IAS 12 Fair Value Adjustments

7 Fair Value Adjustments

Differences arising from fair value adjustments, whether on acquisition or otherwise, are treated the same as any other taxable and deductible differences.

In simple terms, sales generally generate a tax charge. Revaluations (fair value adjustments) generate a deferred tax charge (an accrual for tax).

Differences arising from fair value adjustments examples:

EXAMPLE - Fair Value Adjustments i) financial instruments are carried at fair value, but no matching revaluation may be made for tax purposes.
	I/B	DR	CR
Financial instrument	B	100
Gain – fair value adjustment	I		100
Tax expense (deferred tax) @ 24%	I	24
Deferred tax liability	B		24
Revaluation of financial instrument

EXAMPLE - Deferred tax on available-for-sale equity investments An entity holds an available-for-sale investment, ie, shares in a listed company. The tax base of the shares is £500, which was the amount initially paid for the shares. The fair value of the shares at the year end is £1,000. At the balance sheet date, the entity expects to sell the shares in five years and receive dividends of £500 during this five-year period. Dividends are not expected to impair the carrying amount of the investment when paid. Dividends are non-taxable. Based on the current tax legislation, if the shares were sold after five years, capital gains tax at a rate of 10% would be payable on the excess of sales price over cost. How much deferred tax (if any) should the entity recognise at the balance sheet date? The principle in IAS 12 is that an entity should recognise deferred tax based on the expected manner of recovery of an asset or liability at the balance sheet date. The dividends are expected to be derived from the investee’s future earnings rather than from its existing resources at the balance sheet date. Given that there is no impairment expectation arising from the dividends, the entity does not expect the carrying amount at the balance sheet date to be recovered through future dividends but rather through sale. This is important since the expected manner of recovery will determine the deferred tax treatment. The carrying amount of £1,000 has a corresponding tax base of £500 on sale. There is a taxable temporary difference of £500 at the balance sheet date. The applicable tax rate is the capital gains rate of 10%. The entity should recognise a deferred tax liability of £50 relating to the shares.

EXAMPLE - Fair Value Adjustments  ii) revaluation of property, plant and equipment (IAS 16) to fair value, but no adjustment for is allowed for tax purposes.
	I/B	DR	CR
Revaluation of property, plant and equipment	B	700
Revaluation reserve-equity	B		700
Tax expense (deferred tax) @ 24% charged to equity	B	168
Deferred tax liability	B		168
Revaluation of property

IAS 12 Tax Accounting – the process 2

Calculate temporary differences

The concept of temporary differences is central to deferred tax accounting. This means that the difference will eventually reverse. Temporary may not mean short-term: it may take many years until the accruals are completely reversed.

Temporary differences arise when the carrying amount of an asset or liability differs from its tax base.

A deductible temporary difference generates a deferred tax asset

(which will reduce future payments) and a

taxable temporary difference gives rise to a deferred tax liability

(which will increase future payments).

Taxable temporary differences occur when tax is charged in a period after the accounting period suffers the expense in the financial accounts.

Taxable temporary differences arise when:

-an asset's carrying amount is greater than its tax base; or when

-a liability's carrying amount is less than its tax base.

Many taxable temporary differences arise because the transaction is recognised in different periods for tax and accounting purposes.

EXAMPLE- Deductible Temporary Difference interest revenue is included in pre-tax accounting profit on a time-apportionment basis but may be taxable on a cash basis.
	I/B	DR		CR
Cash	B	300
Interest revenue	I			100
Deferred interest revenue	B			200
Tax expense @ 24%	I	24
Deferred tax asset	B	48
Current tax liability	B			72
Receipt of cash and tax payment -period 1 Partial recognition of revenue and tax
Deferred interest revenue	B		100
Interest revenue	I			100
Tax expense @ 24%	I		24
Deferred tax asset	B			24
Interest revenue and tax expense recognition -period 2 (Same for period 3)

EXAMPLE- Taxable Temporary Difference i) interest revenue is included in pre-tax accounting profit when accrued but may be taxable on a cash basis.
	I/B	DR		CR
Interest receivable	B	700
Interest revenue	I			700
Deferred tax liability	B			168
Tax expense @ 24% (deferred tax)	I	168
Recognition of revenue and application of deferred tax- period 1
Cash	B		700
Interest receivable	I			700
Tax expense @ 24%	I		144
Cash – tax payment	B			144
Deferred tax liability	B		144
Tax expense	I			144
Receipt of cash and tax payment- period 2

EXAMPLE- Taxable Temporary Difference ii) revenue from the sale of goods is included in pre-tax accounting profit when goods are delivered, but may be included in taxable profit when cash is collected. Goods sold for 100 delivered in year 1, cash collected and taxed in year 2.
	I/B	DR	CR
Accounts receivable	B	100
Revenue	I		100
Deferred tax liability	B		24
Tax expense (deferred tax) @ 24%	I	24
Receipt of cash and tax recognition -period 1
Cash	B	100
Accounts receivable	B		100
Deferred tax liability	B	24
Current tax liability	B		24
Receipt of cash and tax liability recognition -period 2

