Concepts, Rules, and Examples | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

Basic Concepts of Interperiod Income Tax Allocation

Over the years, various theories have been advanced regarding the appropriate reporting of income tax expense when there are differences in the timing of recognition of revenue and expense as between tax calculations and financial reporting. The most popular ideas were the deferral method and the liability method. (A third approach, the net of tax method, for a time received a moderate amount of academic support but was far less widely employed [or understood] by practitioners. Its only widespread use was as a valuation technique to record assets and liabilities acquired in a purchase business combination.)

The deferral method, which was widely employed, was soundly based on the matching principle and was never misrepresented as being balance sheet oriented. However, in practice it suffered from some complexity and sometimes also resulted in material distortions of the balance sheet. This was considered an acceptable if regrettable side effect, particularly during the late 1960s and 1970s, a period during which more attention was directed at income measurement than at meaningfulness of corporate balance sheets.

Following the adoption of the IASC's Framework for the Preparation and Presentation of Financial Statements, which serves as the conceptual underpinning for accounting standards promulgated by IASB, it was inevitable that substantial changes in accounting for income taxes would be made. That is because the deferred charges and credits resulting from the application of the deferral method (as permitted by the original IAS 12) were generally not true assets or liabilities as those are defined in the Framework. Accordingly, it became indefensible to place these items on the balance sheet. The liability method (explained below) became the method of choice.

A separate but also important debate had long existed regarding the items of timing differences for which deferred tax effects were to be presented. At one extreme were proponents of no allocation, who favored reporting only the amount of taxes currently payable as income tax expense. Occupying the middle ground were advocates of partial allocation, who accepted the need to provide deferred taxes only for those timing differences whose ultimate reversal could be reasonably predicted. At the other extreme were those favoring comprehensive allocation, which holds that deferred tax effects are to be reported for all timing differences, even if ultimate reversal is far in the future or cannot be predicted at all.

Very different results of operations would be reported under the three approaches to interperiod tax allocation, but this debate was effectively resolved in 1979 when an earlier iteration of IAS 12 decreed the need for comprehensive allocation, albeit with exceptions for certain items for which the tax effects were deemed not likely to reverse within three years. This version of IAS 12 did permit the utilization of either the deferral or the liability method, which are of course based on diametrically opposed theories. Partially for that reason, it was viewed as a flawed standard, but in common with many early IAS it attempted to find value in all major approaches used by various national GAAP at that time.

IASC's goal was to ultimately narrow the range of alternatives that would be deemed acceptable in accounting for given economic events, and it has accomplished that with regard to income tax accounting. The current version of IAS 12 clearly demands that the liability method be employed, using comprehensive allocation, with no alternative methodologies being permitted.

Measurement of Tax Expense

Current tax expense.

Income tax expense will be comprised of two components: current tax expense and deferred tax expense. Either of these can be a benefit (i.e., a credit), rather than an expense (a debit), depending on whether there is taxable profit or loss for the period. For convenience, the term "tax expense" will be used to denote either an expense or a benefit. Current tax expense is easily understood as the tax effect of the entity's reported taxable income or loss for the period, as determined by relevant rules of the various taxing authorities to which it is subject. Deferred tax expense, in general terms, arises as the tax effect of timing differences occurring during the reporting period. However, the actual computation of deferred tax expense varies dramatically, depending on whether a deferred method or a liability method is being applied. (Former IAS 12 allowed a free choice in this regard, making comparisons across entities particularly challenging.) Since IAS 12 currently prohibits the deferred method (as do national GAAP of the remaining major standard-setting bodies), this will not be addressed in this chapter. The following discussion will focus exclusively on the application of the liability method, which is mandated by IAS.

Under the liability method the current period's total income tax expense cannot be computed directly. Rather, it must be calculated as the sum of the two components: current tax expense and deferred tax expense. This total will not, in general, equal the current tax rate applied to pretax accounting profit. The reason is that deferred tax expense is defined as the change in the deferred tax asset and liability accounts in the current period, and this change may encompass more than the mere effect of the current tax rate times the net temporary differences occurring in the present reporting period.

IAS 12, as most recently revised, has mandated a purely balance sheet oriented approach, much like that imposed by SFAS 109 under US GAAP. Thus, it results in the inclusion in current period deferred tax expense the effects of changing tax rates on as yet unreversed temporary differences arising in prior periods. In other words, current period tax expense may include not merely the tax effects of currently reported revenue and expense items, but also certain tax effects of items reported previously.

Although the primary objective of income tax accounting under the liability method is no longer the proper matching of current period revenue and expenses, the matching principle remains very important. Therefore, the tax effects of items excluded from the income statement, such as corrections of errors, are also excluded from the income statement. This is referred to as intraperiod tax allocation, to be distinguished from the interperiod allocation that is the major subject of IAS 12 and of this chapter.

An Overview of the Liability Method

The liability method is balance sheet oriented, in contrast to the now almost extinct deferral method, which is income statement oriented. The primary goal of the liability method is to present the estimated actual taxes to be payable in future periods as the income tax liability on the balance sheet. To accomplish this goal it is necessary to consider the effect of certain enacted future changes in the tax rates when computing the current period's tax provision. The computation of the amount of deferred taxes is based on the rate expected to be in effect when the temporary differences reverse. The annual computation is considered a tentative estimate of the liability (or asset) that is subject to change as the statutory tax rate changes or as the taxpayer moves into other tax rate brackets.

The Framework for the Preparation and Presentation of Financial Statements defines liabilities as obligations resulting from past transactions and involving "giving up resources embodying economic benefits in order to satisfy the claim of [another] party." Assets are defined as "the potential to contribute, directly or indirectly, to the flow of cash ... to the enterprise." As the background paper to revised IAS 12 made clear, the deferred debits and credits generated through the use of the deferral method do not meet the definitions of assets and liabilities prescribed by the Framework. This lack of consistency was one of the primary reasons for the IASC's reconsideration of IAS 12, which culminated in the issuance of revised IAS 12 in 1996.

Application of the liability method is, in concept at least, relatively simple when compared to the deferral method. Unlike the deferral method, there is no need to maintain a historical record of the timing of origination of the various unreversed differences, since the effective rates at which the various components were established is not relevant. As the liability method is strictly a balance sheet approach, the primary concern is to state the obligation for taxes payable as accurately as possible, based on expected tax impact of future reversals. This is accomplished by multiplying the aggregate unreversed temporary differences, including those originating in the current period, by the tax rate expected to be in effect in the future to determine the expected future liability. This expected liability is the amount presented on the balance sheet at the end of the period. The difference between this amount and the amount on the books at the beginning of the period, simply put, is the deferred tax expense or benefit for the current reporting period.

An example of application of the liability method of deferred income tax accounting follows.

Simplified example of interperiod allocation using the liability method

Ghiza International has no permanent differences in either years 2002 or 2003. The company has only two temporary differences, depreciation and prepaid rent. No consideration is given to the nature of the deferred tax account (i.e., current or long-term) as it is not considered necessary for purposes of this example. Ghiza has a credit balance in its deferred tax account at the beginning of 2002 in the amount of $180,000. This balance consists of $228,000 ($475,000 depreciation temporary difference x 48% tax rate) of deferred taxable amounts and $48,000 ($100,000 prepaid rent temporary difference x 48% tax rate) of deferred deductible amounts.

For purposes of this example, it is assumed that there was a constant effective 48% tax rate in all periods prior to 2002. The pretax accounting income and the temporary differences originating and reversing in 2002 and 2003 are as follows:

Ghiza International
		2002		2003
Pretax accounting income			$800,000		$1,200,000
Timing differences:
Depreciation:	originating	$(180,000)		$(160,000)
Depreciation:	reversing	60,000	(120,000)	100,000	(60,000)
Prepaid rental income:	originating	75,000		80,000
Prepaid rental income:	reversing	(25,000)	50,000	(40,000)	40,000
Taxable income			$730,000		$ 1,180,000

The tax rates for years 2002 and 2003 are 46% and 38%, respectively. These rates are assumed to be independent of one another, and the 2003 change in the rate was not known until it took place in 2003.

Computation of tax provision—2002:
Balance of deferred tax account, 1/1/02
Depreciation ($475,000 x 48%)		$228,000
Prepaid rental income ($100,000 x 48%)		(48,000)
		$180,000
Aggregate temporary differences, 12/31/02
Depreciation ($475,000 + $120,000)	$595,000
Prepaid rental income ($100,000 + $50,000)	(150,000)
	$445,000
Expected future rate (2002 rate)	x 46%
Balance required in the deferred tax account, 12/31/02		204,700
Required addition to the deterred tax account		$ 24,700
Income taxes currently payable ($730,000 x 46%)		335,800
Total tax provision		$360,500

Computation of tax provision—2003:
Balance of deterred tax account. 1/1/03
Depreciation ($595,000 x 46%)		$273,700
Prepaid rental income ($150,000 x 46%)		(69,000)
		$204,700
Aggregate timing differences, 12/31/03
Depreciation ($595,000 + $60,000)	$655,000
Prepaid rental income ($150,000 + $40,000)	(190,000)
	$465,000
Expccted future rate (2003 rate)	x 38%
Balance required in the deferred tax account, 12/31/03		176,700
Required reduction in the deferred tax account		$ (28,000)
Income taxes currently payable ($1,180,000 x 38%)		448,400
Total tax provision		$420,400

Liability Method Explained in Detail

While conceptually the liability method is rather straightforward, in practice there are a number of complexities to be addressed. In the following pages, the following measurement and reporting issues are discussed in greater detail.

Nature of temporary differences
Treatment of operating loss carryforwards
Measurement of deferred tax assets and liabilities
Valuation allowance for deferred tax assets that are not assured of realization
Effect of tax law changes on previously recorded deferred tax assets and liabilities
Effect of tax status changes on previously incurred deferred tax assets and liabilities
Tax effects of business combinations
Intercorporate income tax allocation
Exceptions to the general rules of revised IAS 12

Detailed examples of deferred income tax accounting under IAS 12 are presented throughout the following discussion of these issues.

Nature of Temporary Differences

The majority of the typical reporting entity's 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 recognized. Under 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. Common timing differences include those relating to depreciation methods, deferred compensation plans, percentage-of-completion accounting for long-term construction contracts, and cash versus accrual accounting.

The latest revisions to IAS 12 introduced the concept of temporary differences, which is rather more comprehensive than that of timing differences. Temporary differences include all the categories of the earlier concept, plus a number of additional items as well. Temporary differences include all differences between the tax and financial reporting bases of assets and liabilities if those differences will result in taxable or deductible amounts in future years.

