While conceptually the application of the liability method is straightforward, in the application of IAS 12 a number of complexities need to be addressed. The following process needs to be followed to calculate and measure deferred tax assets and liabilities:
1. Identification of temporary differences.
2. Identification of exceptions.
3. Identification of unused tax losses or tax credits.
4. Calculation and measurement of deferred tax assets or deferred tax liabilities.
5. Limitations on the recognition of deferred tax assets.
Identification of Temporary Differences
The preponderance of the typical reporting entity's revenue and expense transactions are treated identically for tax and financial reporting purposes. Some transactions and events, however, will have different tax and accounting implications. In many of these cases, the difference relates to the period in which the income or expense will be recognised. Under earlier iterations of IAS 12, the latter differences were referred to as timing differences and were said to originate in one period and to reverse in a later period.
The current IAS 12 introduced the concept of temporary differences, which is a somewhat more comprehensive concept than that of timing differences. Temporary differences include all the categories of items defined under the earlier concept and add a number of additional items as well. Temporary differences are defined to include all differences between the carrying amount and the tax base of assets and liabilities.
The tax base of an asset or liability is defined as the amount attributable to that asset or liability for tax purposes. The following principles are included in IAS 12 to determine the tax base of assets and liabilities:
Element Tax base
Asset The amount that would be deductible for tax purposes when the carrying amount of the asset is recovered. If the economic benefits recovered from the asset are not taxable, the tax base of the asset is equal to its carrying amount.
Liability The carrying amount less any amount that will be deductible for tax purposes in respect of the liability in future periods. In the case of revenue received in advance, the tax base is the carrying amount less any amount of the revenue that will not be taxed in future periods.
The tax base can also be determined for transactions not recognised in the statement of financial position. For example, if an amount is expensed, but the amount is only deductible for tax purposes in the future, the tax base will be equal to the amount deductible in the future. When the tax base of an item is not immediately apparent, the following general principle of IAS 12 must be followed to determine the tax base:
1. Recognise a deferred tax asset when recovery or settlement of the carrying amount will reduce future taxable income; and 2. A deferred tax liability when the recovery or settlement of the carrying amount will increase future taxable income.
Once the tax base is determined the related temporary difference is calculated as the difference between carrying value and the tax base.
Temporary differences are divided into taxable and deductible temporary differences. Taxable temporary differences represent a liability and are defined as temporary differences that will result in taxable amounts in determining taxable profits of future periods when the carrying amount of the asset or liability is recovered or settled. Deductible temporary differences represent an asset and are defined as temporary differences that will result in amounts that will be deductible in determining the taxable profits of future periods when the carrying amount of the asset or liability is recovered or settled.
Deductible and taxable temporary differences are thus based on the future taxable effect explained in the following examples:
1. Revenue recognised for financial reporting purposes before being recognised for tax purposes. Examples include revenue accounted for by the instalment method for tax purposes but reflected in income currently; certain construction‐related revenue recognised on a
completed‐contract method for tax purposes, but on a percentage‐of‐completion basis for financial reporting; earnings from investees recognised by the equity method for accounting purposes but taxed only when later distributed as dividends to the investor. These are taxable temporary differences because the amounts are taxable in future periods, which give rise to deferred tax liabilities.
2. Revenue recognised for tax purposes prior to recognition in the financial statements. These include certain types of revenue received in advance, such as prepaid rental income and service contract revenue that is taxable when received. Referred to as deductible temporary differences, these items give rise to deferred tax assets.
3. Expenses that are deductible for tax purposes prior to recognition in the financial statements. This results when accelerated depreciation methods or shorter useful lives are used for tax purposes, while straight‐line depreciation or longer useful economic lives are used for financial reporting; and when there are certain pre‐operating costs and certain capitalised interest costs that are deductible currently for tax purposes. These items are taxable temporary differences and give rise to deferred tax liabilities.
4. Expenses that are reported in the financial statements prior to becoming deductible for tax purposes. Certain estimated expenses, such as warranty costs, as well as such contingent losses as accruals of litigation expenses, are not tax deductible until the obligation becomes fixed. These are deductible temporary differences, and accordingly give rise to deferred tax assets.
