Download Deferred taxes

X.1
Chapter 10: Learning objectives
1. Know the accounting criteria for an operating lease vs. a
capital lease and the financial statement effects of each type of
lease.
2. Understanding deferred taxes and the underlying concepts
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Understand how to allocate tax in the financial statements.
Understand the difference between timing differences (income statement concept) and
temporary tax differences (balance sheet concept).
Understand the difference between permanent differences and timing differences.
Understand the expression ”pre-tax income” and be able to distinguish it from book income.
Understand the difference between the taxes payable method and the (taxes) deferral method,
including an understanding of why we allocate deferred taxes from temporary differences.
Understand where in the financial statement tax issues are dealt with.
Understand the rules and regulation of the DCAA concerning tax in the financial statements.
3. Knowledge of the basic accounting relations concerning
derivatives and hedging.
Copyright  2000 by Harcourt Inc. All rights reserved.
X.2
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1. Leasing
Companies can lease assets in stead of buying them.
A genuine leasing contract will give the lessor (the
one who pays for use of the assets) a short-term
(but expensive) right of use to the asset (and a very
low economic risk).
Certain leasing contracts are very similar to a
purchase. They can be non-cancelable, long-term
and place all risk related to use of the asset during
its entire useful life on the lessor.
Private car leasing (common in the US) is typically
so restrictive that the economic reality is a purchase
and not a standard/normal car leasing contract
Copyright  2000 by Harcourt Inc. All rights reserved.
X.3
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1. Leasing - (continued) – capital lease
If a leasing contract is drawn up in such a way that it basically
resembles an installment contract then the contract must be
treated as a purchase in the financial statements on the basis of
a “substance over form” consideration. Otherwise it would be a
kind of off-balance sheet financing.
In such leasing agreements (capital lease) the leasing rights and
obligations are capitalized in the financial statements of the
lessor.
Capitalization means to incorporate the leasing agreement as if
it were a credit purchase, i.e. recognize both an asset and an
obligation.
As in the case of installment purchase: The asset is depreciated
and the leasing obligations are shown as a liability that carry
interests and are repaid (both by the lease payments)
Copyright  2000 by Harcourt Inc. All rights reserved.
X.4
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1. Leasing (continued) - operating leasing.
If the lease contract does not resemble a purchase
then the agreement is treated as a “genuine” lease
agreement (called operating leasing).
In this case the lease payments is treated as
periodic expenses for the leasing period, i.e “as they
are paid” – adjusted, however, for pre-payments or
post-payments relative to the lease period
In that case neither an asset or a long-term
obligation is booked (in contrast to a capital lease).
Copyright  2000 by Harcourt Inc. All rights reserved.
X.5
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1. Leasing (continued) - Criteria (US!)
US GAAP require capitalization if any one of the following
criteria is met by the contract:
1. It transfers ownership to the lessee at the end of the leasing
period.
2. It gives an advantageous right of purchase for the lessee.
3. The leasing agreement runs for over 75% of the asset’s life.
4. The present value of leasing payments equals or exceeds
90% of the fair market value of the asset.
If management wants to treat the agreement as an operating
lease then it can try to make an agreement where all four
criteria are avoided (but especially the last criterion - 90% of
fair market value - can be difficult to avoid if the substance of
the agreement actually is “credit purchase”).
Similar criteria are used in DK but they are more unclear
(DCAA is viewed as requiring capitalization)
Copyright  2000 by Harcourt Inc. All rights reserved.
X.6
1. Leasing - Summary
Operating lease/“genuine lease”:
 Neither a leasing asset nor a leasing obligation is
incorporated in the financial statements
 Leasing costs are recognized as expenses when leasing
payments are made (allocated, however, if payments
occurs prematurely or delayed in relation to the actual
leasing period)
Capital lease:
 Both the leased asset and the the related obligation (to
pay future lease payments) is incorporated in the balance
sheet – as an asset bought and a loan debt
 The asset is written down - the debt is amortized
 The leasing debt entails interest an repayments
Copyright  2000 by Harcourt Inc. All rights reserved.
