03/02/2022
EFIMM0124
Advanced Financial Reporting
Accounting for Taxation
Lei Wang
lei.wang@bristol.ac.uk
Aims and objectives
By the end of this section, you should be able to:
 Explain and illustrate the impact of taxation on financial statements
 Distinguish between accounting profit and taxable profit
 Understand temporary differences and how they require the
operation of a deferred tax account
 Explain alternative approaches to accounting for deferred tax
 Know and apply some of the main requirements of IAS 12 Income
Taxes on accounting for deferred tax
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Readings
 Alexander et al., International Financial Reporting and Analysis (8th
edition) Chapter 20.
 Picker et al., Applying IFRS Standards (4th edition) Chapter 6.
 Summary of IAS 12 Income Taxes on www.iasplus.com
Types of Taxes
 Direct taxes
– Assessed on and collected from ‘individuals’ intended to bear it
– Examples: corporation tax; income tax; capital gains tax
 Indirect taxes
– Burden can be passed on by supplier to final consumer
– Examples include VAT and excise duties
 Note that companies act as both:
– a) Tax collecting agents
– b) Tax payers themselves
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Acting as an Agent
 Employees have to pay NI and income tax on their earnings. These
taxes are collected by the firm.
 Assume a company has to pay the following monthly costs for an
employee:
Net pay £4,000
National Insurance (NI) £240
Income tax (PAYE) £600
Gross pay £4,840
Statement of Financial Position
T1 T2 T3
Cash 10,000 6,000 5,160
Tax and NI due -840
10,000 5,160 5,160
Ordinary shares 10,000 10,000 10,000
Retained earnings -4,840 -4,840
10,000 5,160 5,160
Revenue and Tax: IFRS 15
 In most countries, indirect taxes are charged, such as:
– Sales taxes
– Value-added taxes
– Goods or service taxes
 In financial reporting under IFRS, revenue does not include
amounts collected on behalf of third parties.
 These do not represent economic benefits to the firm and do not
increase equity.
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Revenue and Tax: IFRS 15
Example: VAT
 VAT Rate 20% (VAT Fraction 1/6).
 Assume a firm buys goods for £400 + VAT and sells them for £800 +
VAT.
Inputs (purchases) Outputs (sales)
Transaction value £480 £960
Tax £80 = £480 x 1/6 £160 = £960 x 1/6
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Example: VAT
Balance sheets
Cash 1,000 -480 520
Inventory +400 400
VAT +80 80
1,000 1,000
Ordinary shares 1,000 1,000
Retained earnings
1,000 1,000
Example: VAT
Balance sheets after sale of inventory
Cash 1,000 -480 520 +960 1,480
Inventory +400 400 -400 0
VAT +80 80 -160 -80
1,000 1,000 1,400
Ordinary shares 1,000 1,000 1,000
Retained earnings -400+800 400
1,000 1,000 1,400
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Example: VAT
Balance sheets after settlement
Cash 1,000 -480 520 +960 1,480 -80 1,400
Inventory +400 400 -400 0
VAT +80 80 -160 -80 +80 0
1,000 1,000 1,400 1,400
Ordinary shares 1,000 1,000 1,000 1,000
Retained earnings -400+800 400 400
1,000 1,000 1,400 1,400
Corporation Taxation
 Companies are treated as separate entities for taxation purposes
and are themselves liable for tax on their profits.
 Shareholders are treated separately and are only liable for tax on
distributions of profits (i.e. dividends)
– Shareholders sometimes receive concessions on dividends to avoid ‘double
taxation’.
 Contrast this with partnerships, where each partner is liable for tax
on their share of profits, whether distributed as dividends or not.
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Corporation Tax: The Main Issue
Accounting profit Taxable profit
Accounting
assets/liabilities
Tax
assets/liabilities
Corporation Tax: Differences
 Permanent differences: differences between accounting profit and
taxable profit that arise when amounts recognised as part of accounting
profit are never recognised as part of taxable profit and vice versa.
 Timing differences: differences between accounting profit and taxable
profit that arise when the period in which revenues and expenses are
recognised is different from the period in which such revenues and
expenses are treated as taxable income and allowable deductions for tax
purposes.
 Temporary differences: differences in carrying amounts of assets or
liabilities in the balance sheets and their value for tax purposes (tax base).
