FRA - 10-Income Taxes

Income Taxes
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Why govt. charges tax
➢Govt. of India provides many kind of services to its resident people or to the non-
residents such as infrastructure facility, security etc. and moreover a place where people
can earn and live.
➢In providing these facilities govt. incurs a huge amount of expenditure and to meet those
expenditures, Govt. needs funds and there is no specific source from which govt. can
generate revenue.
➢Therefore, we can say tax is a fees charged by the govt. against the services provided.
➢Govt. major source of revenue is tax (Direct tax and Indirect tax)
Types of Taxes
Income Tax
Direct Tax
Corporate Tax
Excise Duty
Tax
Custom Duty
(Imort /Export
Duty)
Tax On Goods
Indirect Tax Sales Tax
Service Tax
Vat
Income Taxes: Introduction
Income tax is one of the
most important revenue The difference between tax
source of governments code and accounting policies
across the world. The and principles generates room
income tax is paid almost Matching concept for mismatch between
by all individuals and accounting profit and taxable
corporations. income.
The difference
between accounting
tax and actual tax
generates deferred
tax asset or liability
Accounting profit
Taxable Profit
Accounting tax
Actual tax
Accounting Profit and Taxable Income
Company reports Accounting Profits on its income statement in accordance with the prevailing accounting
standards
However the taxable income is computed based on the tax laws of the jurisdiction
Because of differences in guidelines for how income is reported on a company’s financial statements and how it is
measured for income tax purposes, accounting profits and taxable income may differ.
Income Tax Method Accounting Method
Revenue 100 Revenue 100

Expenses Income Tax Expense
Expenses ( Tax) 60 50
(Accounting) = Income Tax Payable
Taxable Income 40 Taxable Income 50 + Deferred Tax
Tax Payable @ 30% 12 Tax Expense @ 30% 15
Profit 28 Profit 35
Income Tax Terms
Income Tax Method
➢Taxable Income – Proportion of income subject to income tax

• Income Tax Payable – Calculated as tax rate * Taxable Income, shown on the balance
sheet
• Income Tax Paid – Actual amount of taxes paid in the period
Financial Accounting
➢Accounting Profit – Earning Before Tax

• Tax Expense – Aggregate of Income Tax Payable and changes in Deferred
Taxes, Appears on the income statement
• Payable + ∆ DTL - ∆ DTA
• Deferred Tax Liability – Balance sheet line item arises when Tax Payable < Tax
Expense, it is a temporary difference
6
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Income Tax Terms
Income Tax Method
➢Tax Base – The amount at which an asset or a liability is
valued for tax purposes
• Tax Loss Carry Forward – loss experienced in the current
period that may be used to reduce future taxable income
Financial Accounting
➢Deferred Tax Asset – Balance sheet line item arises when
Tax Payable > Tax Expense, it is a temporary difference
• Valuation Allowance – Reserve created against deferred tax
assets
• Carrying Amount – Amount at which the asset or liability is
valued as per accounting principles
7
Reporting of Deferred Taxes
Both Deferred tax assets and Deferred tax liabilities are shown on
the balance sheet
Both Deferred tax assets and Deferred tax liabilities are shown on
the balance sheet
According to IFRS – Both DTA and DTL are classified as Non –

current.
Under US GAAP – Can be shown as both current and non-current

based on the classification of the underlying asset or liability
Under US GAAP – Can be shown as both current and non-current

based on the classification of the underlying asset or liability
The changes in DTL or DTA are added back /subtracted from the
income taxes payable to report the tax expense in that period
Reasons for Differences
Subject to tax rules

Revenues and Specific Carrying , tax losses of prior
expenses revenues and amount and years might be Deductibility of
might be expenses tax base of used to reduce gains and losses of
recognized in might be asset and taxable income in assets and
one period for recognized for liabilities might later years, liabilities may vary
accounting accounting differ resulting in for accounting and
differences in income tax
purposes and a purposes and
accounting and purposes
different not for tax taxable income (tax
period for tax purposes and loss carry forward)
purposes vice versa
Deferred Tax
Deferred Deferred
Tax Liability Tax Asset
Income Tax Expense > Income Tax Expense

Taxes Payable < Taxes Payable
Taxable Income < Taxable Income >

Accounting Profit Accounting Profit
Company pays less tax Company pays more

today and more tax in tax today and less tax
the future in the future
Thus it acts as a use of

