11_Income Tax Theory of Accounts

1. Which entities are required to apply deferred tax accounting under PAS 12?

Deferred tax accounting is applicable to all entities, whether public or nonpublic entities. A
public entity is one whose equity and debt securities are traded in a stock exchange or over-
the-counter market or whose equity or debt securities are registered with SEC in preparation
for sale of the securities in the exchange market.

2. Distinguish accounting income and taxable income.

Accounting income or financial income is the net income for the period before deducting
income tax expense. Under IAS, this is known "accounting profit". This is the income
appearing on the traditional income statement and computed in accordance with accounting
standards. Taxable income is the income for the period determined in accordance with the
rules established by the taxation authorities. Taxable income is the income appearing on the
income tax return and computed in accordance with the income tax law. Taxable income
may be defined also as the excess of taxable revenue over tax deductible expenses and
exemptions for the period as defined by the Bureau of Internal Revenue.

3. Explain the two basic differences between accounting income and taxable income.

1. Permanent differences are items of revenue and expenses which are included in either
accounting income or taxable income but will never be included in the other. Actually,
permanent differences pertain to nontaxable revenue and nondeductible expenses.
Permanent differences do not give rise to deferred tax asset or liability because they have
no future tax consequences.
2. Temporary differences are differences between the carrying amount of an asset or liability
and its tax base. Temporary differences include timing differences. Timing differences
are differences between accounting income and taxable income that originate in one
period and reverse in one or more subsequent periods. In other words, timing differences
are items of income and expenses which are included in both accounting income and
taxable income but at different time periods. Accordingly, temporary differences give rise
either to a deferred tax asset or deferred tax liability.

4. Explain the two kinds of temporary difference.

1. Taxable temporary difference is the temporary difference that will result in future taxable
amount in determining taxable income of future periods when the carrying amount of the
asset or liability is recovered or settled.
2. Deductible temporary difference is the temporary difference that will result in future
deductible amount in determining taxable income of future periods when the carrying
amount of the asset or liability is recovered or settled.

5. What is a deferred tax liability?

Deferred tax liability is the amount of income tax payable in future periods with respect to a
taxable temporary difference. A deferred tax liability is the deferred tax consequence
attributable to a future taxable amount or taxable temporary difference.
Actually, a deferred tax liability arises from the following:
a. When the accounting income is higher than taxable income because of timing
differences.
b. When the carrying amount of an asset is higher than the tax base.
11_Income Tax Theory of Accounts

c. When the carrying amount of a liability is lower than the tax base.

6. What is a "tax base"?

The tax base of an asset or a liability is the amount attributable to the asset or liability for tax
purposes. Worded in another way, the tax base of an asset or a liability is the amount of the
asset or liability that is recognized for tax purposes.
The tax base of an asset is the amount that will be deductible for tax purposes against future
profit. For example, if an entity has appropriately capitalized P1,000,000 as software
development cost, the carrying amount is P1,000,000 for accounting purposes. However, if
this amount is allowed as a one-time deduction for tax purposes, the tax base is zero because
the entire amount is expensed in the current year.
The tax base of a liability is normally the carrying amount less the amount that will be
deductible for tax purposes in the future. For example, if an entity has recognized an
estimated warranty liability of P500,000, the carrying amount is P500.000 for accounting
purposes. However, an estimated warranty cost is deductible only when actually paid. Thus,
the tax base is zero. The carrying amount of P500,000 less the future deductible amount of
P500,000 equals zero.

7. What are the types of temporary differences that result to higher accounting income than
taxable income as a result of timing differences?

1. Revenues and gains are included in accounting income of the current period but are
taxable in future periods. For example, an installment sale is included in accounting
income at the time of sale and included in taxable income when cash is collected in future
periods.
2. Expenses and losses are deductible for tax purposes in the current period but deductible
for accounting purposes in future periods.
a. Accelerated depreciation for tax purposes and straight-line depreciation for
accounting purposes.
b. Development cost may be capitalized and amortized over future periods in
determining accounting income but deducted in determining taxable income in the
period in which it is paid.
c. Prepaid expense has already been deducted on a cash basis in determining taxable
income of the current period.

