Chapter 8 Essay Questions – suggested solutions

1. In connection with IAS 12 Income Taxes, deferred taxation must be fully provided for on
all temporary differences. Explain what is meant by “temporary differences” and what
problems can arise with a full provisioning approach.

Basic answer

Temporary differences – difference between the tax base of an asset or liability and its carrying
amount in the balance sheet.

Tax base – the amount attributed to the asset or liability for tax purposes.

IAS 12 requires that deferred tax be accounted for on future tax consequences of all items that
are included in the financial statements and are dealt with for accounting purposes differently
than for tax purposes – explanation of this in terms of flows of economic benefit/tax treatment.

Differences can be taxable/deductible – explanation of this.

Liability measurement used i.e. rate ruling at balance sheet date.

Full provisioning – many will reverse therefore no problem but in the case of accelerated capital
allowances, problems with ever increasing liability.

Good answer

Use of examples other than accelerated capital allowances e.g. pension contributions,
revaluations etc.

Ever increasing provision that will not be settled goes against IASB Framework definition of a
liability.

Reference to discounting and that IAS 12 prohibits this.

2. The deferral method of providing for deferred tax is said to place the emphasis on the profit
and loss account charge whereas the liability method is said to place the emphasis on the
balance sheet. Explain what is meant by the deferral and liability methods of providing for
deferred tax and why each method places its own unique emphasis.

Basic answer

Definition of deferred tax is required.

Discussion of the three possible approaches i.e. full deferral, partial provisioning and flow
through. Then explanation of the deferral method i.e. calculates tax at the tax rate at date the
difference arose. The balance on the deferred tax account is not affected by the change in the tax
rate. The emphasis is therefore on the income statement charge.

Explanation of the liability method i.e. calculate deferred tax using the current tax rate and
therefore shows the best estimate of a future liability. The emphasis is therefore on the balance
sheet liability.

Good answer

Problems with deferral method – extensive record keeping requirements if “strict deferral
method”.

How these record keeping requirements are overcome in practice – net change method.

Explanation of net change method.

- net originating difference – uses the current tax rate
- net reversing difference – use of F.I.F.O. on average basis

Approach adopted by IASB is the liability method i.e. a balance sheet approach is taken where
the tax is seen as a liability. An income statement view would support flow through to reflect the
actual tax charge or at best partial provision.