Other examples of temporary differences include:
1. Reductions in tax‐deductible asset bases arising in connection with tax credits. Under tax provisions in certain jurisdictions, credits are available for certain qualifying investments in plant assets. In some cases, taxpayers are permitted a choice of either full accelerated depreciation coupled with a reduced investment tax credit, or a full investment tax credit coupled with reduced depreciation allowances. If the taxpayer chose the latter option, the asset basis is reduced for tax depreciation, but would still be fully depreciable for financial reporting purposes. Accordingly, this election would be accounted for as a taxable timing difference and give rise to a deferred tax liability.
2. Increases in the tax bases of assets resulting from the indexing of asset costs for the effects of inflation. Occasionally, proposed and sometimes enacted by taxing jurisdictions, such a tax law provision allows taxpaying entities to finance the replacement of depreciable assets through depreciation based on current costs, as computed by the application of indices to the historical costs of the assets being remeasured. This re‐evaluation of asset costs gives rise to deductible temporary differences that would be associated with deferred tax benefits.
3. Certain business combinations accounted for by the acquisition method. Under certain circumstances, the costs assignable to assets or liabilities acquired in purchase business combinations will differ from their tax bases. The usual scenario under which this arises is when the acquirer must continue to report the predecessor's tax bases for tax purposes, although the price paid was more or less than book value.
Such differences may be either taxable or deductible and, accordingly, may give rise to deferred tax liabilities or assets. These are recognised as temporary differences by IAS 12.
4. Assets that are revalued for financial reporting purposes although the tax bases are not affected. This is analogous to the matter discussed in point 2. Under certain IFRS (such as IAS 16 and IAS 40), assets may be upwardly adjusted to current fair values (revaluation amounts), although for tax purposes these adjustments are ignored until and unless the assets are disposed of. The discrepancies between the adjusted book carrying values and the tax bases are temporary differences under IAS 12, and deferred taxes are to be provided on these variations. This is required even if there is no intention to dispose of the assets in question, or if, under the salient tax laws, exchanges for other similar assets (or reinvestment of proceeds of sales in similar assets) would effect a postponement of the tax obligation.
Identification of Exemptions
Two exemptions are applicable to the recognition of deferred tax, namely goodwill and initial recognition exception.
Goodwill
No deferred tax liability should be recognised on the initial recognition of goodwill. Although goodwill represents an asset, no deferred tax is considered to arise since goodwill is measured as a residual of the value of net assets acquired in a business combination. The deferred tax recognised on the acquired net assets of the business combination, however, affects the value of goodwill as the residual. IAS 12 also clarifies that no deferred tax effects are applicable to the later impairment of goodwill.
If goodwill or a gain on a bargain purchase is not deductible or taxable, respectively, in a given tax jurisdiction (that is, it is a permanent difference), in theory its tax base is zero, and thus there is a difference between tax and financial reporting bases, to which one would logically expect deferred taxes would be attributed. However, given the residual nature of goodwill or a gain on a bargain purchase, recognition of deferred taxes would in turn create yet more goodwill, and thus more deferred tax, etc. There would be little purpose achieved by loading up the statement of financial position with goodwill and related deferred tax in such circumstances, and the computation itself would be quite challenging.
Accordingly, IAS 12 prohibits grossing up goodwill in such a fashion. Similarly, no deferred tax benefit will be computed and presented in connection with the financial reporting recognition of a gain on a bargain purchase.
However, IAS 12 states that if the carrying amount of goodwill under a business combination is less than its tax base, a deferred tax asset should
be recognised. This will be in jurisdictions where future tax deductions are available for goodwill. The deferred tax assets will only be recognised to the extent that it is probable that future taxable profits will be available to utilise the deduction.
Initial recognition exemption
No deferred tax liability or asset is recognised on the initial recognition of an asset or liability that is not part of a business combination, and at the time of the transaction affects neither accounting profit nor taxable profits. IAS 12, for example, states that an asset which is not depreciated for tax purposes will be exempt under this initial recognition exemption, provided that any capital gain or loss on the disposal of the asset will also be exempt for tax purposes.
