Accounting Article

Financial Reporting and IAS-12

by Mohammed Ashraf | Published on 3/31/2004


International Accounting Standard number 12 was and is the most misunderstood International Accounting Standard in the financial reporting history of Pakistan, apart from International Accounting Standard 32 and 39. The prime reason of this conceptual misunderstanding is the three-dimensional Income Tax Ordinance, 2001 and Sales Tax Act, 1990. The purpose of this article is to cover International Accounting Standard 12 within the context of three-dimensional Income Tax Ordinance, 2001, impact over corporate financial reporting, removal of doubts raised in different articles and lacunas or shortcomings of International Accounting Standard 12 and Companies' Ordinance, 1984.

Normally the accounting profit before tax figure appearing in the financial statements of corporate entities differ from the taxable profit showed in income tax return. Such a difference may be categorized as permanent difference or temporary difference. Permanent difference arises due to permanent factors while temporary difference arises due to temporary factors.

Permanent factors include inadmissible expenditure mentioned in section 21 of Income Tax Ordinance, 2001, for instance entertainment expense in excess of limit prescribed in rule 10 of Income Tax Rules, 2002. Income exempt from tax mentioned in second schedule of Income Tax Ordinance, 2001, for instance, clause 131 of part I of second schedule of Income Tax Ordinance, 2001 Nothing can be done about that, and the increased [due to inadmissible expenditure] or decreased [due to exempt income] tax charge just has to be accepted. Now we can conclude that if an expense in the profit and loss account is not allowed for tax purposes or an income is not recognized for tax purposes, permanent difference arises.

A temporary difference arises when an expense [temporary factor] is allowed both tax and accounting purposes, but the timing of the allowance difference. Temporary factors include deemed income subject to reversal in subsequent years or treatment difference of depreciation, amortization etc. for instance, if the depreciation rate is higher for tax purposes than the depreciation rate in Financial Statement, the tax charge will be lower in the first year than it would have been if based on accounting profit, but in subsequent year the tax charge will be higher. In order to fully understand the situation, let’s consider an example.

Example 1

A Company bought plant and machinery for Rs. 200,000.00. The useful life of the asset is five years and is to be depreciated on straight-line basis. 

For tax purposes, the initial depreciation rate is 50% and 25% in subsequent years on WDV. The tax relevant tax rate is 43% throughout the period.

 

TAX

ACCOUNTS

 

YEAR

COST /
OPENING
BALANCE

DEP'N

WDV

COST /
OPENING
BALANCE

DEP'N

WDV

DIFFERENCE

1

200,000 180,000 20,000 200,000 40,000 160,000 140,000

2

20,000 5,000 15,000 160,000 40,000 120,000 (35,000)

3

15,000 3,750 11,250 120,000 40,000 80,000 (36,250)

4

11,250 2,813 8,438 80,000 40,000 40,000 (37,188)

5

8,438 2,109 6,328 40,000 40,000 - (37,891)
               
  254,688 193,672   600,000 200,000   (6,328)

The WDV of Rs20,000 is the tax base [amount attributed to the asset or liability for tax purposes] of plant and machinery. While the accounting WDV of Rs 160,000 is the carrying value of plant and machinery.

From the above chart it is apparent that due to the difference in depreciation rates, the company’s depreciation expense, for tax purposes, increased by Rs 140,000.00 in year 1. Alternatively, we could also say that the WDV of the asset has increased by Rs 140,000.00. Hence, we can conclude that the effect of depreciation or WDV has started reversing from year 2 till year 5 and will continue thereafter till the exhaustion of the cost of asset under diminishing balance method, that is, year 35.

It is worthwhile here to note that depreciation expense reduces tax payments. The very impact difference in above referred chart is over the tax payments and can be analyzed as follows.

 

TAX

ACCOUNTS

DIFFERENCE

YEAR

DEP'N

Reduction
in Tax
Payment

DEP'N

Reduction
in Tax
Payment

 

1

180,000 77,400 40,000 17,200 60,200

2

5,000 2,150 40,000 17,200 (15,050)

3

3,750 1,613 40,000 17,200 (15,588)

4

2,813 1,209 40,000 17,200 (15,991)

5

2,109 907 40,000 17,200 (16,293)

From the above chart it is apparent that due to the difference of depreciation rates or more appropriately due to difference in tax and accounting WDV/depreciation expense has resulted in reduced tax payment of Rs 60,200.00 [deferred tax] (140,000 X 43%) in year 1. The difference arose during year 1 has start reversing from year 2 till year 35.

