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Tax-Effect of Accounting

Objectives 

This assessment item relates to the following unit learning outcomes: 

 Interpret the technical requirements and conceptual aspects of selected accounting standards that address advanced issues in financial reporting. 

 Exercise professional judgement to apply the requirements of relevant accounting standards and conceptual accounting knowledge to solve advanced accounting problems. 

 Justify and communicate accounting advice and ideas in straightforward contexts to influence specialists and non-specialists. 

 Reflect on performance feedback to identify and action learning opportunities and self improvements.

Question 1

On 1 July 2017, Dunedin Ltd paid $300,000 to acquire a machine. On this date, management of Dunedin Ltd estimated that the machine had a useful life of five years and a zero residual value. In accordance with AASB 116 Property, Plant and Equipment, Dunedin Ltd uses the cost model as its accounting policy to measure items of property, plant and equipment and the straight-line method of depreciation. For tax purposes, the machine is depreciated over three years using the straight-line method. The company income tax rate is 30%.

Senior management of Dunedin Ltd arranged a meeting with the accounting staff to discuss the effect of depreciating this machine on future company income tax. None of the senior managers have a background in accounting and the meeting stalled when several of the senior managers expressed surprise that the income tax expense reported in Dunedin Ltd’s Statement of profit or loss and other comprehensive income is significantly different to the actual amount of cash paid to the ATO. After the meeting, the Chief Accountant of Dunedin Ltd, Linda May, asked you to draft a memorandum to senior management for her signature.

Required

 Draft a memorandum for Linda May to sign that explains the principles of tax-effect accounting as required by AASB 112 Income Taxes. An example of the memorandum format is included at the end of this assignment.

Your memorandum should address the following: 

 Explain the difference between accounting profit and taxable profit. 

 Explain how taxable profit is calculated. 

 Explain current income tax expense and how is it calculated. 

 Explain deferred income tax expense and how is it calculated. 

 Explain what deferred tax assets and deferred tax liabilities represent. 

 Explain why the amount of income tax expense is different to the amount paid to the ATO.

Your memorandum should also include two schedules in relation to the machine:

  • Schedule One. For the years ending 30 June 2018, 2019, 2020, 2021, and 2022, calculate: the machines carrying amount for accounting purposes; the machine’s tax base; the temporary difference; and the amount of the deferred tax asset or deferred tax liability associated with the machine.
  • Schedule Two. Assume that, for the years ending 30 June 2018, 2019, 2020, 2021, and 2022, accounting profit is $150,000 per year before any expenses are recognised. The only expense to be recognised is the depreciation of the machine. For each of the five years, calculate: current income tax expense; total income tax expense after including deferred income tax expense; and the amount payable to the ATO.

You can use the information in these two schedules to illustrate your written answers.

Question 2

Reflect on this assignment and answer the following: 

 What do you think is a fair mark for this assignment? 

 What was the thing you think you did best in this assignment? 

 What was the thing that you think you did least well in this assignment? 

 What did you find the hardest part of this assignment? 

 What was the most important thing you learned in doing this assignment?


Answer

Memorandum

Tax-effect of accounting as required by AASB 112 Income Taxes

This memo is in reference to the difference that the senior members have enquired about regarding the income tax expense reported in company’s Statement of profit or loss and the actual amount of cash paid to the ATO.  The difference, as we know, is significant but is a very common thing to occur for a company. Let me start by briefing you about what the accounting and taxable profit. A firm usually accounts for two types of profits- accounting and taxable. The need to calculate different profits for the same activities arise because of the difference in rule as per accounting standards and as per the Income Tax Acts. They need to be calculated also because they serve two different but very important purposes.

Accounting profit is the profit calculated by the firm accountant taking in concern various accounting standards and principles like accrual concept, double entry system and GAAP principles. This profit is used for the purpose of financial audit. Whereas, taxable profit is calculated by the firm as per the Income tax rules of accounting. This profit is calculated solely for the purpose of tax audit; i.e. for the tax authorities to cross check that the tax paid by the firm over the years is correct. Accounting profit accounts for all the accrued & advance incomes and prepaid & outstanding expenses, because the company follows the GAAP principles, which suggests to follow the accrual concept and the revenue recognition concept of accounting for book-keeping. Whereas the taxable profits, only the cash expenses and incomes generated in the concerned period are taken in concern to arrive at the taxable profits of the firm. 