In some tax jurisdictions, the costs of certain assets are never deductible in computing taxable profit. For accounting purposes such assets may be subjected to depreciation or amortisation. Thus, the asset in question has a differing accounting base than tax base and this results in a temporary difference. Similarly, certain liabilities may not be recognised for tax purposes resulting in a temporary difference. While IAS 12 accepts that these represent temporary differences, a decision was made not to permit recognition of deferred tax on these. The reason given is that the new result would be to “gross up” the recorded amount of the asset or liability to offset the recorded deferred tax liability or benefit, and this would make the financial statements “less transparent.” It could also be argued that when an asset has, as one of its attributes, non‐
deductibility for tax purposes, the price paid for this asset would have been affected accordingly, so that any such “gross‐up” would cause the asset to be reported at an amount in excess of fair value.
Basic example of initial recognition
Johnson PLC purchases an intangible asset from Peters PLC. Johnson will not be entitled to any tax deductions on the intangible asset. The asset was purchased for €1,000,000.
On day one, the temporary difference would be as follows:
Carrying value €1,000,000
Tax base 0
Temporary difference1,000,000
Tax rate 20%
Deferred tax 200,000
Without this exemption, the journal entries on day one would be as follows:
Intangible asset €1,200,000
Bank €1,000,000
Deferred tax liability 200,000
As a result, the carrying value of the asset would also now be €1,200,000 and deferred tax would again be calculated to incorporate the increase in the asset's carrying value. This is a circular calculation which would eventually result in a carrying amount much higher than the purchase price.
The initial recognition exemption criterion therefore requires no deferred tax to be recognised in this example.
Identification of Unused Tax Losses or Tax Credits
Unused tax losses or unused tax credits must be identified to determine whether deferred tax assets should be recognised in such transactions.
Deferred tax assets are recognised for these amounts if they are regarded to be probable.
Calculation and Measurement of Deferred Tax Assets and Liabilities
The procedure to compute the gross deferred tax provision (i.e., before addressing whether the deferred tax asset is likely to be realised and therefore should be recognised) after exempt temporary differences and unused tax losses and tax credits are identified is as follows:
1. Segregate the temporary differences into those that are taxable and those that are deductible. This step is necessary because under IAS 12 only those deferred tax assets that are likely to be realised are recognised, whereas all deferred tax liabilities are recognised in full.
2. Accumulate information about the deductible temporary differences, particularly the net operating loss and credit carryforwards that have expiration dates or other types of limitations.
3. Measure the tax effect of aggregate taxable temporary differences by applying the appropriate expected tax rates (federal plus any state, local and foreign rates that are applicable under the circumstances).
4. Similarly, measure the tax effects of deductible temporary differences, including net operating loss carryforwards.
It should be emphasised that separate computations should be made for each tax jurisdiction, since in assessing the propriety of recording the tax effects of deductible temporary differences it is necessary to consider the entity's ability to absorb deferred tax assets against tax liabilities.
Inasmuch as assets receivable from one tax jurisdiction will not reduce taxes payable to another jurisdiction, separate calculations will be needed.
Also, for purposes of statement of financial position presentation (discussed below in detail), the offsetting of deferred tax assets and liabilities may be permissible only within jurisdictions, since there may not be a legal right to offset obligations due to and from different taxing authorities.
Similarly, separate computations should be made for each taxpaying component of the business. Thus, if a parent company and its subsidiaries are consolidated for financial reporting purposes but file separate tax returns, the reporting entity comprises a number of components, and the tax benefits of any one will be unavailable to reduce the tax obligations of the others.
The principles set forth above are illustrated by the following examples.
Basic example of the computation of deferred tax liability and asset
Assume that Noori Company has pre‐tax financial income of €250,000 in 202X‐1, a total of €28,000 of taxable temporary differences and a total of €8,000 of deductible temporary differences. Noori has no operating loss or tax credit carryforwards. The tax rate is a flat (i.e., not graduated) 40%. Also assume that there were no deferred tax liabilities or assets in prior years.
