Corporate Financial Reporting Income Tax

Income Tax Expense, Current tax expense, Deferred tax expense, Deferred Tax Asset, Deferred Tax Liability Permanent and Temporary Differences, Impact of these on above

Accounting Income and Taxable Income

Accounting Income: Profit before tax (PBT) calculated following accounting policies and principles and are reported in Income Statement Matching Principle: Tax expenses are incurred by an entity in the process of earning income, they should be matched with the revenue and expenses to which they relate and accounted for in the same period Taxable Income: Amount of profit (or loss) for a period, calculated as per taxation provisions, based upon which taxation authorities determine the tax payable. There might be significant differences between Taxable Income and Accounting Income

Differences
Two main causes of differences between Accounting Income and Taxable Income: 1. Items of Revenue and Expense Permanent Difference : Difference which originates in one period and do not reverse in any subsequent periods Examples: Revenues exempted from tax : Dividend received from subsidiary Expenses not allowed by tax laws : Penalty for violation of law Deferred tax consequences : NO Amount of Revenue and Expense Temporary (Timing) Difference: Difference which originates in one period and can reverse in one or more subsequent periods Examples : Difference in Depreciation due to difference in the Method or difference in the Rate

1.

Tax Expense - Terms

Income Tax Expense : Amount of income tax expense reported in Profit & Loss A/C or IS Accounting Income (over & above permanent difference, if any ) Tax Rate Income tax Expense = Current Tax Expense + Deferred Tax expense Current Tax Expense: Amount of income tax expected to be payable (recoverable) to taxation authorities in respect of taxable income (tax loss) for a period using applicable tax rates and laws. Current Tax Expense = Taxable Income Tax Rate (Statutory) creates Income Tax Payable (Liability) Deferred Tax expense: Is the tax effect of timing differences between Accounting Income and Taxable Income (Accounting Income - Taxable Income) due to Timing difference Tax Rate = DTE increases Deferred Tax

When due to Timing Difference :

Deferred Tax Liability (DTL) & Deferred Tax Assets (DTA)

Taxable timing difference gives rise to Deferred Tax Liability (DTL) Deductible timing difference gives rise to Deferred Tax Assets (DTA)

Accounting Income > Income Tax Expense in Income Statement Taxable Income > Current tax expense as per tax law Deficit in income tax payment. Elimination of deficit in payment expected through payment in future Accounting Income < Taxable Income Income Tax Expense in Income Statement < Current tax expense as per tax law Excess amount is paid for income tax. Recovery expected in future Taxable Timing difference Deductible Timing difference

will result in payment of income taxes in future when the timing difference reverses will result in reduced income taxes in future when the timing difference reverses
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More Examples: Temporary (or Timing) Difference

Depreciation Companies provide depreciation using SLM, Tax law allows depreciation using WDV at higher rates (difference in rates, methods) Initial years : Depreciation higher for tax purpose Accounting Income (PBT) > Taxable Income Income Tax Expense > Current Tax Expense (tax liability) paid lesser tax Taxable Timing Difference Deferred Tax Expense (DTE) DTL Subsequent Years: DTE reverses (-ve DTE) Reduction in DTL to zero Expense recognized in IS before or after recognition for tax purpose If Tax Authorities allow the expense to be deducted only on payment and payment is made in a period different from the period when the expense accrues. Example : Litigation Expenses 6 In the year when expense accrues but not paid : AI < TI =>

More Examples: Temporary (or Timing) Difference

Revenue recognized in IS before or after recognition for tax purpose If Tax Authorities taxes the revenue on cash basis i.e. when the cash is collected but for accounting purposes revenue is recognized in a different year based on revenue recognition principle. Example: Service Revenue received in advance
If a revenue is recognized in year 2 but taxed in year 1 because cash is received in yr 1 In year 1, AI < TI => DTA. Reverses in year 2 when revenue recognized in IS.

Provisions for Doubtful debt (BDE), Provision for Warranties recognized as expense for accounting purpose but actual bad debts or warranty costs allowed for tax purpose
If Provisions > Actual Expense in a year => AI < TI => DTA

Amortization: Period over which expenses are amortized differ for tax purpose and accounting purpose (Preliminary Exp, Deferred Revenue Expenses)
If amortization period for tax purpose shorter than that for accounting purpose Amortization expense in IS lower => AI > TI => DTL
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Prudence
Prudence needs to be exercised while recognising Deferred Tax Assets (DTA) DTA to be recognised and carried forward only to the extent there is Reasonable or virtual certainty (supported by convincing evidence) that sufficient future taxable income will be available to realise DTA At each Balance Sheet date, Deferred Tax Assets should be reviewed. DTA/DTL nor required to be discounted to their present values (Indian GAAP) If there is doubt that some or all DTA will not be realised, a valuation allowance should be created to

Accounting Entry

When DTL / DTA is created due to origination of timing difference Deferred Tax Expense Dr. Deferred Tax Asset Deferred Tax Liability Cr. Dr. Deferred Tax Expense Cr.

