CRASH COURSE 1

HAMMAD SARWAR

LECTURE 1
IAS 12

Temporary differences are defined as being differences between the carrying amount of an asset
(or liability) within the Statement of Financial Position and its tax base ie the amount at which
the asset (or liability) is valued for tax purposes by the relevant tax authority.
Taxable temporary differences are those on which tax will be charged in the future when the
asset (or liability) is recovered (or settled).
IAS 12 requires that a deferred tax liability is recorded in respect of all taxable temporary
differences that exist at the year-end – this is sometimes known as the full provision method.

Carrying value Tax base Temporary

of asset / - of asset / = difference
(Liability) (Liability)

If the temporary difference is positive, a deferred tax liability will arise. If the temporary
difference is negative, a deferred tax asset will arise.

Q1. A non-current asset costing $2,000 was acquired at the start of year 1. It is being depreciated
straight line over four years, resulting in annual depreciation charges of $500. Thus a total of
$2,000 of depreciation is being charged. The capital allowances granted on this asset are:
$
Year 1 800
Year 2 600
Year 3 360
Year 4 240
Total capital allowances 2,000. Relevant Tax rate is 20%
Requirement:
P&l and B/s extract using balance sheet approach

Q2. The trial balance shows a credit balance of $1,500 in respect of a deferred tax liability.
The notes to the question could contain one of the following sets of information:
1. At the year-end, the required deferred tax liability is $2,500.
2. At the year-end, it was determined that an increase in the deferred tax liability of $1,000
was required.
3. At the year-end, there are taxable temporary differences of $10,000. Tax is charged at a
rate of 25%.
4. During the year, taxable temporary differences increased by $4,000. Tax is charged at a
rate of 25%.
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Revaluations of non-current assets

When an NCA is revalued to its current value within the financial statements, the revaluation
surplus is recorded in equity (in a revaluation reserve) and reported as other comprehensive
income. While the carrying value of the asset has increased, the tax base of the asset remains the
same and so a temporary difference arises.
Tax will become payable on the surplus when the asset is sold and so the temporary difference is
taxable. Since the revaluation surplus has been recognised within equity, to comply with
matching, the tax charge on the surplus is also charged to equity

Q3. An entity has revalued its property and has recognized the increase in the revaluation in its
financial statements. The carrying value of the property was $8 million and the revalued amount
was $10 million.
Tax base of the property was $6 million. In this country, the tax rate applicable to profits is 35%
and the tax rate applicable to profits made on the sale of property is 30%. If the revaluation took
place at the entity’s year end of December 31, 20X4, calculate the deferred tax liability on the
property as of that date.

Deferred tax assets:

 Deductible temporary differences give rise to deferred tax assets. Examples of this are tax
losses carried forward or temporary differences arising on provisions that are not
allowable for taxation until the future.
 These deferred tax assets can be recognized if it is probable that the asset will be realized.
 According to IAS 12 the existence of unused tax losses is strong evidence that future
taxable profit may not be available against which to offset the losses. Therefore when an
entity has a history of recent losses, the entity recognizes deferred tax assets arising from
unused tax losses only to the extent that the entity has sufficient taxable temporary
differences or there is convincing other evidence that sufficient taxable profit will be
available.
 The carrying amount of deferred tax assets should be reviewed at each balance sheet date
and reduced to the extent that it is no longer probable that sufficient taxable profit will be
available to allow the benefit of part or all of that deferred tax asset to be utilised. Any
such reduction should be subsequently reversed to the extent that it becomes probable
that sufficient taxable profit will be available

Impairment of non-current asset:

 It is not allowable for tax purposes until the asset is sold
Write down of inventory
 The write down is ignored for tax purposes until the goods are sold.
Accrued pension contributions
 Tax relief is available on pension contributions only when they are paid
Cost of research and development
 Costs of research and development, which may be expensed in one period for accounting
purposes but allowed for tax purposes in later periods
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Q4. An entity has the following assets and liabilities recorded in its balance sheet at December
31, 20X5:
Carrying value
$ million
Property 10
Plant and equipment 5
Inventory 4
Trade receivables 3
Trade payables 6
Cash 2
The value for tax purposes of property and for plant and equipment are $7 million and $4 million
respectively.
The entity has made a provision for inventory obsolescence of $2 million, which is not allowable
for tax purposes until the inventory is sold. Further, an impairment charge against trade
receivables of $1 million has been made. This charge does not relate to any specific trade
receivable but to the entity’s assessment of the overall collectibility of the amount. This charge
will not be allowed in the current year for tax purposes but will be allowed in the future. Income
tax paid is at 30%.

