B301 Unit 9 Deferred Tax and segmental information

HKSSAP 12 Accounting For Deferred Tax                                                          

Illustration

(a) No allowance for deferred taxation.

    Deff Limited has a profit of $100,000 in its first year's trading.  It made capital expenditure on plant and machinery during the year of $80,000.  This expenditure is to be written off over four years in the financial statements but first year allowances are to be claimed in full for tax purposes.

    In this year, Deff will have a profit chargeable to corporation tax of $40,000, calculated as follows:        

    Corporation tax payable, taking a 50% rate for the sake of convenience, will be $20,000.

    The company's profit and loss account will show:

    A strange result, which could give a misleading impression to users of the accounts, as a tax charge of $50,000 might have been expected.

    If we assume no further capital expenditure, and profits remaining steady at $100,000, the position in each of the next three years will be:

    Corporation tax payable will be $60,000, and the company's profit and loss account in each year will be:

(b) With allowance for deferred taxation

    If we introduce deferred taxation into the position, we shall say in year 1: "the tax liability for this year is $50,000, of which $20,000 will arise as a liability on the normal due date and $30,000 will have to be paid later".  In the next three years the $30,000 will arise as a liability at the rate of $10,000 per year.

    The company's profit and loss accounts will show:

    Which set of profit and loss accounts shows the position more fairly, those in (a) or those in (b)?

Deferred taxation

• Permanent differences: arise from income and expense items included in the accounting profit calculation but are disallowed for tax purposes, e.g., dividend income, none-business entertaining expense.
• Timing differences: arise form income and expenses included in the accounts in one period but are allowable for tax purposes in another period, e.g., depreciation.
• Deferred tax: the provision of tax attributable to the difference between accounting and taxable profits caused by timing differences
• Depreciation allowance (capital allowance): a tax allowance for capital expenditure on fixed assets that are used to produce assessable income. Depreciation allowance is different from depreciation expense.

Examples of timing difference

• Short-term: fully reversed in next accounting period
  • Accruals for accounts, and receipts and payments basis for tax
  • General bad debt provision
  • Repairs and maintenance provision

• Long-term: reversing over several years
  • Capital allowances and depreciation
  • Revaluation of assets
  • Leasing of assets

Bases of tax provision                                                                             

• Nil provision (or flow through):
  • Not many countries use; Sweden is one of those few countries.
  • The provision for profits tax is strictly based on the actual tax payable for any financial period in question.
  • No provision for deferred tax.
• Full provision:
  • IAS 12 (revised) & US prescribes this approach.
  • Provision provided on all timing differences no matter they are reversible in subsequent period or not.
  • All timing differences arising in the period are recognized and provided for in the period.
  • Considered preferable by some countries, because it recognizes all tax liabilities and observes the accrual concept of accounting (i.e. matching income with related expenses including tax).
  • More objective because of no arbitrary estimation of the amount and timing of the reversal of timing differences.
• Partial provision:
  • Fall between the two extremes, recommended by HKSSAP12;
  • Provision provided only on timing difference that are reversible in subsequent periods (i.e. 3 to 5 years).
  • Tax is regarded as an expense and the tax liability incurred in the period should be recognized in the same way as other accrued expenses.
  • Present a more realistic picture of the company's tax charges and liabilities.

Methods of computation                                                                        

• Liability method
  • Recommended by HKSSAP 12.
  • Computes the deferred tax provision at the effective tax rate when the tax liabilities are actually paid (i.e. timing differences are reversed.) E.g., a deferred tax is provided in 2001 and would be paid in 2002, the tax rate for 2002 would be used for the computation of provision.
• Deferral method:
  • Computes the deferred tax provision at the tax rate prevailing at the time that the tax liabilities are incurred (i.e. timing differences arised.) For the above example, the tax rate for 2001 would be used.

Deferred tax only has to be provided to the extent that it is probable that tax will become payable as a result of the reversal of timing differences.

