Cumulative
Depreciation Allowance Difference Difference
2014 25,000 40,000 -15,000 -15,000
2015 25,000 30,000 -5,000 -20,000
2016 25,000 20,000 5,000 -15,000
2017 25,000 10,000 15,000 0

In this example the differences caused in a year (2014 and


2015) are reversed in later years (2016 and 2017).
Income Taxes 24
HKAS 12 "Income Tax" issued in 2004 (which supersedes
HKSSAP 12 "Accounting for Deferred Tax" issued in
1987) is concerned with accounting for taxation on profits
that are included in the financial statements in one period
but assessed for taxation in another period.

Compliance with this statement ensures compliance with


International Accounting Standard IAS 12 "Accounting for
Taxes on Income" in all material respects so far as deferred
tax is concerned.

ADDITIONAL READINGS: HKAS 12 "Income Tax". (It


can be found in http://www.hkicpa.org.hk. Click Standards
& Technical, then Accounting & Financial Reporting, and
then choose Members' Handbook Volume II - "Financial
Reporting Standards" .)
Income Taxes 25
4. Deferred Tax Recognition Comprehensive
Recognition Approach
Key Question:
Should the expected tax consequences of the existing
temporary difference be recognized in Millers 2014
financial statements (Example 3)?

Income Taxes 26
Two solutions:

(1)Ignore the temporary difference, recognizing income


tax expense = income tax payable. This is also called
the Nil Provision Approach.

However, it would be misleading to the shareholders


not to tell them of the expected tax to be paid on the
additional to be received in cash in the future years.

Recognition of the deferred tax liability is necessary to


ensure that all expenses associated with 2014 revenues
are reported in the 2014 income statement and that all
obligations are reported in the December 31, 2014
balance sheet.
Income Taxes 27
Therefore, we have the following alternative solution:
(2)Recognize the tax consequences of the temporary
difference by debiting income tax expense (deferred) and
crediting deferred tax liability.

Underlying the valuation of assets and liabilities is the


notion that the reported amounts will be recovered (for
assets) and settled (for liabilities).

The recoverable value concept can be applied here in the


Millers example. The $10,000 revenue is recognized in
the books, implying that the $6,000 unrealized gain will be
collected and tax consequences will result in the future.

Income Taxes 28
Comprehensive Recognition / Full Provision:

The deferred tax consequences of ALL existing temporary


difference must be recognized in the financial statements
when the timing difference originates.
Comprehensive Recognition/Full provision:
We assume with certainty that the tax liability arising
from the timing differences will be settled through
future taxable profits.
Advantage: the amount can be estimated relatively
easily and no subjective projection is required.
Disadvantage: assumption that the tax liability be
settled in (near) future with certainty may not be
realistic.

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Example 5 (The Creation of Deferred Tax Liabilities):
A firm acquires an asset for $9,000 with a three year useful life and
no salvage value. The firm uses straight-line depreciation method.
The asset will generate $5,000 of annual revenue for three years.
The tax rate is 40 percent each year.
The firm is allowed to depreciate the asset over two years for tax
purposes.
Tax Reporting
Year Year Year Total
1 2 3
Revenue $5,000 $5,000 $5,000 $15,000
Depreciation 4,500 4,500 0 9,000
Taxable income 500 500 5,000 6,000
Taxes payable 200 200 2,000 2,400
Net income 300 300 3,000 3,600
Income Taxes 30
Example 5 (Contd):
Financial Reporting
Year 1 Year 2 Year 3 Total
Revenue $5,000 $5,000 $5,000 $15,000
Depreciation 3,000 3,000 3,000 9,000
Pretax income 2,000 2,000 2,000 6,000
Tax expense 800 800 800 2,400
Net income 1,200 1,200 1,200 3,600
Total taxes and total net income over all 3 years are the same in both reports.
Over the life of this asset, the firm will report the following liabilities on the
balance sheet:
Year 1 Year 2 Year 3
Deferred tax liability $600 $1,200 $0

