CHAPTER ONE

Income Taxes
Tax expense (income tax) is the aggregate amount included in the determination of profit or loss
for the period in respect of current tax and deferred tax. Income is defined as every sort of
economic benefit including nonrecurring gains in cash or in kind, from whatever source directed
and in whatever form paid credited or received. The proclamation governing income uses
scheduler system of taxation

Broadly the term “Income includes the following:

 profits and gains ;

 Dividend;
 Voluntary contributions received by certain institutions
 Receipts by employees the value of any benefit or perquisite, whether convertible into
money or not.
 Incomes from business
 any capital gains
 Any sum earlier allowed as deduction and chargeable to income-tax under
 Any winnings from lotteries, crossword puzzles, races including horse races, card
games and other games of any sort or from gambling or betting of any form or nature
whatsoever ;
 any contribution received from employees towards any provident fund or
superannuation fund or any other fund
 any sum of money or value of property received as gift closely held companies
transferred to another company or firm are covered in the definition of gift except in
the case of transfer of such shares for reorganization of business by amalgamation or
demerger etc

Income tax is a tax on the total income of an assessed for a particular assessment year.
This implies that;
o Income-tax is an annual tax on income
o Income of previous year is chargeable to tax in the next following assessment
year at the tax rates applicable for the assessment year.
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The tax base concept

A tax base is the total amount of property, consumption, assets, transactions, income, or other
sort of economic activity that is subject to taxation by an authority, such as the government. A
narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs
and allows more revenue to be raised at lower rates. A tax base may be narrow, rather than broad,
due to:

Tax expenditures that result in reduced tax revenue, such as credits, exemptions, and
deductions
Deductions that reduce taxable income when certain conditions are met
Exemptions that keep things from being subject to taxation due to category, class, or
status
Tax expenditures such as the standard deduction against taxable income, child tax
credits, and certain sales tax exemptions
Services, since taxing services is administratively challenging

The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If
those economic benefits will not be taxable, the tax base of the asset is equal to its carrying
amount.

EXAMPLE1: A machine cost 100. For tax purposes, depreciation of 30 has already been
deducted in the current and prior periods and the remaining cost will be deductible in future
periods, either as depreciation or through a deduction on disposal. Revenue generated by using
the machine is taxable, any gain on disposal of the machine will be taxable and any loss on
disposal will be deductible for tax purposes. The tax base of the machine is 70

The tax base of a liability is its carrying amount, less any amount that will be deductible for tax
purposes in respect of that liability in future periods. In the case of revenue which is received in
advance, the tax base of the resulting liability is its carrying amount, less any amount of the Tax
base concept

Tax base is the amount attributable to that asset or liability for tax purpose. It is
calculated based on the application of tax rule.

The tax base of an asset is the amount that will be deductible for tax purposes
against any taxable economic benefits that will flow to an entity when it
recovers the carrying amount of the asset. If those economic benefits will not
be taxable, the tax base of the asset is equal to its carrying amount.

Example 2
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An asset that costs Br 600,000 has a carrying amount of Br 430,000.
Cumulative depreciation for tax purposes is Br 200,000 and the tax rate is
30%.

1. What is the tax base of the asset?

2. What is the temporary difference?

3. Is it taxable or deductible temporary difference?

4. What is the deferred tax?

5. Is it a deferred tax asset or liability?

Example 2 Solution

1. TB= Br 600,000- Br 200,000=400,000

2. TD= Br 430,000- Br 400,000= 30,000

3. Taxable temporary difference

4. DT= Br 30,000 x 30%= 9,000

5. Deferred tax liability

1.2. Recognition of deferred tax liabilities and assets.

Deferred Tax is the amount of Income taxes payable /recoverable in future periods in respect of
taxable/ deductible temporary differences.
Deferred tax assets and deferred tax liabilities are the opposites of each other. A deferred tax
asset is a business tax credit for future taxes, and a deferred tax liability means the business has a
tax debt that will need to be paid in the future.
Current tax for current and prior periods shall, to the extent unpaid, be recognized as a liability.
If the amount already paid in respect of current and prior periods exceeds the amount due for
those periods, the excess shall be recognized as an asset. The benefit relating to a tax loss that
can be carried back to recover current tax of a previous period shall be recognized as an asset.