Disclosure in financial statements

• Income statement or notes
  • ordinary activities
  • extraordinary items
  • amount un-provided (in note)
  • adjustments arising from changes in tax rates.
• Balance sheet or notes
  • major components
  • transfer to and from deferred tax (in note)
  • amount un-provided (in note)
  • potential amount of deferred tax on a revalued asset not provided (in note).

HKSSAP12 – treatment for tax loss

• A taxable loss to relieve future profits constitutes a timing difference.
• A deferred tax asset will be created and recognized only if :

• the loss results from an identifiable and non-recurring cause.
• the entity has been consistently profitable over a considerable period in the past, and
• future taxable income will be sufficient to offset current losses.

Illustration: please see Example 5 in the Chapter of "Accounting for Deferred Tax" of our text book "Advanced Financial Accounting in HK".

Activity 7.5 (Alternative answer)

Assuming that the balances of all accounting items are the same as that determined by tax authority with the exception of depreciation.

* limited to timing differences to be reversed in the next 3 to 5 years (i.e. 55 +110 = 165)

The above method is simpler than that of Activity 7.5 (the above alternative approach, that is covered by Self-test 1). Please be aware that there are different approaches for the same concept.

HKSSAP 26 Segment report (Feb 2000)/IAS 14                                    

Terms:

• A segment: a distinguishable component of an enterprise that may be classified according to products / services (business segments) or geographical location of operations or markets (geographical segments).
• A reportable segment: segment, business or geographical segment, identified for the disclosure of segment information.
• A segment revenue: turnover and other revenue directly attributable to a segment and allocated by the enterprise. Not include extraordinary items, interest or dividend income, gains on sales of investments, and share of profits of associates and joint ventures.
• A segment expense: expense directly resulting from the operating activities of a segment and other expense allocated by the enterprise. Not include extraordinary items, interest expense, general administrative expenses as a whole, income tax expense, loss on sales of investments and share of losses of associates and joint ventures.

Identification of segments for reporting (3 steps):                                          

• Identify business and geographical segments.
• Determination of primary & secondary segment reporting formats.
• Identify reportable segments.

• Business segments:
  • A segment providing an individual product or service, or group of related products or services, with risks and returns different from those of other segments.
  • Considering factors: nature of its production process, types of customer, methods of distribution, and the nature of the regulatory environment.
  • Dissimilar risks and returns are not generally included in a single business segment vice versa.

• Geographical segments
  • A segment providing products or services within a particular economic environment (i.e. geographical location or region) with risks and returns different from those of other segments.
  • Considering factors: similarity of economic and political conditions, relationship and proximity of operations, special risks associated with operations in a particular area, exchange control and currency risks.
  • Operations in similar economic environments are generally included in a single geographical segment.
  • May based on the geographical location of its operations, e.g. Asia, Europe.

• Primary and secondary segment reporting formats
  • Primary reporting segments: have a dominant effect on the enterprise's risks and returns. Expanded disclosure required.
  • Secondary reporting segments: less extensive information.
  • Summary:

• Reportable segments
  • A separate reporting segment if a majority of segment revenue is earned from sales to external customers and:
    • its revenues (external and inter-segment sales) are at least 10% of the total revenue of all segments; or
    • its segment result is at least 10% of the combined result of all segments; or
    • its assets are at least 10% of the total assets of all segments.

• HKSSSAP26 requires:
  • If total revenue from external sales of reportable segments constitutes less than 75% of the total revenue of all segments, the enterprise should identify additional segments as reportable segments until 75% of total revenue comes from reportable segments.
  • If a segment satisfied 10% thresholds previously, and is considered of continuing significance, then that segment should continue to be identified as a reportable segment in the current period even if it cannot meet the 10% threshold.

• Disclosure requirements:

Other disclosures:

• the amounts of revenue from external sales and internal sales.
• the types of product or service in each reported business segment, and the composition of geographical segments.
• changes in some accounting policies.