Thus it acts as a source of
fund and hence a
fund and hence a liability
asset
Tax Base of asset < Carrying Tax Base of asset > Carrying
Value of asset (hence Value of asset (hence offsetting
offsetting entry in liabilities entry in asset side of balance
side of balance sheet) sheet)
10
Deferred Tax Assets
When Expense is greater in the Financial Accounting v/s Income Tax Method
Financial Accounting Method Income Tax Method
2004 2005 2006 2004 2005 2006

Revenue 25,000 30,000 40,000 Revenue 25,000 30,000 40,000
Other Net Gains - - 2,000 Other Net Gains - - 2,000
Inventory changes 200 180 400 Inventory changes 200 180 400
Raw materials and consumables used (8,000) (4,000) (5,700) Raw materials and consumables used (8,000) (4,000) (5,700)
Depreciation (Depreciate in 5 years) (4,000) (4,000) (4,000) 7 Depreciation (Depreciate in 7 years) (2,857) (2,857) (2,857)
Other expenses (4,500) (5,900) (6,000) Other expenses (4,500) (5,900) (6,000)
Interest Expense (6,000) (3,000) (2,000) Interest Expense (6,000) (3,000) (2,000)
Profit Before Tax 2,700 13,280 24,700 Profit Before Tax 3,843 14,423 25,843
Income Tax Expenses @ 30% 810 3,984 7,410 Income Tax Payable @ 30% 1,153 4,327 7,753
Carrying Value Tax Base
Beginning 20,000 20,000 20,000 Beginning 20,000 20,000 20,000

Accumulated Depreciation (4,000) (8,000) (12,000) Accumulated Depreciation (2,857) (5,714) (8,571)
Ending Value 16,000 12,000 8,000 Ending Value 17,143 14,286 11,429
Change in Deferred Tax Liability - - - As expense is greater in the financial accounting the taxable income
Change in Deferred Tax Asset 343 343 343 as per financial accounting is lower than as per tax method. Thus the
actual tax to be paid will be higher.
Income Tax Payable 1,153 4,327 7,753 Balance Sheet Impact - Deferred Tax Assets will increase (as
+ Change in Deferred Tax Liability - - - Carrying Value of Asset < Tax Base)
- Change in Deferred Tax Asset (343) (343) (343) Income Statement Impact - Income Tax Expense = Income Tax
Income Tax Expense 810 3,984 7,410 Payable - Change in Deferred Tax Asset
Deferred Tax Asset
ABC corporation bought a machine for $500. The accounting profit and taxable income before
depreciation is $1000 for each year for first 5 years. The tax deductible depreciation on the
relevant asset class is 25%. Tax rate 35%. The company charges depreciation on straight line
method with assumption of useful life of 3 yrs and no salvage value.
Year 1 Year 2 Year 3 Year 4 Year 5
Taxable income before depreciation 1000 1000 1000 1000 1000
Less: Depreciation 125 125 125 125 0
Taxable income 875 875 875 875 1000
Tax payable 1 306.25 306.25 306.25 306.25 350
Accounting profit before depreciation 1000 1000 1000 1000 1000

Less: Depreciation 166.67 166.67 166.67 0.00 0.00
Accounting profit 833.33 833.33 833.33 1000.00 1000.00
Income tax expense 2 291.67 291.67 291.67 350.00 350.00
Deferred tax asset 1-2 14.6 14.6 14.6 -43.8 0.0
Deferred Tax Assets
Accounting entries for

DTA arises when a change in the DTA
Higher expenses are
charged on the financial Increase in DTA increases
statements than on the the total assets on the
tax returns balance sheet
Taxable income is higher Increase in DTA is
than pretax or subtracted from taxes
accounting profit payable in the
Taxes payable are higher calculation of income tax
than income tax expense expense, so it increases
A liability’s tax base is the net income, retained
lower than its carrying earnings and equity
value
Deferred Tax Liability
When Expense is lower in the Financial Accounting v/s Income Tax Method
2004 2005 2006 2004 2005 2006

Revenue 25,000 30,000 40,000 Revenue 25,000 30,000 40,000
Other Net Gains - - 2,000 Other Net Gains - - 2,000
Inventory changes 200 180 400 Inventory changes 200 180 400
Raw materials and consumables used (8,000) (4,000) (5,700) Raw materials and consumables used (8,000) (4,000) (5,700)
Depreciation (Depreciate in 10 years) (2,000) (2,000) (2,000) 7 Depreciation (Depreciate in 7 years) (2,857) (2,857) (2,857)
Other expenses (4,500) (5,900) (6,000) Other expenses (4,500) (5,900) (6,000)
Interest Expense (6,000) (3,000) (2,000) Interest Expense (6,000) (3,000) (2,000)
Income Tax Expenses @ 30% 1,410 4,584 8,010 Income Tax Payable @ 30% 1,153 4,327 7,753
Beginning 20,000 20,000 20,000 Beginning 20,000 20,000 20,000