Taxable income is computed as follows:
Pre‐tax financial income €250,000
Taxable temporary differences (€28,000) Deductible temporary differences €8,000
Taxable income €230,000
The journal entry to record required amounts is:
Current income tax expense €92,000
Deferred tax asset €3,200
Income tax expense—deferred €8,000
Deferred tax liability €11,200
Income taxes currently payable €92,000
Current income tax expense and income taxes currently payable are each computed as taxable income times the current rate (€230,000 × 40%).
The deferred tax asset of €3,200 represents 40% of deductible temporary differences of €8,000. The deferred tax liability of €11,200 is calculated as 40% of taxable temporary differences of €28,000. The deferred tax expense of €8,000 is the net of the deferred tax liability of
€11,200 and the deferred tax asset of €3,200.
In 202X, Noori Company has pre‐tax financial income of €450,000, aggregate taxable and deductible temporary differences are €75,000 and
€36,000, respectively, and the tax rate remains a flat 40%. Taxable income is €411,000, computed as pre‐tax financial income of €450,000 minus taxable differences of €75,000 plus deductible differences of €36,000. Current income tax expense and income taxes currently payable each are €164,400 (€411,000 × 40%).
Deferred amounts are calculated as follows:
Deferred tax liability Deferred tax asset Deferred tax expense Required balance at 31/12/202X
€75,000 × 40% €30,000 –
€36,000 × 40% €14,400 –
Balances at 31/12/202X‐1 €11,200 €3,200 –
Adjustment required €18,800 €11,200 €7,600
The journal entry to record the deferred amounts is:
Deferred tax asset €11,200 Income tax expense—deferred €7,600
Deferred tax liability €18,800
Because the increase in the liability in 202X is larger (by €7,600) than the increase in the asset for that year, the result is a deferred tax expense for 202X.
Limitation on the Recognition of Deferred Tax Assets
Although the case for presentation in the financial statements of any amount computed for deferred tax liabilities is clear, it can be argued that deferred tax assets should be included in the statement of financial position only if they are, in fact, very likely to be recovered in future periods.
Since recoverability will almost certainly be dependent on the future profitability of the reporting entity, it may become necessary to ascertain the likelihood that the enterprise will be profitable.
Under IAS 12, deferred tax assets resulting from temporary differences, tax loss carryforwards and tax credits carryforwards are to be given recognition only if realisation is deemed to be probable. The standard establishes that:
1. It is probable that future taxable profit will be available against which a deferred tax asset arising from a deductible temporary difference can be utilised when there are sufficient taxable temporary differences relating to the same taxation authority which will reverse either:
1. In the same period as the reversal of the deductible temporary difference; or 2. In periods into which the deferred tax asset can be carried back or forward; or
2. If there are insufficient taxable temporary differences relating to the same taxation authority, it is probable that the enterprise will have taxable profits in the same period as the reversal of the deductible temporary difference or in periods to which the deferred tax can be carried back or forward, or there are tax‐planning opportunities available to the enterprise that will create taxable profit in appropriate periods.
When an entity assesses whether taxable profits are probable, it must consider the effect of any tax law restrictions on the sources of taxable profits. A deferred tax asset is then assessed in combination only with other deferred tax assets that are also restricted.
There necessarily will be an element of judgement in making an assessment about how probable the realisation of the deferred tax asset is, for those circumstances in which there is not an existing balance of deferred tax liability equal to or greater than the amount of the deferred tax asset.
If it cannot be concluded that realisation is probable, the deferred tax asset is not recognised.
As a practical matter, there are a number of positive and negative factors which may be evaluated in reaching a conclusion as to amount of the deferred tax asset to be recognised. Positive factors (those suggesting that the full amount of the deferred tax asset associated with the gross temporary difference should be recorded) might include:
1. Evidence of sufficient future taxable income, exclusive of reversing temporary differences and carryforwards, to realise the benefit of the deferred tax asset.