When DTL / DTA is adjusted due to reversal of timing difference Deferred Tax Liability Dr. Deferred Tax Expense Deferred Tax Expense Dr. Deferred Tax Asset Cr.
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Cr.

Illustration- 1
Murky Waters, Inc. pays income tax @ 30%. During 2010, its Earnings Before Depreciation and Taxes = $30,000 = Taxable Income before Depreciation. It owns a lake cleaning vessel that is being depreciated under SLM at $ 4,000 per year. Tax allowable depreciation is $6,000 for 2010 Does the difference in the amount of depreciation under book and tax purposes result in a permanent difference? Determine Taxable Income, PBT, Current Tax Expense, Deferred Tax Expense, Net Earnings Before Depreciation and Taxes 30,000 Taxable Income Before Depreciation Less:Income (SLM) Depreciation 4000 Less: Depreciation (Tax Allowable)
Profit Before Tax (Accounting Income) Less: - Current Tax Expense (24000*0.30) - Deferred Tax Expense (26000 -24000)*0.30 Income Tax Expense (Current + Deferred) Net Income (or PAT) 7200 600 7800 18,200 16,800 2,000 26,000 Taxable Income Less: Tax @ 30%

30,000 6,000 24,000 7200

Taxable Temporary (Timing) Difference = Accounting Income (26,000) > Taxable Income (24,000) = Depreciation in IS (4000) < Depreciation allowed for Tax Purpose (6000) Current Tax Expense = Taxable Income Tax Rate Deferred Tax Expense = (Accounting Income - Taxable Income) due to timing difference Tax Rate Deferred Tax Expense Dr. 600

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Illustration - 2
Brecht Company purchased a machinery on April 1, 2010, for $32,000. The machine has an estimated useful life of four years and an estimated residual value of zero, and the company uses the straight-line depreciation method for financial reporting. Income Tax Rules allow declining balance depreciation method, and a rate of 50% for machines. Brecht has income before depreciation and taxes each year (20102017) of $90,000, and an income tax rate of 30% Compute the amount of income tax temporary difference for each year (round off to the nearest dollar). Compute income tax expense, current tax expense, deferred tax expense for each year of the assets life. Does the purchase of the machine result in Deferred Tax Asset or Deferred Tax Liability? How does the balance of the DTA or DTL account change over the assets life.
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1. 2. 3. 4.

Solution to Illustration - 2
Accounting Purpose Income before depreciation and taxes Less: Depreciation ((SLM : [(32,000-0) /4 ]) PBT (Accounting Income, No Permanent difference) Less: Income Tax Expense @30% 2010 90,000 8000 82,000 24600 2011 90,000 8000 82,000 24600 2012 90,000 8000 82,000 24600 2013 90,000 8000 82,000 24600 2014 90,000 0 90,000 27000 2015 90,000 0 90,000 27000 2016 90,000 0 90,000 27000 2017 90,000 0 90,000 27000

Tax Purpose Income before depreciation and taxes Less: Depreciation (Decling Bal : 50% * Opening NBV) Taxable Income Less: Current Tax Expense @30%

2010 90,000 16000 74,000 22200

2011 90,000 8000 82,000 24600

2012 90,000 4000 86,000 25800

2013 90,000 2000 88,000 26400

2014 90,000 1000 89,000 26700

2015 90,000 500 89,500 26850

2016 90,000 250 89,750

2017 90,000 125 89,875

26925 26962.5

Opening NBV

32000

16000

8000

4000

2000

1000

500

250

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Solution to Illustration - 2
Temporary (Timing) Difference ( Accounting Income - Taxable Income) due to Timing. Diff (A) Same as Depreciation as per tax law Minus Depreciation as per IS Tax Effect of Timing Difference Originating During the year (0.3 * A) 2400 2010 8,000 2011 0 2012 -4,000 2013 -6,000 2014 1,000 2015 500 2016 250 2017 125

Tax Effect of Timing Difference Reversing During the year (0.3 * A) Deferred Tax Expense (Tax Effect of Timing differences) Deferred Tax Liability Balance Deferred Tax Asset Balance 2400