X.7
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2. Taxes owed and deferred taxes
Accounting standard 14 section/paragraph 17:
Taxes are to be paid of the company’s taxable
income, which is stated on the basis of the rules and
regulations of the tax laws – not on the basis of the
financial statements
These facts mean that companies in some areas can
choose to defer taxable earnings and – especially push forward the tax deductions of costs and thus
defer its tax payments (and in certain instances the
tax allocation of costs must be different from the
financial statement allocations of costs )
Copyright  2000 by Harcourt Inc. All rights reserved.
X.8
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2. Deferred taxes must be included
§ 47. Liabilities that are uncertain with regard to size or
time for termination, must be included in the balance sheet
and the income statement as provisions for liabilities.
Deferred taxes are to be included.
The financial result (“book income”) before taxes is stated in
the financial statements on the basis of the accounting
principles chosen by the company.
=> Many (though not all large) differences between book
income and taxable income => deferred taxes
Copyright  2000 by Harcourt Inc. All rights reserved.
X.9
2. Central concepts related to deferred
taxes
Concepts related to the differences between tax
income and financial income(/book income):
On the basis of the income statement (differences
between income sizes) differences are either
 Permanent differences
 Timing differences
On the basis of the balance sheet (differences
concerning balance sheet values) differences are
either
 Taxable/deductible temporary differences
 Non-taxable/non-deductible temporary differences
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Copyright  2000 by Harcourt Inc. All rights reserved.
X.10
2. Income statement Inflow :Permanent
differences
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Permanent differences:
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A difference between the book income before tax and
the taxable income which is caused by special
revenues/expenses only being included in one of the two
types of statements (book income before taxes or
taxable income) - they are included in one of these
incomes, but will never be included in the other income.
If no permanent differences existed then the sum of a
company’s book incomes over its total lifetime would be
equal to the sum of that company’s taxable incomes
over its total lifetime.
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Copyright  2000 by Harcourt Inc. All rights reserved.
X.11
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2. Income statement inflow: Timing
differences
Timing differences
Are differences between the book income before
taxes and the taxable income, which stems from
revenues/costs, which are “in the end” included in
both types of statements with equally large amounts
( i.e. over the company´s lifetime), but they are
included in different years in the two incomes.
The timing differences will over the life of the
company sum up to 0.
Copyright  2000 by Harcourt Inc. All rights reserved.
X.12
2. Taxes without allocation
(taxes payable method)
•Taxes in the financial income statement are stated as
the taxes that are calculated from taxable income.
•Taxes payable in the balance sheet are the amount of
taxes not yet paid. They are shown as short-term
liabilities until payment is made.
•Deferred taxes are not included in the balance sheet,
but only in the notes to the financial statements.
The method is no longer allowed.
Copyright  2000 by Harcourt Inc. All rights reserved.
X.13
2. Allocation of taxes
(deferred taxes method)
•Accounting standard 14 section/paragraph 20:
•It is in accordance with basic accounting
principles to make an allocation of the company’s
tax expenses and tax reduction in such a way that
the both the effect of a transaction/an event and the
derived tax effect of that transaction influence the
financial income and shareholders´equity at the
same time (i.e. in the same year).
• I.e. if the company has a high operating pre-tax
result one year then the high taxes resulting from
that result shall be included as an expense in that
year too.
Copyright  2000 by Harcourt Inc. All rights reserved.
X.14
2. Income statement: Calculated tax
expense from financial income
Calculation of tax effect of financial income:
Annual financial income before taxes
- Revenues/gains in the financial income statement which are never
to be included in taxable income (non-taxable revenues).
+ Expenses in the financial income statements which are never to
be included in tax income (non-tax-deductible expenses)
- Deductions in the annual taxable income which are never to be
included in the financial income statements (taxable income
adjustments/deductions)
” The taxable financial income”
= That part of the financial income which will - sooner
or later - result in tax payments.
Copyright  2000 by Harcourt Inc. All rights reserved.
X.15
2. Deferred taxes method in the income
statement
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”Taxable financial income”
 * Tax rate
 = Calculated taxes
Taxes payable
Changes in deferred taxes
That part of calculated taxes to be paid
on the basis of the taxable
income of the period
The difference between ”actual
taxes” for the year- calculated on the taxable
income for the year - and calculated taxes for the year
Copyright  2000 by Harcourt Inc. All rights reserved.
