Tax-Effect Accounting 101 for Australian Businesses

Governments levy taxes on individuals and businesses to finance its activities and/or (in the economic spirit of things) discourage certain certain activities. More likely than not, a business will be required to pay tax on its income. In doing so, that business would need to look at its accounts to determine the tax that is payable (or, if they are doing badly enough, how much they can claim from the tax agency).

The amount of tax a business needs to pay is often a fixed percentage of the profit they earn. Generally, where they earn revenue, the tax payable increases, while incurring expenses decreases tax payable.

If the business is operating in Australia, among others, it would need to follow the accounting standard AASB 112 Income Taxes, which, in general, would require two things:

1. Calculating current tax payable by reconciling from the accounting profit recorded for the year
2. Calculating deferred tax by recognising the differences between the accounting and tax balances of assets and liabilities

Current tax
A business has two measures of profit:

• Accounting profit, which is revenues less expenses. This is the amount recorded in the income statement.
• Taxable profit, which is assessable income less allowable deductions. This is the amount recognised by the tax agency (which, in Australia, is the Australian Taxation Office (ATO)).

Accounting profit rarely equals taxable profit because of:

• Temporary (timing) differences, where there is a time delay between when the activity as recognised by accounting practice and when it is recognised under tax law. Eventually, both events will be recorded and the difference will cancel out to zero. This mostly arises because bookkeeping uses the accrual basis, while tax law requires a modified cash basis in calculating tax. Temporary differences may occur when:
• Revenue is earned before the cash is received (e.g. interest revenue from an investment)
• Cash is received before the revenue is earned (e.g. revenue from a prepaid mobile phone customer received in advance)
• An expense is incurred before the cash is paid out (e.g. wages are accrued and paid periodically rather than continuously)
• Cash is paid out before the expense is incurred (e.g. inventory is bought but not yet sold)
• Permanent differences, where accounting practice and tax law differ on the recognition of items. This means the difference will never cancel out to zero. For example:
• Accounting income earned is never subject to taxation (e.g. tax refunded due to mistake)
• Extra tax is payable on certain revenue (e.g. excise on petrol)
• An expense is not tax deductible (e.g. fines)
• Extra tax is deductible from an expense (e.g. more tax can be deducted from R&D expenses than would be recognised normally)

On calculating the taxable profit based on the accounting profit, these differences will need to be eliminated. Permanent differences involve a one-step process, while temporary differences involve a two-step process:

Given the accounting profit:

• Adding back the accounting expenses that are not tax deductible. As they were initially subtracted in calculating accounting profit, doing this would completely eliminate the related permanent differences.
• Subtracting out the accounting incomes that are never subject to taxation. As they were initially added in calculating accounting profit, doing this would completely eliminate the related permanent differences.
• Subtracting accounting revenues where the amounts differ from the respective taxable amounts. This is step one of eliminating taxable temporary differences.
• Adding taxable amounts where they differ from their respective accounting revenues. This is step two of eliminating taxable temporary differences.
• Adding the accounting expenses where the amounts differ from the respective amounts deductible. This is step one of eliminating deductible temporary differences.
• Subtracting deductible amounts where they differ from their respective accounting expenses. This is step two of eliminating deductible temporary differences.

To calculate the current tax payable, the resulting taxable profit is multiplied by the tax rate (which is 0.3 in Australia):

Current tax payable = Taxable profit × Tax rate

A tax loss would arise when the allowable deductions exceed the assessable income. This may then be used for reducing the current tax payable in a past or future period.

Deferred tax
Barring statutory exceptions like goodwill, every asset and liability has costs and benefits associated with them:

• For an asset, the cost is the amount outlayed to obtain it (subject to depreciation/impairment while it is being used), while the benefit is a combination of the proceeds earned from selling it and the revenue earned by using it. For example, the cost of a depreciable asset is its carrying amount as determined by tax law (cost less tax depreciation), while its benefit is the proceeds from sale expected from it (the recorded carrying amount, which is cost less book depreciation).
• For a liability, the cost is the amount paid in either settling it or passing it on to another person, while the benefit is the opportunity for extra revenue that incurring the liability will open the business up to (consider that a business will incur liabilities in its profit-making activities, and the conversion to revenue is most direct with regard to unearned revenues). For example, accrued expenses would have a cost of the amount that would need to be paid to extinguish it (its carrying amount), while unearned revenue would have a benefit of the income generated when the good or service is provided (its carrying amount).

All of these benefits are taxable (and are called future taxable amounts), while the costs are deductible (and are called future deductible amounts). However, not all of it will be realised in the current period; some amount of both will be deferred for the future.

In calculating the deferred tax, these future taxable and deductible amounts will need to be considered:

• For an asset's carrying amount (CA), the future taxable amounts (FTA) will need to be subtracted and the future deductible amounts (FDA) will need to be added.
• For a liability's carrying amount, the future taxable amounts will need to be added and the future deductible amounts will need to be subtracted.

Evaluating the above yields the tax bases (TB) of the assets and liabilities, the balances as recognised by tax law.

TB for asset = CA - FTA + FDA
TB for liability = CA + FTA - FDA

Where for a given asset/liability the carrying amount is not equal to the tax base, a temporary difference exists:

• Taxable temporary difference where the carrying amount exceeds the tax base. The future taxable amount will exceed the future deductible amount by the same amount.
• Deductible temporary difference where the tax base exceeds the carrying amount. The future deductible amount will exceed the future taxable amount by the same amount.

A taxable temporary difference will give rise to a deferred tax liability (DTL) while a deductible temporary difference will give rise to a deferred tax asset (DTA). The individual temporary differences are aggregated into these two balance sheet accounts.

Bibliography

• Picker, R, Leo, K, Loftus, J, Clark, K, Wise, V (2009), Australian Accounting Standards, 2nd edn, John Wiley & Sons Australia, Ltd, Milton, pp. 253-272.

EDIT 6Nov10: Amended definition of cost of asset. Appended examples of costs and benefits of assets and liabilities.