-1200

-1800

300

150

75

37.5

-1200

-1800

300

150

75

37.5

2400

2400

1200 600 300 150 75 37.5

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Illus. 2 - Alternative Solution (Based on Switch to SLM) Dont use this unless specified
Accounting Purpose Income before depreciation and taxes Less: Depreciation (SLM : [(32,000-0) /4 ] PBT (Accounting Income, No Permanent difference) Less: Income Tax Expense @30% Tax Purpose Income before depreciation and taxes Less: Depreciation (Decling Bal : 50% * Opening NBV) Taxable Income Less: Current Tax Expense @30% 2010 90,000 8000 82,000 24600 2010 90,000 16000 74,000 22200 2010 8,000 2011 90,000 8000 82,000 24600 2011 90,000 8000 82,000 24600 2011 0 2012 90,000 8000 82,000 24600 2012 90,000 4000 86,000 25800 2012 -4,000 2013 90,000 8000 82,000 24600 2013 90,000 4000 86,000 25800 2013 -4,000

Workings: Declining Balance D epreciation Opening N BV SLM using NBV

Temporary (Timing) Difference (A) Accounting Income - Taxable Income due to Timing. Difference Tax Effect of Timing Difference Originating During the year (0.3 * A) Tax Effect of Timing Difference Reversing During the year (0.3 * A) Deferred Tax Expense (Tax Effect of Timing differences) Deferred Tax Liability Balance

2400 0 0 2400
8000 16000 5333.33

2400 2400
16000 32000 8000

-1200 -1200 1200

4000 8000 4000

-1200 -1200 0
2000 4000 4000

N o te : C u rre nt T a x E x p e n se (X ) D e fe rre d T a x E xp e n se (Y ) In co m e T a x E xp e n se (X + Y )

2010 2 2 2 00 2400 2 4 6 00

2 0 1 1 20 1 2 2 0 13T o ta l 2 4 6 0 0 2 5 8 0 0 2 5 8 00 98 4 0 0 0 -1 2 0 0 -1 2 0 0 0 2 4 6 0 0 2 4 6 0 0 2 4 6 00 98 4 0 0
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Illustration - 3
Alvin Company reported pretax accounting income of $20,000 in 2010 and $30,000 in 2011. The following differences between pretax accounting income and taxable income existed during the two years. A $4,000 accounting expense for patent amortization in each of the two years will never be deductible for income tax purposes. Estimated warranty expense exceeded actual warranty costs incurred during 2010 by $15,000. In 2011, the actual warranty costs incurred exceeded the estimated warranty expense by $1,000. Estimated warranty expenses are deducted for financial accounting purposes, and actual warranty costs are deducted for income tax purposes. Unearned rental revenue of $3,000 collected in 2010 was taxable in that year. These revenues were actually earned and reported for financial accounting purposes in 2011. Analyze each of the above and determine whether it results in a temporary or permanent difference. Compute taxable income, income tax expense, deferred income tax expense, income taxes payable and net income for 2010 and 15 2011. Assume a tax rate of 20%.

1. 2.

Solution to Illustration - 3
Effect on Effect on Accounting Taxable Income Income (PBT) (TI)
Amortization of Patent 2010 and 2011 (4000) Reduces No Effect

Timing Difference

PBT < TI Non-Reversible, Permanent Difference

Excess of Estimated Warranty Expense over Actual warranty costs -2010 (15,000)

Estimated warranty expense More Expense

Actual warranty costs Lesser Expense

PBT < TI Tax Exp < Current Tax

Excess of Actual Warranty Costs over Estimated warranty expense -2011 (1,000)

Lesser Expense

More Expense

Deductible Timing Difference PBT > TI Tax Exp > Current Tax

Unearned Rental Revenue Lesser Revenue collected and taxable -2010 (3000)

More Revenue

Taxable Timing Difference PBT < TI Tax Exp < Current Tax

Unearned Revenue collected in 2010 earned in 2011 (3000)

More Revenue

Lesser Revenue

Deductible Timing Difference PBT > TI Tax Exp > Current Tax Taxable (Reversal of deductible) Timing Difference 16

Solution to Illustration - 3
Calculation of Taxable Income Accounting Income or PBT Add: Amortization of Patent Excess of Estimated Warranty Expense over Actual warranty costs Unearned Rental Revenue - Collected and taxable Less: Excess of Actual Warranty Costs over Estimated warranty expense Unearned Revenue collected in 2010 earned in 2011 0 Taxable Income 42,000 4000 15000 3000 22000 4000 1000 3000 4000 30,000 4000 2010 20,000 2011 30,000