When a tax loss is used to recover current tax of a previous period, an entity recognizes the
benefit as an asset in the period in which the tax loss occurs because it is probable that the
benefit will flow to the entity and the benefit can be reliably measured.

Recognition of Deferred Tax Liabilities

Deferred Tax Liabilities are the amounts of income taxes payable in future periods in respect of
taxable temporary differences. A deferred tax liability is the result of differences in the way a
company does its financial accounting for reporting purposes.
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Deferred taxes arising from temporary differences

Carrying amount - Tax base = Temporary difference

Deferred tax asset/liability = Taxable Temporary Differences * tax rate (future)

A deferred tax liability should be recognized for all taxable temporary differences, unless the
deferred tax liability arises from the initial recognition of goodwill or the initial recognition of an
asset or liability in a transaction which

Is not a business combination and

At the time of transaction, affect neither accounting profit nor taxable profit (or tax
loss)

Deferred tax liability examples

 Depreciation of assets: The IRS uses an advanced asset depreciation model which
results in a difference between the company’s balance sheet value and the value
of it for tax purposes. This is the most common example of a deferred tax
liability.
 Tax underpayment: The Company didn’t pay enough tax in the previous cycle,
and will have to make up for it in the next cycle.
 Installment sale: When a product is paid for in installments, the company lists the
full value of the sale in their balance sheet, but only pays taxes for each annual
installment. The company recognizes that they have a deferred tax liability for
future payments on that sale.

Deferred tax liability is the deferred tax consequences attributable to taxable temporary
differences. In other words, a deferred tax liability represents the increase in taxes payable in
future years as a result of taxable temporary differences existing at the end of the current
year. Deferred tax liability Is a taxable amount in the future. Taxable amounts increase
taxable income in future years.

Taxable income = pretax financial income

Less: taxable temporary difference

plus: Deductible temporary difference

current tax expense = taxable income x tax rate

deferred tax expenses = ending deferred tax liability – beginning deferred tax liability
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income tax expenses = current tax expense (income tax payable) + deferred tax
expenses

Deferred tax expenses = deferred tax liability – deferred tax asset

EXAMPLE

At the beginning of 2013, GK Company purchased equipment for Br 200,000. The

equipment had a carrying amount of Br 180,000 at the beginning of 2014 and Br 160,000
at the end of 2014. The accumulated depreciation of the item as per the income tax law is
Br 50,000 at the beginning of 2014 and Br 80,000 at the end of 2014. The tax rate is 30%.
The accounting income before tax is Br 700,000 for 2013 and Br 900,000 for 2014.

1. What was the tax base of the equipment for 2013 and 2014?

2. What is the temporary difference for 2013 and 2014? Is it taxable or deductible
temporary difference?

3. What is the deferred tax for 2013 and 2014? Is it deferred tax asset or deferred tax
liability?

4. What is the taxable income for 2013 and 2014?

5. What is the current tax expense for 2013 and 2014?

6. What is the deferred tax expense for 2013 and 2014?

7. What is the appropriate journal entry for 2013 and 2014?

Solution

End of 2013 End of 2014

Carrying value Br 180,000 Br 160,000

Tax base 150,000 120,000

Taxable temporary difference 30,000 40,000

Deferred tax liability (30%) 9,000 12,000

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 Taxable income 670,000 860,000

current tax expense 201,000 258,000

deferred tax expenses 9,000 3,000

income tax expenses 210,000 261,000

Taxable income = pretax financial income

Less: taxable temporary difference

plus: Deductible temporary difference

2013 Taxable income = $700,000

Less: $30,000

Plus: 0= $670,000

2014 taxable income =$ 900,000

-40,000

+0=

$ 860,000

current tax expense of 2013 = taxable income x tax rate

= 670,000x 30%= $201,000

current tax expense of 2014 = taxable income x tax rate

= 860,000 x30% = $258,000

deferred tax expenses of 2013 = ending deferred tax liability – beginning deferred tax
liability

= $9,000 – 0 = $9,000

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deferred tax expenses of 2014 = ending deferred tax liability of 2014 – beginning
deferred tax liability of 2013

