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Chapter 16: Corporate Income Tax

Income Tax Provision vs. Expense

 Provision for income tax
o Refers to either income tax expense or recovery
o Recovery is generated when a company has a loss for tax purposes; the income
statement entry for income tax may be a credit rather than a debit
 Use ‘Income Tax Expense’ in this book even when the expense is a credit

Interperiod Tax Allocation – Introduction

 Interperiod Tax Allocation
o Allocating tax expense to an appropriate year regardless of when it is actually
paid
 Difference between Taxable and Accounting Income
o Permanent Differences
 Permanent Differences
 Arises when an (Revenue, Expense, Gain, Loss) is either included
in taxable income or pre-tax accounting income, but never both
 Ex. Dividend revenue received from another tax-paying Canadian
corporation is included in accounting earnings but is never included in
taxable income. (Such Dividends are tax-exempt revenue)
 They are a non-reversing or permanent difference because they are
not subject to taxation
 Ex. Selling land and the gain from selling the land is known as a capital
gain for tax purposes. The full amount is recognized in earnings but only
50% of the gain is included in taxable income.
 The other 50% of the gain is not taxed and is a permanent
difference because it is in accounting income but not taxable
income
 Ex. Certain expenses are never deductible for tax purposes. Such as golf
club dues, these are permanent differences between pre-tax accounting
income and taxable income.
 Ex. Deducting tax depreciation called CCA (Capital Cost Allowance)
based on an amount higher than the cost basis of the assets. (CCA rate
could be based on 150% of the asset’s cost)
 Since accounting depreciation expense can never exceed 100% of
the asset’s cost, the excess CCA is a permanent difference
o Temporary Differences
 Temporary Differences
 Arises when there is going to be the same total earnings and tax
revenue or expense over time, but the pattern is different
 When the tax basis of an asset or liability differs from its
accounting carrying value, due to timing of inclusion in accounting
income or taxable income
o Origination and Reversal
 A temporary difference originates in the period in which it first enters the
computation of either taxable income or accounting income and reverses
in the subsequent period when that item enters into the computation of the
other measure. Either:
 Be included in accounting income first then be included in taxable
income in a subsequent period; or
 Be included in taxable income first and then be included in
accounting income in a later period
 Originates
 When it first gets recognized as a difference between accounting
income and taxable income
 Reverses
 When the difference gets reduced by the catch-up recognition for
tax and accounting

Conceptual Issues in Interperiod Tax Allocation

 #1 – The extent of allocation
o All temporary differences give rise to deferred income tax
o This is called comprehensive or full tax allocation
o Tax expense is based on tax payable combined with the effect of temporary
differences
o ASPE
 Allows the use of the comprehensive method of tax allocation
 Also allows companies if they choose, to not record deferred tax for any
temporary differences. (taxes payable method) because tax expense is
based only on tax payable
 #2 – The measurement method
o Deferred tax amounts are measured using the best estimate of the tax rate that will
be in effect when the temporary difference reverses; this must be an enacted tax
rate. Future tax rates are used if they are enacted or substantially enacted. If there
are no future rates enacted, the current year tax rate is used.
o If the enacted tax rate changes, deferred tax amounts must be updated to the new
rate
o This is called the liability or accrual method
 #3 – Discounting
o Deferred tax amounts are not discounted
 Extent of Allocation
o Taxes Payable Method
 Recognizes the amount of taxes assessed in each year as the income tax
expense for that year
 Income tax expense = Current income tax payable
 
There are no deferred tax amounts recognized from any temporary
difference
 Also known as the flow-through method because the actual taxes paid
flow through to earnings
 ASPE permitted, IFRS can’t use
o Comprehensive Tax Allocation
 Recognizes both the current income tax payable and the tax effect of all
temporary differences that arise when determining the income tax expense
for that year
 Income tax expense = Current Income tax payable + Change in deferred
tax balance
 All temporary differences give rise to deferred tax amounts
 ASPE permitted, IFRS must use

