Accounting for Income Tax – Part 1

Need for a standard on income taxes

• Taxable income differs from accounting profit.
• Accounting for income tax must take into account differences in how accounting numbers are calculated for income tax purposes and how they
are calculated for accounting purposes.
• Understanding how income tax is accounted for is vital for proper interpretation of financial statements.

Fundamentals of accounting for income tax

Accounting for income taxes is governed by AASB 112
• AASB 112/IAS 12 requires the tax consequences and other events to be accounted for in the same manner and the same period as the
transactions themselves.
• Need to recognise both current and future tax consequences of current year transactions.
• Two separate calculations are performed each year:
1. current tax liability
2. movements in deferred tax balances.
We need to distinguish between two types of income tax effects:
o current income tax consequences (income tax payable = current tax liability)
o future income tax consequences (deferred tax assets or liabilities)
Both are based on differences between pre-tax accounting profit and taxable profit (generally known as taxable income).

Pre-tax accounting profit

 determined according to accounting standards and principles; measured with objective of providing useful information to investors and
creditors;
 determined under accrual accounting.
The Corporations Act and AASBs are key sources that determine the appropriate accounting treatment of transactions.

Taxable income
 determined according to tax legislation in the country the income is subject to taxation; for our purpose, we assume this is Australia;
 in principle (i.e. with some exceptions), under cash accounting.
The Income Tax Assessment Act determines the tax treatment of transactions.

Differences between accounting profit & taxable profit

• Accounting profit defined: ‘profit or loss for a period before deducting tax expense.’
• Taxable profit defined: ‘the profit for a period determined in accordance with the rules established by the taxation authorities, upon which
income taxes are payable.’
• As Accounting profit and taxable profit are determined by different principles it is unlikely that they will be the same figure in any one period.

Examples of differences of treatment of items under GAAP and ITAA

Accounting vs. tax treatment – Common differences

LIABILITIES ACCOUNTING TAX
Recognised as liability when received, only Taxable income when cash received
Revenue received in advance ③
as revenue in later periods when earned
Accrued expenses ④ (such as interest payable, Liability/provision and expense recognised Tax deduction when paid (payment
rent payable, other payables, provisions for when incurred reduces accounting liability)
warranties, annual leave, long service leave etc.)
 ASSETS ACCOUNTING TAX
Property, plant and equipment Depreciation recognised as expense based on Tax deduction for depreciation based on rates
useful life of asset prescribed by taxation rules (can be higher or
lower than for accounting)
Development costs Can be capitalised (as far as recognition criteria Tax deduction when paid
met) and are amortised over useful life
Accounts receivable (acc/rec.) Allowance and expense recognised for any Tax deduction only when debt physically written
doubtful debt off
Receivables ① Recognised as revenue, with corresponding asset Taxable income only when cash received
(e.g. rent, interest etc., not (receivable) when earned
acc/rec. from sales)
Prepayments ② Recognised as an asset, then expensed in a later Tax deduction when paid
period as benefits received

Accounting vs. tax treatment – Worked example

You are provided with the following information from the accounts of Shelly Ltd for the year ending 30 June 2016. You are to calculate
accounting profit and taxable income.

Sales revenue ($4,000 still to be received in cash) $100,000

Cost of goods sold ($7,000 still to be paid) $40,000
Amounts received in advance for services
to be performed in August 2016 $5,000
Rent expense for year ended 30 June 2016 $10,000
Total rent payments in the year ended 30 June 2016 $11,000
Doubtful debts expense $2,000
Long-service leave expense for year ended 30 June 2016;
no leave was taken during the year. $3,000

Solution
Accounting profit Taxable income

Sales revenue $100,000

Cost of goods sold ($40,000)
Amounts received in advance by Shelly Ltd
for services to be performed in August 2016
Rent expense/paid
Doubtful debts expense
Long-service leave expense/taken
Total

Two types of differences Temporary Differences

Temporary differences reverse over time, i.e. they will increase or decrease taxable income in the future;
therefore, they give rise to deferred taxes;
taxable temporary differences increase taxable income in future years:

A DEFERRED TAX LIABILITY IS RECOGNISED;

deductible temporary differences decrease taxable income in future years:

A DEFERRED TAX ASSET IS RECOGNISED.

