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It's funny how many quotes are credited to Albert Einstein. Some years ago, I came across this quote credited to Einstein, "the hardest thing in the world to understand is the income tax".
Income taxes truly can be complex but the main aim is to ensure companies provide a fair and accurate representation of their income tax liabilities. Some of the key concepts in IAS 12 are explained below.
Current tax: The amount of income tax payable (or recoverable) for the current period.
Deferred tax: The amount of income tax that will be payable (or recoverable) in future periods as a result of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax bases.
Temporary differences: Differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax bases.
Permanent differences: Differences between pre-tax accounting income and taxable income that will never reverse over time. Unlike temporary differences, which eventually even out over time, permanent differences are just that – permanent. They never go away. Because they don't reverse, permanent differences do not create deferred tax assets or liabilities. Deferred taxes are only for temporary differences.
Deferred tax asset: A deferred tax asset is recognized when it is probable that future taxable profits will be available against which the deductible temporary differences can be utilized.
Deferred tax liability: A deferred tax liability is recognized for all taxable temporary differences, except for those that arise from goodwill and certain other intangible assets.
This blog post compiles for you guidance made available by thought leaders to help you with the learning and understanding of IAS 12 Income taxes.
Fun facts:
- The world's oldest known income tax system was implemented in ancient Egypt around 3000 BC.
- In some countries, such as Denmark and Sweden, citizens are required to pay taxes on their pets.
- In the United Kingdom, there is a tax on gambling winnings, but not on losses.
- The first income tax in the United States was introduced in 1861 to help fund the Civil War.
- The highest income tax rate in the United States was 94% during World War II.
- The average American spends about 7 hours per year filling out their income tax form.
- The Internal Revenue Service (IRS) receives over 150 million individual income tax returns each year.
We will use the scenario below to explain the key concepts in IAS 12.
Company A has an item of property, plant and equipment of $600,000 to be depreciated over 3 years. The Company uses the straight-line method of depreciation for financial reporting purposes, however, the tax authorities uses the accelerated depreciation method for tax purposes, resulting in different depreciation expense recognized over the 3 years as follows.
| Year | Company Depreciation | Tax Depreciation |
|---|---|---|
| 1 | $200,000 | $300,000 |
| 2 | $200,000 | $200,000 |
| 3 | $200,000 | $100,000 |
- Temporary difference arising from its depreciation charge in year 1 that was less than what the tax authorities charged, that is, $300,000 - $200,000 = $100,000
- Temporary difference arising from its warranty expense in year 1 that was more than what the tax authorities charged, that is, $150,000 - $70,000 = $80,000
- Permanent difference arising from the fines and penalties paid in year 1 that will never reverse because it is not tax deductible now or in the future, that is, $10,000
Taxable income * Tax rate = Current tax expense
$990,000 * 30% = $297,000
The company's temporary difference is calculated as follows:
Temporary difference on depreciation expense = $100,000
Temporary difference on warranty expense = $80,000
The company's deferred tax liability is calculated as follows:
Temporary difference * Tax rate = Deferred tax liability
$100,000 * 30% = $30,000
The company's deferred tax asset is calculated as follows:
Temporary difference * Tax rate = Deferred tax asset
$80,000 * 30% = $24,000
Change in deferred tax liability during the year + Change in deferred tax asset during the year = Deferred tax expense
$30,000 (Deferred tax liability is credited and Deferred tax expense is debited as expense)
+
$24,000 (Deferred tax asset is debited and Deferred tax benefit is credited as income)
=
$6,000 (This is a net amount referred to as a Net deferred tax charge because the expense is more than the income, otherwise it would have been a Net deferred tax benefit)
In summary
Current tax is the amount of income tax payable (or recoverable) for the current period. In this scenario, Company A's current tax expense is $297,000.
Deferred tax is the amount of income tax that will be payable (or recoverable) in future periods as a result of temporary differences. In this scenario, Company A's Net deferred tax charge is $6,000.
Temporary differences are differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax bases. In this scenario, the temporary difference is the difference between the company's depreciation and warranty expense for financial reporting and for tax purposes of $100,000 and $80,000 respectively.
Permanent differences are differences that are never reversed and as such they do not give rise to deferred tax assets or deferred tax liabilities. In this scenario, the difference arising from the fines and penalties will never be reversed because neither now nor in the future will the Company be able to take the $10,000 fines and penalties as a deductible expense for tax purposes.
A deferred tax asset is recognized when it is probable that future taxable profits will be available against which the deductible temporary differences can be utilized. In this scenario, the company has a deferred tax asset of $24,000 because it is probable that the company will have future taxable profits against which it can utilize the warranty expense in deductible temporary differences.
A deferred tax liability is recognized for all taxable temporary differences, except for those that arise from goodwill and certain other intangible assets. In this scenario, the company has a deferred tax liability of $30,000 because it is probable that the company will have to pay taxes on the $100,000 in taxable temporary differences in the future.
The below resources (PDF and eLearn) provide comprehensive coverage of IAS 12 Income taxes, including its key requirements and practical guidance. Whether you are new to IAS 12 or need a refresher, these resources will be helpful.
Click the links below to download them.
IAS 12 Income taxes:
Source: ACCA
eLearn
Source: Deloitte
Deloitte IAS 12 Income taxes eLearn 1
Deloitte IAS 12 Income taxes eLearn 2
Source: BDO
IAS 12 Standard
Source: IASB
Access the IAS 12 Standard here
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