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Solution to Illustration - 3
Taxable Income Current Tax Expense (or tax payable)(20%*Taxable Income) (A) Deferred Tax Expense (20% * Timing difference) (B) Income Tax Expense (A +B ) Accounting Income or PBT Net Income (PBT - Income Tax Expense) Permanent Difference Patent Amortization Temporary (Timing) Difference: Taxable Timing Difference (AI>TI) Excess of Warranty Costs over warranty expense Unearned Revenue collected in 2010 earned in 2011 Deductible Timing Difference [when (AI <TI)] Excess of Warranty Expense over warranty costs Unearned Rental Revenue -collected and taxable Net Timing Difference Deferred Tax Expense (0.2 * Timing Difference) 2010 42000 8400 -3600 4,800 20,000 15,200 2011 30000 6000 800 6,800 30,000 23,200

4000

4000

0 15000 3000 18000 -18000 -3600

1000 3000 4000

0 4000 800
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Impact of Permanent Difference and Temporary Difference Summarized

Impact - Summarized Income Tax Expense & Deferred Tax Current Tax Expense Expense (DTE) Deferred Tax Liability (DTL) Deferred Tax Asset (DTA)

1 1a

Permanent Difference - Non-Deductible Expense (AI < TI) - Tax Exempt Revenue (AI > TI) Income Tax Expense < Current Tax Expense Income Tax Expense > Current Tax Expense No Impact No Impact No Impact

1b

No Impact

No Impact No Impact

2 2a

Temporary or Timing Difference - Taxable (AI >TI) Income Tax Expense > Current Tax Expense DTE Debited (+DTE) Increases Decreases When negative DTL DTE credited (- DTE) De creases Increases When negative DTA
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2b

- Deductible (AI<TI)

Income Tax Expense < Current Tax Expense

Extras
Cash Paid for Income Tax = Current Tax Expense + (Opening Tax Payable Closing Tax Payable) + (Closing Advance Tax Opening Advance Tax) Where, Current Tax Expense = Income tax Expense Increase in DTL (caused by DTE during the year) Effective Tax Rate = Income Tax Expense / PBT Might be different from Statutory Rate Likely reasons : Permanent differences, Operations in multiple tax jurisdictions Some Deferred Tax Implications Lease Depreciation is tax deductible for the lessor (since Tax law considers lessor as the owner). It doesnt allow depreciation as tax deductible for lessee even if it is classified as capital lease and lessee is booking the depreciation. For Capital Lease, Lessee: AI < TI => DTA Deduct from NI while calculating CFO under Indirect Method Revaluation: Upward Revaluation of tangible fixed assets: 20 Higher Depreciation in Income Statement

Disclosure Indian GAAP (AS 22)

DTA separately from Current assets after the head Investments DTL separately from Current Liabilities after the head Unsecured Loans Component wise break up of the DTA and DTL in Notes to Accounts. If there is unabsorbed depreciation or carry forward of losses under tax laws, the nature of evidence supporting recognition of DTA. DTA and DTL can be offset if The entity has legally enforceable rights to set off assets against liabilities representing current tax DTA and DTL relate to tax levied by same governing tax laws
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Deferred Tax Expense in Income Statement - ACC

22

Deferred Tax Liabilities in Balance Sheet

- ACC

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Disclosure ACCs Example

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Capital Lease Lessees Book (Additional Info)

Initial Direct Cost (Legal fees) = Rs 10,000, Executory cost (Insurance Prem =Rs 5,000) 1 . R e c o r d i n g th e l e a s e a t th e b e g i n n i n g o f y e a r 1 Y ear 1 Y ear 2 Y ear 3 In s u r a n c e E x p e n s e D r. 5 ,0 0 0 A s s e t o n L e a s e (5 1 , 2 4 0 + 1 0 , 0 0 0 ) D r. 6 1 ,2 4 0 L e a s e O b lig a t io n s C r. 5 1 ,2 4 0 Cash C r. 1 5 ,0 0 0 2 . U p o n p a y m e n t o f le a se re n ta l L e a s e O b lig a t io n s Dr 1 4 ,8 7 6 1 6 ,3 6 4 1 8 ,0 0 0 In t e re s t E x p e n s e Dr 5124 3636 2000 Cash C r. 2 0 ,0 0 0 2 0 ,0 0 0 2 0 ,0 0 0 3 . D e p r e c i a ti o n E x p e n s e = ( 6 1 2 4 0 2 0 0 0 ) / 3 = R s 1 9 , 7 4 7 D e p r e c ia t io n E x p e n s e Dr 1 9 ,7 4 7 1 9 ,7 4 7 1 9 ,7 4 7 A c c u m u la t e d D e p re c ia t io n o n le a s e d a s s e t C r . 1 9 ,7 4 7 1 9 ,7 4 7 1 9 ,7 4 7 4 . R e m o v a l o f th e a s s e t a n d t h e l e a s e o b l i g a ti o n o n e x p i r y o f l e a s e te r m L e a s e O b lig a t io n s Dr 2000 A c c u m u la t e d D e p re c ia t io n Dr 5 9 ,2 4 0 L e a s e E q u ip m e n t C r. 6 1 ,2 4 0
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Warranty
1. At the time of providing warranty: (Sold Rs 2,00,000 with warranty) Matching Principle : Match the expenses with the revenue Best guess as to what warranty costs might be incurred : (5% of 2,00,000 = 10,000) Warranty Expense Dr 10,000 Provision for Warranty Cr 10,000 2. When warranty costs actually incurred : (Rs 8,000) Provision for Warranty Dr. 8,000 Cash Cr. 8,000 (Balance in Provision for warranty = 10,000 - 8,000 = 2,000) 3. Provision for warranty required at the end of the year : (Rs 14,000) Warranty Expense Dr 12,000 Provision for Warranty Cr 12,000 (Required 14,000 Existing balance 2000)
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Review of the Course