We will discuss how to calculate these deferred tax liabilities and assets next week (week 3) (future tax consequences).

Accounting for current tax consequences

Calculation of income tax payable = current tax liability:
Income tax payable is based on taxable income, not accounting profit;
necessary to adjust accounting profit to taxable income for all differences, e.g.:
 ADD BACK ACCOUNTING DEPRECIATION;
 DEDUCT DEPRECIATION FOR TAXATION PURPOSES;
calculation of income tax payable:
TAX RATE MULTIPLIED BY TAXABLE INCOME.

Calculation of current tax

Accounting Profit (Loss)
+ (-) accounting expenses not deductible for tax
+ (-) accounting expenses where the amount differs from deductible amounts
+ (-) taxable income where the amount differs from accounting revenue
- (+) accounting revenues not subject to taxation
- (+) accounting revenues where the amount differs from taxable income
- (+) Deductible expenses where the amount differs from accounting expense

= Taxable profit
x tax rate %
= Current Tax Payable
(Refer Illustrative Example 12.1)
Recognition and payment of tax
• Recognition of current tax:
– refer AASB 112/IAS 12 para 12 & 58.
• Payment of tax:
– determined by legislation
– some jurisdictions require payments in advance.

Current tax liability – Worked example

Profit before tax for ABC Ltd for the year to 30 June 2016 is as follows: in (000’s)
Sales revenue 1,000
Interest revenue 40 Additional information:
Government grant 80 $60 allowed as a tax deduction for depreciation of plant.
COGS (450) Interest has not yet been received.
Depreciation expense (plant) (50) Bad debts of $20 were written off during the year.
Goodwill impairment (20) Payments of $30 were made to employees in relation to
Doubtful debts expense (30) annual leave taken during the year.
Annual leave expense (10) The tax rate is 30%
Other expenses (260)
Profit before income tax 300

Required:
Calculate the current tax liability of ABC Ltd as at 30 June 2016 and prepare the required journal entry.
Solution
Accounting profit before tax exempt income
Permanent
Government grant not deductible
differences
Goodwill impairment
Adjusted accounting profit
Interest not yet received
Temporary Adjustment for plant depreciation
differences Adjustment for doubtful debts expense
Adjustment for annual leave expense
Taxable income
Current tax liability (CTL) (30%)

Acctg depn 50 Dbtf. debts expense-acctg 30 A/L expense- acctg 10

Tax depn (60) B/debts w/off - tax (20) Paid - tax (30)
Adj req (10) Adj req 10 Adj req (20)

The journal entry at 30 June 2016 for the current tax consequences only would be:
Dr Income tax expense
Cr Current tax liability = Income tax payable
Example – Determining Taxable Income by Reconstructing Accounts
Profit before tax for ABC Ltd for the year ended 30 June 2016 is $100 000, including the following items of income and expense:

Entertainment Expenses (non-deductible) $ 5 000

Interest revenue 25 000
Bad debts expense 24 000
Long-service leave expense 10 000

Additional information
(a) Interest receivable at 30 June 2016 is $25 000 (2015: $23 000).
(b) Allowance for doubtful debts at 30 June 2016 is $32 000 (2015: $39 000).
(c) Provision for long-service leave of $18 000 at 30 June 2016 (2015: $12 000).

Required:
Calculate the current tax liability of ABC Ltd for 2016 and provide the journal entry for income tax expense.
Solution
Accounting profit $100 000
Add:
Entertainment expense
Interest received
Bad debts expense
LSL expense
Deduct:
Interest Revenue
Bad debts written off
LSL paid
Taxable income
Current tax liability @ 30%

The appropriate journal entry is:

Income Tax Expense (current) 30 600
Current Tax Liability 30 600

Readings
 ACCG224 Textbook:
pp. 361-367