Examples of temporary differences that were also deemed to be timing differences under the original IAS 12 are the following:

Revenue recognized for financial reporting purposes before being recognized for tax purposes. Examples include revenue accounted for by the installment method for tax purposes, but reflected in income currently; certain construction-related revenue recognized on a completed-contract method for tax purposes, but on a percentage-of-completion basis for financial reporting; earnings from investees recognized by the equity method for accounting purposes but taxed only when later distributed as dividends to the investor. These are taxable temporary differences, which give rise to deferred tax liabilities.
Revenue recognized 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. Referred to as deductible temporary differences, these items give rise to deferred tax assets.
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 preoperating costs and certain capitalized interest costs that are deductible currently for tax purposes. These items are taxable temporary differences and give rise to deferred tax liabilities.
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.

In addition to these familiar and well-understood timing differences, temporary differences include a number of other categories that also involve differences between the tax and financial reporting bases of assets or liabilities. These are

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.
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 re-measured. This reevaluation of asset costs gives rise to deductible temporary differences that would be associated with deferred tax benefits.
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 differences were treated as timing differences under the original IAS 12, and will now be recognized as temporary differences by revised IAS 12.
Assets which are revalued for financial reporting purposes although the tax bases are not affected. This is analogous to the matter discussed in the preceding paragraph. Under certain international accounting standards (such as IAS 16 and IAS 40), assets are written up to fair value 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 tax laws, exchanges for other similar assets (or reinvestment of proceeds of sales in similar assets) would effect a postponement of the tax obligation.

Items that would not have been deemed timing differences under the original standard IAS 12 but are temporary differences under revised IAS 12 include the following:

Assets and liabilities acquired in transactions that are not business combinations which are not deductible or taxable in determining taxable profit. In some tax jurisdictions, certain assets are never deductible in computing taxable profit. Depending on jurisdiction, buildings, intangibles, and other assets may be nondeductible. Thus, the asset in question has a differing accounting basis than tax basis, which defines a temporary difference. Similarly, certain liabilities may not be recognized for tax purposes. While IAS 12 agrees that these represent temporary differences (since the tax basis of zero differs from the book basis in each instance) and that, under the principles of tax accounting using the liability method, this should result in the recognition of deferred tax liabilities or assets, the decision was made to not permit this. 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 nondeductibility for tax purposes, the price paid for this asset has been affected accordingly, so that any such "gross-up" would cause the asset to be reported at an amount in excess of fair value.
Assets and liabilities acquired in business combinations. When assets and liabilities are valued at fair value, as required under IAS 22, but the tax basis is not adjusted (i.e., there is a carryforward basis for tax purposes), there will be differences between the tax and financial reporting bases of these assets and liabilities which constitute temporary differences. Deferred tax benefits and obligations need to be recognized for these differences.
Goodwill that cannot be amortized (deducted) for tax purposes. In some jurisdictions, goodwill cannot be deducted for tax purposes. Conceptually, when goodwill is carried on the balance sheet but cannot be amortized for tax purposes the tax basis of this asset is zero, which thus differs from the financial reporting basis and would therefore require that deferred taxes be assessed thereon. However, since goodwill or negative goodwill is a residual amount, any attempt to compute the deferred tax effect of the difference between tax and book bases would result in grossing up that very account (goodwill or negative goodwill, as the case may be). Although such a presentation could be rationalized, it would be of dubious usefulness to the readers of the financial statements. For this reason, IAS 12 holds that no deferred taxes are to be provided on the difference between the tax and book bases of nondeductible goodwill or nontaxable negative goodwill.

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 probable of being realized and therefore should be recognized) is as follows:

Identify all temporary differences existing as of the reporting date.
Segregate the temporary differences into those that are taxable and those that are deductible. This step is necessary because under revised IAS 12 only those deferred tax benefits which are probable of being realized are recognized, whereas all deferred obligations are given full recognition.
Accumulate information about the deductible temporary differences, particularly the net operating loss and credit carryforwards that have expiration dates or other types of limitations.
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).
Similarly, measure the tax effects of deductible temporary differences, including net operating loss carryforwards.

It should be emphasized 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 benefits against tax liabilities. Inasmuch as benefits in one tax jurisdiction will not reduce taxes payable in another jurisdiction, separate calculations will be needed. Also, for purposes of balance sheet presentation (discussed below in detail), offsetting of deferred tax assets and liabilities is permissible only within jurisdictions, since there would never 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 (i.e., 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 pretax financial income of $250,000 in 2003, a total of $28,000 of taxable temporary differences, and a total of $8,000 of deductible temporary differences. There are 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:

Pretax 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—deterred	8,000
Deferred tax liability		11,200
Income tuxes 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 x 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 2004, Noori Company has pretax 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 pretax 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 x 40%).

Deferred amounts are calculated as follows:

	Deferred tax liability	Deferred tax asset	Income tax expense—deferred
Required balance at 12/31/04
$75,000 x 40%	$30,000		--
$36,000 x 40%		$14,400	--
Balances at 12/31/03	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 2004 is larger (by $7,600) than the increase in the asset for that year, the result is a deferred tax expense for 2004.

Considerations for 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 balance sheet only if they are, in fact, very likely to be realized in future periods. Since realization 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. Absent convincing evidence of that, the concepts of conservatism and realization would suggest that the asset be treated as a contingent gain, and not accorded recognition until and unless ultimately realized.

In revised IAS 12, the IASC adopted a posture which holds that deferred tax assets resulting from temporary differences and from tax loss carryforwards are to be given recognition only if realization is deemed to be probable. To operationalize this concept, the standard sets forth several criteria, which variously apply to deferred tax assets arising from temporary differences and from tax loss carryforwards. The standard establishes that

It is probable that future taxable profit will be available against which a deferred tax asset arising from a deductible temporary difference can be utilized 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
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.

Thus, there will be a modest element of judgment required in making an assessment about how probable the realization of the deferred tax asset is, in circumstances in which there is not a balance of deferred tax liability equal to or greater than the amount of the deferred tax asset. If it cannot be concluded that realization is probable, the deferred tax asset is not given recognition. The methodology of revised IAS 12 is somewhat different than that which is applied under current US GAAP, which is prescribed by SFAS 109. In conformity with that standard, all deferred tax assets are first recorded, after which a valuation allowance or reserve is established to offset that portion which is not deemed to be "more likely than not" realizable. The net effect is similar under either approach, however, although the consensus opinion is that the US GAAP realization threshold, "more likely than not," represents a somewhat lower boundary than does IAS 12's "probable." While the former implies a probability of just slightly over 50%, the latter is thought to connote a likelihood in the range of 75–80% or even higher. Worded yet another way, it would be more challenging to support the existence of a valid deferred tax asset under the IAS standard than under US GAAP rules as they now exist.

Future temporary differences as a source for taxable profit to offset deductible differences.

In some instances, an entity may have deferred tax assets that will be realizable when future tax deductions are taken, but it cannot be concluded that there will be sufficient taxable profits to absorb these future deductions. However, the enterprise can reasonably predict that if it continues as a going concern, it will generate other temporary differences such that taxable profits will be created. It has often been argued that the going concern assumption underlying much of accounting theory is sufficient rationale for the recognition of deferred tax assets in such circumstances.

However, revised IAS 12 makes it clear that this is not valid reasoning. The reason is that the taxable temporary differences anticipated for future periods will themselves reverse in even later periods; these cannot do "double duty" by also being projected to be available to absorb currently existing deductible temporary differences. Thus, in evaluating whether realization of currently outstanding deferred tax benefits is probable, it is appropriate to consider the currently outstanding taxable temporary differences, but not taxable temporary differences which are projected to be created in later periods.

Tax planning opportunities that will help realize deferred tax assets.

When an entity has deductible temporary differences and taxable temporary differences pertaining to the same tax jurisdiction, there is a presumption that realization of the relevant deferred tax assets is probable, since the relevant deferred tax liabilities should be available to offset these. However, before concluding on this it is necessary to consider further the timing of the two sets of reversals. If the deductible temporary differences will reverse, say, in the very near term, and the taxable differences will not reverse for many years, it is a concern that the tax benefits created by the former occurrence may expire unused prior to the latter event. Thus, when the availability of deferred tax obligations is the basis for recognition of deferred tax assets, it is also necessary to consider whether, under pertinent tax regulations, the benefit carryforward period is sufficient to assure that it will not be lost to the reporting enterprise.

For example, if the deductible temporary difference is projected to reverse in two years but the taxable temporary difference is not anticipated to occur for another ten years, and the tax jurisdiction in question offers only a five-year tax loss carryforward, then (absent other facts suggesting that the tax benefit is probable of realization) the deferred tax benefit could not be given recognition.

However, the entity might have certain tax planning opportunities available to it, such that the pattern of taxable profits could be altered to make the deferred tax benefit, which might otherwise be lost, probable of realization. For example, again depending on the rules of the salient tax jurisdiction, an election might be made to tax interest income on an accrual rather than a cash received basis, which might accelerate income recognition such that it would be available to offset or absorb the deductible temporary differences. Also, claimed tax deductions might be deferred to later periods, similarly boosting taxable profits in the short term.

More subtly, a reporting entity may have certain assets, such as buildings, which have appreciated in value. It is entirely feasible, in many situations, for an enterprise to take certain steps, such as selling the building to realize the taxable gain thereon and then either leasing back the premises or acquiring another suitable building, to salvage the tax deduction that would otherwise be lost to it due to the expiration of a loss carryforward period. If such a strategy is deemed to be reasonably available, even if the entity does not expect to have to implement it (for example, because it expects other taxable temporary differences to be originated in the interim), it may be used to justify recognition of the deferred tax benefits.

Consider the following example of how an available tax planning strategy might be used to support recognition of a deferred tax asset that otherwise might have to go unrecognized.

Example of the impact of a qualifying tax strategy

Assume that Kirloski Company has a $180,000 operating loss carryforward as of 12/31/02, scheduled to expire at the end of the next year. Taxable temporary differences of $240,000 exist that are expected to reverse in approximately equal amounts of $80,000 in 2003, 2004, and 2005. Kirloski Company estimates that taxable income for 2003 (exclusive of the reversal of existing temporary differences and the operating loss carryforward) will be $20,000. Kirloski Company expects to implement a qualifying tax planning strategy that will accelerate the total of $240,000 of taxable temporary differences to 2003. Expenses to implement the strategy are estimated to approximate $30,000. The applicable expected tax rate is 40%.

In the absence of the tax planning strategy, $100,000 of the operating loss carryforward could be realized in 2003 based on estimated taxable income of $20,000 plus $80,000 of the reversal of taxable temporary differences. Thus, $80,000 would expire unused at the end of 2003 and the net amount of the deferred tax asset at 12/31/02 would be recognized at $40,000, computed as $72,000 ($180,000 x 40%) minus the valuation allowance of $32,000 ($80,000 x 40%).

