IFRS : The ‘Balance Sheet Approach’ to Deferred TaxSubject : Month-Year : Author/s : Topic : Article Details : Accountancy & Financial Management Mar 2011 Anand Banka Chartered Accountant IFRS : The ‘Balance Sheet Approach’ to Deferred Tax January 2010 brought a firm assertion from the Ministry of Corporate Affairs (MCA) indicating International Financial Reporting Standards (IFRS) is the only way forward — but companies may reach the destination in a phased manner starting 2011. One year hence, news is in the air that based on several representations from India Inc, the Ministry is likely to postpone the convergence. On the other hand, India will have to rethink whether it wants to go back on its word given to the G20. Hence, to balance the mounting global pressure and India Inc’s demands, the Ministry is said to be contemplating making it optional. In the meantime, the Institute of Chartered Accountants of India (ICAI) has already issued nearfinal IFRS-equivalent Indian Accounting Standards (Ind-AS), pending approval of the Ministry. Now, for India Inc, the most vital step is to be ready for Ind-AS as is, and wait and watch for any further bumps (amendments) on this rollercoaster ride. One of the standards that will make your ride bumpier is Ind-AS 12 Income Taxes. For almost every adjustment that it is made to comply with IFRS, there will be a deferred tax impact staring right back at you. Bridging the gap between the income statement approach under Indian GAAP and the balance sheet approach under IFRS itself is intimidating to many. This article makes an attempt at simplifying the new concepts IAS 12 brings. To understand the impact of deferred taxes, it is imperative to understand why deferred tax is required in the first place. The example below explains why deferred taxes are accounted for. Company X purchases a machine costing Rs.100 million having a useful life of two years. As per the tax laws, 100% depreciation is allowed in the first year itself. Profit before depreciation and tax was Rs.200 million. The profits of the Company X, without considering the deferred tax impact is as shown in Table I. Table I Year 1 Profit before depreciation and tax Depreciation (100,000,000/2) Profit before tax Profit as per taxation laws 200,000,000 (50,000,000) 150,000,000 100,000,000 Year 2 200,000,000 (50,000,000) 150,000,000 200,000,000 in insurance companies and banks. Under this approach. items like gain on revaluation of fixed assets (i. in 1996. deferred tax is created on only those items that have an impact on the income statement. we account for ‘deferred taxes’. the tax expense is different and consequently the profit after tax is different.000 40% 90.000. ‘income statement approach’ assumes that all the incomes are accrued in the income statement.000 60. Also. Under this approach. Then. However. Income statement approach : Accounting Standard (AS) 22 Taxes on Income advocates income statement approach. came up with the concept of temporary differences/balance sheet approach. deferred tax is created on all timing differences. Is this accounting in line with our basic concepts ? 1.000. . 2. Although the income is earned in the above cases deferred tax on the same is not recognised as the transactions don’t impact the income statement directly. revaluation reserve) are not considered for deferred tax purposes.e.000. current tax is provided based on taxation laws. or income not earned/accrued but taxed as per the taxation laws of the country. Hence. However. (2) Although the profits and the tax rate for both the years remain unchanged. In simple terms. investments are marked to market and the gain thereon is parked in a reserve till it is realised. IASB. tax should be accounted for in the books of accounts as and when it accrues. profit as per books is compared with profit as per tax. Timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods. Matching concept : Taxes should be accounted for in the same period as the related incomes and expenses are accrued.000. Hence. In other words.000 (1) The effective tax rate is different from the actual tax rate in both the years. deferred tax is a tax (book entry) on the gap between the books of account and the tax books.000 20% 120.Current tax expense (30% of tax profits) Effective tax rate Profit after tax Notes : 30. What is deferred tax ? Deferred tax is the tax on: • • income earned/accrued but not taxed as per the taxation laws of the country. to prepare the books of accounts in line with the above-mentioned concepts.. No deferred tax is created on permanent differences. Accrual concept : As per the accrual concept. no corresponding liability would exist as per tax books i. For tax purposes. This tax base will be compared with the carrying amount of assets and liabilities in the books of accounts. (2) Dividends receivable from a subsidiary of Rs. The difference in carrying the amount of the liability is regarded as a temporary difference under the balance sheet approach. The dividends are not taxable. the tax base of the asset is equal to its carrying amount..120.Balance sheet approach : ‘Temporary difference’ is wider in scope as compared to ‘timing difference’. Now. Since the asset owner has paid just Rs. the tax base of the asset is equal to its carrying amount.) (3) Similarly. An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.100. Thus. The related interest revenue was taxed on a cash basis.100. In simple terms. For example — if interest expense is allowed on cash basis under tax laws. a few