Taxes Payable and Comprehensive Tax Allocation Method Example

 Suppose that Bowen Ltd. has pre-tax income in 20X1, 20X2, and 20X3 of 1,000,000. The
first year’s income includes a revenue amount of 400,000 that will not be collected until
20X3. As a result there’s a 400,000 receivable on the books. There will be taxable
revenue of 400,000, but not until the money is collected in 20X3. Since total accounting
income and taxable income are the same over time, but the timing is different, this is a
temporary difference related to the 400,000 accounts receivable.. Bowen Ltd. has a tax
rate of 35%.
 If Bowen gives no recognition to the temporary difference and uses the taxes payable
method:
o The company’s taxable income will be 600,000 in 20X1, 1,000,000 in 20X2, and
1,400,000 in 20X3.
o Using the tax rate of 35%, the taxes due for each period are 210,000 for 20X1,
350,000 in 20X2, and 490,000 in 20X3.
o Earnings for each year equal to 790,000 for 20X1, 650,000 for 20X2, and 510,000
for 20X3.
 If Bowen uses the comprehensive tax allocation method:
o The 400,000 temporary difference relating to the accounts receivable gives rise to
a future income tax impact of 140,000 (400,000 * 35%)
o The 140,000 income tax impact of the 400,000 revenue is recognized in the same
period as the revenue itself.
o 20X1 Journal Entry
 Income Tax Expense 350,000
Income Tax Payable 210,000
Deferred Income Tax Liability 140,000
o 20X2 Journal Entry
 Income Tax Expense
Income Tax Payable
o 20X3 Journal Entry
 Income Tax Expense 350,000
 Deferred Income Tax Liability 140,000
Income Tax Payable 490,000
 o The deferred income tax liability originates in 20X1. It will be shown on the SFP
at the end of 20X1 and 20X2, and then is drawn down in 20X3 when the
temporary difference reverses and the tax is actually due
 Tax Rate to Use: The Liability Method
o Accounting standards require use of the liability method to measure deferred
income tax
 Estimates of future rates are not acceptable, only enacted rates are
acceptable
o Deferred income tax = temporary difference * tax rate
o Records the future tax impacts using the tax rate that will be in effect in the year
of the reversal
o If enacted rate for future year is known use tax rate for future year
o If enacted rate for future year is unknown use tax rate for current year

Approach to Income Tax Questions

 Step 1 – Calculate taxable income and income tax payable
 Step 2 – Determine the change in deferred income tax accounts
 Step 3 – Combine income tax payable with the change in deferred income tax accounts to
determine tax expense for the year
 This approach is often called the balance sheet approach as it is driven by balance sheet
accounts
 Income Tax Expense = Income Tax Payable + Change in deferred income tax liability
 Components of tax expense:
o Current Income Tax Expense = Income Tax Payable
o Deferred Income Tax Expense = Change in deferred income tax liability (asset)

Income Tax Example

 The following facts pertain to accounting and taxable income for Mirage ltd. in 20X1
 Earnings before taxes = 825,000
 In determining pre-tax earnings, Mirage deducted the following expense
o Political contribution = 10,000
o Golf club dues = 25,000
o Accrued estimated warranty expense = 150,000
o Depreciation = 200,000 (Capital asset cost = 1,600,000 depreciated at SLD over
8yrs)
 For tax purposes, Mirage deducts the following expenses
o Actual warranty costs incurred = 100,000
o CCA = 300,000
 Tax rate = 30%

STEP #1 – Calculate Taxable Income and Income Tax Payable

20X1 20X2 20X3
Accounting Earnings 825,000 900,000 725,000
Permanent Differences
Political Contributions 10,000 0 0
 Golf Club Dues 25,000 25,000 30,000
Temporary Differences
Warranty Expense 150,000 200,000 160,000
Warranty paid -100,000 -140,000 -230,000
Depreciation 200,000 200,000 200,000
CCA -300,000 -240,000 -180,000
Taxable Income 810,000 945,000 705,000
Tax Rate 30% 28% 27%
Income Tax Payable $243,000 $264,600 $190,350

STEP #2 – Determine the Change in Deferred Income Tax

Tax Basis Accounting Basis Difference DTL Opening Adjustment
Year 1: 172,000 190,000 -18,000 -5400 0 -5400
Year 2: 136,000 160,000 -24,000 -6000 -5400 -600

Impact of the change in tax rate:

-18,000 * (-5%) = 900
-6000 * 25% = -1500
$ - 600

STEP #3 – Combine Income Tax Payable with the Change in Deferred Income Tax to
Determine Tax Expense for the Year

Income Tax Journal Entry – 20X1

Income Tax Expense 258,000
Deferred Income Tax Asset/Liability 15,000
Income Tax Payable 243,000

Income Tax Journal Entry – 20X2

Income Tax Expense 258,000
Deferred Income Tax Asset/Liability 6,600
Income Tax Payable 264,600