However, by implementing the tax planning strategy, the deferred tax asset is calculated as follows:

Taxable income for 2003:
Expected amount without reversal of taxable temporary differences	$ 20,000
Reversal of taxable temporary differences due to tax planning strategy, net of costs	210,000
	230,000
Operating loss to be carried forward	(180,000)
Operating loss expiring unused at 12/31/03	$ 0

The deferred tax asset to be recorded at 12/31/02 is $54,000. This is computed as follows:

Full benefit of tax loss carryforward $180,000 x 40% =		$72,000
Less:	Net-of-tax effect of anticipated expenses related to implementation of the strategy $30,000 - ($30,000 x 40%) =	18,000
Net		$54,000

Kirloski Company will also recognize a deferred tax liability of $96,000 at the end of 2002 (40% of the taxable temporary differences of $240,000).

Revised expectations that a deferred tax benefit is realizable.

It may happen that in a reporting period a deferred asset is deemed not probable of being realized and accordingly is not recognized, but in a later reporting period the judgment is made that the amount in fact is realizable. If this change in expectation occurs, the deferred tax asset previously not recognized will now be recorded. This does not constitute a prior period adjustment, but instead is included in earnings, consistent with other changes in accounting estimates, in the current period. Thus, the tax provision in the period when the estimate is revised will be affected.

Similarly, if a deferred tax benefit provision is made in a given reporting period, but later events suggest that the amount is, in whole or in part, not probable of being realized, the provision should be partially or completely reversed. Again, this adjustment will be included in the tax provision in the period in which the estimate is altered. Under either scenario the footnotes to the financial statements will need to offer sufficient information to the users to permit meaningful interpretations to be made, since the amount of tax expense will bear an unusual relationship to the accounting profit for the period.

If the deferred tax provision in a given period is misstated due to a clerical error such as miscalculation of the effective expected tax rate, this would constitute an accounting error, and the effect of the correction may be reflected in opening retained earnings. This should be distinguished from a change in an accounting estimate. Accounting errors are discussed in Chapter 21.

Determining the extent to which the deferred tax asset is realizable.

Assume that Zacharias Corporation has a deductible temporary difference of $60,000 at December 31, 2002. The applicable tax rate is a flat 40%. Based on available evidence, management of Zacharias Corporation concludes that it is probable that all sources will not result in future taxable income sufficient to realize more than $15,000 (i.e., 25%) of the deductible temporary difference. Also, assume that there were no deferred tax assets in previous years and that prior years' taxable income was inconsequential.

At 12/31/02 Zacharias Corporation records a deferred tax asset in the amount of $6,000 ($60,000 x 25% x 40%). The journal entry at 12/31/02 is

Deferred tax asset	6,000
Income tax benefit—deferred		6,000

The deferred income tax benefit of $6,000 represents the tax effect of that portion of the deferred tax asset (25%) that is probable of being realized. In 2003 assume that Zacharias Corporation's results are

Pretax financial loss	$(32,000)
Reversing deductible differences from 2002	(10,000)
Loss carryforward for tax purposes	$(42,000)

The total of the loss carryforward ($42,000, as computed above) plus the amount of deductible temporary differences from 2002 not reversing in 2003 ($50,000) equals $92,000. Before considering how much of the benefit is probable of being realized, a deferred tax asset of $36,800 ($92,000 x 40%) is computed at the end of 2003. However, the management of Zacharias Corporation has to consider what portion of this deferred tax asset is probable of being realized. It concludes that it is probable that $25,000 of the tax loss carryforward will not be realized. Thus, the net tax loss carryforward that is probable of being realized is $92,000 - $25,000 = $67,000, which yields a tax benefit of $26,800 ($67,000 x 40%).

Since the balance in the deferred tax asset account had been $6,000, the adjustment needed is now as follows. The journal entry at 12/31/03 is

Deferred tax asset	20,800
Income tax benefit—deferred		20,800

While the commonsense meaning of the probable criterion is clear enough, there can be a practical difficulty of assessing whether or not this threshold test is net in a given standard. Revised IAS 12 states that deferred tax assets can be recognized when there are sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity which are expected to reverse in the same period as the expected reversal of the deductible temporary difference or in periods into which a tax loss arising from the deferred tax asset can be carried back or forward. The standard also suggests that, if there is an insufficiency of taxable temporary differences to absorb the deductible temporary differences, but it is deemed probable that sufficient taxable income will otherwise be earned, or that tax planning strategies are available to the entity, this can be used as a basis for concluding that it is probable that the benefits will be received.

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 recognized. Positive factors (those suggesting that the full amount of the deferred tax asset associated with the gross temporary difference should be recorded) might include

Evidence of sufficient future taxable income, exclusive of reversing temporary differences and carryforwards, to realize the benefit of the deferred tax asset
Evidence of sufficient future taxable income arising from the reversals of existing taxable temporary differences (deferred tax liabilities) to realize the benefit of the tax asset
Evidence of sufficient taxable income in prior year(s) available for realization of an operating loss carryback under existing statutory limitations
Evidence of the existence of prudent, feasible tax planning strategies under management control which, if implemented, would permit the realization of the tax asset. These are discussed in greater detail below.
An excess of appreciated asset values over their tax bases, in an amount sufficient to realize the deferred tax asset. This can be thought of as a subset of the tax strategies idea, since a sale or sale/leaseback of appreciated property is one rather obvious tax planning strategy to salvage a deferred tax benefit which might otherwise expire unused.
A strong earnings history exclusive of the loss that created the deferred tax asset. This would, under many circumstances, suggest that future profitability is likely and therefore that realization of deferred tax assets are probable.

Although the foregoing may suggest that the reporting entity will be able to realize the benefits of the deductible temporary differences outstanding as of the balance sheet date, certain negative factors should also be considered in determining whether realization of the full amount of the deferred tax benefit is probable under the circumstances. These factors could include

A cumulative recent history of accounting losses. Depending on extent and length of time over which losses were experienced, this could reduce the assessment of likelihood of realization below the important "probable" threshold.
A history of operating losses or of tax operating loss or credit carryforwards that have expired unused
Losses that are anticipated in the near future years, despite a history of profitable operations

Thus, the process of determining how much of the computed gross deferred tax benefit should be recognized involves the weighing of both positive and negative factors to determine whether, based on the preponderance of available evidence, it is probable that the deferred tax asset will be realized. IAS 12 notes that a history of unused tax losses should be considered "strong evidence" that future taxable profits might prove elusive. In such cases, it would be expected that primary reliance would be placed on the existence of taxable temporary differences which, upon reversal, would provide taxable income to absorb the deferred tax benefits that are candidates for recognition in the financial statements. Absent those taxable temporary differences, recognition would be much more difficult.

To illustrate this computation in a more specific fact situation, assume the following facts:

Malpasa Corporation reports on a calendar year and adopted revised IAS 12 in 2001.
As of the December 31, 2002 balance sheet, Malpasa has taxable temporary differences of $85,000 relating to depreciation, deductible temporary differences of $12,000 relating to deferred compensation arrangements, a net operating loss carryforward (which arose in 2000) of $40,000, and a capital loss carryover of $10,000.
Malpasa's expected tax rate for future years is 40% for ordinary income, and 25% for net long-term capital gains. Capital losses cannot be offset against ordinary income.

The first steps are to compute the required balances of the deferred tax asset and liability accounts, without consideration of whether the tax asset would be probable of realization. The computations would proceed as follows:

Deferred tax liability:
Taxable temporary difference (depreciation)	$85,000
Effective tax rate	x 40%
Required balance	$34,000
Deferred tax asset:
Deductible temporary differences:
Deferred compensation	$12,000
Net operating loss	40,000
	$52,000
Effective tax rate	x 40%
Required balance (a)	$20,800
Capital loss	$10,000
Effective tax rate	x 25%
Required balance (b)	$ 2,500
Total deferred tax asset:
Ordinary (a)	$20,800
Capital (b)	2,500
Total required balance	$23,300

The next step would be to consider whether realization of the deferred tax asset is probable. Malpasa management must evaluate both positive and negative evidence to determine this matter. Assume now that management identifies the following factors which may be relevant:

Before the net operating loss deduction, Malpasa reported taxable income of $5,000 in 2002. Management believes that taxable income in future years, apart from NOL deductions, should continue at about the same level experienced in 2002.
The taxable temporary differences are not expected to reverse in the foreseeable future.
The capital loss arose in connection with a transaction of a type that is unlikely to recur. The company does not generally engage in activities that have the potential to result in capital gains or losses.
Management estimates that certain productive assets have a fair value exceeding their respective tax bases by about $30,000. The entire gain, if realized for tax purposes, would be a recapture of depreciation previously taken. Since the current plans call for a substantial upgrading of the company's plant assets, management feels that it could easily accelerate those actions to realize taxable gains, should it be desirable to do so for tax planning purposes.

Based on the foregoing information, Malpasa Corporation management concludes that a $2,500 adjustment to deferred tax assets is required. The reasoning is as follows:

There will be some taxable operating income generated in future years ($5,000 annually, based on the earnings experienced in 2002), which will absorb a modest portion of the reversal of the deductible temporary difference ($12,000) and net operating loss carryforward ($40,000) existing at year-end 2002.
More important, the feasible tax planning strategy of accelerating the taxable gain relating to appreciated assets ($30,000) would certainly be sufficient, in conjunction with operating income over several years, to permit Malpasa to realize the tax benefits of the deductible temporary difference and NOL carryover.
However, since capital loss carryovers are only usable to offset future capital gains and Malpasa management is unable to project future realization of capital gains, the associated tax benefit accrued ($2,500) will probably not be realized, and thus cannot be recognized.

Based on this analysis, deferred tax benefits in the amount of $20,800 should be recognized.

Effect of Tax Law Changes on Previously Recorded Deferred Tax Assets and Liabilities

The balance sheet oriented measurement approach of IAS 12 necessitates the reevaluation of the deferred tax asset and liability balances at each year-end. Although IAS 12 does not directly address the question of changes to tax rates or other provisions of the tax law (e.g., deductibility of items) which may be enacted that will affect the realization of future deferred tax assets or liabilities, the effect of these changes should be reflected in the year-end deferred tax accounts in the period the changes are enacted. The offsetting adjustments should be made through the current period tax provision.

When revised tax rates are enacted, they may affect not only the unreversed effects of items which were originally reported in the continuing operations section of the income statement, but also the unreversed effects of items first presented as extraordinary items or in other income statement captions. Although it might be conceptually superior to report the effects of tax law changes on such unreversed temporary differences in these same income statement captions, as a practical matter the complexities of identifying the diverse treatments of these originating transactions or events would make such an approach unworkable. Accordingly, remeasurements of the effects of tax law changes should generally be reported in the tax provision associated with continuing operations.

Example of the computation of a deferred tax asset with a change in rates

Assume that the Fanuzzi Company has $80,000 of deductible temporary differences at the end of 2002, which are expected to result in tax deductions of approximately $40,000 each on tax returns for 2003–2004. Enacted tax rates are 50% for the years 1998–2002, and 40% for 2003 and thereafter.