Q5. An entity has spent $600,000 in developing a new product. These costs meet the definition
of an intangible asset under IAS 38 and have been recognized in the balance sheet. Local tax
legislation allows these costs to be deducted for tax purposes when they are incurred. Therefore,
they have been recognized as an expense for tax purposes. At the year-end the intangible asset is
deemed to be impaired by $50,000.
Required
Calculate the tax base of the intangible asset at the accounting year-end.

Q6. An entity has acquired a subsidiary on January 1, 20X4. Goodwill of $2 million has arisen
on the purchase of this subsidiary. The subsidiary has deductible temporary differences of $1
million and it is probable that future taxable profits are going to be available for the offset of this
deductible temporary difference. The tax rate during 20X4 is 30%. The deductible temporary
difference has not been taken into account in calculating goodwill.
Required
What is the figure for goodwill that should be recognized in the consolidated balance sheet of the
parent?

Sundry Points
 Every asset or liability is assumed to have a tax base. Normally this tax base will be the amount
that is allowed for tax purposes.
 Some items of income and expenditure may not be taxable or tax deductible, and they will never
enter into the computation of taxable profit. These items sometimes are called permanent
differences.
 Generally speaking, these items will have the same tax base as their carrying amount; that is, no
temporary difference will arise.
 There are some temporary differences that are not recognized for deferred tax purposes.
These arise
(a) From goodwill
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(b) From the initial recognition of certain assets and liabilities

(c) From investments when certain conditions apply

Group financial statements

When dealing with deferred tax in group accounts, it is important to remember that a group does
not legally exist and so is not subject to tax.
Instead, tax is levied on the individual legal entities within the group and their individual tax
assets and liabilities are cross-cast in the consolidation process. To calculate the deferred tax
implications on consolidation adjustments when preparing the group accounts, the carrying value
refers to the carrying value within the group accounts while the tax base will be the tax base in
the entities’ individual accounts.

Fair value adjustments

At the date of acquisition, a subsidiary’s net assets are measured at fair value. The fair value
adjustments may not alter the tax base of the net assets and hence a temporary difference may
arise.
Any deferred tax asset/liability arising as a result is included within the fair value of the
subsidiary’s net assets at acquisition for the purposes of calculating goodwill.

Goodwill
Goodwill only arises on consolidation – it is not recognised as an asset within the individual
financial statements. Theoretically, goodwill gives rise to a temporary difference that would
result in a deferred tax liability as it is an asset with a carrying value within the group accounts
but will have a nil tax base.
However, IAS 12 specifically excludes a deferred tax liability being recognised in respect of
goodwill.

Provisions for unrealised profits (PUPs)

When goods are sold between group companies and remain in the inventory of the buying
company at the year-end, an adjustment is made to remove the unrealised profit from the
consolidated accounts.
This adjustment also reduces the inventory to the original cost when a group company first
purchased it. However, the tax base of the inventory will be based on individual financial
statements and so will be at the higher transfer price. Consequently, a deferred tax asset will
arise. Recognition of the asset and the consequent decrease in the tax expense will ensure that the
tax already charged to the individual selling company is not reflected in the current year’s
consolidated income statement but will be matched against the future period when the profit is
recognised by the group.

Q7. P owns 100% of the equity share capital of S.

