Chapter 18
Accounting for
income taxes
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Objectives of this lecture
• Understand that there is typically a difference between an
organisation’s profit or loss for accounting purposes, and its
profit or loss for taxation purposes
• Be able to identify some of the factors that will cause a
difference between profit or loss for accounting purposes
and profit or loss for taxation purposes
• Understand that a difference between the carrying amount
of an asset or liability will lead to a ‘temporary difference’
and understand when a temporary difference causes a
deferred tax asset, or a deferred tax liability
• Understand how deferred tax assets and deferred tax
liabilities arise
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Objectives (cont.)
• Understand how to account for taxation losses incurred
by companies and understand how, in certain
circumstances, taxation losses can lead to the recognition
of assets in the form of deferred tax assets
• Be able to critically evaluate the balance sheet approach
to accounting for taxation and the associated asset,
deferred tax asset, and liability, deferred tax liability
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Introduction to accounting for
income taxes
• Profit for taxation purposes is known as taxable profit
• Accounting profit is based on applying accounting
standards and conventions
• Tax expense for accounting purposes calculated after
applying relevant accounting standards
• Income tax payable based on taxable profit derived by
the entity applying the rules of taxation law
• The difference between tax expense and income tax
payable creates ‘temporary differences’
Worked Example 18.1 (p. 631) shows the difference
between taxable profit and accounting profit
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Some differences between accounting
and tax rules
Item
Generally accepted Tax rule
accounting rule
Many accrued expenses (e.g.
long-service leave, warranty
costs)
An expense when accrued
Recognised as a tax
deduction when paid
Many prepaid expenses (e.g.
prepaid rent)
Initially an asset—expensed
when economic benefits used
Typically a tax deduction
when paid
Revenue received in advance
(e.g. rental revenue)
Treated as a liability and
recognised as revenue when
earned
Typically taxed when received
Entertainment and goodwill
impairment
Treated as an expense
Not a tax deduction in current
or subsequent periods
Doubtful debts
Treated as an expense when
recognised
Treated as a tax deduction
when debtor is actually written
off in subsequent period
Development expenditure
Often capitalised and
subsequently amortised
Typically a tax deduction
when paid for
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Balance sheet approach to
accounting for taxation
Accounting for income taxes
• Governed by AASB 112
• Applies the ‘balance sheet’ method
• Focuses on comparing the carrying value of an entity’s assets
and liabilities with the tax base for those assets and liabilities
Carrying amount vs tax base of asset or liability
• Carrying amount is the amount the asset or liability is recorded
at in the accounting records
• Tax base is defined as the amount that is attributed to an asset
or liability for tax purposes (AASB 112)
• Where the carrying amount of an asset or liability is different
from the tax base a ‘temporary difference’ can arise
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Balance sheet approach to
accounting for taxation (cont.)
Temporary differences can be of two types:
1. A taxable temporary difference
– will result in an increase (decrease) in income tax
payable (recoverable) in future periods when the
carrying amount of the asset or liability is recovered or
settled
 Creates a liability—deferred tax liability
2. A deductible temporary difference
– will result in a decrease (increase) in income tax payable
(recoverable) in future periods when the carrying amount
of the asset or liability is recovered or settled
 Creates an asset—deferred tax asset
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Balance sheet approach to
accounting for taxation (cont.)
• Deferred tax liability
– The carrying amount of the asset exceeds the tax base
– Taxation payments have effectively been deferred to future
periods
– Tax is reduced or ‘saved’ in early years, but additional tax
will need to be paid later
• Example of deferred tax liability
– Carrying amount of a non-current depreciable asset
exceeds the tax base in early years, as depreciation
allowable as a deduction for tax purposes is greater than
depreciation for accounting purposes
– This will be reversed in later years when no depreciation is
allowable for tax purposes
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Balance sheet approach to
accounting for taxation (cont.)
Deferred tax asset
– The carrying amount of an asset is less than the tax base
Example of deferred tax asset:
– Tax base of a depreciable asset exceeds the carrying
amount in early years, as depreciation allowable as a
deduction for tax purposes is less than depreciation for
accounting purposes
– This will be reversed in later years when the asset is fully
depreciated for accounting purposes, but depreciation is
still allowable as a deduction for tax purposes
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Balance sheet approach to accounting
for taxation (cont.)
Income tax expense
• Represents the sum of the tax attributable to taxable
profit, plus or minus any adjustments relating to
temporary differences
• Defined in AASB 112 as:
– the aggregate amount included in the determination of
profit or loss for the period in respect of current tax and
deferred tax
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Balance sheet approach to accounting
for taxation (cont.)
Income tax payable
• The amount of tax generally expected to be paid to the
tax office, as a result of the year’s operations, within
the next financial period
• Under the ‘taxes payable method’ would be same as
tax expense
• Under balance sheet method income tax payable does
not necessarily equate to tax expense
• Calculation of income tax payable
Refer to Worked Example 18.2, pp. 632–35—Temporary
differences caused by the depreciation of a non-current
asset
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Balance sheet approach to accounting
for taxation (cont.)