The deferred tax asset is computed at 12/31/02 under each of the following independent assumptions:

If Fanuzzi Company expects to offset the deductible temporary differences against taxable income in the years 2003–2004, the deferred tax asset is $32,000 ($80,000 x 40%).
If Fanuzzi Company expects to realize a tax benefit for the deductible temporary differences by loss carryback refund, the deferred tax asset is $40,000 ($80,000 x 50%).

Assume that Fanuzzi Company expects to realize a tax asset of $32,000 at the end of 2002. Also assume that taxes payable in each of the years 1998–2001 were $8,000 (or 50% of taxable income). Realization of $24,000 of the $32,000 deferred tax asset is assured through carryback refunds even if no taxable income is earned in the years 2003–2004. Whether some or all of the remaining $8,000 will be recognized depends on Fanuzzi Company's assessment of the levels of future taxable earnings (i.e., whether the probable threshold is exceeded).

The foregoing estimate of the certain tax benefit, based on a loss carryback to periods of higher tax rates than are statutorily in effect for future periods, should be utilized only when future losses (for tax purposes) are expected. This restriction applies since the benefit thus recognized exceeds benefits that would be available in future periods, when tax rates will be lower.

Reporting the Effect of Tax Status Changes

Changes in the tax status of the reporting entity should be reported in a manner that is entirely analogous to the reporting of enacted tax law changes. When the tax status change becomes effective, the consequent adjustments to deferred tax assets and liabilities are reported in current tax expense as part of the tax provision relating to continuing operations.

The most commonly encountered changes in status are those attendant to an election, where permitted, to be taxed as a partnership or other flow-through enterprise. (This means that the corporation will not be treated as a taxable entity but rather as an enterprise that "flows through" its taxable income to the owners on a current basis. This favorable tax treatment is available to encourage small businesses, and often will be limited to entities having sales revenue under a particular threshold level, or to entities having no more than a maximum number of shareholders.) Enterprises subject to such optional tax treatment may also request that a previous election be terminated. When a previously taxable corporation becomes a nontaxed corporation, the stockholders become personally liable for taxes on the company's earnings, whether the earnings are distributed to them or not (similar to the relationship among a partnership and its partners).

As issued, IAS 12 did not explicitly address the matter of reporting the effects of a change in tax status, although (as discussed in earlier editions of this book) the appropriate treatment was quite obvious given the underlying concepts of that standard. This residual ambiguity was subsequently resolved by the issuance of SIC 25, which stipulates that in most cases the current and deferred tax consequences of the change in tax status should be included in net profit or loss for the period in which the change in status occurs. The tax effects of a change in status are included in results of operations because a change in an enterprise's (or its shareholders') tax status does not give rise to increases or decreases in the pretax amounts recognized directly in equity.

The exception to the foregoing general rule arises in connection with those tax consequences which relate to transactions and events that result, in the same or a different period, in a direct credit or charge to the recognized amount of equity. For example, an event that is recognized directly in equity is a change in the carrying amount of property, plant, or equipment revalued under IAS 16. Those tax consequences that relate to change in the recognized amount of equity, in the same or a different period (not included in net profit or loss) should be charged or credited directly to equity.

The most common situation giving rise to a change in tax status would be the election by a corporation, in those jurisdictions where it is permitted to do so, to be taxed as a partnership, trust, or other flow-through entity. If a corporation having a net deferred tax liability elects nontaxed status, the deferred taxes will be eliminated through a credit to current period earnings. That is because what had been an obligation of the corporation has been eliminated (by being accepted directly by the shareholders, typically); a debt thus removed constitutes earnings for the formerly obligated party.

Similarly, if a previously nontaxed corporation becomes a taxable entity, the effect is to assume a net tax benefit or obligation for unreversed temporary differences existing at the date the change becomes effective. Accordingly, the financial statements for the period of such a change will report the effects of the event in the current tax provision. If the entity had at that date many taxable temporary differences as yet unreversed, it would report a large tax expense in that period. Conversely, if it had a large quantity of unreversed deductible temporary differences, a substantial deferred tax benefit (if probable of realization) would need to be recorded, with a concomitant credit to the current period's tax provision in the income statement. Whether eliminating an existing deferred tax balance or recording an initial deferred tax asset or liability, the income tax footnote to the financial statements will need to fully explain the nature of the events that transpired.

In some jurisdictions, nontaxed corporation elections are automatically effective when filed. In such a case, if a reporting entity makes an election before the end of the current fiscal year, it is logical that the effects be reported in current year income to become effective at the start of the following period. For example, an election filed in December 2002 would be reported in the 2002 financial statements to become effective at the beginning of the company's next fiscal year, January 1, 2003. No deferred tax assets or liabilities would appear on the December 31, 2002 balance sheet, and the tax provision for the year then ended would include the effects of any reversals that had previously been recorded. Practice varies, however, and in some instances the effect of the elimination of the deferred tax assets and liabilities would be reported in the year the election actually becomes effective.

Reporting the Effect of Accounting Changes Made for Tax Purposes

Occasionally, an entity will initiate or be required to adopt changes in accounting that affect income tax reporting but will not affect financial statement reporting. For example, in certain jurisdictions at varying times, the following changes have been mandated: use of the direct write-off method of bad debt recognition instead of providing an allowance for bad debts, while continuing to use the reserve method as required by GAAP for financial reporting; the "full costing" method of computing inventory valuations for tax purposes (adding some items that are administrative costs to overhead), while continuing to expense currently those costs not inventoriable under GAAP; and use of accelerated capital recovery (depreciation) methods for tax reporting while continuing to use normal methods for financial reporting. Often, these changes really involve two distinct temporary differences. The first of these is the onetime, catch-up adjustment which either immediately or over a prescribed time period affects the tax basis of the asset or liability in question (net receivables or inventory, in the examples above), and which then reverses as these assets or liabilities are later realized or settled and are eliminated from the balance sheet. The second change is the ongoing differential in the amount of newly acquired assets or incurred liabilities being recognized for tax and accounting purposes; these differences also eventually reverse. This second type of change is the normal temporary difference which has already been discussed. It is the first change that differs from those previously discussed earlier in the chapter.

As an example, consider that Leipzig Corporation has, at December 31, 2002, gross receivables of $12,000,000 and an allowance for bad debts in the amount of $600,000. Also assume that expected future taxes will be at a 40% rate. Effective January 1, 2003, the tax law is revised to eliminate deductions for accrued bad debts, with existing allowances required to be taken into income ratably over three years (a three-year spread). A balance sheet of Leipzig Corporation prepared on January 1, 2003, would report a deferred tax benefit in the amount of $240,000 (i.e., $600,000 x 40%, which is the tax effect of future deductions to be taken when specific receivables are written off and bad debts are incurred for tax purposes); a current tax liability of $80,000 (one-third of the tax obligation); and a noncurrent tax liability of $160,000 (two-thirds of the tax obligation). Under the requirements of IAS 12, the deferred tax benefit must be entirely reported as noncurrent in classified balance sheets, inasmuch as no deferred tax benefits or obligations can be shown as current.

Implications of Changes in Tax Rates and Status Made in Interim Periods

Tax rate changes may occur during an interim reporting period, either because a tax law change mandated a mid-year effective date, or because tax law changes were effective at year-end but the reporting entity has adopted a fiscal year-end other than the natural year (December 31). The IAS on interim reporting, IAS 34 (addressed in detail in Chapter 19), has essentially embraced a mixed view on interim reporting—with many aspects conforming to a "discrete" approach (each interim period standing on its own) but others, including accounting for income taxes, conforming to the "integral" manner of reporting. Whatever the philosophical strengths and weaknesses of the discrete and integral approaches in general, the integral approach was clearly warranted in the matter of accounting for income taxes.

The fact that income taxes are assessed annually is the primary reason for reaching a conclusion that taxes are to be accrued based on an entity's estimated average annual effective tax rate for the full fiscal year. If rate changes have been enacted to take effect later in the fiscal year, the expected effective rate should take into account the rate changes as well as the anticipated pattern of earnings to be experienced over the course of the year. Thus, the rate to be applied to interim period earnings (or losses, as discussed further below) will take into account the expected level of earnings for the entire forthcoming year, as well as the effect of enacted (or substantially enacted) changes in the tax rates to become operative later in the fiscal year. In other words, as expressed by IAS 34, the estimated average annual rate would "reflect a blend of the progressive tax rate structure expected to be applicable to the full year's earnings enacted or substantially enacted changes in the income tax rates scheduled to take effect later in the financial year."

While the principle espoused by IAS 34 is both clear and logical, a number of practical issues arise in most situations. The standard does address in detail the various computational aspects of an effective interim period tax rate, some of which are summarized in the following paragraphs.

Many enterprises are subject to multiplicity of taxing jurisdictions, and in some instances the amount of income subject to tax will vary from one to the next, since the tax laws in different jurisdictions will include and exclude disparate items of income or expense from the tax base. For example, interest earned on government-issued bonds may be exempted from tax by the jurisdiction which issued them, but be defined as fully taxable by other tax jurisdictions the entity is subject to. To the extent feasible, the appropriate estimated average annual effective tax rate should be separately ascertained for each taxing jurisdiction and applied individually to the interim period pretax income of each jurisdiction, so that the most accurate estimate of income taxes can be developed at each interim reporting date. In general, an overall estimated effective tax rate will not be as satisfactory for this purpose as would a more carefully constructed set of estimated rates, since the pattern of taxable and deductible items will fluctuate from one period to the next.

Similarly, if the tax law prescribes different income tax rates for different categories of income, then to the extent practicable, a separate tax rate should be applied to each category of interim period pretax income. IAS 34, while mandating such detailed rules of computing and applying tax rates across jurisdiction or across categories of income, nonetheless recognized that such a degree of precision may not be achievable in all cases. Thus, IAS 34 allows usage of a weighted-average of rates across jurisdictions or across categories of income provided it is a reasonable approximation of the effect of using more specific rates.

In computing an expected effective tax rate given for a tax jurisdiction, all relevant features of the tax regulations should be taken into account. Jurisdictions may provide for tax credits based on new investment in plant and machinery, relocation of facilities to backward or underdeveloped areas, research and development expenditures, levels of export sales, and so forth, and the expected credits against the tax for the full year should be given consideration in the determination of an expected effective tax rate. Thus, the tax effect of new investment in plant and machinery, when the local taxing body offers an investment credit for qualifying investment in tangible productive assets, will be reflected in those interim periods of the fiscal year in which the new investment occurs (assuming it can be forecast to occur later in a given fiscal year), and not merely in the period in which the new investment occurs. This is consistent with the underlying concept that taxes are strictly an annual phenomenon, but it is at variance with the purely discrete view of interim financial reporting.