8. Give examples of temporary differences that technically are not timing differences but
nevertheless give rise to deferred tax liability.
ANSWER 10-8
1. Asset is revalued upward and no equivalent adjustment is made for tax purposes.
2. The carrying amount of investment in subsidiary, associate or joint venture is higher than
the tax base because the subsidiary, associate or joint venture has not distributed the
entire income to the parent or investor.
3. The cost of a business combination that is accounted for as an acquisition is allocated to
the identifiable assets and liabilities acquired at fair value and no equivalent adjustment
is made for tax purposes.

9. Explain the recognition of a deferred tax liability.

PAS 12, paragraph 15, provides that "a deferred tax liability shall be recognized for all taxable
temporary differences".
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However, a deferred tax liability is not recognized when the taxable temporary difference
arises from:
1. Goodwill resulting from a business combination and which is nondeductible for tax
purposes.
2. Initial recognition of an asset or liability in a transaction that is not a business combination
and affects neither accounting income nor taxable income.
3. Undistributed profit of subsidiary, associate or joint venture when:
a. The parent, investor or venturer is able to control the timing of the reversal of the
temporary difference.
b. It is probable that the temporary difference will not reverse in the foreseeable future.

10. What is deferred tax asset?

A deferred tax asset is the amount of income tax recoverable in future periods with respect
to deductible temporary difference and operating loss carry forward. A deferred tax asset is
the deferred tax consequence attributable to a future deductible amount or deductible
temporary difference and operating loss carry forward. A deferred tax asset arises from the
following:
a. When the taxable income is higher than accounting income because of timing
differences.
b. When the tax base of asset is higher than carrying amount.
c. When the tax base of a liability is lower than carrying amount.

11. What are the types of temporary differences that will result to taxable income higher than
financial income because of timing differences?

1. Revenues and gains are included in taxable income of current period but are included in
accounting income of future periods. For example, rent received in advance is taxable
at the time of receipt but deferred in future periods for accounting purposes.
2. Expenses and losses are deducted from accounting income of current period but are
deductible for tax purposes in future periods. Examples are:
a. A probable and measurable litigation loss is recognized for accounting purposes but
deducted in determining taxable income when actually incurred or paid.
b. Estimated product warranty cost is recognized for accounting purposes in the current
period but deducted in determining taxable income when actually incurred or paid.
c. Research cost is recognized as expense in determining accounting income but not
permitted as a deduction in determining taxable income until a later period.
d. An impairment loss is recognized for accounting purposes but ignored for tax purposes
until the asset is sold.
e. Doubtful accounts are recognized as expense for accounting purposes but deductible for
tax purposes only when written off as worthless.

12. Give examples of temporary differences that technically are not timing differences but
nevertheless give rise to deferred tax asset.

1. Asset is revalued downward and no equivalent adjustment is made for tax purposes.
2. The tax base of investment in subsidiary, associate or joint venture is higher than carrying
amount because the subsidiary, associate or joint venture has suffered continuing losses
in current and prior years.
3. Financial asset is carried at fair value which is less than cost but no equivalent adjustment
is made for tax purposes.
11_Income Tax Theory of Accounts

13. Explain the recognition of a deferred tax asset.

PAS 12, paragraph 24, provides that "a deferred tax asset shall be recognized for all
deductible temporary differences and operating loss carryforward when it is probable that
taxable income will be available against which the deferred tax asset can be used".

14. What is an operating loss carryforward?

Operating loss carryforward is an excess of tax deductions over gross income in a year that
may be carried forward to reduce taxable income in a future year. Thus, an operating loss
carryforward will give rise to a deferred tax asset. Certain entities registered with the Board
of Investments are permitted to carry over net operating loss for tax purposes subject to
limitations of the relevant law and implementing regulations of the Board of Investments.

15. Define the following:

1. Current tax expense is the amount of income tax paid or payable for the year as
determined by applying the provisions of the enacted tax law to the taxable income. In
other words, current tax expense is equal to taxable income multiplied by the current tax
rate.
2. Deferred tax expense or benefit is the change during the year in an entity's deferred tax
liability and deferred tax asset. If the increase in deferred tax liability is more than the
increase in deferred tax asset, there is a net deferred tax expense. Conversely, if the
increase in deferred tax asset is more than the increase in deferred tax liability, there is
a net deferred tax benefit. In other words, taxable temporary difference multiplied by the
tax rate equals deferred tax expense. Deductible temporary difference multiplied by tax
rate equals deferred tax benefit.
3. Income tax expense is the sum of current tax expense and deferred tax expense or
benefit. This is the amount of tax expense that appears on the income statement.

