Lecture Video 2

Lecture 2: Deferred Tax Basic Illustration – SOFP Approach

Today, we are going to look at a basic illustration of accounting for deferred tax and current tax under IAS12. So let’s start off with the information relating to our little question.  

Tabaldi Limited, the company we are dealing with, has a profit for 2011 of a R100 000. The 2010 profit was also R100 000 before tax. Tabaldi however, purchased an asset, let’s say it’s an item of PPE (Property Plant and Equipment), for R5 000 on the first day of 2010. The useful life of the asset is two years, and the residual value is zero. Therefore, the accounting depreciation for each of the years is as follows:    

Accounting Depreciation: 

R5 000 / by 2 years 

  • 2011: R2 500 

  • 2010: R2 500

The Tax Authority, however, allows 100% deduction for this type of asset, in the first year it’s purchased. So, let’s say, that for tax depreciation or tax wear and tear - in 2010 there is a R5 000 deduction; a full deduction in the first year. The 2011 deduction for tax purposes, is nil. Can we see that the accounting depreciation here is different to the tax depreciation?  That’s going to create a temporary difference and therefore, deferred tax.  

Deductions: 

2010: R5 000 deductions  
2011: R0 deductions

Just for completeness’ sake, the current tax liability is paid within three months after the year-end. Assume that there is no interim for provisional tax payments for this scenario. 

Let’s have a look at what the current tax computation is going to look like. First of all, profit before tax for both years (2010 and 2011) is R100 000. What we need to do is, we need to go from profit before tax, which is the accounting profit figure, down to taxable income, which is the tax profit. 

The reason for this: The difference in this question is going to be that the depreciation period for accounting versus tax is different. So the easiest way to do that is to reverse the accounting depreciation by adding back the R2 500 in each of the years and then taking into account the tax depreciation figures. In 2010 that was a R5 000 deduction, and in 2011 it was R0. So the difference between the accounting versus tax depreciation figures here was: 

The tax depreciation was bigger by R2 500, therefore a larger deduction of R2 500. This will have the effect of decreasing the accounting profit from a R100 000, down to R97 500 to get taxable income or tax profits. 

In 2011 however, the R2 500 depreciation is added back, and there is no tax depreciation. That will increase taxable income by R2 500, as compared to accounting profit before tax. Therefore, taxable income in 2011 is R102 500. Now based on that taxable income figure, you will calculate your current tax expense for the year. So R97 500 x 28% = R27 300 current tax expense for 2010. For 2011 we take R102 500 x 28% = R28 700. So that is the current tax expense, that will be declared to the tax authority. 

The concept here is that our total tax expense in the accounting records should hypothetically match up to the profit before tax. This has got to do with the accrual basis of accounting. So here what we are saying is that accounting tax might be different from the actual tax that’s going to be declared. 

Assuming that there are no permanent differences in this question, such as items like dividends that are income for accounting, but never taxable under the current income tax. Here, what we are saying is that my accounting profit before tax, hypothetically, is R100 000. Therefore tax should be R100 000 x 28% = R28 000. If we want to comply with the accrual concept here, raise the tax in the period to which the accounting incomes are raised.

So in 2010, because of the timing or temporary difference between the accounting and tax depreciation, I’m going to have a R700 difference between current tax versus accounting hypothetical tax. So what are we doing here? We’re increasing that tax, right?

In 2011, that difference that we had, that R2 500, that was a decrease in taxable income in 2010, reversed out and became a positive R2 500 in 2011. Therefore, our current tax expense was R28 700. But my R100 000 x 28% accounting tax = R28 000. So here I need to decrease my tax expense by R700. 

So conceptually now, this little over/under of R700 in each of the years, is what we are going to call deferred tax expenses. That’s not declared to the tax authority. That’s purely an accounting transaction to match up an accrue for the tax expense, in the period to which it relates. Now, we can hypothetically calculate deferred tax from my current tax computation. That’s not the approach I want you to master, first of all. 

First of all, we need to look at what we call the Statement of Financial Position Approach (SoFP). This is dictated by IAS12, and in reality, income and financial position - two different sides of the same coin over a period. So let’s follow what IAS12 says, and show you the consistent approach that will help you throughout your practice and your academic career. 

So starting off - Carrying amount of PPE on the day you purchased it (day one) was R5 000. The tax base, which is your tax carrying amount, on that day is also R5 000. 