Accumulated Depreciation (2,000) (4,000) (6,000) Accumulated Depreciation (2,857) (5,714) (8,571)
Ending Value 18,000 16,000 14,000 Ending Value 17,143 14,286 11,429
Change in Deferred Tax Liability 257 257 257 As expense is lower in the financial accounting, the taxable income
Change in Deferred Tax Asset - - - as per financial accounting is higher than as per tax method. The
actual tax to be paid will be lower.
Income Tax Payable 1,153 4,327 7,753 Balance Sheet Impact - Deferred Tax Liability increases as (Carrying
+ Change in Deferred Tax Liability 257 257 257 Vaue of Asset > Tax Base)
- Change in Deferred Tax Asset - - - Income Statement Impact - Income Tax Expense = Income Tax
Income Tax Expense 1,410 4,584 8,010 Payable + Change in Deferred Tax Liability
Example:
ABC corporation bought a machine for $500. The accounting profit and taxable income
before depreciation is $1000 for each year for first 5 years. The tax deductible depreciation
on the relevant asset class is 25%. Tax rate 35%. The company charges depreciation on
straight line method with assumption of useful life of 5 yrs and no salvage value.
Year 1 Year 2 Year 3 Year 4 Year 5
Taxable income before depreciation 1000 1000 1000 1000 1000
Taxable income 875 875 875 875 1000
Tax payable 1 306.25 306.25 306.25 306.25 350
Accounting profit before depreciation 1000 1000 1000 1000 1000

Accounting profit 900 900 900 900 900
Income tax expense 2 315 315 315 315 315
Deferred tax liability 1-2 8.75 8.75 8.75 8.75 -35
DTL arises when

Higher expenses are charged on the tax return as compared to the financial statements
Taxable income is lower than pretax or accounting profit
Taxes payable are lower than income tax expense
An asset’s tax base is lower than its carrying value
Accounting entries for a change in the DTL
Increase in DTL increases liabilities on the balance sheet

Increase in DTL is added to tax payable in the calculation of income tax expense, so it decreases net
income, retained earnings and reduces owners’ equity
Determining the Tax Base of An Asset
Example, if the historical cost of

the asset is $10,000 and $4,000
worth of accumulated
depreciation had already been
charged against it on the tax
returns over previous period ,
the assets tax base equals
$6,000
Tax Base of Assets
Tax Base = Cost – Accumulated tax Allowable Depreciation
Carrying Value = Cost – Accumulated Accounting Depreciation
Example: ABC company depreciates an asset worth $15000 with straight line method for
accounting purposes. Life of equipment is 5 years. For tax accounting purposes the company
uses a double declining balance method. Find out the carrying value and tax base of the
asset at end of year 1
Solution
 Carrying Value = 15000 – (15000 / 5) = 12000
 Tax Base = 15000 – 2* (15000 / 5) = 9000
 Timing Difference created = $3000 will result in an increase in Deferred Tax
Liability by  3000 * Applicable Tax Rate
Tax Base of Assets
Tax Base = Cost – Proportion of
costs to be expensed per tax Research &
method Development
Carrying Value = 0 as R&D Costs
expenses should be expensed off
ABC company incurred $5 million in

research and development costs.
Applicable tax legislation requires
research and development costs to be Example
expensed over four years. Find out the
carrying value and tax base of the asset
at end of year 1
Carrying Value = 0 (R&D costs are to be

expensed off as per US GAAP and IFRS)
Tax Base = 5,000,000 – 5,000,000 / 4 =
3,750,000 Solution
Timing Difference created = $3,750,000
will result in an increase of Deferred Tax
Asset by 3,750,000 * Applicable Tax Rate
Determining the Tax Base of a Liability
Tax base of Accrued

Two Types of liabilities Expense Liability:
result from Accrual Carrying amount of the
Accounting: liability on the balance
Unearned Revenue sheet – amounts that have
not been expensed for tax
Accrued Expenses purposes yet, but can be
expensed in the future
Tax base of Unearned