The difference between accounting and taxable profit occurs because of the accrual concept & revenue recognition and matching principle of accounting. These principles of accounting propose that the income should be accounted for and taxed within the period in which the income was recognized. Additionally, the tax shield i.e. the tax benefits pertaining to an item should also be recognized and deducted from the taxable profit in the same period in which that item is recognized. Whereas, the tax rules don’t operate in this way.

Current income tax of a period is the amount of tax payable by the firm to the tax authorities on the profits calculated as per GAAP principles, i.e. 

Current Tax Rate × [Incomes as per GAAP – Expenses as per GAAP]

Current tax expenses are calculated by firm for its internal use but it is not accepted by the Income Tax Department, therefore this is not a correct representation of what is the actual tax liability of the firm. Hence, current tax liabilities need to be adjusted for some items to arrive at the actual tax liability of the firm. This process is called deferment of taxes and through this process arise the deferred taxes of the firm.

Deferred income tax is the liability that arises due to the differences in the tax amount as per the tax laws and the tax amount as per the company’s accounting methods, i.e.

Tax amount reported in the books of company – Tax amount payable as the tax laws

Deferred income tax can be a liability or an asset both. If the amount of tax reported by the firm is more than the tax amount payable as per tax laws, it means that company accounted for more liabilities than it actually owes. Hence, it is an asset for the firm and it will be recorded as Deferred tax income on the asset side of the Balance Sheet. If the amount of tax reported by the firm is less than the tax amount payable as per tax laws, it means that company accounted for lesser amount of liabilities than it actually owes. Hence, the firm needs to account for more liabilities and it will be recorded as Deferred tax liability on the asset side of the Balance Sheet.

The items for which the Current tax amount needs to be adjusted for to arrive at the actual taxable amounts are-

  1. The tax payable on accrued incomes & outstanding expenses and tax deductions related to that income should be carried forward to the period in which the income will be received or expenses will be paid
  2. The tax payable on advance incomes & prepaid expenses and its tax deductions should be charged in the current period in which the income is received or expenses are paid

The abovementioned points are the reasons because of which there was a difference in the amount of income tax expense appearing in the books to the amount paid to the ATO. For better understanding and detailed analysis, I’ve attached schedules showing the calculation as per both the rules. Please feel free to enquire for any further queries.

Thanks,

Schedule I

Depreciation (as per straight line method) = [Original cost – Residual Value] / Useful life

Depreciation recorded in the books for accounting purpose = $ [300,000 – 0] / 5 

                                                                                                 = $60,000 /year

Carrying Value (as per cost model) = Original cost– Accumulated depreciation-   Impairment losses

YearBook ValueAccumulated DepreciationCarrying ValueTax base
20183,00,00060,0002,40,00030%
20193,00,0001,20,0001,80,00030%
20203,00,0001,80,0001,20,00030%
20213,00,0002,40,00060,00030%
20223,00,0003,00,000030%


Schedule II

   Depreciation charged for tax purposes = $ [300,000 – 0] / 3 = $100,000 / year

Note: Greater the depreciation, lesser the profit. Hence, lesser taxes.

Tax liability = Tax Rate * Taxable Amount

= Tax Rate * [Profits – Depreciation]

Deferred Tax = Recorded/Accounted Tax expenses – Actual tax expenses


YearProfitActual recorded Depreciation Depreciation for tax purposesTax baseTax as per recorded depreciationTax paid to the ATO / tax as per charged depreciationDeferred Tax
2018150,00060,000100,00030%27,00015,00012,000 [A]
2019150,00060,000100,00030%27,00015,00012,000 [A]
2020150,00060,000100,00030%27,00015,00012,000 [A]
2021150,00060,000030%27,00045,00018,000 [L]
2022150,00060,000030%27,00045,00018,000 [L]


QUESTION 2

  1. I think the fair marks for this assignment should be 30 marks. Since the first part of the assignment requires a good amount of calculations and a fair knowledge of both the accounting concepts as well as the tax rules of AASB 112.
  2. I have very well explained each and every basic concept required to do the question. It is very clear for anyone to understand. I feel the knowledge of the basics is more important than getting the right answer for the calculations, and that’s what I have focused on.
  3. The question can be perceived in many ways. There was not clear instruction in the question regarding the book keeping or financial period of the company. I have prepared the schedule as per my understanding of the question but I feel others might perceive it differently and prepare a different schedule.
  4. To interpret the question, take assumptions, do calculations and prepare the schedule accordingly.
  5. I learnt that every accountant can have a different take on the accounting treatment a type of expense or any other item. I also learnt that a company can take different measures for tax saving. 
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