This example illustrates the creation of a deferred tax liability when taxable
income is less than pretax income early in the asset life. This timing
difference is reversed as the asset ages.
Income Taxes 31
Example 6 (The Creation of Deferred Tax Assets):
A firm has sales of $10,000 for each of two years.
The firm estimates that warranty expense will be 5 percent of year 1 sales
($500).
No warranty is given for year 2 sales.
The actual expenditure of $500 to meet warranty claims was not made until
the second year.
The tax rate is 40 percent each year.
Tax Reporting
Year 1 Year 2 Total
Revenue $10,000 $10,000 $20,000
Warranty expense 0 500 500
Taxable income 10,000 9,500 19,500
Taxes payable 4,000 3,800 7,800
Net income 6,000 5,700 11,700
Income Taxes 32
Example 6 (Contd):
Financial Reporting
Year 1 Year 2 Total
Revenue $10,000 $10,000 $20,000
Warranty expense 500 0 500
Pretax income 9,500 10,000 19,500
Tax expense 3,800 4,000 7,800
Net income 5,700 6,000 11,700
Total taxes and total net income over all 2 years are the same in both reports.
Over the two-year period, the firm will report the following assets on the
balance sheet:
Year 1 Year 2
Deferred tax asset $200 $0
This example illustrates the creation of a deferred tax asset when taxable
income is more than pretax income and the difference will reverse in future
years. Income Taxes 33
5. Deferred Tax Measurement Asset/Liability Method
Under the Asset/Liability Method, the tax rate to use when
calculating deferred tax balances is the rate at which the tax
will be paid when the timing differences reverse.
Usually this will be the current tax rate, but if you know the tax
rate is to change then you should use the new tax rate for the
deferred tax balance.
If the tax rate does change, deferred tax balances are adjusted
to reflect changes in tax rates.
This method recognizes that the deferred tax balance is a
liability (an asset) which will become payable (recoverable) at
some time in the future.
The provision represents the best estimate of the amount that
would be payable or recoverable when the relevant timing
differences reverse.

Income Taxes 34
Example 7 (Accounting for Income Taxes Using
the Asset/Liability Method):
During year one, the tax rate is 40 percent.
Starting in year two, the tax rate will fall to 35%
Assume taxable income is $20,000
Pretax income is $30,000
The $10,000 difference is temporary (reverses in the future)
The deferred tax liability is determined by the tax rate that will
exist when the reversal occurs (35%)
Results
The deferred tax liability is $3,500 [(0.35)($10,000)] not
[(0.40)($10,000)=]$4,000
The tax expense is [equal to current tax rate times taxable income
(0.40)($20,000) plus the deferred tax liability of $3,500] $11,500 and
not [(0.4)(30,000)=] $12,000.
Income Taxes 35
Example 8:
Continued with Example 3. Further assume the followings:

Year Pre-tax financial Taxable Current Cumulative Tax


income income difference difference rate
2014 10,000 4,000 6,000 6,000 25%
2015 0 4,000 -4,000 2,000 35%
2016 0 2,000 -2,000 0 35%

Income Taxes 36
Example 8 (Contd):
The journal entries to record Millers income taxes for 2014 would be as
follows:

Income tax expense - current (25% 4,000) 1,000


Income tax payable 1,000

Income tax expense - deferred* 2,100


Deferred tax liability 2,100

* 35% 4,000 + 35% 2,000, which is the sum of the amounts need to be
settled in 2015 and 2016, respectively.

Note: HKAS 1 states that DTA/DTL should be classified as non-current (i.e.,


long-term) regardless when the temporary differences will reverse. Moreover,
we do NOT need to do discounting for the amounts need to be settled in 2015
and 2016 because deferred tax accounting does not allow for the recognition
of time value of money.
Income Taxes 37
Example 8 (Contd):
Income taxes would be shown on Millers 2014 income statement
as follows:
Miller Co.
2014 Partial Income Statement
Income before income taxes $10,000
Income tax expense:
Current $1,000
Deferred 2,100 3,100
Net income $6,900
=====

The December 31, 2014 balance sheet would report a liability of


$1,000 for income taxes payable and, as noted above, a deferred tax
liability of $2,100.

Income Taxes 38
Example 8 (Contd):
In each subsequent year, the ending deferred tax liability is
determined and compared with the beginning balance. The
difference between the beginning and ending balances is
recorded as an adjustment to the deferred tax liability
account. For example, at the end of 2015, we have :

Year Pre-tax financial Taxable Current Cumulative Tax


income income difference difference rate
2015 0 4,000 -4,000 2,000 35%
2016 0 2,000 -2,000 0 35%

Income Taxes 39
Example 8 (Contd):
The accumulated difference of $6,000 starts to reverse and,
therefore, the deferred tax liability account must be adjusted to a
balance of $700 ($2,000 .35). The amount of the adjustment
is $1,400 ($700 less the beginning balance of $2,100),
recorded as follows:

Deferred tax liability 1,400


Income tax expense - reversed benefit 1,400

Moreover, the entry in 2015 to record the income tax would be:

Income tax expense 1,400


Income tax payable ($4,000 35%) 1,400

Income Taxes 40
Example 8 (Contd):

Thus the reversed income tax expense (or the income tax
benefit) exactly offsets the current income tax expense for
2015 and reduces the net income tax to zero.