Income Tax Journal Entry – 20X1

Income Tax Expense 203,550
Deferred Income Tax Asset/Liability 13,200
Income Tax Payable 190,350

Approach to Income Tax Questions pt. 2

o Determining the Accounting Basis
Source of Temporary Difference Related SFP Account
Depreciation and Amortization NBV of capital assets (tang/intang)
Inventory Write-downs & Reversals Inventory
Fair-value adjustments Investment property or biological assets
Revenue Accounts Receivable or Deferred Revenue
 Warranty Warranty Provision
Bond discount/premium amortization Net bond liability
Revaluation surplus Capital assets
o Determining the Tax Basis
 With respect to assets
 For monetary assets (receivables), the tax basis of a taxable asset is
its accounting carrying value less any amount that will be added to
taxable income in future periods
 For non-monetary assets, the tax basis is the tax-deductible amount
less all amounts already deducted in determining taxable income of
the current and prior periods
 With respect to liabilities
 For monetary liabilities, the tax basis is the accounting carrying
value less any amount that will be deductible for income tax in
future periods
 For non-monetary liabilities (unearned revenue), the tax basis is its
carrying amounts less any amount that will not be taxable in future
periods.

Statement of Financial Position Elements

 Deferred Income Tax Liabilities
o Created when tax paid is less than accounting accrual-based income tax expense
o Occurs when revenue is recognized on the books but is not taxable until a later
period
o An accounting asset (A/R) exists and its tax basis is 0
o Also created when tax expense deductions precede accounting expense
deductions
 Deferred Income Tax Assets
o Created when tax is effectively prepaid
o Tax on revenue is paid before the revenue is reflected on the income statement
o Unearned revenue might appear on the books but deposits may be taxable when
received
o Tax is paid before revenue is recognized for accounting purposes
o Also created when expenses are on the accounting income statement before they
are tax deductible, as for accrued warranty liabilities and the related expenses
o Asset Recognition Limit
 Deferred income tax assets will be realized only when future years come
to pass and those temporary differences reverse in taxable income
 Deferred income tax assets on the balance sheet can be recognized only to
the extent that their realization is probable
 Classification
o The deferred income tax account is always a noncurrent asset or a noncurrent
liability
o Income taxes currently payable or receivable must be shown separately as a
current asset or liability
 o Current taxes receivable or payable cannot be combined with deferred income tax
balances
o Netting
 The deferred income taxes relating to all temporary differences are lumped
together and netted as a single amount if for the same taxable company
and the same taxing government
 Consolidated statements often show both a deferred tax asset and a
deferred tax liability
 Ex. Asset for parent company and liability for subsidiary
 In this case 2 accounts are included on the SFP
o Example
o If the company reports 21,600 deferred income tax liability in 20X3, the net of
deferred tax liability of 32,400 relating to capital assets, and a 10,800 deferred tax
asset relating to a warranty provision
o If these 2 deferred tax balances were in different legal companies, in different tax
jurisdictions, they would not be netted
o If the liability was in Canada parent company and the asset in Mexican subsidiary,
the deferred tax liability would be a 32,400 liability and there would be a separate
long-term deferred tax asset of 10,800 on the SFP.
Disclosure
 General Requirements
o Income Tax Expense
 The amount of income tax expense on earnings from continuing
operations must be reported separately in the SCI; income tax expense
should not be combined with other items of expense
 the amount of income tax expense that is attributable to (1) current income
tax and (2) deferred income tax should be disclosed, either on the face of
the statement or in the notes
 discontinued operations and each component of OCI are reported net of
income tax, and the amounts of income tax expense that relate to each
item should be disclosed. Also, any income tax relating to capital
transactions (share repurchase) should be disclosed.
 the change in deferred income tax due to (1) changes in temporary
differences and (2) tax rate changes (or imposition of new taxes) should be
disclosed in the notes.
o Temporary Differences
 Publicly accountable enterprises are also required to disclose the types of
temporary differences
 For each type, an entity should disclose the amount of deferred tax
recognized in the deferred tax balance on the statement of financial
position.
 Some companies have many different kinds of temporary differences,
some are substantial while others may be quite small.
 Usually the small ones are combined into another category rather
than being separately disclosed to save space.
o Reconciliation of Effective Tax Rates
 Companies are required to provide a reconciliation between the statutory
tax rate and the company's effective tax rate
 There are two general categories of causes for variations in the rate of tax
 #1 - Permanent differences which causes items of income and or
expense to be reported in accounting income that is not included in
taxable income
 #2 - Differences in tax rates, due to
o Different tax rates used in different tax jurisdictions
o Special taxes levied by the taxation authorities
o Changes in tax rates relating to temporary differences that
will reverse in future periods
 Temporary differences themselves are not a cause of effective tax free
variations
 The effective tax rate is based on income tax expense and not on
the amount of taxes the company actually paid
 Therefore, deferred income tax expense is included in the apparent
effective tax rate
o Accountants versus Analysts concepts of effective tax rate
 The definition of effective tax rate prescribed by accounting standards
includes deferred income tax
 Financial analysts usually view the effective tax rate as the amount of
current taxes divided by pre-tax earnings
 Financial analysts and banks are sometimes interested in what the
company has to pay in cash not what it might have to pay sometime in the
future when the temporary difference reverse

