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Corporate Financial

Reporting

Income Tax Income Tax Expense, Current tax expense,

Deferred tax expense, Deferred Tax Asset,Deferred Tax Liability

Permanent and Temporary Differences, Impact ofthese on above

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Accounting Income and Taxable Income

Accounting Income:

Profit before tax (PBT) calculated following accountingpolicies and principles and are reported in IncomeStatement

Matching Principle: Tax expenses are incurred by an

entity in the process of earning income, they should bematched with the revenue and expenses to which theyrelate and accounted for in the same period

Taxable Income:

Amount of profit (or loss) for a period, calculated as pertaxation provisions, based upon which taxationauthorities determine the tax payable.

There might be significant differences between TaxableIncome and Accounting Income 2

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Differences

Two main causes of differences between Accounting Income and

Taxable Income:

1. Items of Revenue and Expense

Permanent Difference : Difference which originates in oneperiod and do not reverse in any subsequent periods

Examples:

Revenues exempted from tax : Dividend received fromsubsidiary

Expenses not allowed by tax laws : Penalty for violation oflaw

Deferred tax consequences : NO

1. Amount of Revenue and Expense

Temporary (Timing) Difference: Difference whichoriginates in one period and can reverse in one or moresubsequent periods

Examples : Difference in Depreciation due to difference in theMethod or difference in the Rate

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Tax Expense - Terms

Income Tax Expense :

Amount of income tax expense reported in Profit & Loss A/C orIS

Accounting Income (over & above permanent difference, ifany ) Tax Rate

Income tax Expense = Current Tax Expense +Deferred Tax expense

Current Tax Expense:

Amount of income tax expected to be payable (recoverable) totaxation authorities in respect of taxable income (tax loss) for aperiod using applicable tax rates and laws.

Current Tax Expense = Taxable Income Tax Rate

(Statutory) creates Income Tax Payable (Liability)

Deferred Tax expense:

Is the tax effect of timing differences between AccountingIncome and Taxable Income

(Accounting Income - Taxable Income) due to Timingdifference Tax Rate = DTE increases Deferred Tax

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Deferred Tax Liability (DTL) & Deferred Tax Assets(DTA)

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When due to Timing Difference :

Accounting Income >Taxable Income

Income Tax Expense in Income Statement> Current tax expense as per tax law

Taxable timingdifference

Deficit in income tax payment. gives rise to

Elimination of deficit in payment expectedthrough payment in future

Deferred Tax Liability(DTL)

Accounting Income< Taxable Income

Income Tax Expense in Income Statement< Current tax expense as per tax law

Deductible timingdifference

Excess amount is paid for income tax. gives rise to

Recovery expected in future Deferred Tax Assets

(DTA)

TaxableTiming difference

will result in payment of income taxes in future when the timingdifference reverses

DeductibleTiming difference

will result in reduced income taxes in future when the timingdifference reverses

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Depreciation Companies provide depreciation using SLM, Taxlaw allows depreciation using WDV at higher rates (difference inrates, methods)

Initial years : Depreciation higher for tax purpose

Accounting Income (PBT) > Taxable Income

Income Tax Expense > Current Tax Expense (tax liability)

paid lesser tax

Taxable Timing Difference Deferred Tax Expense (DTE) DTL

Subsequent Years: DTE reverses (-ve DTE) Reduction inDTL to zero

Expense recognized in IS before or after recognition for taxpurpose

If Tax Authorities allow the expense to be deducted only onpayment and payment is made in a period different from the

period when the expense accrues. Example : Litigation Expenses In the year when expense accrues but not paid : AI < TI =>

More Examples: Temporary (or Timing) Difference

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Revenue recognized in IS before or after recognition for tax

purpose If Tax Authorities taxes the revenue on cash basis i.e.when the cash is collected but for accounting purposes revenue isrecognized in a different year based on revenue recognitionprinciple. Example: Service Revenue received in advance

If a revenue is recognized in year 2 but taxed in year 1 because cash isreceived in yr 1

In year 1, AI < TI => DTA. Reverses in year 2 when revenue recognizedin IS.