Pre-Mid Term - Mechanics Introduction to Users, Accounting Process, Principles and Concepts Journal Entries, Ledger and Trial Balance Balance Sheet, Income Statement, Cash Flow Statement Financial Statement Analysis Post Mid Term Accounting Policies Inventory, Revenue Recognition Tangible Fixed Assets acquisition, depreciation, impairment and sale Accounting for equity, debt and lease in the books of lessee Income Tax Deferred Tax concept 27

Thank You

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Debt Versus Equity Decision Debt Versus Equity Decision

T ra d in g o n e q u ity

A B C E F G H I J K

A s s e ts D ebt E q u ity

U s in g e q u ity c a p ita l a s a b o rro w in g b a s e to re a p e x c e s s re tu R osy D a is y Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 1000 1000 1000 1000 1000 1000 400 400 400 0 0 0 600 600 600 1000 1000 1000 200 40 160 64 96 16% 100 40 60 24 36 6% 60 6% 6% 50 40 10 4 6 1% 30 3% 6% 200 0 200 80 120 12% 120 12% 6% 100 0 100 40 60 6% 60 6% 6% 50 0 50 20 30 3% 30 3% 6%

E B IT le s s : In te re s t o n d e b t (1 0 % o f 4 0 0 ) EBT L e s s : T a x e s (4 0 % ) PAT R O E ( G /C )

P ro fit b e fo re In te re s t a d ju s te d fo r ta x 1 2 0 R e tu rn o n A s s e ts (a d j fo r In te re s t) (I/A1)2 % A fte r ta x c o s t o f d e b t [1 0 % *(1 -0 .4 0 )] 6 %

J>K J =K J <K J>K J =K J <K A s lo n g a s th e re tu rn o n a s s e ts ra te e x c e e d s th e ra te p a id o n d e b t, th e R O E w ill b e in c re a s e d b y th e u

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Solution to Illustration- 1
E a r n i n g s B e fo r e D e p r e c i a t i o n a n d 3 T0 a, 0 0 0 T a x a b l e In c o m e B e fo r 3 0D, 0e 0p xes e

L e s s : D e p re c ia t io n ( S L M ) 4 0 0 0 L e s s : D e p r e c i a t i o n ( T a 6x , 0A 0l l0o P r o f i t B e f o r e T a x ( A c c o u n t i n g I2n 6c, o 0 0 e )T a x a b l e I n c o m e 0m 2 4 ,0 0 L e s s : In c o m e T a x E x p e n s e @ 3 0 %7 8 0 0 L e s s : T a x @ 3 0 % 7200 C- u r r e n t T a x ( 2E4 x0 p e *n0s. e3 0 ) 00 7200

D- e f e r r e d T a x ( 2E6 x0 p e n- 2 e 0 0 0 ) *6 00 . 03 0 0 0 s4 N e t In c o m e (o r P A T ) 1 8 ,2 0 0 1 6 ,8 0 T a x a b l e T i m i n g D i ffe r e n c e - A c c o u n t i n g In c o m e ( 2 6 , 0 0 0 ) > T a x a 2b , l0e 0 In 0 C u r r e n t T a x E x p e n s e = T a x a b l e In c o m e T a x R a t e D e fe r r e d T a x E x p e n s e = ( A c c o u n t i n g In c o m e - T a x a b l e In c o m e ) d u e t D e fe r r e d T a x E x p e n s e D r. 600 D e fe r r e d T a x L i a C irl .i t y 6 0 0 b

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