Overview of journal entries
• Journal entry if temporary differences result in deferred
tax asset
– To recognise tax expense that relates to the temporary
difference
Dr Deferred tax asset (temp. difference x tax rate)
Cr
Tax expense
– To recognise tax expense that relates to the entity’s
taxable profit
Dr Taxation expense
Cr
Income tax payable
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Balance sheet approach to accounting
for taxation (cont.)
• Journal entry if temporary differences result in deferred tax
liability
– To recognise tax expense that relates to the temporary
difference
Dr Tax expense
Cr
Deferred tax liability (temp. difference x tax rate)
– To recognise tax expense that relates to the entity’s taxable
profit
Dr Taxation expense
Cr
Income tax payable
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Balance sheet approach to accounting
for taxation (cont.)
Reversal in future periods
• In future periods, timing differences will reverse:
– Deferred tax asset will be credited
– Deferred tax liability will be debited
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Tax base of asset and liabilities:
further consideration
Calculation of tax base for assets
• Carrying amount + future deductible amount—future
assessable amount
• Although an asset might be expected to give rise to
future assessable amounts that exceed the asset’s
carrying amount, AASB 112 focuses on the tax
consequences of recovering an asset to the extent of its
carrying amount only
• Where the carrying amount of an asset exceeds the tax
base there is a deferred tax liability
• If the carrying amount of the asset is less than the tax
base there will be a deferred tax asset
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Tax base of asset and liabilities:
further consideration (cont.)
• Consideration of doubtful debts when examining
accounts receivable
– amounts provided for doubtful debts via an allowance for
doubtful debts are not deductible for tax purposes
 deductible only when the account receivable is
actually written off
– any allowance for doubtful debts will result in a difference
between carrying amount and tax base
 this will result in a deferred tax asset
Refer to Worked Example 18.3 on p. 636—Determining the tax
base of assets
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Tax base of asset and liabilities:
further consideration (cont.)
Calculation of tax base for liabilities
• Carrying amount—future deductible amount + future
assessable amount
• Exception to the rule
• Tax base of a liability for ‘revenue received in advance’
Refer to Worked Example 18.4 on pp. 637—Determining the tax
base of liabilities
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Deferred tax assets and deferred
tax liabilities
Assets
– Deferred tax liability arises when:
 carrying amount > tax base
– Deferred tax asset arises when:
 carrying amount < tax base
Liabilities
– Deferred tax liability arises when:
 carrying amount < tax base
– Deferred tax asset arises when:
 carrying amount > tax base
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Deferred tax assets and deferred tax
liabilities (cont.)
Summary
• Carrying amount of assets or liabilities—tax bases of assets or
liabilities = taxable or deductible temporary differences
• Taxable or deductible temporary differences x tax rate =
deferred tax liabilities or deferred tax assets
– Assessable temporary difference results in increase in tax
payable in future years
– Deductible temporary difference results in decrease in tax
payable in future years
Refer to Worked Example 18.5 on p. 639—Temporary differences
and the recognition of a deferred tax liability
Refer to Worked Example 18.6 on p. 640—A deductible temporary
difference resulting in a deferred tax asset
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Deferred tax assets and deferred tax
liabilities (cont.)
Deferred tax asset—Recognition criteria
• A number of assumptions are made:
– The entity will remain in business (going concern)
– Taxable income will be derived in future years
– Recognition of deferred tax asset same as applied to
other assets—reliance on ‘probability’ test
• AASB 112 notes that the ‘probable’ test will always be
met in relation to deferred tax liabilities
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Unused tax losses
• Deferred tax assets can arise as a result of tax losses
• Tax losses can generate subsequent benefits
• Consistent with the test for deferred tax assets generated by
temporary differences, deferred tax assets generated as a
result of unused tax losses must also be able to satisfy the
‘probable’ test before they are recognised as assets
• Recognition of a deferred tax asset arising from the carryforward of unused tax losses and unused tax credits
• As a general principle applicable to all deferred tax assets it
is a requirement that they be reviewed at the end of each
reporting period to ensure that the assets are not overstated
(refer to AASB 112, par. 56)
Refer to Worked Example 18.7 on p. 641, which illustrates the
utilisation of unused tax losses
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Transfer of tax losses to other
entities within a group
• Transfer of tax losses within a group or economic entity
is not addressed in AASB 112
• Importance of this issue diminished following
introduction (from 1 July 2001) of tax consolidation
regime in Australia
• Loss transfer rules in the Income Tax Assessment Act
1997 no longer apply to most entities
• New legislation requires corporate groups to form a ‘tax
consolidated group’ if they want to be treated as a
single entity for income and capital gains tax purposes
• Election to form a ‘tax consolidated group’ is optional
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Revaluation of non-current assets
• According to AASB 112 (par. 20) revaluations of non-current
assets can create temporary differences
• When non-current assets are revalued, the revaluation
increment is not deductible for tax purposes, even though
depreciation for accounting purposes will be based on the
revalued amount
• The tax base is not affected by the revaluation because
depreciation for tax purposes will be based on the original
cost of the asset
• Any increase in the carrying value of a non-current asset
through a revaluation implies an expected increase in the
future flow of economic benefits
• This increase can be taxable and can lead to a deferred tax
liability if the carrying amount is greater than the tax base
(refer to AASB 112, par. 20)
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Revaluation of non-current assets
(cont.)