Provisions for Doubtful debt (BDE), Provision for Warrantiesrecognized as expense for accounting purpose but actual baddebts or warranty costs allowed for tax purpose

If Provisions > Actual Expense in a year => AI < TI => DTA

Amortization: Period over which expenses are amortized differ fortax purpose and accounting purpose (Preliminary Exp, DeferredRevenue Expenses)

If amortization period for tax purpose shorter than that for accounting

purpose

Amortization ex ense in IS lower => AI > TI => DTL

More Examples: Temporary (or Timing) Difference

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Prudence

Prudence needs to be exercised while recognising DeferredTax Assets (DTA)

DTA to be recognised and carried forward only to the extentthere is

Reasonable or virtual certainty (supported byconvincing evidence) that sufficient future taxableincome will be available to realise DTA

At each Balance Sheet date, Deferred Tax Assets should

be reviewed. DTA/DTL nor required to be discounted to their

present values (Indian GAAP)

If there is doubt that some or all DTA will not be

realised, a valuation allowance should be created to 8

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Accounting Entry

9

A When DTL / DTA is created due to origination of timingdifference

Deferred Tax Expense Dr.

Deferred Tax Liability Cr.

Deferred Tax Asset

Dr.Deferred Tax ExpenseCr.

B When DTL / DTA is adjusted due to reversal of timingdifference

Deferred Tax LiabilityDr.

Deferred Tax Expense Cr.

Deferred Tax ExpenseDr.

Deferred Tax AssetCr.

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Illustration- 1 Murky Waters, Inc. pays income tax @ 30%. During 2010, its

Earnings Before Depreciation and Taxes = $30,000 = TaxableIncome before Depreciation. It owns a lake cleaning vessel that is

being depreciated under SLM at $ 4,000 per year. Tax allowabledepreciation is $6,000 for 2010

Does the difference in the amount of depreciation under book andtax purposes result in a permanent difference? Determine TaxableIncome, PBT, Current Tax Expense, Deferred Tax Expense, Net

Income

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Earnings Before Depreciation and Taxes 30,000 Taxable Income Before Depreciation 30,000

Less: Depreciation (SLM) 4000 Less: Depreciation (Tax Allowable) 6,000

Profit Before Tax (Accounting Income) 26,000 Taxable Income 24,000

Less: Less: Tax @ 30% 7200

- Current Tax Expense (24000*0.30) 7200

- Deferred Tax Expense (26000 -24000)*0.30 600

Income Tax Expense (Current + Deferred) 7800

Net Income (or PAT) 18,200 16,800

Taxable Temporary (Timing) Difference = Accounting Income (26,000) > Taxable Income (24,000) 2,000

= Depreciation in IS (4000) < Depreciation allowed for Tax Purpose (6000)

Current Tax Expense = Taxable Income Tax Rate

Deferred Tax Expense = (Accounting Income - Taxable Income) due to timing difference Tax Rate

Deferred Tax Expense Dr. 600

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Illustration - 2

Brecht Company purchased a machinery on April 1, 2010, for$32,000. The machine has an estimated useful life offour years andan estimated residual value ofzero, and the company uses thestraight-line depreciation method for financial reporting.

Income Tax Rules allow declining balance depreciation method,and a rate of50% for machines.