IAS 34 notes that, although tax credits and similar modifying elements are to be taken into account in developing the expected effective tax rate to apply to interim earnings, tax benefits which will relate to onetime events are to be reflected from the interim period when those events take place. This is perhaps most likely to be encountered in the context of capital gains taxes incurred in connection with occasional dispositions of investments and other capital assets; since it is not feasible to project the rate at which such transactions will occur over the course of a year, the tax effects should be recognized only as the underlying events transpire.

While in most cases tax credits are to be handled as suggested in the foregoing paragraphs, in some jurisdictions tax credits, particularly those which relate to export revenue or capital expenditures, are in effect government grants. Accounting for government grants is set forth in IAS 20; in brief, grants are recognized in income over the period necessary to properly match them to the costs which the grants are intended to offset or defray. Thus, compliance with both IAS 20 and IAS 34 would necessitate that tax credits be carefully analyzed to identify those which are in substance grants, and then accounting for the credit consistent with its true nature.

When an interim period loss gives rise to a tax loss carryback, it should be fully reflected in that interim period. Similarly, if a loss in an interim period produces a tax loss carryforward, it should be recognized immediately, but only if the criteria set forth in IAS 12 are met. Specifically, it must be deemed probable that the benefits will be realizable before the loss benefits can be given formal recognition in the financial statements. In the case of interim period losses, it may be necessary to assess not only whether the enterprise will be profitable enough in future fiscal years to utilize the tax benefits associated with the loss, but furthermore, whether interim periods later in the same year will provide earnings of sufficient magnitude to absorb the losses of the current period.

IAS 12 provides that changes in expectations regarding the realizability of benefits related to net operating loss carryforwards should be reflected currently in tax expense. Similarly, if a net operating loss carryforward benefit is not deemed probable of being realized until the interim (or annual) period when it in fact becomes realized, the tax effect will be included in tax expense of that period. Appropriate explanatory material must be included in the notes to the financial statements, even on an interim basis, to provide the user with an understanding of the unusual relationship between pretax accounting income and the provision for income taxes.

Income Tax Consequences of Dividends Paid

Historically, some taxing jurisdictions have levied income tax rates on corporate earnings at differential rates, depending on whether the earnings are retained by the entity or are distributed to shareholders. Typically, the rationale for this disparate treatment is that it motivates the enterprises to make distributions to shareholders, which is deemed a socially worthwhile goal by some (it doesn't really alter wealth accumulation unless distortions are introduced by fiscal policy). A secondary reason for such rules is that this partially ameliorates the impact of the double taxation of corporate profits (which are first taxed at the corporate level, then taxed again as distributed to shareholders as taxable dividends). IAS 12 specifically abstained from addressing the issue of how to account for this phenomenon, but this was subsequently dealt with by a 2001 amendment.

Under the provisions of the amended IAS 12, tax effects are to be provided for current taxable earnings without making any assumptions about future dividend declarations. In other words, the tax provision is to be computed using the tax rate applicable to undistributed earnings, even if the enterprise has a long history of making earnings distributions subsequent to year-end, which when made will generate tax savings. Under the amendment to IAS 12, if dividends are later declared, the tax effect of this event will be accounted for in the period in which the proposed dividend is paid or becomes accruable as a liability of the enterprise, if earlier. Since there is typically no legal requirement to declare distributions to shareholders, this approach is clearly appropriate because to recognize tax benefits associated with dividend payments before declaration would be to anticipate income (in the form of tax benefits) before it is earned.

The standard holds that the tax effect of the dividend declaration (or payment) is to be included in the current period's tax provision, not as an adjustment to the earlier period's earnings, taken through the retained earnings account. This is true even when it is clear that the dividend is a distribution being made out of the earlier period's profits. The logic of this requirement is that the tax benefits are more closely linked to events reported in the income statement (i.e., past or current transactions producing net income) than they are to the dividend distribution. In other words, it is the transactions and events resulting in earnings and not the act of distributing some of these earnings to shareholders that is of the greatest pertinence to financial statement users. Accordingly, it is that with which the matching should occur.

If dividends are declared before the end of the year, but are payable after year-end, the dividends become a legal liability of the reporting entity and taxes should be computed at the appropriate rate on the amount thus declared. If the dividend is declared after year-end but before the financial statements are issued, under IAS 10 a liability cannot be recognized on the balance sheet at year-end, and thus the tax effect related thereto also cannot be given recognition.

To illustrate the foregoing, consider the following example:

Amir Corporation operates in a jurisdiction where income taxes are payable at a higher rate on undistributed profits than on distributed earnings. For the year 2003, the company's taxable income is $150,000. Amir also has net taxable temporary differences amounting to $50,000 for the year, thus creating the need for a deferred tax provision. The tax rate on distributed profits is 25%, and the rate on undistributed profits is 40%; the difference is refundable if profits are later distributed. As of the balance sheet date no liability for dividends proposed or declared has been reflected on the balance sheet. On March 31, 2004, however, the company distributes dividends of $50,000.
The tax consequences of dividends on undistributed profits, current and deferred taxes for the year 2003, and the recovery of 2003 income taxes when dividends are subsequently declared would be as follows:
1. Amir Corporation recognizes a current tax liability and a current tax expense for 2003 of $150,000 x 40% = $160,000;
2. No asset is recognized for the amount (potentially) recoverable when dividends are distributed;
3. Deferred tax liability and deferred tax expense for 2003 would be $50,000 x 40% = $20,000, and
4. In the following year (2004) when the company recognizes dividends of $50,000, the company will also recognize the recovery of income taxes of $50,000 x (40% - 25%) = $7,500 as a current tax asset and a reduction of the current income tax expense.

The only exception to the foregoing accounting for tax effects of dividends that are subject to differential tax rates, under amended IAS 12, arises in the situation of a dividend-paying corporation which is required to withhold taxes on the distribution and remit these to the taxing authorities. In general, withholding tax is offset against the amounts distributed to shareholders, and is later forwarded to the taxing bodies rather than to the shareholders, so that the total amount of the dividend declaration is not altered. However, if the corporation pays the tax in addition to the full amount of the dividend payments to shareholders, some might view this as a tax falling on the corporation and, accordingly, add this to the tax provision reported on the income statement. Amended IAS 12, however, makes it clear that such an amount, if paid or payable to the taxing authorities, is to be charged to equity as part of the dividend declaration if it does not affect income taxes payable or recoverable by the enterprise in the same or a different period.

Finally, the amendment to IAS 12 provides that disclosure will be required of the potential income tax consequences of dividends. The reporting enterprise should disclose the amounts of the potential income tax consequences which are practically determinable, and whether there are any potential income tax consequences not practically determinable.

Accounting for Income Taxes in Business Combinations

One of the more complex aspects of interperiod income tax accounting occurs when business combinations, treated as acquisitions as defined by IAS 22, are consummated. The principal complexity relates to the recognition, at the date of the purchase, of the deferred tax effects of the differences between the tax and financial reporting bases of assets and liabilities acquired. Further difficulties arise in connection with the recognition of goodwill and negative goodwill. If the reporting entity expects that the ultimate tax allocation will differ from the initial one (such as when disallowance by the tax authorities of an allocation made to identifiable intangibles is anticipated by the taxpayer), yet another complex accounting matter must be dealt with.

Under the provisions of IAS 12, the tax effects of any differences in tax and financial reporting bases are to be reflected, from the date of the purchase, as deferred tax assets and liabilities. The same rules that apply to the recognition of deferred tax assets and liabilities arising under other circumstances (i.e., the origination of temporary differences by the reporting entity) are equally applicable to such instances, except for the initial recognition of an asset or liability in a transaction other than a business combination when, at the time of the transaction, neither accounting profit nor taxable profit is affected. Accordingly, if deferred tax assets are not deemed to be probable of ultimate realization, they are not recognized in any of these circumstances.

Depending on the tax jurisdiction in which they occur, acquisitions can be either taxable or nontaxable in nature. In a taxable acquisition, the total purchase price paid will be allocated to assets and liabilities for both tax and financial reporting purposes, although under some circumstances the specifics of these allocations may differ, and to the extent the allocation is made to nondeductible goodwill there will be differences in future periods' taxable and accounting profit. In a nontaxable acquisition, the predecessor entity's tax bases for the various assets and liabilities will be carried forward, while for financial reporting the purchase price will be allocated to the assets and liabilities acquired. Thus, in most cases, there will be significant differences between the tax and financial reporting bases. For this reason, both taxable and nontaxable acquisitions can involve the application of deferred income tax accounting.

Accounting for Purchase Business Combinations at Acquisition Date

IAS 12 requires that the tax effects of the tax-book basis differences of all assets and liabilities generally be presented as deferred tax assets and liabilities as of the acquisition date. In general, this grossing-up of the balance sheet is a straightforward matter. An example, in the context of the business acquisition of Windlass Corp., follows:

The income tax rate is a flat 40%.
The acquisition of a business is effected at a cost of $500,000.
The fair values of assets acquired total $750,000.
The carryforward tax bases of assets acquired total $600,000.
The fair and carryforward tax bases of the liabilities assumed in the purchase are $250,000.
The difference between the tax and fair values of the assets acquired, $150,000, consists of taxable temporary differences of $200,000 and deductible temporary differences of $50,000.
There is no doubt as to the realizability of the deductible temporary differences in this case.

Based on the foregoing facts, allocation of the purchase price is as follows:

Gross purchase price	$ 500,000
Allocation to identifiable assets and (liabilities):
Assets other than goodwill and deferred tax benefits	750,000
Deferred tax benefits	20,000
Liabilities, other than deferred tax obligations	(250,000)
Deferred tax obligations	(80,000)
Net of the above allocations	440,000
Allocation to goodwill	$ 60,000

Goodwill and negative goodwill.

Goodwill arises when part of the price paid in a business combination accounted for as a purchase cannot be allocated to identifiable assets; negative goodwill results from bargain purchases. Goodwill may be tax deductible, depending on tax jurisdiction, or may be nondeductible. If it is deductible, the mandated amortization period may differ from that prescribed by IAS 22. Since under IAS goodwill is to be amortized over its expected economic life (generally not to exceed twenty years, although longer amortization periods can be supported), a temporary difference will often develop. Since negative goodwill is offset against all nonmonetary assets for financial reporting (if the benchmark treatment is employed), differences between tax and book depreciation will result in many situations.

If goodwill or negative goodwill is not deductible or taxable, respectively, in a given tax jurisdiction, in theory its tax basis 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 negative goodwill, 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 balance sheet with more 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, if there is negative goodwill which is not allocated to the cost of assets, but rather which is presented as a deferred credit items and which is not taxable, no deferred tax benefit will be computed and presented.

It is important to understand the slight inconsistency of the rules of IAS 12 as they relate to goodwill.