Deferred tax can be defined as ‘The estimated future tax consequences of transactions and events recognized in the financial statements of the current and previous periods’.

As stated earlier, tax saving of Rs 60,200.00 in year 1 is not an actual tax saving but primarily tax liability is effectively deferred to the extent of useful life of the asset. Now let’s analyze the concept of difference arose in the above referred chart through tax accounting, to the extent of year 5. This can be illustrated as follows.

 

TAX

ACCOUNTS

YEAR

CURRENT

 

TOTAL

CURRENT

DEFERRED

TOTAL

1

- -            - 34,200 60,200 94,400

2

4,150 23,285 30,866 34,200 (15,050) 19,150

3

54,863 23,591 31,272 34,200 (15,588) 18,613

4

55,397 23,821 31,576 34,200 (15,991) 18,209

5

55,798 23,993 31,805 34,200 (16,293) 17,907
             
  220,207 94,689 125,518 171,000 (2,721) 168,279

One must not confuse with the negative aggregate balance of Rs 2,721.00, this will be reversed in 35th year. The most important point is that why should we recognize deferred tax? It is worthwhile here to note that if an entity fails to recognize deferred tax, it eventually fails to recognize a liability or asset, which will ultimately lead to distortion of the post tax profit. Hence, it can be concluded that it is basically the accrual concept, which requires its recognition. Failing to recognize deferred tax may lead to over/under optimistic dividend payment based on inflated or understated profit, distortion of EPS and PE ratio and above all shareholders will be misled.

There are two main methods of accounting for deferred tax, Deferral method [the original amount set aside for deferred tax is retained without alteration for subsequent changes in tax rate] and the liability method [the deferred tax balance is adjusted as the tax rate change in order to maintain the actual liability expected to arise].

The liability method is sub-divided into two methods, Income statement liability method [focuses on difference between taxable profit and accounting profits timing difference] and balance sheet liability method – IAS 12 preferred [calculation is made by reference to differences between balance sheet values and tax values of asset and liabilities temporary differences].

It is worthwhile here to note that as per division II of part I of 1st schedule of Income Tax Ordinance, 2001, the tax rates are continually decreasing till tax year 2007, that is, 35%. Hence, if an entity adopts the liability method, it must consider the falling tax rates in advance, that is, during the 1st year of recognition of deferred tax. Although International Accounting Standard 12 is silent over the issue of continually reduced tax rates, but in order to incorporate a transparent, crystal clear and objective recognition of deferred tax asset or liability, it is of utmost importance.

Whatsoever the method a corporate entity adopts for deferred tax, still International Accounting Standard 12 gives a choice in respect of extent of the provision. The extent of the provision may be nil provision [no provision is made – flow through method], Full provision – IAS 12 preferred [provision is made for the tax effect of all temporary differences] and partial provision [provision is made to the extent that expected liability will actually arise].

The nil provision, or flow through basis ignores the taxation effects of timing differences completely. Tax is accounted for as it is assessed on the basis that taxation is an appropriation of profits by the government, and so is not relevant as a performance indicator. A theoretical justification for this argument is that the only tax liability that satisfies the statement of principles’ definition of a liability (an obligation to transfer economic benefits out of past transactions and events) is current taxation.

The full provision is based on the view that every transaction has a tax consequence and it is possible to make a reasonable estimate of the future tax consequences of transactions that have occurred by the balance sheet date. If this basis of deferred tax accounting is adopted, the computation of the deferred taxation figures is a relatively straightforward arithmetical exercise. The approach of International Accounting Standard 12 to tax accounting under the full provision approach is commonly known as the valuation adjustment approach. This approach recognizes deferred tax on all differences between the carrying values of assets and liabilities in the financial statements and their tax base. An alternative approach to deferred tax accounting under the full provision basis is the incremental liability approach. This approach recognizes deferred tax only when it could be regarded as meeting the definition of an asset or a liability in its own right.