Brecht has income before depreciation and taxes each year (2010-2017) of $90,000, and an income tax rate of30%

1. Compute the amount of income tax temporary difference for eachyear (round off to the nearest dollar).

2. Compute income tax expense, current tax expense, deferred taxexpense for each year of the assets life.

3. Does the purchase of the machine result in Deferred Tax Asset orDeferred Tax Liability?

4. How does the balance of the DTA or DTL account change over theassets life.

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Accounting Purpose 2010 2011 2012 2013 2014 2015 2016 2017

Income before depreciation and taxes 90,000 90,000 90,000 90,000 90,000 90,000 90,000 90,000

Less: Depreciation ((SLM : [(32,000-0) /4 ]) 8000 8000 8000 8000 0 0 0 0

PBT (Accounting Income, No Permanent difference) 82,000 82,000 82,000 82,000 90,000 90,000 90,000 90,000

Less: Income Tax Expense @30% 24600 24600 24600 24600 27000 27000 27000 27000

Tax Purpose 2010 2011 2012 2013 2014 2015 2016 2017

Income before depreciation and taxes 90,000 90,000 90,000 90,000 90,000 90,000 90,000 90,000

Less: Depreciation (Decling Bal : 50% * Opening NBV) 16000 8000 4000 2000 1000 500 250 125

Taxable Income 74,000 82,000 86,000 88,000 89,000 89,500 89,750 89,875

Less: Current Tax Expense @30% 22200 24600 25800 26400 26700 26850 26925 26962.5

Opening NBV 32000 16000 8000 4000 2000 1000 500 250

Solution to Illustration - 2

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Temporary (Timing) Difference 2010 2011 2012 2013 2014 2015 2016 2017

( Accounting Income - Taxable Income) due toTiming. Diff (A) 8,000 0 -4,000 -6,000 1,000 500 250 125

Same as Depreciation as per tax law MinusDepreciation as per IS

Tax Effect of Timing Difference OriginatingDuring the year (0.3 * A)

2400

Tax Effect of Timing Difference ReversingDuring the year (0.3 * A)

0 -1200 -1800 300 150 75 37.5

Deferred Tax Expense(Tax Effect of Timing differences)

2400 0 -1200 -1800 300 150 75 37.5

Deferred Tax Liability Balance 2400 2400 1200

Deferred Tax Asset Balance 600 300 150 75 37.5

Solution to Illustration - 2

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Accounting Purpose 2010 2011 2012 2013

Income before depreciation and taxes 90,000 90,000 90,000 90,000

Less: Depreciation

(SLM : [(32,000-0) /4 ] 8000 8000 8000 8000

PBT (Accounting Income, No Permanent difference) 82,000 82,000 82,000 82,000Less: Income Tax Expense @30% 24600 24600 24600 24600

Tax Purpose 2010 2011 2012 2013

Income before depreciation and taxes 90,000 90,000 90,000 90,000

Less: Depreciation 16000 8000 4000 4000

(Decling Bal : 50% * Opening NBV)

Taxable Income 74,000 82,000 86,000 86,000Less: Current Tax Expense @30% 22200 24600 25800 25800

Temporary (Timing) Difference (A) 2010 2011 2012 2013

Accounting Income - Taxable Income due to Timing. Difference 8,000 0 -4,000 -4,000

Tax Effect of Timing Difference Originating During the year

(0.3 * A) 2400Tax Effect of Timing Difference Reversing During the year

(0.3 * A) 0 -1200 -1200

Deferred Tax Expense (Tax Effect of Timing differences) 2400 0 -1200 -1200

Deferred Tax Liability Balance 2400 2400 1200 0

N ote : 2010 20 11 2012 2013T ota l

C urrent T ax Expense (X ) 22 200 24600 25800 258 00 9840

D eferred T ax Expense (Y ) 2400 0 -120 0 -12 00 0

Incom e T ax Exp ense (X +Y) 24600 24600 24600 246 00 9840

Workings:Declining Balance Depreciation 16000 8000 4000 2000

Opening NBV 32000 16000 8000 4000

SLM using NBV 8000 5333.33 4000 4000

Illus. 2 - Alternative Solution (Based on Switch to SLM) Dontuse this unless specified

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Illustration - 3

Alvin Company reported pretax accounting income of $20,000 in

2010 and $30,000 in 2011. The following differences betweenpretax accounting income and taxable income existed during thetwo years.