If positive goodwill is nondeductible for tax purposes, no deferred tax liability should be associated with it; but
No negative goodwill reported as a deferred revenue account in the financial statements should have a deferred tax benefit associated with it.

The accounting for a taxable purchase business combination is essentially similar to that for a nontaxable one. However, unlike the previous example, in which there were numerous assets with different tax and financial reporting bases, there are likely to be only a few differences in the case of taxable purchases. In jurisdictions in which goodwill is not deductible, attempts are often made for tax purposes to allocate excess purchase cost to tangible assets as well as to other intangibles, such as covenants not to compete. (Such attempts may or not survive review by the tax authorities, of course.) In jurisdictions where goodwill is deductible, presumably this is not a motivation, although because goodwill is often viewed as a suspect asset, entities will still be more comfortable if purchase cost can be attributed to "real" assets, even when goodwill can be amortized for tax purposes.

Note that proposals outstanding in late 2002 would change the accounting for certain business combinations, change the treatment of negative goodwill, and eliminate amortization of (positive) goodwill. See Chapters 9 and 11 for discussions.

Accounting for Purchase Business Combinations After the Acquisition

Under the provisions of the original IAS 12, net deferred tax benefits were not to be carried forward as assets unless there was a reasonable expectation they would be realized. Under revised IAS 12 the criterion has evolved slightly; deferred tax assets must be probable of being realized in order to be recognized. The assessment of this probability was discussed earlier in the chapter.

In the example above, it was specified that all deductible temporary differences were fully realizable, and therefore the deferred tax benefits associated with those temporary differences were recorded as of the acquisition date. In other situations there may be substantial doubt concerning realizability; that is, it may not be probable that the benefits will be realized, and accordingly, the deferred tax asset would not be recognized, under IAS 12, at the date of the business acquisition. If so, the allocation of the purchase price would have to reflect that fact, and more of the purchase cost would be allocated to goodwill than would otherwise be the case. If at a later date it is decided that some or all of the deferred tax asset not recognized at the time of the acquisition is, in fact, probable of being ultimately realized, the effect of that reevaluation will be taken into tax expense (benefit) in the period in which the reevaluation is made. Furthermore, the portion of the extra goodwill recognized at the time of the business acquisition that remains unamortized at the date of the reevaluation must be written off to expense.

To illustrate this last concept, assume that a business acquisition is made on January 1, 2003, and the deferred tax assets of $100,000 are not recognized at that time, due to an assessment that realization is not probable. The unrecognized tax benefit is implicitly allocated to goodwill. Also assume that the goodwill is being amortized over five years. On January 1, 2005, the likelihood of ultimately realizing the tax benefit is reassessed as being probable, and all of these are projected for later years. The entries at that date are as follows:

Deferred tax benefit	100,000
Income tax expense (benefit)		100,000
Amortization of goodwill	60,000
Goodwill		60,000

Note that only the remaining unamortized balance of goodwill associated with the original nonrecognition of the deferred tax benefit is charged to expense at the date the deferred tax benefit is reassessed.

In some situations, the amount of deferred tax benefits upon reassessment will exceed the balance in the goodwill account, or there may have been no goodwill recognized in connection with the business acquisition at all. IAS 12 stipulates that, as a result of this reassessment, negative goodwill cannot be recognized, nor can any existing negative goodwill be increased. The implication is that, while negative goodwill could have been first recognized at the time of a business acquisition which involved recognition of deferred assets, it would not be possible to later recognize deferred tax benefits under such circumstances.

A related issue arises when the acquirer, rather than the acquiree, had not previously recognized deferred tax benefits prior to the acquisition, due to imposition of the "probable" test. If as a result of the acquisition, this asset becomes probable of realization (e.g., if under relevant tax laws the earnings of the acquired entity will provide the acquirer with an opportunity to utilize the deductible temporary differences), it will be given recognition, with the result that the goodwill otherwise recorded in the transaction will be reduced, or negative goodwill will be increased or first given recognition.

Unitings of Interests

In unitings of interests, the combining entities generally do not adjust carrying values of assets and liabilities. Reissued or comparative financial statements of periods before the effective date of the combination are restated on a combined basis. Although IAS 12 does not address the question, one issue that may arise is if one of the combining entities had an unrecognized deferred tax benefit (i.e., the deferred tax benefit was not deemed to be probable of realization), the restated financials may or may not reflect the benefits. That is, the deferred tax benefits may be restored on a retrospective basis.

This treatment depends on whether the combined entity will be able, under provisions of the tax laws, to utilize the operating loss and tax credit carryforwards of the merged companies. If it can do so, the deferred tax benefits should be recognized in any restated prior period financial statements. If, under the law, the benefits cannot be utilized in a consolidated tax return, or if a consolidated return is not expected to be filed, the tax benefits would not be recognized in financial statements restated for the uniting of interests.

Under some circumstances, unitings of interests may be taxable, meaning that for tax purposes there will be a step-up of the net assets of one of the merged entities. The differences between the new stepped-up tax bases and the carryforward book values utilized for financial reporting purposes are temporary differences giving rise to deferred tax benefits. Whether these benefits are given recognition depends on whether realization is deemed to be probable. If the deferred tax benefit is not recognized at inception, and it is later partially or fully recognized when it is determined that the likelihood of ultimate realization is probable, the effect of this accounting recognition should be reflected in tax expense for the current period.

Note that unitings (poolings) of interest will probably be banned under revisions currently being considered by IASB. See discussion in Chapter 11.

Tax Allocation for Business Investments

As noted in Chapter 10, there are two basic methods of accounting for investments in the common stock of other corporations: (1) the cost method and (2) the equity method. The cost method requires that the investing corporation (investor) record the investment at its purchase price, and no additional entry is made to the account over the life of the asset (this does not include any valuation contra accounts). The cost method is used in instances where the investor is not considered to have significant influence over the investee. The ownership threshold generally used is 20% of ownership. This figure is not considered an absolute, but it will be used to identify the break between application of the cost and equity methods. Under the cost method, ordinary income is recognized as dividends are declared by the investee, and capital gains (losses) are recognized on disposal of the investment. For tax purposes, no provision is made during the holding period for the allocable undistributed earnings of the investee. Deferred tax computation is not necessary when using the cost method because there is no temporary difference.

The equity method is generally used whenever an investor owns more than 20% of an investee or has significant influence over its operations. The equity method calls for recording the investment at cost and then increasing this carrying amount by the allocable portion of the investee's earnings. The allocable portion of the investee's earnings is then included in the pretax accounting income of the investor. Dividend payments are no longer included in pretax accounting income but are considered to be a reduction in the carrying amount of the investment. However, for tax purposes, dividends are the only revenue realized. As a result, the investor needs to recognize deferred income tax expense on the undistributed earnings of the associate that will be taxed in the future.

IAS 28 distinguishes between an associate and a subsidiary and prescribes different accounting treatments for each. An associate is considered to be a corporation whose stock is owned by an investor who holds more than 20% but no greater than 50% of the outstanding stock. An association situation occurs when the investor has significant influence but not control over the corporation invested in. A subsidiary, on the other hand, exists when one enterprise exerts control over another, which is presumed when it holds more than 50% of the stock of the other entity.

Under IAS 12, two conditions must both be satisfied to justify not reflecting deferred taxes in connection with the earnings of a subsidiary (a control situation), branches and associates (significant influence), and joint ventures. These are (1) that the parent, investor or venturer is able to control the timing of the reversal of the temporary difference and (2) it is probable that the difference will not reverse in the foreseeable future. Unless both conditions are met, the tax effects of these temporary differences must be given recognition.

When a parent company that has the ability to control the dividend and other policies of its subsidiary determines that dividends will not be declared, and thus that the undistributed profit of the subsidiary will not be taxed at the parent company level, no deferred tax liability is to be recognized. If this intention is later altered, the tax effect of this change in estimate would be reflected in the current period's tax provision.

On the other hand, an investor, even one having significant influence, cannot absolutely determine the associate's dividend policy. Accordingly, it has to be presumed that earnings will eventually be distributed and that these will create taxable income at the investor company level. Therefore, deferred tax liability must be provided for the reporting entity's share of all undistributed earnings of its associates for which it is accounting by the equity method, unless there is a binding agreement for the earnings of the investee to not be distributed within the foreseeable future.

In the case of joint ventures there are a wide range of possible relationships between the venturers, and in some cases the reporting entity has the ability to control the payment of dividends. As in the foregoing, if the reporting entity has the ability to exercise this level of control and it is probable that distributions will not be made within the foreseeable future, no deferred tax liability will be reported.

In all these various circumstances, it will be necessary to assess whether distributions within the foreseeable future are probable. The standard does not define "foreseeable future" and thus this will remain a matter of subjective judgment. The criteria of IAS 12, while subjective, are less ambiguous than under the original standard, which permitted nonrecognition of deferred tax liability when it was "reasonable to assume that (the associates's) profits will not be distributed."

To illustrate the application of these concepts, assume that Parent Company owns 30% of the outstanding common stock of Investee Company and 70% of the outstanding common stock of Subsidiary Company. Additional data for the year 2003 are as follows:

	Investee Company	Subsidiary Company
Net income	$50,000	$100,000
Dividends paid	20,000	60,000

How the foregoing data are used to recognize the tax effects of the stated events is discussed below.

Income Tax Effects from Investee Company

The 2003 accounting profit of Parent Company will include equity in its associate's income equal to $15,000 ($50,000 x 30%). Parent's taxable income, however, will include dividend income of $6,000 ($20,000 x 30%), and, under applicable tax law, a credit of 80% of the $6,000, or $4,800, will also be allowed for the dividends received. This 80% dividends received deduction is a permanent difference between accounting and taxable profits.

The amount of the deferred tax credit in 2003 depends on the expectations of Parent Company as to the manner in which the $9,000 of undistributed income will be received. In many tax jurisdictions, the effective tax rate will differ based on method of realization; dividend income may be taxed at a different rate than capital gains (achieved on the sale of an investment in an associate, for example). If the expectation of receipt is via dividends, the temporary difference is 20% of $9,000, or $1,800, and the deferred tax credit for this originating temporary difference in 2003 is the current tax rate times $1,800. However, if the expectation is that receipt will be through future sale of the investment, the gain on which would be fully taxed, the temporary difference is $9,000 and the deferred tax credit is the current capital gains rate times the $9,000.

The entries below illustrate these alternatives. A tax rate of 34% is used for both ordinary income and for capital gains. Note that the amounts in the entries below relate only to Investee Company's incremental impact on Parent Company's tax accounts.