Revenue Liability:
Carrying value of the
liability – the amount of
revenue that has already
been taxed and therefore
will not be taxed in the
future
Tax Base of Liability
Unearned Revenues Example Solution
• Carrying value of the • ABC Corp recognized • Advance rent is

liability – the amount $10 million for Unearned Revenue
of revenue that has advanced rent received (Liability as per
already been taxed and from a lessee. Rent accounting treatment)
therefore will not be received in advance is • Carrying Value = $10
taxed in the future deferred for accounting million
purposes but taxed on • Tax Base = 0
a cash basis
• Timing Difference
created = $10 million
will result in an
increase in Deferred
• Tax Asset by  $10
million * Applicable
Tax Rate
Solution:
Warranty Paid is a Accrued Expense
Accrued Expenses (Liability as per accounting
Example:
treatment)
Carrying amount of the ABC Corp has a warranty
liability on the balance At the end of year 1
expense of $1000 for two
sheet – amounts that have years. The expenditure was Carrying Value = $1000
not been expensed for tax not recognized until year Tax Base = 0
purposes yet, but can be two, at which point it
expensed in the future becomes tax allowable Timing Difference created = $1000
will result in an increase in Deferred
Tax Asset by  $1000 * Applicable
Tax Rate
Example
 A firm has revenues of $8000 for each of three years. Other expenses
incurred by the company are $4000 for each year. The firm estimates
the warranty expense to be 12.5% of revenues each year. The actual
expenditure of $3000 to meet the warranty claims was not made
until the third year. Calculate the effects on deferred tax assets for
each year.
When Expense is lower in the Financial Accounting v/s Income Tax Method
2004 2005 2006 2004 2005 2006

Revenue 8,000 8,000 8,000 Revenue 8,000 8,000 8,000
Warranty Expense (1,000) (1,000) (1,000) Warranty Expense - - (3,000)
Other Expenses (4,000) (4,000) (4,000) Other Expenses (4,000) (4,000) (4,000)
Income Tax Expenses @ 30% 900 900 900 Income Tax Payable @ 30% 1,200 1,200 300
Beginning Accrued Warranty Expense - 1,000 2,000 Beginning Accrued Warranty Expense - - -
Warranty Expenses Accrued 1,000 1,000 1,000 Warranty Expenses Accrued - - 3,000
Ending Value 1,000 2,000 3,000 Ending Value - - 3,000
Change in Deferred Tax Liability - - - As expense is greater in the financial accounting the taxable income
Change in Deferred Tax Asset 300 300 (600) as per financial accounting is lower than as per tax method. Thus the
actual tax to be paid will be higher.
Income Tax Payable 1,200 1,200 300 Balance Sheet Impact - Deferred Tax Assets will increase (as
+ Change in Deferred Tax Liability - - - Carrying Value of Liability > Tax Base)
- Change in Deferred Tax Asset (300) (300) 600 Income Statement Impact - Income Tax Expense = Income Tax
Income Tax Expense 900 900 900 Payable - Change in Deferred Tax Asset
Effect of changes in Tax Rates
When tax rate When tax rate

rises- Balance falls- Balance
of both DTA of both DTA
and DTL rises and DTL falls
Formula:
Income Tax Expense = Taxes Payable +

Change in DTL – Change in DTA
Effect of changes in Tax Rates…
If a company has a net DTL (DTL > DTA) a

reduction in tax rates would reduce liabilities,
reduce income tax expense and increase
equity
If a company has a net DTA (DTL < DTA) a
reduction in tax rates would reduce assets,
increase income tax expense and reduce
equity
If a company has a net DTL (DTL > DTA) a
increase in tax rates would increase
liabilities, increase income tax expense and
reduce equity
If a company has a net DTA (DTL < DTA) a
increase in tax rates would increase assets,
reduce income tax expense and increase
equity
Temporary versus permanent differences
Temporary differences
arise because of
differences between tax
base and carrying value of
assets and liabilities
Permanent differences are

differences between tax and
financial reporting of revenues
and expenses that will not
reverse at any point in the
future.
Examples of the items giving
rise to permanent differences:
Revenue items that are not
taxable
Expense items that are not tax
deductible
Tax credits for some expenses
that directly reduce taxes
Temporary Differences between Pretax Income
and Taxable Income
Accelerated
depreciation
for tax
Gain and
Losses on
Impairments
marketable
securities
Examples of
differences that
are expected to
reverse in the
future:
Inventory
Restructuring
Accounting
Warranty
expense >
Actual costs
Permanent differences
 Permanent differences do not result in deferred taxes.

