Income Taxes (PAS 12)

Accounting profit and taxable profit answer to different masters. PAS 12 does not try to reconcile them once and for all. It asks a narrower question: of the differences between the two, which will reverse in the future, and what tax will be paid or saved when they do?

Core concept

Permanent against temporary differences

A permanent difference never reverses. It enters accounting profit but never taxable profit, or the other way round. Interest income on tax-exempt government securities and non-deductible fines and penalties are the standard examples. Permanent differences create no deferred tax. They simply make the effective tax rate diverge from the statutory rate.

A temporary difference is the difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. It reverses, and its reversal is what PAS 12 recognises today.

Tax base, and reading the sign

The tax base of an asset is the amount deductible for tax purposes against future taxable economic benefits. The tax base of a liability is its carrying amount less any amount deductible for tax purposes in the future.

	Relationship	Difference	Recognise
Asset	Carrying amount greater than tax base	Taxable temporary difference	Deferred tax liability
Asset	Carrying amount less than tax base	Deductible temporary difference	Deferred tax asset
Liability	Carrying amount greater than tax base	Deductible temporary difference	Deferred tax asset
Liability	Carrying amount less than tax base	Taxable temporary difference	Deferred tax liability

The intuition is worth more than the table. An asset carried above its tax base means the entity has already taken the income for books but not for tax, so tax is owed later: a liability. A liability carried above its tax base means the entity has already taken the expense for books but cannot deduct it until later, so tax will be saved later: an asset.

Common sources:

• Tax depreciation faster than accounting depreciation. The asset's carrying amount exceeds its tax base. Deferred tax liability.
• Accrued warranty or bad debt expense, deductible only when paid or written off. The liability's carrying amount exceeds its tax base of nil. Deferred tax asset.
• Unearned rent taxed on receipt. The liability's carrying amount exceeds its tax base of nil. Deferred tax asset.
• Revaluation surplus on property, where tax allows only historical cost. Deferred tax liability, and the deferred tax is charged to other comprehensive income, following the item that gave rise to it.

Recognition and measurement

A deferred tax liability is recognised for all taxable temporary differences, subject to narrow exceptions such as the initial recognition of goodwill.

A deferred tax asset is recognised only to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. The same probable test governs the carryforward of unused tax losses and unused tax credits. The carrying amount of a deferred tax asset is reviewed at each reporting date and reduced where it is no longer probable that sufficient taxable profit will be available.

Deferred tax is measured at the tax rates enacted or substantively enacted by the end of the reporting period that are expected to apply when the asset is realised or the liability settled. It is never discounted, however long the reversal takes. This is a deliberate practical exception, not an oversight.

Deferred tax assets and liabilities are always classified as non-current under PAS 1. They are offset only where a legally enforceable right to set off current tax exists and they relate to income taxes levied by the same taxation authority on the same taxable entity.

The tax expense that lands in profit or loss

Total income tax expense = current tax expense + deferred tax expense

where current tax expense is the tax rate applied to taxable profit, and deferred tax expense is the net movement in the deferred tax liability and deferred tax asset accounts during the period, excluding movements charged directly to other comprehensive income or equity.

A shortcut worth internalising: since temporary differences only shift tax between periods,

Total tax expense = tax rate x (accounting profit adjusted for permanent differences only)

This is the check you run against a long computation. If the two do not agree, a temporary difference has been misclassified as permanent, or vice versa.

How this appears in the exam

• A reconciliation from accounting profit to taxable profit, with a mix of permanent and temporary items, followed by a request for current tax expense, total tax expense, or the year-end deferred tax balance.
• A single asset or liability with its carrying amount and tax base given. The item asks for the nature of the difference and the account to be recognised.
• A change in tax rate enacted before year-end. The entire deferred tax balance is remeasured at the new rate, and the effect goes to profit or loss, unless the original item went to other comprehensive income.
• A deferred tax asset arising from a tax loss carryforward, with facts hinting that future taxable profit is doubtful. The item tests the probable recognition threshold.

Common traps

• Discounting deferred taxes. PAS 12 prohibits it outright, even where reversal is many years away.
• Classifying deferred tax as current. It is always non-current, whatever the reversal date of the underlying difference.
• Sending all deferred tax to profit or loss. Deferred tax follows the item that created it. Deferred tax on a revaluation surplus goes to other comprehensive income.
• Recognising a deferred tax liability for a permanent difference. A non-deductible fine changes taxable profit forever; nothing reverses, so nothing is deferred.
• Applying the probable test to deferred tax liabilities. The test constrains only deferred tax assets. Liabilities are recognised in full.

