LOS H requires us to:
explain recognition and measurement of current and deferred tax items
The current taxes are based on the rates of taxes applicable on the balance sheet date. On the balance sheet, there would be a liability with respect to the taxes payable. This reflects the entire amount payable on that date (since the tax return is filed up to a specified date after the balance sheet date, therefore, the whole amount of taxes for the accounting year remains unpaid on that date, except for the taxes paid in advance). There may also be some assets in the form of tax recoverable in the balance sheet. These reflect the amount of tax paid over and above the tax liability of the year. This is the amount usually due for a refund.
Deferred taxes, on the other hand, are measured at the rate that is expected to apply when they are realized. That is the reason the deferred tax assets are also revalued every time there is a change in the rates of taxation, as the recoverable amount of taxes also changes along.
The change in the valuation of deferred tax should be treated in the same way as the underlying assets or liabilities. For example, under both IFRS and GAAP, depreciation is a line item in the income statement (it goes to the income statement as depreciation expense). Any change that affects the depreciation estimates is also treated through the income statement. Thus, any deferred tax asset or liability also created resulting from the depreciation should be revalued through the income statement, if there is a change in their estimates.
This can be explained in detail through the following example:
Example: Suppose there is an asset, worth $ 1,000,000. This asset has an estimated useful life of 10 years and a depreciation rate of 10% each year, for the financial reporting purpose. But, for the taxation purpose, suppose the asset needs to be depreciated in 5 years at the rate of 20%. Now the carrying value, tax base and deferred tax liability (assuming a tax rate of 40%), of the asset for the next two years would be:
Now suppose, at the end of year 3, the asset is revalued to $ 1,200,000 and its life is re-estimated to survive a further 10-year period. This would result in the carrying value of the asset being revised to $ 1,080,000. Also, assume that this revaluation is not recognized for taxation purposes. Therefore, the tax base of the asset would remain the same. The depreciation is a line item in the income statement, thus any change in deferred tax liability due to changes in estimates for depreciation should also be treated through the income statement. Now, at the end of year 3, the revised values are:
But, our deferred tax liability would not be $ 192,000 (i.e. 40% of 480,000). Out of the current year’s depreciation of $ 120,000, $ 40,000 (i.e. 10% of 400,000) worth of depreciation pertains to revaluation, and the remaining $ 80,000 belongs to depreciation on original carrying value. Thus, the carrying value for the original asset would be $ 680,000 (i.e. 800,000 – 120,000). This is mainly because the revalued amount can’t be depreciated. Therefore, the temporary difference at the end of year 3, would be $ 80,000. And, the deferred tax liability on the same would be $ 32,000. And the taxable value of the revalued amount would be adjusted through the equity in the form of retained earnings and reserve surplus. |