	Expectations for undistributed income
	Dividends		Capital gains
Income tax expense	1,020		2,208
Deferred tax liability		612^b		1,800^C
Income taxes payable		408^a		408^a
^aCompulation of income taxes payable:
Dividend income—30% x ($20,000) $6,000				$6,000
Less 80% dividends received deduction				(4,800)
Amount included in Parent's taxable income				$1,200
Tax liability—34% x ($1,200)				$ 408
^bComputation of deferred tax liability (dividend assumption):
Originating temporary difference:
Parent's share of undistributed income—30% x ($30,000)				$9,000
Less 80% dividends received deduction				(7,200)
Originating temporary difference				$1,800
Deferred tax liability—34% x ($1,800)				$ 612
^cComputation of deferred tax liability (capital gain assumption):
Originating temporary difference: Parent's share of undistributed income—30% x ($30,000)				$9,000
Deferred tax liability—20% x ($9,000)				$1,800

Income Tax Effects from Subsidiary Company

The accounting profit of Parent Company will also include equity in Subsidiary income of $70,000 (70% x $100,000). This $70,000 will be included in pretax consolidated income if Parent and Subsidiary issue consolidated financial statements. Depending on the rules of the particular tax jurisdiction, it may be that for tax purposes, Parent and Subsidiary will not file a consolidated tax return (e.g., because the prescribed minimum level of control, that is, 80%, is not present). In the present example, assume that it will not be possible to file consolidated tax returns. Consequently, the taxable income of Parent will include dividend income of $42,000 (70% x $60,000). Assume further that there will be an 80% dividends received deduction, which will amount to $33,600. The originating temporary difference results from Parent's equity ($28,000) in Subsidiary's undistributed earnings of $40,000.

The amount of the deferred tax credit in 2003 depends on the expectations of Parent Company as to the manner in which this $28,000 of undistributed income will be received. The same expectations can exist as discussed previously, for Parent's equity in Investee's undistributed earnings (i.e., through future dividend distributions or capital gains).

The entries below illustrate these alternatives. A marginal tax rate of 34% is assumed. The amounts in the entries below relate only to Subsidiary Company's incremental impact on Parent Company's tax accounts.

	Expectations for undistributed income
	Dividends		Capital gains
Income tax expense	4,760		12,376
Deterred tax liability		1,904^b		9,520^c
Income taxes payable		2,856^a		2,856^a
^aComputation of income taxes pavable:
Dividend income—70% x ($60,000)				$42,000
Less 80% dividends received deduction				(33,600)
Amount included in Parent's taxable income				$ 8,400
Tax liability—34% x ($5,600)				$ 2,856
^bCompulation of deferred tax liability (dividend assumption):
Originating temporary difference:
Parent's share of undistributed income—70% x ($40,000)				$28,000
Less 80% dividends received deduction				(22,400)
Originating temporary difference				$ 5,600
Deferred tax liability—34% x ($5,600)				$ 1,904
^cComputation of deferred tax liability (capital gain assumption):
Originating temporary difference: Parent's share of undistributed income—70%. x ($40,000)				$28,000
Deferred tax liability—4% x ($28,000)				$ 9,420

If a parent company owns a large enough percentage of the voting stock of a subsidiary and the parent, so that it may consolidate the subsidiary for both financial and tax reports, no temporary differences exist between pretax consolidated income and taxable income. Under the rules in some jurisdictions, it may be possible to submit separate tax returns even if consolidated returns could alternatively be filed; in such circumstances, there may be a tax rule that grants a 100% dividends received deduction, to avoid incurring double taxation. If, in the circumstances noted above, consolidated financial statements are prepared but a consolidated tax return is not, it would be the case that a dividends received deduction of 100% would be allowed. Accordingly, the temporary difference between pretax consolidated income and taxable income is zero if the parent assumes that the undistributed income will be realized in dividends.

Tax Effects of Compound Financial Instruments

IAS 32 established the important notion that when financial instruments are compound, the separately identifiable components are to be accounted for according to their distinct natures. For example, when an enterprise sells convertible debt instruments, those instruments have characteristics of both debt and equity securities, and accordingly, the issuance proceeds should be allocated among those components in the ratio which the fair values bear to the total proceeds. A problem arises, however, because the taxing authorities may not agree that a portion of the proceeds should be allocated to a secondary instrument. For example, when convertible bonds are sold, for tax reporting purposes the entire proceeds are considered to be the basis of the debt instrument in most jurisdictions, with no basis being allocated to the conversion feature. Accordingly this will create a temporary difference between the interest expense to be recognized for financial reporting purposes and interest to be recognized for income tax purposes, which in turn will have deferred tax implications.

Consider the following scenario. Tamara Corp. issues 6% convertible bonds due in ten years with a face value of $3,000,000, with the bonds being convertible into Tamara common stock at the holders' option. Proceeds of the offering amount to $3,200,000, for an effective yield of approximately 5.13% at a time when "straight" debt with similar risks and time to maturity is yielding just under 6.95% in the market. Since the fair value of the debt component is thus $2.8 million out of the actual proceeds of $3.2 million, the convertibility feature is seemingly worth $400,000 in the financial marketplace. Thus the ratio of fair values is as follows:

Debt portion: $2,700,000 + $3,200,000 = .875 (i.e., 87.5%)
Equity portion: $400,000 + $3,200,000 = .125 (i.e., 12.5%)

If these ratios are then applied to the actual proceeds of the offering of the convertible debt, $3 million, the resulting computed amounts are used to record the transaction under the guidance of IAS 32, as follows:

Cash	3,000,000
Unamortized net discount	375,000
Debt payable		3,000,000
Equity—paid-in capital account		375,000

The unamortized debt discount will be amortized as additional interest cost over the life of the bonds (ten years, in this example) for financial reporting purposes, but for tax purposes the deductible interest cost will be limited, typically, to the actual interest paid in this instance. The "originating" phase of the temporary difference will be when the compound security is first sold; the "reversing" of this temporary difference will occur as the debt discount is amortized until the net carrying value of the debt equals the face value.

To illustrate, assume that the tax rate is 30%, and for simplicity, also assume that the debt discount will be amortized on a straight-line basis over the ten-year term ($375,000 10 = $47,500 per year), although in practice amortization using the "effective yield" method is preferred. The entries to establish deferred tax liability accounting at inception, and to reflect interest accrual and reversal of the deferred tax account are as follows:

At inception (in addition to the entry shown above)
Equity—paid-in capital account	112,500
Deferred tax payable		112,500
Each year there after
Interest expense	217,500
Interest expense		180,000
Unamortized debt discount		37,500
Deferred tax payable	11,250
Tax expense—deferred		11,250

Note that the offset to deferred tax liability at inception is a charge to equity, in effect reducing the credit to paid-in capital for the equity portion of the compound financial instrument to a net of tax basis, since allocating a portion of the proceeds to the equity component caused the creation of a nondeductible deferred charge, debt discount. When the deferred charge is later amortized, however, the reversing of the temporary difference leads to a reduction in tax expense to better "match" the higher interest expense reported in the financial statements than on the tax return.

Accounting for Income Taxes: Intraperiod Tax Allocation

While IAS 12 is concerned predominantly with the requirements of interperiod income tax allocation (deferred tax accounting), it also addresses the questions of intraperiod tax allocation. Intraperiod tax allocation relates to the matching in the income (or other financial) statement of various categories of comprehensive income or expense (continuing operations, extraordinary items, corrections of fundamental errors, etc.) with the tax effects of those items. The general principle is that tax effects should follow the items to which they relate. The computation of the tax effects of these items is, however, complicated by the fact that many, if not most, jurisdictions feature progressive tax rates. For that reason, a question arises as to whether overall "blended" rates should be apportioned across all the disparate elements (ordinary income, corrections of errors, etc.), or whether the marginal tax effects of items other than ordinary income should be reported instead.

IAS 12 does not answer this question or even address it. It might, however, be instructive to consider the two approaches, since this will affect the presentation of the income statement and, in the case of fundamental errors, the statement of retained earnings as well.

The blended rate approach would calculate the average, or effective, rate applicable to all an entity's taxable earnings for a given year (including the deferred tax effects of items that will be deductible or taxable in later periods, but that are being reported in the current year's financial statements). This effective rate is then used to compute income taxes on each of the individually reportable components. For example, if an entity has an effective blended rate of 46% in a given year, after considering the various tax brackets and any available credits against the gross amount of the tax computed, this rate is used to calculate the taxes on ordinary income, extraordinary income, the results of discontinued operations, the correction of fundamental errors, and the effects of changes in accounting principles, if any.

The alternative to the blended rate approach is what can be called the marginal tax effect approach. Using this computational technique, a series of "with-and-without" calculations will be made to identify the marginal, or incremental, effects of items other than those arising from ordinary, continuing operations. This is essentially the approach dictated under US GAAP (SFAS 109 and its various predecessors) and is the primary approach employed under UK GAAP as well. Since the prescription of this with-and-without method is detailed most extensively in current US GAAP, that explanation is referred to extensively in the following discussion.

Prior to the promulgation of current US GAAP, the with-and-without technique was applied under prior US standards in a step-by-step fashion proceeding down the face of the income statement. For example, an entity having continuing operations, discontinued operations, and extraordinary items would calculate tax expense as follows:

Tax would be computed for the aggregate results and for continuing operations. The difference between the two amounts would be allocated to the total of discontinued operations and extraordinary items.
Tax expense would be computed on discontinued operations. The residual amount (i.e., the difference between tax on the discontinued operations and the tax on the total of discontinued operations and extraordinary items) would then be allocated to extraordinary items.

Thus, the amount of tax expense allocated to any given classification in the statement of income (and the other financial statements, if relevant) was partially a function of the location in which the item was traditionally presented in the income and retained earnings statements.

Under current US GAAP, total income tax expense or benefit for the period is allocated among continuing operations, discontinued operations, extraordinary items, and stockholders' equity. The standard creates a few anomalies since, as defined in current US GAAP, the tax provisions on income from continuing operations include not only taxes on the income earned from continuing operations, as expected, but also a number of other tax effects including the following:

The impact of changes in tax laws and rates, which includes the effects of such changes on items that were previously reflected directly in stockholders' equity
The impact of changes in tax status
Changes in estimates about whether the tax benefits of deductible temporary differences or net operating loss or credit carryforwards are probable of realization.

Note
Under current US GAAP the actual criterion is "more likely than not," which differs from IAS's "probable" criterion.

Under current US GAAP, stockholders' equity is charged or credited with the initial tax effects of items that are reported directly in stockholders' equity, including that related to corrections of the effects of accounting errors of previous periods, which under the international standards are known as fundamental errors. The effects of tax rate or other tax law changes on items for which the tax effects were originally reported directly in stockholders' equity are reported in continuing operations if they occur in any period after the original event. This approach was adopted by current US GAAP because of the presumed difficulty of identifying the original reporting location of items that are affected possibly years later by changing rates; the expedient solution was to require all such effects to be reported in the tax provision allocated to continuing operations.

Example of intraperiod allocation using the with-and-without approach

Assume that there were $50,000 in deductible temporary differences at 12/31/02; these remain unchanged during the current year, 2003.

