EFIMM0124 Advanced Financial Reporting
Advanced Financial Reporting
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EFIMM0124
Advanced Financial Reporting
Accounting for Taxation
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.