P sold goods to S for $1,000 recording a profit of $200. All of the goods remain in the inventory
of S at the year-end.
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Deferred tax and the Framework

IAS 12 considers deferred tax by taking a balance sheet approach to the accounting problem by
considering temporary differences in terms of the difference between the carrying values and the
tax values of assets and liabilities – also known as the valuation approach. This can be said to be
consistent with the IASB Framework’s approach to recognition within financial statements.
However, the valuation approach is applied regardless of whether the resulting deferred tax will
meet the definition of an asset or liability in its own right.
Thus, IAS 12 considers the overriding accounting issue behind deferred tax to be the application
of matching – ensuring that the tax consequences of an item reported within the financial
statements are reported in the same accounting period as the item itself.
For example, in the case of a revaluation surplus, since the gain has been recognised in the
financial statements, the tax consequences of this gain should also be recognised – that is to say,
a tax charge. In order to recognise a tax charge, it is necessary to complete the double entry by
also recording a corresponding deferred tax liability.
However, part of the Framework’s definition of a liability is that there is a ‘present obligation’.
Therefore, the deferred tax liability arising on the revaluation gain should represent the current
obligation to pay tax in the future when the asset is sold. However, since there is no present
obligation to sell the asset, there is no present obligation to pay the tax.
Therefore, it is also acknowledged that IAS 12 is inconsistent with the Framework to the extent
that a deferred tax asset or liability does not necessarily meet the definition of an asset or
liability.

EXAM questions:
Cate is an entity in the software industry. Cate had incurred substantial losses in the financial
years 31 May 2004 to 31 May 2009. In the financial year to 31 May 2010 Cate made a small
profit before tax. This included significant non-operating gains. In 2009, Cate recognised a
material deferred tax asset in respect of carried forward losses, which will expire during 2012.
Cate again recognised the deferred tax asset in 2010
on the basis of anticipated performance in the years from 2010 to 2012, based on budgets
prepared in 2010.
The budgets included high growth rates in profitability. Cate argued that the budgets were
realistic as there were positive indications from customers about future orders. Cate also had
plans to expand sales to new markets and to sell new products whose development would be
completed soon. Cate was taking measures to increase sales, implementing new programs to
improve both productivity and profitability. Deferred tax assets less deferred tax liabilities
represent 25% of shareholders’ equity at 31 May 2010. There are no tax planning opportunities
available to Cate that would create taxable profi t in the near future.

Solution
Deferred taxation
A deferred tax asset should be recognised for deductible temporary differences, unused tax losses
and unused tax credits to the extent that it is probable that taxable profit will be available against
which the deductible temporary differences can be utilised.
The recognition of deferred tax assets on losses carried forward does not seem to be in
accordance with IAS 12 Income Taxes.
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Cate is not able to provide convincing evidence that sufficient taxable profits will be generated
against which the unused tax losses can be offset. According to IAS 12 the existence of unused
tax losses is strong evidence that future taxable profit may not be available against which to
offset the losses. Therefore when an entity has a history of recent losses, the entity recognizes
deferred tax assets arising from unused tax losses only to the extent that the entity has sufficient
taxable temporary differences or there is convincing other evidence that sufficient taxable profit
will be available. As Cate has a history of recent losses and as it does not have sufficient taxable
temporary differences, Cate needs to provide convincing other evidence that sufficient taxable
profit would be available against which the unused tax losses could be offset. The unused tax
losses in question did not result from identifiable causes, which were unlikely to recur (IAS 12)
as the losses are due to ordinary business activities.
Additionally there are no tax planning opportunities available to Cate that would create taxable
profit in the period in which the unused tax losses could be offset (IAS 12).
Thus at 31 May 2010 it is unlikely that the entity would generate taxable profits before the
unused tax losses expired. The improved performance in 2010 would not be indicative of future
good performance as Cate would have suffered a net loss before tax had it not been for the non-
operating gains.
Cate’s anticipation of improved future trading could not alone be regarded as meeting the
requirement for strong evidence of future profits. When assessing the use of carry-forward tax
losses, weight should be given to revenues from existing orders or confirmed contracts rather
than those that are merely expected from improved trading. Estimates of future taxable profits
can rarely be objectively verified. Thus the recognition of deferred tax assets on losses carried
forward is not in accordance with
IAS 12 as Cate is not able to provide convincing evidence that sufficient taxable profits would be
generated against which the unused tax losses could be offset.