examples have been given below : (1) A machine costs Rs. To understand the logic behind the balance sheet approach. Where the economic benefits are not taxable or expense not deductible. Temporary differences are of two types : (1) Taxable temporary differences (Deferred tax liability) : Taxable temporary differences are temporary differences that will result in taxable amounts in determining taxable profit/loss of future periods when the carrying amount of the asset or liability is recovered or settled. the upfront benefit of Rs. The tax base of the loan is Rs.100. Hence.100 is valued at Rs. (Note : If the economic benefits will not be taxable.e. For example — incomes accrued as per books of accounts (fair value of financial instruments) but taxable on . many argue that the revaluation gain is a notional gain and does not give rise to any tax in future periods.100. the tax base of the dividends receivable is 100.100.100 to get a benefit of Rs. On the other hand.70.120. In short. of accounts in one or more subsequent periods. an entity will have to draw a tax balance sheet. it means that the asset owner will receive future economic benefit of Rs.30 has already been deducted in the current and prior periods and the remaining cost will be deductible in future periods. when an asset costing Rs. Deferred tax will be calculated on the difference so calculated. For example. (4) Current liabilities include interest revenue received in advance of Rs. a loan receivable has a carrying amount of Rs. For example. no expense would have been booked. depreciation of Rs. It also covers those differences that originate in the books of accounts in one period and are capable of reversal in the same books.120. The numbers appearing in the tax balance sheet is termed as ‘tax base’.20 (120-100) is considered for deferred tax. tax base is nil. The tax base of the machine is Rs. Temporary Difference is defined as a difference between the carrying amount of an asset or liability and its tax base. it is important to go back to the definition of an asset. The tax base of the interest received in advance is nil. a liability for the interest will be recorded in the books of accounts. The repayment of the loan will have no tax consequences. it is based on an assumption that the recovery of all assets and settlement of all liabilities have tax consequences and these consequences can be estimated reliably and cannot be avoided. gain on revaluation arises in books of accounts and reverses in the same books by way of higher depreciation charge. where tax base is the amount that will be deductible for tax purposes. To better understand the concept of ‘tax base’. either as depreciation or through a deduction on disposal. the tax will ultimately become payable on sale or use of the similar assets. outside profit or loss. the tax base of the asset is not adjusted.100 on 1st April. Company A buys an asset worth Rs. it results in deductible temporary differences. in the same or a different period. (2) Deductible temporary differences (Deferred tax assets) : Deductible temporary differences are temporary differences that will result in amounts that are deductible in determining taxable profit/loss of future periods when the carrying amount of the asset or liability is recovered or settled. For example. the revalued carrying amount of the asset will be recovered through use and this will generate taxable income which exceeds the depreciation that will be allowable for tax purposes in future periods. the Company revalues the asset to Rs. 2011. where the carrying value of assets is more as per books of accounts or carrying value of liability is less as per books of accounts when compared to tax base. One year later.. In simple words. Nevertheless. For example. IAS 16 Property. deferred tax on revaluation of assets should be recognised in revaluation reserve in OCI. shall be recognised directly in equity i. Consequently. Deferred tax on revaluation of assets : IFRSs permit or require certain assets to be carried at fair value or to be revalued (for example. IAS 38 Intangible Assets. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset. or (b) tax on capital gains is deferred if the proceeds of the disposal of the asset are invested in similar assets. where the carrying value of assets is less as per books of accounts or carrying value of liability is more as per books of accounts when compared to tax base.120. in the Statement of Changes in Equity (SOCIE). in the same or a different period : (a) in other comprehensive income. the future recovery of the carrying amount (on sale or otherwise) will result in a taxable flow of economic benefits to the entity and the amount that will be deductible for tax purposes will differ from the amount of those economic benefits. The useful life of the asset is five years and the tax laws allow it to be depreciated over four years. there will not be any charge to profit or loss. In such cases. current tax and deferred tax that relate to items that are recognised. on 31st March. Deferred tax on items recognised outside profit or loss : Current tax and deferred tax shall be recognised outside profit or loss if the tax relates to items that are recognised. This is true even if : (a) the entity does not intend to dispose of the asset. IAS 39 Financial Instruments: Recognition and Measurement and IAS 40 Investment Property). Table 2 . In such cases. as per the tax laws. Therefore. Hence. In such a case the temproary difference will be as shown in Table 2. Plant and Equipment. shall be recognised in other comprehensive income (OCI) (b) directly in equity. it results in taxable temporary differences. For example — higher depreciation charge in books of accounts. revaluation of assets is not considered while computing the taxable income.e.receipt basis and lower depreciation charge in books of accounts. 