A $4,000 accounting expense for patent amortization in each ofthe two years will never be deductible for income tax purposes.

Estimated warranty expense exceeded actual warranty costs

incurred during 2010 by $15,000. In 2011, the actual warrantycosts incurred exceeded the estimated warranty expense by$1,000. Estimated warranty expenses are deducted for financialaccounting purposes, and actual warranty costs are deducted forincome tax purposes.

Unearned rental revenue of $3,000 collected in 2010 was taxablein that year. These revenues were actually earned and reportedfor financial accounting purposes in 2011.

1. Analyze each of the above and determine whether it results in atemporary or permanent difference.

2. Compute taxable income, income tax expense, deferred income

tax expense, income taxes payable and net income for 2010 and2011. Assume a tax rate of 20%.

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Effect onAccounting

Income (PBT)

Effect onTaxable Income

(TI)

Timing Difference

Amortization of Patent 2010 and2011 (4000)

Reduces No Effect PBT < TI Non-Reversible,Permanent Difference

Estimatedwarranty expense

Actual warrantycosts

Excess of Estimated WarrantyExpense overActual warrantycosts -2010 (15,000)

More Expense Lesser Expense PBT < TI Tax Exp < Current Tax

Deductible TimingDifference

Excess of Actual Warranty CostsoverEstimated warranty expense-2011(1,000)

Lesser Expense More Expense PBT > TI Tax Exp > Current Tax

Taxable TimingDifference

Unearned Rental Revenue -collected and taxable -2010 (3000)

Lesser Revenue More Revenue PBT < TI Tax Exp < Current Tax

Deductible TimingDifference

Unearned Revenue collected in2010 earned in 2011 (3000)

More Revenue Lesser Revenue PBT > TI Tax Exp > Current Tax

Taxable (Reversal ofdeductible) TimingDifference

Solution to Illustration - 3

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Calculation of Taxable Income 2010 2011

Accounting Income or PBT 20,000 30,000

Add:

Amortization of Patent 4000 4000

Excess of Estimated Warranty Expense over Actual warranty costs 15000

Unearned Rental Revenue - Collected and taxable 3000

Less: 22000 4000Excess of Actual Warranty Costs over Estimated warranty expense 1000

Unearned Revenue collected in 2010 earned in 2011 3000

0 4000

Taxable Income 42,000 30,000

Solution to Illustration - 3

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Permanent Difference

Patent Amortization 4000 4000

Temporary (Timing) Difference:

Taxable Timing Difference (AI>TI)

Excess of Warranty Costs over warranty expense 1000

Unearned Revenue collected in 2010 earned in 2011 3000

0 4000

Deductible Timing Difference [when (AI

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Impact - Summarized Income Tax Expense &Current Tax Expense

Deferred TaxExpense (DTE)

DeferredTaxLiability(DTL)

DeferredTax Asset(DTA)

1 Permanent Difference

1a - Non-Deductible Expense(AI < TI)

Income Tax Expense TI)

Income Tax Expense >Current Tax Expense

No Impact No Impact No Impact

2 Temporary or Timing Difference

2a - Taxable (AI >TI) Income Tax Expense >

Current Tax Expense

DTE Debited (+DTE) Increases Decreases

Whennegative

DTL

2b - Deductible (AI

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Extras

Cash Paid for Income Tax= Current Tax Expense + (Opening Tax Payable Closing TaxPayable)

+ (Closing Advance Tax Opening AdvanceTax)

Where, Current Tax Expense = Income tax Expense Increase inDTL (caused by DTE during the year)

Effective Tax Rate = Income Tax Expense / PBT

Might be different from Statutory Rate Likely reasons : Permanent differences, Operations in multiple tax

jurisdictions

Some Deferred Tax Implications Lease

Depreciation is tax deductible for the lessor (since Tax law

considers lessor as the owner). It doesnt allow depreciation as tax deductible for lessee even if

it is classified as capital lease and lessee is booking thedepreciation.