16. Explain a current tax liability and a current tax asset

A current tax liability is the current tax expense or the amount of income tax actually payable.
This is classified as current liability. Under our income tax law, income tax for corporations
is payable every quarter. If the amount of tax already paid for the current period exceeds the
amount actually payable for the period, the excess is recognized as a current tax asset.
Actually, a current tax asset is a prepaid income tax and shall be classified as current asset.

17. Explain the measurement of current tax liability and current tax asset.

A current tax liability or current tax asset shall be measured using the tax rate that has been
enacted and effective at the end of the reporting period.

18. Explain the measurement of deferred tax liability or deferred tax asset.

A deferred tax liability or deferred tax asset shall be measured using the tax rate that has
been enacted by the end of the reporting period and expected to apply to the period when
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the asset is realized or the liability is settled.

19. Explain the presentation of deferred tax liability and deferred tax asset.
ANSWER 10-19
PAS 12, paragraph 70, provides that "when an entity makes a distinction between current
and noncurrent assets and liabilities, it shall not classify deferred tax assets as current assets
and deferred tax liabilities as current liabilities." Accordingly, a deferred tax asset shall be
classified as noncurrent asset and a deferred tax liability shall be classified as noncurrent
liability regardless of reversal period. Moreover, a deferred tax asset or deferred tax liability
shall not be discounted.

20. May a deferred tax asset and deferred tax liability be offset against the other for presentation
purposes?

PAS 12, paragraph 74, provides that an entity shall offset deferred tax asset and deferred
tax liability when:
a. The deferred tax asset and deferred tax liability relate to income taxes levied by the same
taxing authority.
b. The entity has a legal enforceable right to set off a current tax asset against a current tax
liability.

21. Explain the deferred tax consequence of revaluation of asset,

Generally, revaluation of an asset is not a taxable event. However, the future recovery of the
asset either through continuing use or through disposal would lead to a taxable amount. The
amount of depreciation based on cost deductible for tax purposes would differ from the
amount of depreciation based on revalued amount that is recognized for accounting
purposes. Consequently, the difference between the carrying amount and tax base of a
revalued asset is a temporary difference. An upward revaluation shall give rise to a taxable
temporary difference resulting to a deferred tax liability. Since the revaluation surplus is a
component of other comprehensive income, the deferred tax consequence is also recognized
in other comprehensive income, meaning the deferred tax is deducted from the revaluation
surplus.

22. Explain "intraperiod tax allocation" and "interperiod tax allocation."

Intraperiod tax allocation is the allocation of income tax expense to the various revenues that
brought about the tax. Intraperiod tax allocation associates the tax expense with the items
in the income statement. Thus, the total income tax expense is allocated to income from
continuing operations, income from discontinued operations and prior period errors or items
directly charged or credited to retained earnings. Interperiod tax allocation is the recognition
of a deferred tax asset or deferred tax liability.

23. What are the approaches of accounting for deferred income tax? Which approach is
required?
11_Income Tax Theory of Accounts

1. Income statement approach - This approach focuses on timing differences only in the
computation of deferred tax asset or deferred tax liability. As the approach suggests,
timing differences affect the income statement of one period and will reverse in the
income statement of one or more subsequent periods.
2. Statement of financial position approach - This approach considers all temporary
differences including timing differences. There are temporary differences that affect the
statement of financial position only and therefore technically are not timing differences
but nonetheless are recognized in computing deferred tax asset or liability. PAS 12
requires the use of the statement of financial position approach.

24. What are the procedures in determining the deferred tax asset or liability using the "statement
of financial position approach"?

To account for a deferred tax asset or liability, first prepare a statement of financial position
that shows all the assets and liabilities at their carrying amount.
The following procedures are then followed:
1. Determine the tax base of the assets and liabilities in the statement of financial position.
2. Compare the carrying amount with the tax base.
3. The difference between the carrying amount and tax base normally will result to a
deferred tax asset or liability.
4. Permanent differences do not give rise to deferred tax asset or liability.
5. Apply the tax rate to the temporary differences.
6. Determine the beginning and ending balance of deferred tax asset or liability.
7. Recognize the net change between the beginning and ending balance of deferred tax
asset or liability.
8. The net change is the adjustment for the deferred tax asset or liability.