2010. In simple words. However. Year ending March 31.1. To Deferred tax liability A/c 45 45 Suppose on 31st March.200 crore) for Rs. but a permanent one. Deferred tax on business combination : IFRS 3 Business Combinations require the identifiable assets acquired and liabilities assumed in a business combination to be recognised at their fair values at the acquisition date. thus offsetting the temporary difference of Rs. of Rs.1. Goodwill being the difference between the consideration paid and fair value was Rs.35. there would be a gain of Rs. The deferred tax would hence be 100 crore (assuming tax rate of 50%). Indian GAAP : Accounting Standard (AS) 22 Taxes on income does not permit creation of deferred tax on the excess depreciation charged on the revalued portion. Temporary differences arise when the tax bases of the identifiable assets acquired and liabilities assumed are not affected by the business combination or are affected differently.200 — 1. the Company decides to sell the asset at Rs.400 crore (300 + 100 crore). Now. a taxable temporary difference arises which results in a deferred tax liability.000 crore as compared to the revised carrying amount of Rs. 100 crore will be added to goodwill and the total goodwill will be Rs.200 crore. 2013. To Deferred tax liability A/c Indian GAAP : 100 100 . The underlying reason is that.10 as per the books of accounts. a deferred tax liability is not created on the date of revaluation (since it does not have an effect on the income statement). It is not considered as a timing difference. Net book value Tax base Temporary difference 2011 120 75 45 2012 90 50 40 2013 60 25 35 2014 30 0 30 2015 0 0 0 In the above case. These Rs. The accounting entry would be : Goodwill A/c Dr. the tax books will show a gain of Rs. the deferred tax liability created on revaluation on 31st March.45. For example.1.200 crore).200 crore (1. Thus.500 — 1.000 crore). For example. under the income statement approach. In this case. deferred tax assets (reversal of deferred tax liability) cannot be recorded on the excess depreciation charged. Company A merges Company B with itself.1. Company A will have to calculate the deferred tax on the fair valued portion of Rs.300 crore (1. The resulting deferred tax liability affects goodwill.000 crore (fair value Rs. In the process it acquires net assets of Rs. However. 2011. the tax base being the cost to previous owner of Rs.45 reverses in the subsequent periods.1.70. The accounting entry for the year 2011 would be : Revaluation reserve A/c Dr.500 crore. when the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner. Please note : the tax rate used in this case would be the rate applicable to the Company S. Deferred tax on consolidation : IAS 12 requires re-calculation of deferred tax at consolidated level.200 — 1.200 (1. the consolidated books has an inventory of Rs. an entity is exempted from the above requirement if the following conditions are satisfied : (a) the investor/venturer is able to control the timing of the reversal of the temporary difference. reduced by distributions received. Hence. To Deferred tax expense A/c [(1.000) is not eliminated in the tax books i. 2006. The consequent differences between the amounts of depreciation for accounting purposes and tax purposes in respect of such assets in subsequent years would also be permanent differences.200. Then entry in the consolidated books is as follows : Deferred tax asset A/c Dr. Assume tax rate 0f 50%.000 to Company S. On the other hand. an entity will have to calculate deferred tax impact on inter-company transactions. an entity is required to account for its investment in associates as per equity method in the consolidated financial statements. Deferred tax on undistributed profits : As per IAS 28 Investments in Associates. the subsidiary company.1.200. its tax base will remain the cost of investment.1. it is generally noted that companies treat such difference as permanent difference and do not create any deferred tax on the same. In effect. The goods are lying in the closing stock of Company S. 60 60 . an entity will have to provide for deferred tax on its share of undistributed reserves of the investee company in its consolidated books..e.000)*50%] Here. Nevertheless. Indian GAAP : Under Indian GAAP.000 but the tax books of Company S has an inventory of Rs. Deferred tax is also calculated in the consolidated books as a summation of deferred tax appearing in the individual books of accounts. since the deduction will be available to Company S. ASI 11 is not applicable to companies. for Rs. the deferred tax asset is created because the profit element of Rs. the investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition. For example — Company H. However. the practice followed is to consolidate the books by adding lineby-line items. Under the equity method. Similar is the treatment under IAS 31 Interests in Joint Ventures where an entity elects equity method of accounting. sells goods costing Rs. deferred tax on such differences should not be recognised as this constitutes a permanent difference. The difference between the books of accounts and tax base is investor’s share of undistributed