For Capital Lease, Lessee: AI < TI => DTA Deduct from NI while calculating CFO under Indirect Method

Revaluation: Upward Revaluation of tangible fixed assets: Hi her De reciation in Income Statement

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Disclosure Indian GAAP (AS 22)

DTA separately from Current assets after the headInvestments

DTL separately from Current Liabilities after the headUnsecured Loans

Component wise break up of the DTA and DTL in Notes toAccounts.

If there is unabsorbed depreciation or carry forward oflosses under tax laws, the nature of evidence supportingrecognition of DTA.

DTA and DTL can be offset if The entity has legally enforceable rights to set off

assets against liabilities representing current tax

DTA and DTL relate to tax levied by same governingtax laws

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Deferred Tax Expense in Income Statement- ACC

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Deferred Tax Liabilities in Balance Sheet - ACC

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Disclosure ACCs Example

C it l L L B k (Additi l

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1 . R e c o r d i n g t h e l e a s e a t th e b e g i n n i n g o f y e a r 1 Y e a r 1 Y e a r 2 Y e a r 3In s u r a n c e E x p e n s e D r . 5 , 0 0 0

A s s e t o n L e a s e (5 1 , 2 4 0 + 1 0 , 0 0 0 ) D r . 6 1 , 2 4 0

L e a s e O b l ig a t i o n s C r . 5 1 , 2 4 0

C a s h C r . 1 5 , 0 0 0

2 . U p o n p a y m e n t o f l e a s e r e n t a lL e a s e O b l i g a t i o n s D r 1 4 , 8 7 6 1 6 , 3 6 4 1 8 , 0

In t e re s t E x p e n s e D r 5 1 2 4 3 6 3 6 2 0 0

C a s h C r . 2 0 , 0 0 0 2 0 , 0 0 0 2 0 , 0

3 . D e p r e c i a t i o n E x p e n s e = ( 6 1 2 4 0 2 0 0 0 )/ 3 = R s 1 9 , 7 4 7

D e p r e c ia t i o n E x p e n s e D r 1 9 , 7 4 7 1 9 , 7 4 7 1 9 , 7

A c c u m u la t e d D e p r e c ia t i o n o n le a s e d a s s e t C r . 1 9 , 7 4 7 1 9 , 7 4 7 1 9 , 7

4 . R e m o v a l o f t h e a s s e t a n d t h e l e a s e o b l i g a t i o n o n e x p i r y o f l e a s e te r m

L e a s e O b l i g a t i o n s D r 2 0 0

A c c u m u l a t e d D e p r e c ia t i o n D r 5 9 , 2

L e a s e E q u ip m e n t C r . 6 1 , 2

Capital Lease Lessees Book (AdditionalInfo)

Initial Direct Cost (Legal fees) = Rs 10,000, Executory cost (InsurancePrem =Rs 5,000)

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Warranty

1. At the time of providing warranty: (Sold Rs 2,00,000 with

warranty)Matching Principle : Match the expenses with the revenue

Best guess as to what warranty costs might be incurred : (5% of2,00,000 = 10,000)

Warranty Expense Dr 10,000

Provision for Warranty Cr 10,000

2. When warranty costs actually incurred : (Rs 8,000)

Provision for Warranty Dr. 8,000

Cash Cr. 8,000

(Balance in Provision for warranty = 10,000 - 8,000 = 2,000)

3. Provision for warranty required at the end of the year : (Rs14,000)

Warranty Expense Dr 12,000

Provision for Warranty Cr 12,000

(Required 14,000 Existing balance 2000)

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Pre-Mid Term - Mechanics Introduction to Users, Accounting Process,Principles and Concepts

Journal Entries, Ledger and Trial Balance Balance Sheet, Income Statement, Cash Flow