Similarly, at the end of 2016, the deferred tax liability must be


reduced to zero with the following adjustment:

Deferred tax liability 700


Income tax expense - reversed benefit 700

Income Taxes 41
Example 8 (Contd):

The entry in 2016 to record the income tax would be:

Income tax expense 700


Income tax payable ($2,000 35%) 700

Again, the reversed income tax expense (or the income tax
benefit) exactly offsets the current income tax expense for 2016
and reduces the net income tax to zero.

Income Taxes 42
Effect of Tax Rate and Tax Law Changes
Under the asset/liability method all deferred tax assets
and liabilities are revalued using the new tax rate at the
date the rate is changed.
If tax rates fall; deferred tax liabilities fall, tax expense
decreases, net income increases.
If tax rates rise; deferred tax liabilities rise, tax expense
increases, net income decreases.

Income Taxes 43
Example 9 (Deferred Taxes and a Change in Tax
Rates):
A firm has a deferred tax asset of $1,000 and deferred tax liability
of $5,000 each deferred at a 40 percent tax rate.
Assume the tax rate is reduced to 36% (a 10 percent reduction in
tax rate).
Under the asset/liability method, the deferred tax asset and
liability must be revalued at the new tax rate; the asset and
liability is reduced by the 10 percent reduction in tax rates.
Results
The deferred tax asset is reduced by $100 to $900
The deferred tax liability is reduced by $500 to $4,500
Tax expense in the current period is reduced by $400 ($500
decrease in liability less $100 decrease in asset)

Income Taxes 44
Example 10 (Future Taxable Amount, Deferred Tax Liability,
Permanent and Temporary Differences, Multiple Years,
Comprehensive Recognition Approach and Asset and Liability
Method):
Praise Company began operation on January 1, 2014. At the end of
the first year of operations, Praise reported $1,000 income before
income taxes on its income statement, but only $700 taxable income
on its tax return. Analysis of the $300 difference revealed that $100
was a permanent difference and $200 was a temporary difference
related to a fixed asset. The enacted tax rate for 2014 and future
years is 35%. Praise uses the comprehensive recognition approach
and the asset and liability method to account for deferred tax items.

Income Taxes 45
Example 10 (Contd):
a. Does Praise have a Future Taxable Amount or Future Deductible
Amount, and how much?

Future Taxable Amount = $200 Deferred Tax Liability = $200


35% = $70

b. Prepare the journal entries to record income taxes for 2014.

Income tax expense - current 245


Income tax payable ($700 35%) 245

Income tax expense - deferred 70


Deferred tax liability 70
Income Taxes 46
Example 10 (Contd):
c. Assume that at the end of 2015, the accumulated temporary tax
liability difference (future taxable amount) related to future years is
$800. (This means that the future taxable amount has increased
from $200 to $800). Prepare the entry to record any adjustment to
deferred taxation at the end of 2015.

Ending balance in Deferred Tax Liability in 2015 should be $800


35% = $280

Income tax expense - deferred 210


Deferred tax liability ($280 $70) 210

Income Taxes 47
Example 10 (Contd):
d. If on Jan 1, 2015, the income tax rate is changed to 40% for 2015
and all future years. How would your answer in part c change?

Ending balance in Deferred Tax Liability in 2015 should be $800


40% = $320

Income tax expense - deferred 250


Deferred tax liability ($320 $70) 250

Note:
This adjusting entry is NOT $600 40% = $240 because there is
also an increase in tax rate for the 2014 Future Taxable Amount of
$200 5% = $10 that is carried forward in 2015. Thus, the total =
$250 = $240 + $10.
Income Taxes 48
6. Disclosure Rules for Temporary Differences

1. If a company has temporary differences that give rise to


both deferred tax liability and deferred tax asset, the
company should just report the net amount.
2. Deferred tax net debit should not be carried forward as
assets unless treatment of such balances as assets can be
justified.
3. Normally, the recognition and carry forward of deferred
tax net debit should be discontinued if the company has
operating losses. Sound judgment is required to assess if
future taxable income would be adequate to recover the
deferred tax asset.

Income Taxes 49

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