= $12,000 – $9,000 =$3,000

income tax expenses of 2013 = current tax expense (income tax payable) of 2013 +
deferred tax expenses of 2013

= $201,000+ $9,000 = $210,000

ITE of 2014 = $258,000 + $3000 =261,00

Journal entry at the end of 2013

Income tax expense—Current ………………. 201,000

Income tax expense—Deferred ……………... 9,000

Deferred tax liability…………………………….…………….... 9,000

Income taxes payable …………………………………………201,000

Journal entry at the end of 2014

Income tax expense—Current……………… 258,000

Income tax expense—Deferred ………...... 3,000

Deferred tax liability………………………………………….... 3,000

Income taxes payable …………………………………………258,000

Recognition of Deferred Tax Assets

Deferred Tax assets are the amounts of income taxes recoverable in future period in respect of

Deductible temporary differences.

The carry forward of unused tax losses and
The carry forward of unused tax credits.

A deferred tax asset is the deferred tax consequence attributable to deductible

temporary differences. In other words, a deferred tax asset represents the increase in

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taxes refundable (or saved) in future years as a result of deductible temporary
differences existing at the end of the current year.

A deferred tax asset shall be recognized for all deductible differences to the extent that it is
probable that taxable profit will be available against which the deductible temporary differences
can be utilized.

Examples of deferred tax assets

 Net operating loss: The business incurred a financial loss for that period.
 Tax overpayment: You paid too much in taxes in the previous period.
 Business expenses: When expenses are recognized in one accounting method but
not the other.
 Revenue: Instances where revenue is collected during one accounting period, but
recognized in another.
 Bad debt: Before an unpaid debt is written off as uncollectible, it’s reported as
revenue. When the unpaid receivable is finally recognized, that bad debt becomes
a deferred tax asset.

EXAMPLE: The total income tax expense of $180,000 on the income statement for 2022
thus consists of two elements—current tax expense of $200,000 and a deferred tax benefit
of $20,000. Hunt makes the following journal entry at the end of 2022 to record income tax
expense, deferred tax Asset, and income taxes payable.

Income tax expense ---------------------------- 180,000

Deferred tax Asset ---------------------------- --20,000

Income tax payable ----------------------------200,000

1.2.1. Future taxable temporary differences

Which are temporary differences that will result in taxable amounts in determining taxable profit
(tax loss) of future periods when the carrying amount of the asset or liability is recovered or
settled?

A deferred tax liability shall be recognized for all taxable temporary differences, except to the
extent that the deferred tax liability arises from:

i. The initial recognition of goodwill; or

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 ii. The initial recognition of an asset or liability in a transaction which is not a
business combination; and at the time of the transaction, affects neither
accounting profit nor taxable profit (tax loss).

An entity shall recognize a deferred tax liability for all taxable temporary differences associated
with investments in subsidiaries, branches and associates, and interests in joint arrangements.

Example An asset which cost 150 has a carrying amount of 100. Cumulative depreciation for tax
purposes is 90 and the tax rate is 25%. The tax base of the asset is 60 (cost of 150 less
cumulative tax depreciation of 90). To recover the carrying amount of 100, the entity must earn
taxable income of 100, but will only be able to deduct tax depreciation of 60. Consequently, the
entity will pay income taxes of 10 (40 at 25%) when it recovers the carrying amount of the asset.
The difference between the carrying amount of 100 and the tax base of 60 is a taxable temporary
difference of 40. Therefore, the entity recognizes a deferred tax liability of 10 (40 at 25%)
representing the income taxes that it will pay when it recovers the carrying amount of the asset

1.2.2. Future deductible temporary differences

Which are temporary differences that will result in amounts that are deductible in taxable profit
(tax loss) of future periods when the carrying amount of the asset or liability is recovered or
settled. A deferred tax asset shall be recognized for all deductible temporary differences to the
extent that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilized, unless the deferred tax asset arises from the initial
recognition of an asset or liability in a transaction that:

a) Is not a business combination; and

b) At the time of the transaction, affects neither accounting profit nor taxable profit
(tax loss).

An entity shall recognize a deferred tax asset for all deductible temporary differences arising
from investments in subsidiaries, branches and associates, and interests in joint arrangements, to
the extent that, and only to the extent that, it is probable that the temporary difference will
reverse in the foreseeable future; and taxable profit will be available against which the temporary
difference can be utilized.