Income from continuing operations	$400,000
Loss from discontinued operations	(120,000)
Extraordinary gain on involuntary conversion	60,000
Correction of fundamental error: understatement of depreciation in 2002	(20,000)
Tax credits	5,000

Tax rates are: 15% on first $100,000 of taxable income; 20% on next $100,000; 25% on next $100,000; 30% thereafter.

Expected future tax rates were 20% at December 31, 2002, but are judged to be 28% at December 31, 2003.

Retained earnings at December 31, 2002, totaled $650,000.

Intraperiod tax allocation proceeds as follows:

Step 1 —	Tax on total taxable income of $320,000 ($400,000 - $120,000 + $60,000 -$20,000) is $61,000 ($66,000 based on rate structure, less tax credit of $5,000).
Step 2 —	Tax on income from continuing operations of $400,000 is $85,000, net of tax credit.
Step 3 —	The difference, $24,000, is allocated pro rata to discontinued operations, extraordinary gain, and correction of the error in prior year depreciation.
Step 4 —	Adjustment of the deferred tax asset, amounting to a $4,000 increase due to an effective tax rate estimate change [$50,000 x (.28 - .20)] is allocated to continuing operations, regardless of the source of the temporary difference.

A summary combined income and retained earnings statement is presented below.

Income from continuing operations, before income taxes		$400,000
Income taxes on income from continuing operations:
Current	$90,000
Deferred	(4,000)
Tax credits	(5,000)	81,000
Income from continuing operations, net		319,000
Loss from discontinued operations, net of tax benefit of $36,000		(84,000)
Extraordinary gain, net of tax of $18,000		42,000
Net income		277,000
Retained earnings, January 1, 2003		650,000
Correction of fundamental error, net of tax effects of $6,000		(14,000)
Retained earnings, December 31, 2003		$913,000

Applicability to international accounting standards.

Since IAS 12 is silent on the method to be used to compute the tax effects of individual captions in the statement of income and the statement of retained earnings, financial statement preparers have the option of using essentially a with-and-without or blended rate approach. Both can be rationalized from either practical or theoretical perspectives. The blended rate method would clearly be easier to apply, since only one set of computations using progressive tax rates would be needed. The blended rate method also avoids the implication that items other than income from continuing operations represented the "last dollars" earned, since the rates applicable to those items would not be the highest marginal rates. On the other hand, the with-and-without method averts the situation where the blended rate applied to income from continuing operations is subject to wide variation due simply to the occasional existence of extraordinary and other unusual items.

On balance, and given the lack of a prescribed methodology in IAS 12, the authors slightly favor the blended rate approach. Whichever methodology is employed, however, it is vital that the notes to the financial statements clearly describe how the computation was made and disclose the tax effects of the various components presented. IAS 12 does, however, permit the tax effects of all extraordinary items to be presented in one amount, if computation of each extraordinary item is not readily accomplished.

Classification of Deferred Taxes

Somewhat surprisingly, IAS 12 states that should the reporting entity classify its balance sheet (into current and noncurrent assets and liabilities), deferred tax assets and liabilities may never be included in the current category. While not articulated in the standard, presumably the anticipated difficulties of assessing the amount and pattern of temporary difference reversals led to this decision. Arguably, the extent of any required scheduling would have been rather limited, since the only concern would have been to assess whether the expected reversals would occur before or after the one-year threshold. However, having established a clear prohibition, IAS 12 is undeniably easier to apply.

Deferred tax assets pertaining to certain tax jurisdictions may be fully or partially recognizable, while those pertaining to others may not be recognized at all, based on the circumstances. Applying IAS 12's "probable" criterion to the expected timing and availability of taxable temporary differences and other items entering into the computation of taxable profit in each jurisdiction is necessary to make these determinations.

Tax assets and liabilities may never be offset in the balance sheet, except to the extent that they pertain to taxes levied by the same taxing authority. This follows from the fact that amounts due to or from independent taxing bodies would not be subject to offsetting in practice.

Finally, when entities included in consolidated financial statements are taxed separately, a tax asset recognized by one member of the group should not be offset against a liability recognized by another member of the same group, unless a legal right of offset exists. For example, in some jurisdictions the tax loss carryforward of an acquired affiliate entity cannot be used to reduce taxable profit of another member of the group, even if consolidated tax returns are being prepared. In such a case, the deferred tax asset recognized in connection with the tax loss carryforward cannot be offset against a deferred tax liability of another member of the consolidated group. Further, in evaluating whether realization of the tax asset is probable, the existence of the tax liability could not be considered.

Financial Statement Disclosures

IAS 12 mandates a number of disclosures, including some which have not been required under earlier practice. The purpose of these disclosures is to provide the user with an understanding of the relationship between accounting profit and the related tax effects, as well as to aid in predicting future cash inflows or outflows related to tax effects of assets and liabilities already reflected in the balance sheet. Newly imposed disclosures are intended to provide greater insight into the relationship between deferred tax assets and liabilities recognized, the related tax expense or benefit recognized in earnings, and the underlying natures of the related temporary differences resulting in those items. There is also enhanced disclosure for discontinued operations under IAS 12. Finally, when deferred tax assets are given recognition under defined conditions, there will be disclosure of the nature of the evidence supporting recognition. The specific disclosures are presented in the following paragraphs in greater detail.

Balance sheet disclosures.

A reporting entity is required to disclose the amount of a deferred tax asset and the nature of evidence supporting its recognition, when

Utilization of the deferred tax asset is dependent on future taxable profits in excess of the profits arising from the reversal of the existing taxable temporary differences; and
The enterprise has suffered a loss in the same tax jurisdiction to which the deferred tax assets relate in either the current or preceding period.

Income statement disclosures.

IAS 12 places primary emphasis on disclosure of the components of income tax expense or benefit. The following information must be disclosed about the components of tax expense for each year for which an income statement is presented.

The components of tax expense or benefit, which may include some or all of the following:

Current tax expense or benefit
Any adjustments recognized in the current period for taxes of prior periods
The amount of deferred tax expense or benefit relating to the origination and reversal of temporary differences
The amount of deferred tax expense or benefit relating to changes in tax rates or the imposition of new taxes
The amount of the tax benefit arising from a previously unrecognized tax loss, tax credit, or temporary difference of a prior period that is used to reduce current period tax expense
The amount of the tax benefit from a previously unrecognized tax loss, tax credit, or temporary difference of a prior period that is used to reduce deferred tax expense
Deferred tax expense arising from the write-down of a deferred tax asset because it is no longer deemed probable of realization
The amount of tax expense relating to changes in accounting policies and fundamental errors accounted for in accordance with the allowed alternative treatment stipulated by IAS 8 (i.e., by inclusion in income of the current period)

In addition to the foregoing, IAS 12 also requires that disclosures be made of the following items which are to be separately stated:

The aggregate current and deferred tax relating to items that are charged or credited to equity
Tax expense related to extraordinary items recognized during the period
The relationship between tax expense or benefit and accounting profit or loss either (or both) as
1. A numerical reconciliation between tax expense or benefit and the product of accounting profit or loss times the applicable tax rate(s), with disclosure of how the rate(s) was determined; or
2. A numerical reconciliation between the average effective tax rate and applicable rate, also with disclosure of how the applicable rate was determined
An explanation of changes in the applicable rate vs. the prior reporting period
The amount and date of expiration of unrecognized tax assets relating to deductible temporary differences, tax losses and tax credits
The aggregate amount of any temporary differences relating to investments in subsidiaries, branches, and associates and interests in joint ventures for which deferred liabilities have not been recognized
For each type of temporary difference, including unused tax losses and credits, disclosure of
1. The amount of the deferred tax assets and liabilities included in each balance sheet presented; and
2. The amount of deferred income or expense recognized in the income statement, if not otherwise apparent from changes in the balance sheets
Regarding discontinued operations, disclosure of the tax expense or benefit related to
1. The gain or loss on discontinuance; and
2. The profit or loss from the ordinary activities of the discontinued operation for the period and all prior periods presented.

Finally, in a new requirement, disclosure must be made of the amount of deferred tax asset and the evidence supporting its presentation in the balance sheet, when both these conditions exist: Utilization is dependent upon future profitability beyond that assured by the future reversal of taxable temporary differences, and the enterprise has suffered a loss in either the current period or the preceding period in the jurisdiction to which the deferred tax asset relates.

Examples of informative disclosures about income tax expense

The disclosure requirements imposed by IAS 12 are extensive and in some instances complicated. The following examples have been adapted from the standard itself, with some modifications.

Note

Income tax expense

Major components of the provisions for income taxes are as follows:

	2002	2003
Current tax expense	$75,500	$82,450
Deferred tax expense (benefit), relating to the origination and reversal of temporary differences	12,300	(16,275)
Effect on previously provided deferred tax assets and liabilities resulting from increase in statutory tax rates	--	7,600
Total tax provision for the period	$87,800	$73,775

The aggregate current and deferred income tax expense (benefit) which was charged (credited) to stockholder's equity for the periods

	2002	2003
Current tax, related to correction of fundamental error	$(5,200)	$--
Deferred tax, related to revaluation of investments	--	45,000
Total	$(5,200)	$45,000

The relationship between tax expense and accounting profit is explained by the following reconciliations:

Note

Only one required.

	2002	2003
Accounting profit	$167,907	$132,398
Tax at statutory rate (43% in 2002; 49% in 2003)	$ 72,200	$ 64,875
Tax effect of expenses which are not deductible:
Charitable contributions	600	1,300
Civil fines imposed on the entity	15,000
Effect on previously provided deferred tax assets and liabilities resulting from increase in statutory rates	--	7,600
Total tax provision for the period	$ 87,800	$ 73,775

	%
	2002	2003
Statutory tax rate	43.0	49.0
Tax effect of expenses which are not deductible:
Charitable contributions	0.4	1.0
Civil fines imposed on the entity	8.9	--
Effect on previously provided deferred tax assets and liabilities resulting from increase in statutory rates	--	5.7
Total tax provision for the period	52.3	55.7

In 2003, the federal government imposed a 14% surcharge on the income tax. which has affected 2003 current tax expense as well as the recorded amounts of deferred tax assets and liabilities, since when these benefits are ultimately received or settled, the new higher tax rates will be applicable.

Deferred tax assets and liabilities included in the accompanying balance sheets as of December 31, 2002 and 2003 are as follows, as classified by categories of temporary differences:

	2002	2003
Accelerated depreciation tor tax purposes	$26,890	$22,300
Liabilities for postretirement health care that are deductible only when paid	(15,675)	(19,420)
Product development costs deducted from taxable profits in prior years	2,500	--
Revaluation of fixed assets, net of accumulated depreciation	--	2,160
Deferred tax liability, net	$13,715	$ 5,040