Definitions: 

Carrying amount is future economic benefits.
Tax base is equal to the future tax deductions.

So, on day one, we assume that there are at least future economic benefits of R5 000, as a carrying amount. On day one, we have not yet claimed the tax deductions. Therefore there is R5 000 in future tax deductions.  

At that stage, the difference between the carrying amount - tax base, which will give me my temporary difference, is R0. I take my temporary difference x 28% tax rate = deferred tax balance on the first day of 2010 of R0. Remember, here we are dealing with balances as our starting point for our calculation.

Now let’s go to PPE on the 2010 reporting date.

At the end of the year we have depreciated R2 500, therefore carrying amount is R5 000 - R2 500 depreciation = R2 500. The tax base at this point is R5 000 original tax base - tax deduction that was claimed during the year = future tax deduction of R0. 

R2 500 future income – R0 future tax deductions = temporary difference of R2 500. In the future, that will be a future increase in taxable income. At the end of 2010, the future taxable income will increase by R2 500. Therefore, this is a taxable temporary difference. I take that taxable temporary difference of R2 500 x 28% = R700 deferred tax liability balance. How do I know it’s a liability?  There is going to be future taxable income increasing, therefore there will be a future current tax liability increase. Definitely a deferred tax liability, a future outflow or rise because of this.

So, what I need to do now, is I need to look at the 2011 closing balance, which carrying amount, asset is fully depreciated, tax base no future tax deductions, both are R0. Therefore, temporary difference and deferred tax is R0. That is the deferred tax balance. 

In order to get the deferred tax movement or deferred tax expense, we need to calculate the difference between the opening and closing balance. In order to go from a R0 deferred tax balance on the first day of 2010 to a R700 deferred tax liability, we will need to credit deferred tax financial position R700 (credit).

What is the other side of the transaction? What caused the temporary difference? It was depreciation. Depreciation is a profit and loss item, therefore we will debit deferred tax expense in profit or loss and that’s R700. That is my deferred tax movement for 2010. 

Movement for the 2011 year, is going to be what?  We are going from a R700 deferred tax liability back to R0. How do I journalise that financial position movement? I debit deferred tax financial position, use up the liability, and I will credit the deferred tax profit and loss (also R700). That is my deferred tax movement for 2010 and 2011. Let's make sure that it’s matching up. 

Understand that, behind the deferred tax balance and movements, there is this thing called a temporary difference. The amount, before we’ve timesed it by the tax rate. Opening balance on the first day was R0. At the end of 2010, I had R2 500 taxable temporary difference. So what happened there, there was a taxable temporary difference movement of R2 500, and from 2010 to 2011, we’ve gone back to R0 temporary difference. So, therefore, there will be a deductible temporary difference movement for 2011 to take us back to R0 temporary difference balance. Let’s make sure we can match that up. So going back to my current tax computation, let’s have a look at the first year. 

The first year I had a R2 500 temporary difference movement. As you can see, this was a negative. That thinking is, we had a negative R2 500, a decrease in taxable income, which will reverse out in the future, to increase taxable income in the future. Which you can see in the following year the R2 500 deposited. Therefore, that is a taxable temporary difference movement in 2010. 

In the 2011 year, we have a positive, which is going to be a deductible temporary difference movement. Take your calculator out quickly and let’s have a look. Does that R2 500 match up to our journal? Well, the R2 500 in 2010 is called proof of deferred tax movement. In 2010, I had R2 500 x 28% = R700. And that would be journalised as what? 

We’ve just done that journal, haven’t we? We’ve done that debit deferred tax (profit and loss), created deferred tax (financial position) = R700. That’s the same journal as I just did on the deferred tax balance calculation. All we are doing, is making sure that the proof that the deferred tax movement on the balance sheet side is the same as our current tax calculation, and if they reconcile, things like your tax rate recon would be nice and easy.        

In 2011, again, I have a R2 500 taxable temporary difference, well a temporary difference movement. Sorry, that is a deductible temporary difference. This means that I have a debit to the deferred tax balance sheet or financial position, and I’m going to credit deferred tax (profit and loss) with R700. So this proves that the journals are exactly the same, whether we’re doing it from the financial position side, or the tax computation – the proof works.

Please remember, that you’d also need to do your current tax expense journal. Let’s quickly do that. 