Worked examples

Example 1: from accounting profit to total tax expense

Bulacan Foods reports accounting profit of P5,000,000 for the year. Assume an income tax rate of 25%. The following items are embedded in that figure:

1. Interest income on tax-exempt government securities, P200,000.
2. Fines and penalties, not deductible for tax, P100,000.
3. Accounting depreciation P600,000; tax depreciation P900,000.
4. Warranty expense accrued P250,000; warranties actually paid P150,000.

Step 1: taxable profit.

Accounting profit	5,000,000
Less tax-exempt interest income (permanent)	(200,000)
Add non-deductible fines (permanent)	100,000
Less excess tax depreciation, 900,000 - 600,000 (temporary)	(300,000)
Add excess warranty accrued over paid, 250,000 - 150,000 (temporary)	100,000
Taxable profit	4,700,000

Step 2: current tax expense. 25% x P4,700,000 = P1,175,000

Step 3: deferred tax.

• Excess tax depreciation of P300,000 leaves the asset's carrying amount above its tax base: a taxable temporary difference. Deferred tax liability increases by 25% x 300,000 = P75,000, a deferred tax expense.
• The P100,000 of warranty accrued but unpaid leaves the liability's carrying amount above its tax base of nil: a deductible temporary difference. Deferred tax asset increases by 25% x 100,000 = P25,000, a deferred tax benefit.

Step 4: total income tax expense.

P1,175,000 + P75,000 - P25,000 = P1,225,000

Step 5: the check. Accounting profit adjusted for permanent differences only:

5,000,000 - 200,000 + 100,000 = P4,900,000, and 25% x 4,900,000 = P1,225,000. The two agree, so no item has been misclassified.

Example 2: reading the tax base

For each item, identify the difference and the account.

Equipment with a carrying amount of P800,000 and a tax base of P500,000. An asset carried above its tax base. Taxable temporary difference of P300,000. Deferred tax liability.

Receivables of P1,000,000 gross, with an allowance for doubtful accounts of P120,000, so a carrying amount of P880,000. Tax allows a deduction only on actual write-off, so the tax base is P1,000,000. An asset carried below its tax base. Deductible temporary difference of P120,000. Deferred tax asset.

Unearned rent of P400,000, taxable on receipt, so its tax base is nil. A liability carried above its tax base. Deductible temporary difference of P400,000. Deferred tax asset.

A fine payable of P50,000 that is never deductible. The tax base equals the carrying amount of P50,000, because no future deduction is available. No temporary difference, and no deferred tax.

Example 3: a change in the tax rate

At the start of the year Cavite Steel carries a deferred tax liability of P480,000, measured at the then-prevailing rate of 30%, on cumulative taxable temporary differences of P1,600,000. During the year those differences grow to P2,000,000, and a new rate of 25% is enacted before year-end, effective next year.

The deferred tax liability is remeasured in full at the rate expected to apply on reversal:

Closing deferred tax liability = 25% x P2,000,000 = P500,000

Deferred tax expense for the year = P500,000 - P480,000 = P20,000

Note what happened. The temporary difference grew by P400,000, which alone would have added 25% x 400,000 = P100,000. But remeasuring the opening balance from 30% to 25% released P1,600,000 x 5% = P80,000. The net is P20,000. Both effects go to profit or loss, since the underlying differences arose there.

Quick review

• Permanent differences never reverse and create no deferred tax. They only move the effective tax rate away from the statutory rate.
• Temporary difference = carrying amount less tax base. For an asset, carrying amount above tax base gives a deferred tax liability. For a liability, carrying amount above tax base gives a deferred tax asset.
• Recognise all deferred tax liabilities. Recognise a deferred tax asset only to the extent it is probable that taxable profit will be available, and review it at each reporting date.
• Measure at the rate enacted or substantively enacted by the end of the reporting period. Never discount. Always classify as non-current.
• Deferred tax follows its item: to profit or loss, to other comprehensive income, or to equity.
• Total income tax expense = current + deferred, and it equals the tax rate applied to accounting profit adjusted for permanent differences only. Use that identity as your check.