EXAMPLE- Taxable Temporary Difference iii) accumulated accounting depreciation may differ from cumulative tax depreciation because depreciation is accelerated for tax purposes; Accounting depreciation is 100 and for tax purposes it is 150.
	I/B	DR	CR
Depreciation	I	100
Accumulated depreciation	B		100
Current tax (reduction) 150 @ 24%	B	36
Tax income	I		24
Deferred tax liability	B		12
Depreciation and higher tax credit -period 1
Depreciation	I	100
Accumulated depreciation	B		100
Current tax (reduction) 50 @ 24%	B	12
Tax income	I		24
Deferred tax liability	B	12
Depreciation and lower tax credit -period 2

EXAMPLE- Taxable Temporary Difference iv) development costs have been capitalised for accounting purposes and will be amortised to the income statement, but may have been deducted as an expense in determining taxable profit in the period in which they were incurred. Amortised over 4 years starting from the year after they were incurred.
	I/B	DR	CR
Development costs (capitalised)	B	100
Cash	B		100
Current tax (reduction) @ 24%	B	24
Deferred tax liability	B		24
Development costs capitalised but allowed for tax credit -period 1
Depreciation – development costs	I	25
Accumulated depreciation	B		25
Deferred tax liability	B	6
Tax income @ 24%	I		6
Depreciation and adjustment for tax -period 2

EXAMPLE- Taxable Temporary Difference v) prepaid expenses for accounting purposes may have been deducted on a cash basis in determining the taxable profit.
	I/B	DR	CR
Cash	B		100
Prepaid expenses	B	100
Current tax (reduction) @ 24%	B	24
Deferred tax liability	B		24
Payment of cash and tax credit -period 1
Expense	I	100
Prepaid expenses	B		100
Deferred tax liability	B	24
Tax income (deferred tax)  @ 24%	I		24
Cost and tax income recognition -period 2

The tax laws of the undertaking's operations will determine the temporary differences.

Deductible temporary differences occur when tax is charged in a period after the accounting period suffered the expense in the financial accounts.

Deductible temporary differences arise when:

-an asset's carrying amount is less than its tax base; or when

-a liability's carrying amount is greater than its tax base.

Like taxable temporary differences, many deductible temporary differences arise from differences in the timing of recording the underlying transaction for accounting and tax purposes.

Deductible temporary differences examples:

EXAMPLE- Deductible Temporary Difference i) accumulated depreciation differs from cumulative tax depreciation as depreciation may be accelerated for accounting purposes. Accumulated depreciation is 150 but cumulative tax depreciation is 100.
	I/B	DR	CR
Depreciation	I	100
Accumulated depreciation	B		100
Current tax (reduction) 50 @ 24%	B	12
Tax income	I		24
Deferred tax asset	B	12
Depreciation and lower tax credit -period 1
Depreciation	I	100
Accumulated depreciation	B		100
Current tax (reduction) 150 @ 24%	B	36
Tax income	I		24
Deferred tax asset	B		12
Depreciation and higher tax credit -period 2

EXAMPLE- Deductible Temporary Difference ii) employee expenses, or pension payments, are recorded when incurred for accounting purposes and but only for tax purposes when paid in cash.
	I/B	DR	CR
Pension expense	I	100
Accrual	B		100
Deferred tax asset	B	24
Tax income (deferred tax) @ 24%	I		24
Accrual of pension costs
Cash	B		100
Accrual	B	100
Current tax (reduction) @ 24%	B	24
Deferred tax asset	B		24
Cost and tax income recognition -period 2

EXAMPLE- Deductible Temporary Difference iii) an impairment loss recorded for accounting purposes will not affect the current tax liability until disposal of the property.
	I/B	DR	CR
Impairment of property	I	10m
Accumulated depreciation of property	B		10m
Tax income (deferred tax) @ 24%	I		2,4m
Deferred tax asset	B	2,4m
Recording impairment charge and (deferred) tax charge

EXAMPLE- Deductible Temporary Difference iv) research costs are expensed in the period for accounting purposes, but may only be deducted in a later period for tax purposes.
	I/B	DR	CR
Research cost	I	10m
Cash	B		10m
Tax income (deferred tax) @ 24%	I		2,4m
Deferred tax asset	B	2,4m
Research cost and deferred tax asset -period 1
Current tax liability (reduction)	B	2,4m
Deferred tax asset	B		2,4m
Tax income -later period

EXAMPLE- Deductible Temporary Difference v) the recognition of income is deferred for accounting purposes, but may be included in taxable profit in the current period.
	I/B	DR	CR
Cash	B	500
Deferred revenue	B		500
Deferred tax asset @ 24%	B	120
Current tax liability	B		120
Receipt of cash and tax payment -period 1
Deferred revenue	B	500
Revenue	I		500
Tax expense (deferred tax) @ 24%	I	120
Deferred tax asset	B		120
Revenue and tax expense recognition -period 2