Statement of Cash Flows

 All tax allocation amounts must be reversed out of transactions reported on the SCF
 The SCF must include only the actual taxes paid
 When a company uses the direct method of presenting cash flow from operating
activities, the amount of tax paid (recovered) during the year is a deduction (addition)
 When the indirect method of presentation is used for operating activities, the deferred tax
liability and/or asset that has been charged (or credited) to earnings must be added back
to (or subtracted from) earnings
 Companies are required to disclose the amount of income taxes paid on the face of the
statement of cash flows
 Companies using the indirect approach typically add back income tax expense, and then
show the income taxes paid as a separate item.

Is Deferred Income Tax a Liability?

 Deferred Income Tax is an allocation of an amount that arises largely from other
allocations
 The major single cause of temporary differences is the difference between two
allocations: depreciation for accounting vs. CCA for tax.
  One important aspect of the liability definition is that a liability represents an existing
obligation. But to whom is this obligation owed?
 The reality of having to pay out cash in the future as recurring temporary differences are
reversed depends on the joint occurrence of 2 conditions
o #1 - The asset basis of the temporary differences (capital assets being depreciated)
must shrink before there can be a net reversal, precipitating an actual cash outflow
o #2 - The company must be earning taxable income while the net reversals are
occurring
o The co-existence is unlikely
o Accounting standards call for recognizing a contingent liability when a cash flow
probably will be realized
o Deferred income tax liabilities relating to recurring temporary differences should
be evaluated as a contingent liability because the conditions necessary to
precipitate a cash flow are not likely to occur – the liability is neither likely to
occur, not is the amount of future cash flow measurable

ASPE
 Private enterprises can choose either the Taxes Payable method or the Comprehensive
Allocation Method (Liability Method)
 Tax Payable Method
o Income tax expense is simply the amount of current income tax paid (or payable
to the government
o There is no inter-period allocation of income taxes and there are no deferred
income tax amounts reported on the SFP
 Intra-period allocation is still applied however, income tax expense must be allocated to:
o Earnings from continuing operations
o Discontinued operations
o Gains and Losses recorded directly in retained earnings
o Capital transactions recorded directly in share capital
 A company cannot decide to use deferred income tax accounting for some types of
temporary differences while using the taxes payable basis for other types
 Example – Taxes Payable Method
o Income Tax Journal Entry – 20X1:
Income Tax Expense 243,000
Income Tax Payable 243,000
o Income Tax Journal Entry – 20X2:
Income Tax Expense 264,000
Income Tax Payable 264,000
o Income Tax Journal Entry – 20X3:
Income Tax Expense 190,350
Income Tax Payable 190,350
 Classification
o ASPE requires companies to classify deferred/future income tax liabilities and
assets as either current or long-term
 o Deferred tax amounts are classifies as current or noncurrent on the basis of the
assets or liabilities that generated the temporary differences
 If the balance sheet accounts that causes the deferred tax is a current asset
or a current liability  The related deferred tax balance is a current asset
or a current liability
 If the balance sheet account that causes the deferred tax is a noncurrent
asset or a noncurrent liability  The related deferred tax balance is a
noncurrent asset or a noncurrent liability
o A company would NOT have just one net deferred tax account, as is the case
under IFRS
 All current amounts would be lumped together
 All noncurrent amounts would be lumped together
 Disclosure
o There is less disclosure required for private companies
o A company should disclose the fact that it’s using the taxes payable method
o The company should reconcile its income tax expense to the avg. statutory
income tax rate
o The reconciliation would include items such as:
 Large corporation tax
 Non-deductible expenses
 Non-taxable gains. Including the non-taxable portion of capital gains; and
 The amount of deductible temporary differences for which a future tax
asset has not been recorded.
o