Like the full provision basis the partial provision basis is based on the premise that the future reversal of a timing difference gives rise to a tax liability (or asset). However, instead of focusing on the individual components of the tax computation the partial provision basis analyses the components as a whole in a single net assessment. To the extent that timing differences are expected to continue in future (by the existing timing differences being replaced by future timing differences as they reverse) the tax is viewed as being deferred permanently. The computation of deferred tax balances under the partial provision basis is rather more complicated than under the full provision basis because of the need to use forecasts of future transactions to estimate the incidence of future timing differences.

Professional accountants must keep an eye over the three dimensional Income Tax Ordinance, 2001 – Minimum tax, Presumptive tax regime and normal tax on profit. One may think that Minimum tax needs to be adjusted in deferred tax provision. It is worthwhile here to note that minimum tax is a dead tax and have nothing to do with the future adjustment of losses due unabsorbed depreciation. Although care need to be taken, in subsequent years, where the losses are converted into profits after the audit under Income Tax Ordinance, 2001. This situation may require adjustment of deferred tax, recognized in earlier years, through International Accounting Standard 8, before continuing with the current year provision. As far as presumptive tax regime is concerned, decision of either to make a provision of deferred tax or not, lies over the conclusion drawn from the future budgeted activities of the corporate entity. Similarly, a proportionate return requires careful consideration.  

It is worthwhile here to note that under the balance sheet liability method, deferred tax is calculated by reference to the tax base [amount attributed to the asset or liability for tax purposes]. The tax base of an asset is the amount that will be deductible for tax purposes against any future taxable benefit derived from the asset, hence, where the benefit will not be taxable [e.g. Income is exempt] the tax base of an asset is equal to the carrying amount. The tax base of a liability is the carrying amount less any amount that will not be deductible for tax purposes [e.g. advance revenue on account of exempt income] in respect of liability in future period.

The problem lies in identifying whether the deferred tax is an asset or liability, that is, figure of Rs 60,200.00 in the chart. It is worthwhile here to note that deferred tax liability needs to be recognized for all taxable temporary difference [where carrying value is greater than tax base or Carrying value > tax base] while deferred tax asset needs to be recognized for all deductible temporary difference [where tax base is greater then carrying value or Tax base >Carrying value].  Care need to be taken where an item is neither an asset nor a liability, for instance, research cost.

In our above-referred example the difference arose due to the difference in tax base and carrying value. The tax base of the asset is Rs 20,000.00 while the carrying value is Rs 160,000.00. In this case, the carrying value is greater than the tax base [taxable temporary difference], hence, it can be effectively concluded that Rs 60,200.00 is a deferred tax liability.

Apart from other issues, creation of deferred tax asset on tax losses is the most critically appraised hot topic. In order to understand the spirit of the problem, let’s go through an example.

Example 2

A (Pvt.) Ltd sustained a loss of Rs 100,000.00 in year 1. In order to identify the reason of sustaining the loss, the auditor has obtained the reason of loss and budgeted profit and loss account for next five year. The reasons were found satisfactory and the budgeted data is as follows.

Tax year

PROFIT/
LOSS

DEFERRED
TAX

 

2003

(100,000)

(37,400)

37.4%

2004

20,000

8,200

41%

2005

20,000

7,800

39%

2006

20,000

7,400

37%

2007

20,000

7,000

35%

2008

20,000

7,000

35%

The auditor allowed the creation of deferred tax asset to the extent of Rs 37,400.00. It is worthwhile here to note that a deferred tax does neither extract cash nor insert cash into the accounts of the company. The amount of Rs 37,400.00 credited to Profit and loss account will subsequently reverse in future years and profit and loss account will be debited by Rs 8,200.00, Rs 7,800.00 and so on in subsequent years. This will ultimately save the interest of shareholder and serve as a deterrent to the intention of the management to show inflated profit after taxation in subsequent years and deceive prospective investors. A management may increase the EPS ratio through creation of deferred tax asset but same EPS ratio will also be kept in line with normal practice in future years just because of deferred tax. Deferred tax is normally recognized on all timing differences that have originated but not reversed by the balance sheet date. However, deferred tax is not recognized on permanent differences.

The author Mohammed Ashraf, ACCA, APA, AFA, CAT is an international tax advisor. He can be contacted at mdashraf73@accamail.com.

Article courtesy of Mohammed Ashraf


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