X.16
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2. Deferred taxes method in the income
statement
The relation between ”taxable annual financial
result” and book income:
Taxable financial income
+/- Timing differences
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= Financial income/Book income before taxes
Copyright  2000 by Harcourt Inc. All rights reserved.
X.17
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2.Deferred taxes derived from the
balance sheets
By the balance sheet approach to deferred taxes, focus is on
the temporary differences, i.e. the differences between (1) the
valuations in the balance sheet in the financial statement
and (2) valuations in the tax balance sheet
The (taxable/deductible) temporary differences is found as:
The difference between the financial accounting valuations
and the tax account valuations at the same point of time
(year end)
A temporary difference will give rise too either a deferred
tax liability (most often) or a deferred tax asset
Tax rate x the total of temporary tax differences = deferred
taxes in the financial balance sheet
Copyright  2000 by Harcourt Inc. All rights reserved.
X.18
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2. Balance sheet approach: Deferred
taxes - temporary differences
Net temporary differences result in deferred tax
(an obligation) and arise
typically when the financial account value of an
asset is higher than the tax account value of the
asset.
Example: if a machine will recover its book value
sale or use, this “recovery” will result in taxes when
its book value>its taxable value – due to positive
effect on taxable income.
Example: if the taxable value of a liability is higher
than the accounted value (but it is rare)
Copyright  2000 by Harcourt Inc. All rights reserved.
X.19
2. Balance sheet: deferred taxes in the
balance sheet - positive temporary
differences
Reasons for positive temporary differences:
 Fixed assets are depreciated more slowly in the financial
accounts than in the tax accounts1).
 Some costs are expensed when incurred in the tax
accounts but capitalized in the financial accounts 1).
 Revenues/gains are recognized in the financial income
statement before they are included in the tax accounts 1).
 An asset is written up/revaluated in the financial
statement but its value in the tax accounts is not
altered2).
1) Temporary difference = sum of past timing differences
2) Temporary difference, but no timing difference in the past
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Copyright  2000 by Harcourt Inc. All rights reserved.
X.20
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2. Deferred taxes in the balance sheetnegative temporary differences
Examples of deductible temporary differences (=>negative deferred
taxes):
 Fixed assets are written down/off faster in the financial accounts
than in the tax accounts (e.g. because a machine has become
worthless and has thus been written down to 0 in the financial
accounts).
 Expense recognition is carried out earlier in financial accounts than
in tax accounts (e.g. in terms of inventories that have been written
down to their net realizable value in the financial accounts).
 Charges in the financial accounts for estimated loss on receivables
or for provisions for warranty costs are recognized earlier in the
financial statements than in the tax accounts (loss/costs are typically
not accepted as deductions from taxable income until they have been
proved/incurred).
Copyright  2000 by Harcourt Inc. All rights reserved.
X.21
Deferred taxes and calculated tax expense
DCAA and – especially – AS14 (somewhat simplified):
Deferred taxes in the balance sheet=
Temporary taxable differences * tax rate
(balance sheet oriented)
Tax expense for the year = taxable financial income for
the year times the tax rate (calculated taxes, cf.
above)*
(income statement oriented)
*However, possibly with addition/deduction of effect of
a change of tax rate
X.22
Deferred taxes in the balance sheet and the
income statement
 AS 14 and the DCAA. :
 Deferred taxes are to be stated of all
temporary differences.
 Calculated tax expense must include taxes
derived from taxable income plus changes in
deferred taxes that are caused by income items
that are recognized in different years in the
financial accounts and in the tax accounts, (i.e.,
plus that part of the change in deferred taxes
resulting from timing differences).