Example; an entity recognizes a liability of 100 for accrued product warranty costs. For tax
purposes, the product warranty costs will not be deductible until the entity pays claims. The tax
rate is 25%. The tax base of the liability is nil (carrying amount of 100, less the amount that will
be deductible for tax purposes in respect of that liability in future periods). In settling the liability
for its carrying amount, the entity will reduce its future taxable profit by an amount of 100 and,
consequently, reduce its future tax payments by 25 (100 at 25%). The difference between the
carrying amount of 100 and the tax base of nil is a deductible temporary difference of 100.
Therefore, the entity recognizes a deferred tax asset of 25 (100 at 25%), provided that it is

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probable that the entity will earn sufficient taxable profit in future periods to benefit from a
reduction in tax payments.

1.3. Recognition of current and deferred tax

Current tax

 It is the tax that the entity expects to pay (recover) in respect of a financial period. It
is that determined in accordance with the rules established by the tax authorities, upon
which income taxes are payable (recoverable)
 IAS 12’s basic requirement is that, to the extent that current tax for the current and
prior reporting periods is unpaid, it should be recognized as a liability. Conversely, if
the amount already paid in respect of current and prior period exceeds the amount due
for those periods, the excess should be recognized as an asset (IAS 12:12).
 Similarly, an asset is recognized if a tax loss can be carried back or recovers the
current tax paid in an earlier period.
 Generally, Current tax is recognized in profit and loss.
 In other cases, it is recognized in equity through other comprehensive income.

Deferred tax

• IAS 12 focuses on the balance sheet by recognizing the tax effects of temporary
differences.

• Deferred tax liabilities are defined as the amounts of income taxes payable in future
periods in respect of taxable temporary differences. [IAS 12:5]

• Deferred tax assets are defined as the amounts of income taxes recoverable in future
periods in respect of:

− Deductible temporary differences;

− The carry forward of unused tax losses; and

− The carry forward of unused tax credits.

• Deferred tax should:

Be recognized in respect of all timing differences that have originated but not
reversed by the balance sheet date;
Not be recognized on permanent differences.

1.5. Income tax presentation and disclosures

Income tax Presentation
The requirements for Statement of Financial Position are:

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 − Deferred tax asset and liability and current assets and liabilities should be presented
separately from other assets and liabilities in the Statement of Financial Position
− Deferred tax assets and liabilities should not be classified within current assets and
liabilities, if the Statement of Financial Position makes such a distinction.

Offset of Deferred Tax Asset and Liabilities

 It has a legally enforceable right to setoff

 The deferred tax assets and liabilities relate to tax levied by the same authority on
either the same taxable entity or different taxable entities, which intend either to settle
current tax liabilities and assets on a net basis, or realize the assets and settle the
liabilities simultaneously, in each future period in which significant amount of
deferred tax liabilities or assets are expected to be settled or recovered.

Income tax Disclosures

For each type of temporary difference, the amount of the deferred tax asset and liabilities
recognized in the Statement of Financial Position.
For each type of temporary differences, the amount of the deferred tax income or expense
recognized in the Statement of Comprehensive Income, if the information is not evident
from the movement in Statement of Financial Position amounts.
Temporary Difference Reversals: the deferred tax expense relating to the organization or
reversal of temporary differences and changes in tax rates or to the importation of new
taxes.
Reduction of taxes: by using previously unrecognized tax loss, tax credit or temporary
difference of a prior period.
The written down of a deferred tax asset.
Deductible Temporary Difference: the amount and expiry date (if any) of deductible
temporary differences, unused tax losses, and unused tax credits for which no deferred
tax asset is recognized in the Statement of Financial Position.
The aggregate amount of temporary differences related to specific Investments.
Deferred tax relating to items that are charged or credited to equity.
Future taxable profits: the amount of deferred tax asset and the nature of the evidence
supporting its recognition. When its utilization depends on future taxable profits
exceeding those arising from the reversal of existing taxable temporary differences. And
the entity has made a taxable loss in either the current or proceeding period in the
relevant tax jurisdiction.

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