Statement Financial Statement Analysis

Post Mid Term Accounting Policies

Inventory, Revenue Recognition Tangible Fixed Assets acquisition, depreciation,impairment and sale

Accounting for equity, debt and lease in the booksof lessee

Income Tax Deferred Tax concept

Review of the Course

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Thank You

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Debt Versus Equity DecisionDebt Versus Equity DecisionDebt Versus Equity DecisionDebt Versus Equity Decision

T ra d in g o n e q u ity U s in g e q u ity c a p ita l a s a b o r ro w in g b a s e to re a p e x c e s

R o s y D a is y

Y e a r 1 Y e a r 2 Y e a r 3 Y e a r 1 Y e a r 2 Y e a r 3A A s s e ts 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0

B D e b t 4 0 0 4 0 0 4 0 0 0 0 0

C E q u ity 6 0 0 6 0 0 6 0 0 1 0 0 0 1 0 0 0 1 0 0

E E B IT 2 0 0 1 0 0 5 0 2 0 0 1 0 0 5 0

le s s : In te re s t o n d e b t (1 0 % o f 4 0 0 ) 4 0 4 0 4 0 0 0 0

F E B T 1 6 0 6 0 1 0 2 0 0 1 0 0 5 0

L e s s : T a x e s (4 0 % ) 6 4 2 4 4 8 0 4 0 2 0

G P A T 9 6 3 6 6 1 2 0 6 0 3 0

H R O E ( G /C ) 1 6 % 6 % 1 % 1 2 % 6 % 3 %

I P ro f it b e fo re In te re s t a d ju s te d fo r ta x 1 2 0 6 0 3 0 1 2 0 6 0 3 0J R e t u r n o n A s s e t s ( a d j f o r In t e r e s t ) (I /A )1 2 % 6 % 3 % 1 2 % 6 % 3 %

K A fte r ta x c o s t o f d e b t [1 0 % * (1 -0 .4 0 ) ] 6 % 6 % 6 % 6 % 6 % 6 %

J > K J = K J < K J > K J = K J < K

A s lo n g a s th e re tu rn o n a s s e ts ra te e x c e e d s th e ra te p a id o n d e b t, th e R O E w il l b e in c re a s e d b y

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E a r n i n g s B e f o r e D e p r e c i a t i o n a n d T a x e s3 0 , 0 0 0 T a x a b l e I n c o m e B e f o r e D3 0 , 0

L e s s : D e p r e c i a t i o n ( S L M ) 4 0 0 0 L e s s : D e p r e c i a t i o n ( T a x A6 , 0

P r o f i t B e f o r e T a x ( A c c o u n t i n g I n c o m e )2 6 , 0 0 0 T a x a b l e I n c o m e 2 4 , 0

L e s s : I n c o m e T a x E x p e n s e @ 3 0 %7 8 0 0 L e s s : T a x @ 3 0 % 7 2

-C u r r e n t T a x E x p e n s e( 2 4 0 0 0 * 0 . 3 0 ) 7 2 0 0-D e f e r r e d T a x E x p e n s e( 2 6 0 0 0 - 2 4 0 0 0 ) * 0 . 3 06 0 0

N e t I n c o m e ( o r P A T ) 1 8 , 2 0 0 1 6 , 8

T a x a b l e T i m i n g D i f f e r e n c e - A c c o u n t i n g I n c o m e ( 2 6 , 0 0 0 ) > T a x a b l e2 , 0

C u r r e n t T a x E x p e n s e = T a x a b l e I n c o m e T a x R a t eD e f e r r e d T a x E x p e n s e = ( A c c o u n t i n g I n c o m e - T a x a b l e I n c o m e ) d u

D e f e r r e d T a x E x p e n s e D r . 6 0 0

D e f e r r e d T a x L i a b i l i t yC r . 6 0 0

Solution to Illustration- 1