X.23
The relation: Deferred taxes - Calculated
tax expense
Changes in deferred taxes
Deferred taxes
opening balance + resulting from all changes in =
temporary (balance) differences
Those changes in deferred
taxes resulting from timing
differences (in the income
statements)
Deferred taxes
ending balance
Those changes that
resulted from valuation
adjustments that do not
influence income
+
Taxes on taxable income
= Calculated tax expenses in
the income statement
Direct adjustment of deferred taxes in
the balance sheet
X.24
Several possible calculation approaches (1)
Examples
 Calculated tax expense, taxes on taxable income,
direct valuation changes of balance items, and the
deferred taxes at the beginning of the financial year
are all known => the change in deferred taxes in the
year and deferred taxes at the end of that year can
be found
 Deferred taxes, “directly made changes” in deferred
taxes, and tax from taxable income are all known =>
calculated taxes/the tax expense in the financial
income statement (the unknown factor)
X.25
Several possible calculation approaches (2)
Knowledge of/possibility to determine:
A. Deferred taxes in opening balance
B. Taxable income resulting from the financial statement income
(i.e. calculated taxes) and tax income/taxes resulting from
taxable income => change in deferred taxes via the income
statement
C. Changes in deferred taxes by direct value adjustment of
balance items outside, adjustments not included in the
financial income statement (c. is often zero)
=> Deferred taxes in ending balance (the unknown factor)
X.26
Several possible calculation approaches (3)
Knowledge of/possibility of deciding:
A. deferred taxes opening balance
B. deferred taxes ending balance. (A and B) => Change
in deferred taxes
C. The change in deferred taxes that does not result
from the financial income statement.
D. Change in deferred taxes via the income statement.
E. Taxes on taxable income
=> Calculated taxes/tax expense in the financial income
statement (the unknown factor)
X.27
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2. Deferred taxes - tax rate/tax rate
change
Deferred taxes shall be determined by the use of
that tax rate that is expected to apply for those
years when the temporary differences are expected
to be reduced/ to disappear, i.e. when the temporary
differences are turned into additions to taxable
income - the future tax rates are, however,
presumed to be identical to the current tax rate
unless a tax rate tax change has been enacted.
A change in deferred taxes due to a tax rate change
is charged to the financial income statement
(included in calculated tax expense).
Copyright  2000 by Harcourt Inc. All rights reserved.
X.28
3. Derivatives (derived financial
instruments)
Companies encounter many risks when running a
business:
1. The risk of customers stopping buying the
company’s products and services.
2. The risk of prices for raw materials used for
production increasing after the company has
irrevocably committed itself to sell at a fixed price.
3. The risk of exchange rates changing after the
company has entered into a contract/transaction
denominated in a foreign currency.
4. The risk of interest rates changing.
5. The risk of employees quitting or retiring.
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Copyright  2000 by Harcourt Inc. All rights reserved.
X.29
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3. Derivatives (continued)
The company can acquire derivatives which may be used
for speculation in and hedging against certain risks (interest
and currency risks as well as certain other ”market value”risks)
A distinction is made between hedging of an item that is
exposed for a risk of changes in market value (“fair-valuehedge) and hedging of an item that is exposed for a risk of
cash flow will change (“cash-flow-hedge”)
Example: Fair-value hedge: hedging of a receivable in DEM
falling due in three months, for example by selling the
amount via a futures contract (“a short sale”)
Example: Cash-flow-hedge: hedging of the amount value
for payment for orders received for goods, which have not
yet been delivered (=> still not a receivable). Can also be
hedged a futures contract .
Copyright  2000 by Harcourt Inc. All rights reserved.
X.30
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3. Derivatives (continued)
The accounted treatment is “international” (and now also used in
DK -despite the wording of the law!):
Derivatives are valued at the (estimated) market value in the balance
sheet
In relation to speculation (called “trade”) value changes are
recognized in the income statement when market value changes
occur
For fair-value hedges value changes are recognized in the income
statement for both the hedged item and its hedging derivative when
change in market values occur=> only net gain or loss if the hedging
is not totally efficient
For cash-flow hedges the value changes in the derivative (hedging)
instrument are recognizes directly in owners´ equity (i.e. not included
in income). Only temporarily though, for is de-recognized in owner´s
equity when the hedged transaction is included in the financial
statements - at that point it is seen as an adjustment to the price of
that transaction=> coupling.
Copyright  2000 by Harcourt Inc. All rights reserved.