• AASB 112 requires that, to the extent that the deferred tax
relates to amounts that were previously recognised in equity as
either direct credits or direct debits, the journal entry to
recognise the deferred tax asset or liability must also be
adjusted against the equity account
• As the revaluation is adjusted against equity, the accounting
entry to record the recognition of the deferred tax liability is
Dr
Revaluation surplus
Cr
Deferred tax liability
• Recognition of future tax associated with an revalued asset acts
to reduce the amount of the revaluation surplus account
• Entry assumes that the revalued amount of the asset will be
recovered by the entity’s continued use of the asset
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Revaluation of non-current assets
(cont.)
• If there is an expectation that the revalued asset is to be
sold
– Journal entries to record the deferred tax liability will
be different if the entity operates in a country with
capital gains tax indexation
– If a non-current asset is sold there is often a ‘tax
break’ given to the organisation as the tax base is
increased by an index that reflects general price
increases
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Revaluation of non-current assets
(cont.)
– If the tax that will be assessed in future is to be
reduced because of capital gains indexation, the
reduction in the amount of tax that would be paid is
accounted for by debiting the deferred tax liability
and crediting the revaluation reserve
– Result—the tax base of an asset can depend on
the manner in which the entity's management
expects to recover the benefits inherent in the asset
Refer to Worked Examples 18.8 and 18.9 on pp. 644–
645—Accounting for a revaluation
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Offsetting deferred tax assets and
deferred tax liabilities
• Given that in most cases the tax is payable to the same
authority, AASB 112 requires that, if certain conditions
are met, then both the current tax liabilities and current
tax assets as well as the deferred tax liabilities and
deferred tax assets be set off against one another and
that only the net amount of each set off be disclosed in
the statement of financial position
• The requirements pertaining to offsetting deferred tax
assets and deferred tax liabilities are included at
paragraph 74 of AASB 112
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Change of tax rates
• Tax rates will change across time
• Will have implications for value to be attributed to preexisting deferred tax assets and deferred tax liabilities
• An increase in tax rates will create an expense (which will
be of the nature of income tax expense) when an entity
has deferred tax liabilities, and will create income in the
presence of deferred tax assets
• Conversely, a decrease in tax rates will create income
when an entity has deferred tax liabilities, whereas a
decrease will create an expense in the presence of
deferred tax assets
Refer to Worked Examples 18.11—Change in tax rates—and
18.12—Impact of changing tax rates (p. 651)
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Evaluation of the assets and
liabilities created by AASB 112
Deferred tax assets vs the IASB/AASB Conceptual
Framework
– Deferred tax asset might not meet Conceptual Framework
definition of asset
– At the end of the reporting period the company really has
no claim against the government for the value of the
deferred tax asset
– The realisation of the benefit will only arise if the company
earns sufficient revenue in the future and if the relevant tax
legislation does not change
– It is questionable whether benefits are actually controlled
by the entity at balance date as there might be a
contingent element involved
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Evaluation of the assets and liabilities
created by AASB 112 (cont.)
Definition of liability under Conceptual Framework:
a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from
the entity of resources embodying economic benefits
– When a deferred tax liability exists the company is not
presently obliged to transfer funds of an amount equal to the
balance of the account
– Funds will only be transferred in the future if the company
earns sufficient revenue—there is a dependency on future
events, not past events
– Also an assumption that the relevant taxation legislation will
not change
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Summary
• The main purpose of the lecture is to consider how to
account for tax
• Taxable profit and accounting profit will often be different
because expense and recognition rules used in accounting
are often different from those applied for taxation purposes
• AASB 112 Income Taxes applies the balance sheet
method in accounting for taxes—carrying values and tax
bases are compared for assets and liabilities
• The difference between carrying amounts and tax bases
leads to either deductible temporary differences or taxable
(assessable) temporary differences—multiplying these
differences by the tax rate gives rise to either a deferred tax
asset or deferred tax liability
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Summary (cont.)
• Generally speaking, if the carrying amount of an asset
is greater than its tax base there will be a deferred tax
liability and if the carrying amount of an asset is less
than its tax base there will be a deferred tax asset
• If the carrying amount of a liability is greater than its
tax base there will be a deferred tax asset and if the
carrying amount is less than the tax base there will be
a deferred tax liability
• For an entity to recognise deferred tax assets there is
a requirement that the derived associated economic
benefits be probable
• When a temporary difference associated with the
revaluation of a non-current asset takes place the
balance of the revaluation reserve account is reduced
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