 They result in a difference between effective and statutory
tax rates and should be considered in the analysis of effective
tax rates
 A firm’s effective tax rate is given by:
Formula
Effective Tax Rate = Income Tax Expense / Pretax Income
Temporary differences
Taxable temporary differences

Result in DTL
Future taxable income Deductible temporary differences
Carrying amount of asset > Tax base Result in DTA
Carrying amount of liability < Tax Future tax deductions
base
Carrying amount of asset < Tax base
Carrying amount of liability > Tax base
Temporary differences…
Carrying Value v/s

Balance Sheet item Results in
Tax Base
Carrying Amount >
Asset DTL
Tax Base
Carrying Amount <
Asset DTA
Tax Base
Carrying Amount >
Liability DTA
Tax Base
Carrying Amount <
Liability DTL
Tax Base
Valuation Allowance
DTA must be evaluated at each DTA is reduced by creating a

balance sheet date to ensure contra-asset account called as
that they will be recovered Valuation Allowance Reduction in DTA causes an
In case of any doubts regarding their Increase in valuation allowance reduces increase in income tax expense
realization, their carrying value should DTA
be reduced to the expected
recoverable amount.
If the likelihood of realizing

Higher income tax expense deferred tax assets increases,
causes a lower net income, the previous reduction in DTA
Thus a lower retained earnings is reversed by reducing the
valuation allowance
Required Deferred Tax Disclosures
Unrecognized deferred tax liability

Current – year tax effect of each
for undistributed earnings of
type of temporary difference
subsidiaries and joint ventures
Tax loss carry

forwards and credits
Reconciliation of difference
Components of income tax expense between income tax expense as a %
of pretax and statutory tax rate
Deferred Tax Liabilities as Equity
Consider a firm with deferred tax liabilities from accelerated
depreciation:
Capital Analyst This can If the capital

expenditures should reduce the expenditures of
are expected reduce debt – to – the same firm are
to grow for liabilities on equity ratio expected to stop
the the balance significantly or slow
foreseeable sheet and significantly,
future; increase expect the
therefore, equity by the liability to reverse
the liability is same amount in the future.
not expected (as payment Consider the DTL
to reverse need not be as a true liability
done) (as liability will be
paid)
Analyst Adjustments: DTL
The key for analyst adjustments is to identify whether the difference in taxable
income and accounting profit is temporary or not.
If difference is genuinely Treat DTL as debt (as the company

temporary: is expected to pay these taxes in
future)
If difference is not temporary: Treat DTL as equity as the

company is not expected to pay
these taxes
If difference is neither Exclude from both debt and equity
temporary nor permanent:
In the example of a growing company, the asset base will grow constantly, Tax
Payable will always be less than Accounting Profit and the DTL will never reverse.
The analyst should treat DTL as equity

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Income Taxes

Indirect Tax Sales Tax

Income Tax Method Accounting Method

Revenue 100 Revenue 100

➢Taxable Income – Proportion of income subject to income tax

➢Accounting Profit – Earning Before Tax

According to IFRS – Both DTA and DTL are classified as Non –

Under US GAAP – Can be shown as both current and non-current

Under US GAAP – Can be shown as both current and non-current

Subject to tax rules

Income Tax Expense > Income Tax Expense

Taxable Income < Taxable Income >

Company pays less tax Company pays more

Thus it acts as a use of

Financial Accounting Method Income Tax Method

2004 2005 2006 2004 2005 2006

Carrying Value Tax Base

Beginning 20,000 20,000 20,000 Beginning 20,000 20,000 20,000

Accounting profit before depreciation 1000 1000 1000 1000 1000

Deferred tax asset 1-2 14.6 14.6 14.6 -43.8 0.0

Accounting entries for

Financial Accounting Method Income Tax Method

2004 2005 2006 2004 2005 2006

Carrying Value Tax Base

Beginning 20,000 20,000 20,000 Beginning 20,000 20,000 20,000

Accounting profit before depreciation 1000 1000 1000 1000 1000

Deferred tax liability 1-2 8.75 8.75 8.75 8.75 -35

DTL arises when

Accounting entries for a change in the DTL

Increase in DTL increases liabilities on the balance sheet

Example, if the historical cost of

ABC company incurred $5 million in

Carrying Value = 0 (R&D costs are to be

Tax base of Accrued

Tax base of Unearned

Unearned Revenues Example Solution

• Carrying value of the • ABC Corp recognized • Advance rent is

Financial Accounting Method Income Tax Method

2004 2005 2006 2004 2005 2006

Carrying Value Tax Base

When tax rate When tax rate

Income Tax Expense = Taxes Payable +

If a company has a net DTL (DTL > DTA) a

Permanent differences are

 Permanent differences do not result in deferred taxes.

Effective Tax Rate = Income Tax Expense / Pretax Income

Taxable temporary differences

Carrying Value v/s

DTA must be evaluated at each DTA is reduced by creating a

If the likelihood of realizing

Unrecognized deferred tax liability

Tax loss carry

Capital Analyst This can If the capital

If difference is genuinely Treat DTL as debt (as the company

If difference is not temporary: Treat DTL as equity as the

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