My current tax journal for 2010 (This is the amount that will be payable to a tax authority in the current year):
Debit current tax expense (profit and loss item) of R27 300 and debit current tax payable (financial position account) of R27 300. 

My current tax journal for 2011 (Tax based on taxable income of R102 500; tax expense that is current and owing to the tax authority is R28 700):
Debit current tax expense (profit and loss) of R28 700 and credit current tax payable (financial position account) of R28 700.  

Let’s add the two up 

2010: R27 300 + R700 = R28 000 going through profit and loss  
2011: R28 700 – R700 = R28 000 in profit and loss       

Now, this is very simplified, in many examples, there’s going to be capital gains tax; there’s going to be foreign income, which is taxed at a different rate; there’s going to be some permanent differences and exempt differences. Now those will result in the total tax expense not being exactly 28% of PBT. But this is a very simplified example, purely to look at movement in temporary differences.

So, let’s move on. We’ve got our current tax computation and deferred tax balance and movement calculations. And all we’re going to do is quickly journalise those. The journals as I had them, just to sum up. 

Journals 2010
Journal 1 2010: Current tax expense 

Debit current tax expense (profit and loss) - R27 300
Current tax liability or payable (financial position) - R27 300

Journal 2 2010: Deferred tax expense  

Debit deferred tax (profit and loss) - R700
Credit deferred tax (financial position) - R700

Write these journals down, because from the journals I’m going to ask you to do the basic disclosures.

Journals 2011 

Journal 1 2011: Current tax expense 

Debit current tax expense (profit and loss) - R28 700
Credit current tax liability (financial position) - R28 700

Journal 2 2011: Deferred tax expense 

Debit deferred tax (financial position) - R700
Credit deferred tax (profit and loss) - R700 

Journal 3 2011: Payment of 2010 current tax liability 

Debit current tax liability (financial position) - R27 300
Credit to bank (Financial position) - R27 300

From here, please note that I’ve called all the current tax expense journals, Journal 1. And the deferred tax journals, Journal 2.

Now, let’s take a look at what disclosures are going to look like. Disclosure would generally be the income tax expense note, which is going to be made up out of major components and tax recon. Here there are no permanent differences or capital gains etc. So there is no tax rate recon required, and a balance sheet note.

The income tax expense, we are going to start with major components of tax expense, and you will split that up into current tax expense and deferred tax expense. Later on, I’m going to fill out a whole bunch of extra items that will go under current tax and deferred tax expense. 

Now, this is a very simplified example. All we had was our local current tax expense from Journal 1. And that’s for 2010 with a debit current tax expense of R27 300, made the expense bigger, so it’s a positive. The year 2011, the expense for current tax was R28 700 for the journal. 

Now for the deferred tax expense, we look at Journal 2, and all we had in this example was movement in normal temporary differences. This example was based on PPE, whether depreciation was different for accounting and tax purposes. So in 2010 we went debit deferred tax (profit and loss) and made the expense bigger. 

In 2011 we credited deferred tax (profit and loss) and made the expense smaller. The total tax expense in this example, because it was a perfect one with no reconciling items, the total tax expense was exactly R28 000. 

To complete this little illustration, we are going to have a quick look at the notes to the financial position side of the taxation that we just discussed. 

Deferred Tax Balance: 

Sometimes we can call this analysis of temporary differences; I just prefer calling this deferred tax balance. Here we need to list of what each of the items, that creates a temporary difference, is. For me, Property Plant and Equipment (PPE) is perfect. 

If you are going to call it accelerated tax depreciation, or accelerated wear and tear for tax, you need to make sure that you’re landing up with wear and tear that is bigger than the accounting depreciation. Keep it simple and call it PPE. 

So in 2010, the balance was R700, and that was a liability. In 2011 however, it went back to R0. That’s the balances now, not the movements – different concepts. 

Current Tax Payable: 

The actual amount owing to the tax authority in 2010 - that was R27 300. In 2011 we had the R27 300 as an opening balance. We paid the R27 300 to the tax authority and raised a new tax expense and tax payable of R28 700. Please, both of those are liabilities. I just put debits in positive and credits in negative. 

I hope this has got you started on your road to learning about deferred tax. Please watch the rest of our videos now to start looking into the detail of what is arguably one of the most complex areas within financial accounting.

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