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IAS 12 Income Taxes
 IAS 12 focuses on temporary differences (an approach based on
the balance sheet).
 Treatment: requires full provision for deferred tax based on the
liability method (i.e. in the event of a change in tax rates, the
balance on the deferred tax account also changes)
 Potential alternatives to liability method are:
– Flow through: no provision for deferred tax.
– Partial provision: previous UK standard SSAP15 used this method but there
was much ‘creativity’.
IAS 12 Income Taxes – definitions
Temporary difference: a difference between the carrying amount of
an asset or liability and its tax base.
– Taxable temporary difference: a temporary difference that will result in
taxable amounts in the future when the carrying amount of the asset is
recovered or the liability is settled.
– Deductible temporary difference: a temporary difference that will result in
amounts that are tax deductible in the future when the carrying amount of
the asset is recovered or the liability is settled.
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Example: accounting profit and taxable
profit
£m
Profit from income statement 93
Add back: depreciation charge 10
Add back: entertainment expenses 2
105
Less: capital allowances -25
Taxable profit 80
This is a TIMING difference
This is a PERMANENT difference
Example: accounting values and tax bases
£m
Carrying value of asset 90
Add back: accumulated depreciation 10
Cost 100
Less: accumulated capital allowances -25
Tax base 75
• Temporary difference: difference in the carrying amount for tax
purposes and accounting purposes
• Temporary difference = 90 − 75 = 15
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Tax in Income Statement v.s. Tax to be paid
Tax rate 28%; Accounting profit 93; Taxable profit 80
Question: how do we account for the difference?
Tax in Income Statement
(based on accounting profit) 28% x 93 = 26.04
Tax to be paid 28% x 80 = 22.40
Three approaches
 ‘Flow through’ method: don’t account for timing differences.
 Timing difference method: account for the difference between
accounting profit and taxable profit.
 Temporary difference method: account for the difference between
carrying value and tax base.
IAS 12 requires this
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Example: Capital allowances and deferred
tax
 An asset costs £30,000.
 It has a 6 year life and zero residual value.
 The company buying the asset has profit before depreciation of
£12,000.
 The tax rate is 35% and annual capital allowances for taxation are
25% on a reducing balance basis.
 All payments and receipts are in cash.
 The asset is still in use at the end of year 6.
Method 1: Flow through – no deferred tax
(NOT ALLOWED UNDER IAS 12)
Depreciation
charge
Accounting
profit
Capital
allowances
Taxable
profit
Tax payable Profit after
tax
A B
12,000 − A
C D
12,000 − C
E
D x 35%
F
B − E
Year 1 5,000 7,000 7,500 4,500 1,575 5,425
Year 2 5,000 7,000 5,625 6,375 2,231 4,769
Year 3 5,000 7,000 4,219 7,781 2,723 4,277
Year 4 5,000 7,000 3,164 8,836 3,093 3,907
Year 5 5,000 7,000 2,373 9,627 3,369 3,631
Year 6 5,000 7,000 1,780 10,220 3,577 3,423
Total 30,000 42,000 24,661 47,339 16,568 25,432
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Method 1: Flow through – no deferred tax
(NOT ALLOWED UNDER IAS 12)
End of year 1 2 3 4 5 6
Fixed assets 25,000 20,000 15,000 10,000 5,000 0
Cash 12,000 22,425 32,194 41,471 50,378 59,009
Tax due -1,575 -2,231 -2,723 -3,093 -3,369 -3,577
35,425 40,194 44,471 48,378 52,009 55,432
Share capital 30,000 30,000 30,000 30,000 30,000 30,000
Retained earnings 5,425 10,194 14,471 18,378 22,009 25,432
35,425 40,194 44,471 48,378 52,009 55,432
Statements of Financial Position
Method 2: Timing differences approach (not
covered by IAS 12)
Year Accounting/
pre-tax profit
Tax payable Deferred tax
transfer
Profit after
tax
Deferred tax
a/c balance
1 7,000 1,575 875 4,550 875
2 7,000 2,231 219 4,550 1,094
3 7,000 2,723 -273 4,550 821
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Temporary Differences Approach
Based on the SOFP
1. Value asset for accounting (net book or carrying value)
