IAS 12 Deferred Taxes: Understanding its Rationale and Application
Recently, I had a discussion with my company’s auditors regarding the issue of deferred tax in IAS 12, and I learn one important thing. As the company’s accountant, it is always advisable to read and understand the accounting standards by yourself, instead of adopting the mentality that the auditors are always right in their interpretation of the accounting standards. I must admit accounting standards, like the standard on deferred tax in IAS 12, can be daunting to read for non-accounting geeks.
For most people, reading accounting standards is their perfect bedtime story and cure for insomnia. Except for some accounting geeks and weirdos like me who derive mental stimulation from debits and credits. Let me explain why deferred tax is so interesting (okay, maybe not). For the benefit of non-accounting guys, let’s first understand what deferred tax is all about.
What is deferred tax?
What do the standards say about deferred tax?
The standards say that ‘deferred tax’ is the amount of income tax payable or receivable in future periods in respect of taxable temporary differences. Ok, the next question you have is ‘what are taxable temporary differences?’ ‘Temporary differences are differences between carrying amount of an asset or liability in the statement of financial position and its tax base.’ Seriously, why do standard-setters make these definitions so hard to understand? I think the best way to explain deferred tax, its basis and application is to use an example.
Let’s consider company ABC with a computer costing $1000.
Let’s say depreciation policy is 5 years, straight-line (meaning depreciation is $200 per year, over 5 years). So, value of the computer decreases by $200 every year, as per table below.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Value of computer | $1000 | $800 | $600 | $400 | $200 |
I think it is important to understand that each company needs to maintain 2 sets of accounts. One set of accounts is for financial reporting; another set of accounts is for tax reporting. This is simply because tax rules are different from accounting rules. Accounting rules are governed by financial reporting standards (either IFRS or US GAAP), while tax rules are created by local tax offices and differ country to country.
Let’s consider the income statement reported based on accounting standards. The final goal of the income statement is to arrive at the Net Income figure. If accounting rules and tax rules are congruent, then I can simply multiply the Net Income before tax by prevailing tax rate to determine the tax expense. Unfortunately, this is not the case for most countries, and we cannot use the Net income before tax to calculate amount of taxes payable directly. For example, not all revenue recognized under financial reporting standards are taxable, and not all expenses recognized are deductible (if the expenses incurred are not for the production of income, they will need to be added back to the Net Income before tax). This means that we will need to make some adjustments to the Net income before tax figure to arrive at the Chargeable Income to determine amount of taxes payable by the company. In a nutshell, under accounting standards, we are interested in the Net income figure, but under tax laws, we are interested in the Chargeable Income figure.
Let’s return to our example of company ABC and consider 2 cases.
Case 1: Company ABC is in a country where depreciation expenses are tax-deductible. This is not common.
If depreciation expenses are tax-deductible, there is no difference between accounting standards and tax laws.
| Year 1 | Year 2 T | Year 3 | Year 4 | Year 5 | |
| Tax Value of computer (or TWDV, tax written down value) | $1000 | $800 | $600 | $400 | $200 |
| Value of computer (in accounting books) | $1000 | $800 | $600 | $400 | $200 |
So, there is no deferred tax in this case.
Case 2: Company ABC is in a country where purchase of computers can be claimed 100% as a capital allowance in the first year.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Tax Value of computer (or TWDV, tax written down value) | - | - | - | - | - |
| Value of computer (in accounting books) | $1000 | $800 | $600 | $400 | $200 |
In Singapore tax law, purchase of computers can be claimed 100% as a capital allowance in the first year (subject to some criteria which won’t be discussed here). Let’s just assume that the computers can be claimed in full in the first year, which means that the TWDV or Tax Written Down Value of computers will be zero at end of year 1.
Now, notice there is a difference between the company’s tax books and accounting books.
This difference is a temporary difference, as defined in the accounting standards. Recall the definition of temporary differences: ‘differences between carrying amount of an asset or liability in the statement of financial position and its tax base.’ The carrying amount of the computers in the statement of financial position, i.e. balance sheet, is the purchase value ($1000) less depreciation each year. The tax base is basically the Tax Written Down Value of the asset, recorded in the tax accounts.
Whenever we have a temporary difference, i.e. difference between carrying value in your accounting books and tax value in your tax books, there will be a deferred tax asset or liability. In this case of company ABC, we need to record a deferred tax liability because company ABC has claimed full 100% tax depreciation (100% capital allowance in the first year) and paid a lower tax in current year, as per local tax laws. Since the computer has been fully written down in the tax books, company ABC will not be able to claim depreciation anymore, and therefore need to pay higher taxes in future years, therefore arising in the deferred tax liability.
Reason for deferred taxes
‘What a strange way of accounting!’ you might think. But if you go back to basic principles of accounting, it makes perfect sense. Why do I say so?
Remember the matching principle? Let me give a short illustration of the matching principle. If I sell 3 goods in January, I recognise the selling price of the 3 goods as revenue. But that’s not all! I also need to recognise the cost of goods sold to match against the revenue recognized from the sale of the 3 goods.
Now let’s come back to taxes. If I recognize $5000 revenue and $2000 expenses in period A, I will have $3000 Net Income before Tax for Period A. To satisfy matching principle, I need to recognize a corresponding tax expense that match the revenues and expenses recognized in the same period. So, if company ABC recognizes depreciation expense of $200 in Year 2, it should recognize a tax expense that match the depreciation expense recorded in the accounting books. However, the actual tax payable is different because actual tax payable depends on tax laws, which allow 100% tax depreciation in the first year, which is different from the accounting standards we are used to! Therefore, there will be a mismatch in our accounting books if we recognize tax expense based on tax laws, and we need to reconcile the difference by recognizing a deferred tax liability or asset.
So what are the accounting entries?
To make things easier, just remember that if carrying value of assets in accounting books is greater than TWDV, you should recognize a deferred tax liability. If carrying value of liabilities in accounting books is greater than TWDV, you should recognize a deferred tax asset.
In the case of company ABC,
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Tax Value of computer (or TWDV, tax written down value) | - | - | - | - | - |
| Value of computer (in accounting books) | $1000 | $800 | $600 | $400 | $200 |
Notice in year 1, carrying amount of computer in accounting books is $1000 greater than TWDV. Assume prevailing tax rate is 17%, like in Singapore. A deferred tax liability of $170 ($1000 x 17%) should be recorded in the books in Year 1.
DR tax expenses $170
CR deferred tax liability $170
Over the years, as company A depreciates the value of computers, the carrying amount of computer will converge to the TWDV of zero in the tax books. You only need to reverse out the deferred tax liability and credit tax expenses from Year 2 to Year 6 by $34 ($200 x 17%).
DR deferred tax liability $34
CR tax expenses $34
So, as you can see, the difference between the value in your accounting books and tax books is just a temporary difference that will be reversed out eventually. The reason for accountants making life difficult recognizing deferred tax in year 1 to 5 is to satisfy the matching principle, i.e. match tax expense against corresponding revenues and expenses recognized in the same period. The mismatch in tax payable arises due to differences between tax laws and accounting standards.
If you are interested in other situations that can lead to deferred taxes, or if you want to know more about the discussion on deferred tax I had with my company’s auditors, I would be happy to share with you at another time!