reserves of the investee entity. the holding company. It may be noted that ASI 11 has been issued by the ICAI but has not been incorporated in the standards notified under the Companies (Accounting Standards) Rules.1.1.200-1.As per Accounting Standard Interpretation (ASI) 11* Accounting for Taxes on Income in case of an Amalgamation. In simple terms. as below : (1) Initial recognition of goodwill : Para 21 of IAS 12 Income Taxes prohibits recognition of deferred tax liability on initial recognition of goodwill. As per ASI 9 Virtual certainty supported by convincing evidence. a deferred tax asset will have to be created on this difference. Carried forward business losses and unabsorbed depreciation : A deferred tax asset shall be recognised for the carried forward business losses and unabsorbed depreciation to the extent that it is probable that future taxable profit will be available against which such losses and depreciation can be utilised. Keeping in view ‘virtual certainty’ as against ‘probable certainty’ it seems that Indian GAAP is more conservative on the matter of recognition of deferred tax asset. Although the term ‘probable’ is not defined by the standard. a penalty was paid in the process of bringing an asset to its working condition as intended by the management and hence. for all practical purposes. in the absence of an agreement requiring that the profits of the associate/venturer will not be distributed in the foreseeable future. because goodwill is measured as a residual and the recognition of the deferred tax liability would increase the carrying amount of goodwill. Evidence is matter of fact. generally. Hence. Therefore. However. Deferred tax on land : The Income-tax Act. nor the profit as per books. its tax base) will exceed the book value of land by the indexation benefit provided. This indexed cost of land (i. As per .. It should be supported by convincing evidence. which. 1961 provides for indexation of cost of non-depreciable assets like land. when computing the capital gain/loss on sale. virtual certainty is not a matter of perception. (2) Initial recognition of an asset or liability in a transaction which : (a) is not a business combination. an investor in an associate/a venturer in a joint venture. deferred tax is not provided as per Indian GAAP. For example.e.and (b) it is probable that the temporary difference will not reverse in the foreseeable future. it was capitalised. can be considered certain. Indian GAAP : AS 22 mandates virtual certainty for recognition of deferred tax assets in case of carried forward business losses and unabsorbed depreciation. and (b) at the time of transaction. affects neither accounting profit nor taxable profit/loss. an investor/venturer recognises a deferred tax liability arising from taxable temporary differences associated with its investment in the associate/joint venture. Indian GAAP : Since the indexation benefit neither affects the current year’s tax profit. does not control that entity and is usually not in a position to determine its dividend policy. Exceptions : There continues to remain certain items over which the standard does not permit creation of deferred taxes. probable in general terms is ‘more likely than not’. Virtual certainty refers to the extent of certainty. there are three important takeaways : (1) An entity will have to calculate the tax base for each asset and liability and compare the same with the financial statements. an improvement in trading conditions may make it more probable that the entity will be able to generate sufficient taxable profit in the future for the deferred tax asset to meet the recognition criteria. deferred taxes will impact almost all IFRS adjustments. Current/Non-current : IAS 1 Presentation of financial statements requires an entity to present current and non-current assets. the deferred tax assets and liabilities shall not be discounted. and (3) Deferred taxes. In most cases detailed scheduling of the timing of the reversal of each temporary difference is impracticable and highly complex for the purpose of reliable determination of deferred tax assets and liabilities on a discounted basis. for certain items. Discounting : The principles of IFRS require long-term assets and liabilities to be discounted to the present value. an entity reassesses unrecognised deferred tax assets.taxation laws. . deferred taxes shall always be classified as non-current. To conclude. Re-assessment : At the end of each reporting period.e. penalty is not allowed as an expense. Therefore. For example. Now. will be recognised outside profit or loss i. no deferred tax shall be created on this difference. Hence. One will have to consider all IFRS adjustments like fair valuation. Takeaways : As mentioned above. The entity recognises a previously unrecognised deferred tax asset to the extent that it has become probable that future taxable profit will allow the deferred tax asset to be recovered. this penalty affects neither accounting profit nor taxable profits.. as separate classifications in its statement of financial position. as per the above said exception. an entity shall not classify deferred tax assets/liabilities as current assets/liabilities. in OCI or SOCIE.e. i. use of effective interest rates.. derivative and hedge accounting to calculate accurate deferred taxes. and current and non-current liabilities. (2) Items that were earlier considered as permanent difference as per Indian GAAP may have to be considered as temporary difference as per IFRS. However.