The income statement approach

The ‘accountant’ and the ‘tax authorities’ calculate profits in different ways:

International Financial Reporting Standards govern the manner in which the accountant calculates accounting profit:

• profit or loss for a period before deducting (the) tax expense.

Tax legislation governs the manner in which the tax authorities calculate taxable profit:

• the profit (or loss) for the period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable or recoverable.

In order for the accountant to calculate the estimated current tax for the year, he converts his accounting profits into taxable profits. This is done as follows:

Conversion of accounting profits into taxable profits: C

Profit before tax (accounting profits) xxx

Adjusted for permanent differences: xxx

- less exempt income (e.g. certain capital profits and dividend income) - add non-deductible expenses (e.g. certain donations and fines)

(xxx) xxx Accounting profits that are taxable (A x 30% = tax expense incurred) A

Adjusted for movements in temporary differences: xxx

- add depreciation

- less depreciation for tax purposes (e.g. wear and tear)

- add income received in advance (closing balance): if taxed when received

- less income received in advance (opening balance): if taxed when received

- less expenses prepaid (closing balance): if deductible when paid - add expenses prepaid (opening balance): if deductible when paid - add provisions (closing balance): if deductible when paid - less provisions (opening balance): if deductible when paid

xxx

As can be seen from the calculation above, the difference between accounting profits and taxable profits may be classified into two main types:

• temporary differences; and

• permanent differences.

Accounting profits

= Profit before tax

+/- Permanent differences

Taxable accounting profits

=

Portion of the accounting profits that are taxable although not necessarily

= Profits that are taxable now, based purely on tax laws

X 30% =

Current tax expense

The difference between total accounting profits and the taxable accounting profits are permanent differences. These differences include, for instance, items of income that will never be taxed as income and yet are recognised as income in the accounting records.

The difference between taxable accounting profits (A above) and taxable profits (B above) are caused by the movement in temporary differences. These differences relate to the issue of timing: for instance, when the income is taxed versus when it is recognised as income in the accounting records.

A deferred tax adjustment is made for the movement relating to temporary differences only.

Example 3A: income received in advance (income statement approach)

A company receives rent income of C10 000 in 20X1 that relates to rent earned in 20X2 and then receives C110 000 in rent income in 20X2 (all of which was earned in 20X2). The company has no other income. The tax authority taxes income on the earlier of receipt or earning.

Required:

Calculate, for 20X1 and 20X2, the current tax expense, the deferred tax adjustment and the final tax expense to appear in the statement of comprehensive income and show the related ledger accounts.

Solution to example 3A: income received in advance (income statement approach)

Current tax calculation: 20X1 Profits Tax at

30%

Profit before tax (accounting profits) (10 000 – 10 000) ⁽¹⁾ 0

Adjusted for permanent differences: 0

Taxable accounting profits and tax expense ⁽³⁾ 0 0

Adjusted for movement in temporary differences: ⁽⁵⁾ 10 000 3 000 add income received in advance (closing balance): taxed in the current

year ⁽²⁾

10 000 less income received in advance (opening balance): previously taxed (0)

Taxable profits and current normal tax ⁽⁴⁾ 10 000 3 000 Since the income is not recognised in the statement of comprehensive income in 20X1, it does not make sense to recognise the related tax in 20X1, (it makes more sense to recognise the tax on income when the income is recognised). Thus the recognition of this current tax is deferred to this future year (20X2).

Current tax calculation: 20X2 Profits Tax at

30%

Profit before tax (accounting profits) (110 000 + 10 000) ⁽⁶⁾ 120 000

Adjusted for permanent differences: 0

Taxable accounting profits and tax expense ⁽⁸⁾ 120 000 36 000 Adjusted for movement in temporary differences: ⁽⁹⁾ (10 000) (3 000) add income received in advance (closing balance): taxed in the

current year

0 less income received in advance (opening balance): previously taxed

(7) (10 000)

Taxable profits and current normal tax ⁽⁷⁾ 110 000 33 000

(1) The receipt in 20X1 is not yet earned and is therefore not recognised as income but as a liability.

(2) The income is taxed by the tax authority on the earlier date of receipt or earning: the amount is received in 20X1 and earned in 20X2 and is therefore taxed in 20X1 (the earlier date).

(3) The tax that appears on the face of the statement of comprehensive income should be zero since it should reflect the tax owing on the income earned. Since no income has been earned, no tax should be reflected.

(4) The difference between the current tax charged (3 000) and the tax expense (0) is the deferred tax adjustment, deferring the current tax to another period.

(5) Notice that the deferred tax account has a debit balance at the end of 20X1 and is therefore classified as an asset: tax has been charged in 20X1 for taxes that will only be incurred in 20X2.

(6) The income in 20X2 includes the C10 000 received in 20X1 since it is earned in 20X2.

The income received in advance liability is reversed out.

(7) Notice that the tax authority charges current tax in 20X2 on just the C110 000 received since the balance of C10 000 was received and taxed in an earlier year.

(8) The accountant believes that the C36 000 tax should be expensed in 20X2 (together with the related income of C120 000).

(9) This requires that the C33 000 current tax recorded in the books in 20X2 be adjusted to include the tax of C3 000 that was charged in 20X1 but not recognised in 20X1. This results in a reversal of the deferred tax balance of C3 000 brought forward from 20X1.

Ledger accounts: 20X1

Bank Rent received in advance (L)

RRIA ⁽¹⁾ 10 000 Bank ⁽¹⁾ 10 000

Tax: normal tax (E) Current tax payable: normal tax (L)

CTP: NT ⁽²⁾ 3 000 DT ⁽⁴⁾ 3 000 Tax ⁽²⁾ 3 000

Total b/f ⁽³⁾ 0

Deferred tax (A) Tax (4 & 5)

3 000

Ledger accounts: 20X2

Bank Rent received in advance (L)

Rent 110 000 Rent ⁽⁶⁾ 10 000 Balance b/f 10 000

Tax: normal tax (E) Current tax payable: normal tax (L)

CTP:NT ⁽⁷⁾ 33 000 Balance b/f 3 000

DT ⁽⁹⁾ 3 000 Tax ⁽⁷⁾ 33 000

Total ⁽⁸⁾ 36 000

Deferred tax Rent (I)

Balance b/f 3 000 Tax ⁽⁹⁾ 3 000 RRIA ⁽⁶⁾ 10 000

Bank 110 000

120 000