2. Value asset for tax (tax base)
3. Find the difference
4. Difference x tax rate = deferred tax balance
5. Adjust balance via the income statement
Carrying values and tax base
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Carrying value 30,000 25,000 20,000 15,000 10,000 5,000 0
Tax base 30,000 22,500 16,875 12,656 9,492 7,119 5,339
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
Carrying value Tax base
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Temporary differences: balance in year 3
Carrying value for accounting: 30,000 − (3 x 5,000) 15,000
Carrying value for tax (tax base): 30,000 − 7,500 − 5,625 − 4,219 12,656
Difference: 15,000 − 12,656 2,344
Difference @ 35% 820
Temporary differences: year 1 and 2
Year 1 Year 2
Accounting value 25,000 20,000
Tax value 22,500 16,875
Difference 2,500 3,125
Difference @ 35% 875 1,094
Opening value -0 -875
Charge 875 219
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Full deferral
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Fixed assets 25,000 20,000 15,000 10,000 5,000 0
Cash 12,000 22,425 32,194 41,471 50,378 59,009
Tax due -1,575 -2,231 -2,723 -3,093 -3,369 -3,577
35,425 40,194 44,471 48,378 52,009 55,432
Share capital 30,000 30,000 30,000 30,000 30,000 30,000
Retained earning
b/f 0 4,550 9,100 13,650 18,200 22,750
for year 5,425 4,769 4,277 3,907 3,631 3,423
transfer to deferred tax -875 -219 273 643 919 1,127
c/f 4,550 9,100 13,650 18,200 22,750 27,300
Deferred tax 875 1,094 821 178 -741 -1,868
35,425 40,194 44,471 48,378 52,009 55,432
Deferred tax balance
Year 1 Year 2 Year 3
Tax based on accounting profit: 7,000 x 35% 2,450 2,450 2,450
Actual tax charge -1,575 -2,231 -2,723
Balance b/f 0 875 1,094
Deferred tax balance 875 1,094 821
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Differences between the three methods
 Flow through: profit declines gradually even though the firm has the
same operating profits every year and the tax rate is unchanged.
 Timing differences method and temporary differences methods give
the same result.
 Why is IAS12 based on temporary differences method?
– If tax rates change, timing differences method will give incorrect liability.
– If asset is revalued, timing differences method will give incorrect liability.
Example: Change in the tax rate
A company has a deferred tax liability of £900,000 at 31st March
20X0 and in September 20X0 the tax rate is reduced from 40% to
30%, effective from 1st April 20X0.
Balance is now overstated so it must be reduced:
Double entry: Dr deferred tax liability; Cr corporation tax expense
Opening balance £900,000
Adjustment for change in rate: (40 − 30) ÷ 40 -£225,000
Restated balance £675,000
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Example: Revaluation
 In 20X0, a company buys land costing £10m.
 In 20X5, it is re-valued to £15m.
 In 20X9 it is sold for £18m.
 Assume that the tax rate is 35% and there is no inflation.
Example: Revaluation
20X0 20X5 With DT 20X9
Land 10.00 15.00 15.00 0.00
Cash 18.00
10.00 15.00 15.00 18.00
Ordinary shares 10.00 10.00 10.00 10.00
Revaluation reserve 5.00 3.25 0.00
Retained earnings 5.20
Deferred tax 1.75
Tax due 2.80
10.00 15.00 15.00 18.00
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Recap
1. Compute carrying value of asset/liability for financial reporting (FRV)
2. Compute value (the tax base) for taxation (TB)
3. Take the difference (FRV − TB) = Temporary difference (TD) (see next
slide)
4. Take the temporary difference at the tax rate = balance on DT account
5. Compare with opening balance and adjust balance through I/S:
• To increase deferred tax liability, Dr I/S tax expense, Cr DTL
• To reduce deferred tax liability, Cr I/S tax expense, Dr DTL
• To increase deferred tax asset, Cr I/S tax expense, Dr DTA
• To reduce deferred tax asset, Dr I/S tax expense, Cr DTA
Summary table (EY, 2014)
Asset / Liability Carrying amount
higher / lower
than tax base?
Nature of
temporary
difference
Resulting
deferred tax (if
recognised)
Asset Higher Taxable Liability
Asset Lowe Deductible Asset
Liability Higher Deductible Asset
Liability Lower Taxable Liability
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