IAS 12 – Income Taxes
Are income taxes an expense or an appropriation of profits?
The preliminary question underlying the accounting treatment of income taxes is whether income taxes represent an expense or rather an appropriation of profits. Unlike other accounting expenses, income taxes are not paid in exchange for specific goods or services, and in fact, they are not considered expenses incurred in generating income, meaning that even without the tax, the entity would still earn its revenue. Moreover, unlike other expenses, the entity cannot avoid paying income taxes. These characteristics could seemingly resemble those of a profit appropriation, whereby income taxes could be viewed as a payment to the government as if it were a shareholder, with its “shareholding” determined by the applicable tax rate. This question has far-reaching implications for the accounting treatment of income taxes. Current accounting standards worldwide treat income taxes as an expense and therefore primarily address issues of matching tax expenses to pre-tax profit (i.e., the recognition of deferred taxes). It is important to emphasise that if income taxes were regarded as a profit appropriation, all issues relating to matching expenses to revenue would be irrelevant, since no “dividends” would need to be allocated to accounting periods, unlike the treatment of expenses.
Why is the allocation of tax expense across periods a central issue?
The most significant accounting issue in relation to income taxes, therefore, is how to allocate tax expenses across reporting periods. IFRS Accounting Standards set recognition principles for transactions and events during the reporting period with the aim of providing relevant and reliable information to users of financial statements. Tax laws, however, are influenced by social and political considerations, which do not necessarily align with the objectives of accounting principles. Consequently, taxable income, as determined by tax law, often differs from accounting profit as determined by accounting recognition and measurement principles. The gap between tax law and IFRS Accounting Standards arises both from timing differences in the recognition of income and expenses, and from differences in recognition itself. For example, there may be cases where the reporting entity is required to pay taxes on taxable income even though, under IFRS, the related income is only recognised in financial statements in a subsequent period. Conversely, the entity may be required to pay taxes in periods following the recognition of income in the financial statements. This divergence may impair the matching of expenses and revenue.
How do deferred taxes achieve matching between tax expense and accounting profit?
To achieve matching between the recognition of tax expense in the financial statements and pre-tax accounting profit, IFRS Accounting Standards require adjustments to reconcile the differences between accounting principles and tax law. This is achieved through deferred taxes—deferred tax assets and deferred tax liabilities. This mechanism ensures recognition of the tax effects of transactions in the same period in which the transactions themselves are reflected in the financial statements.
What is the balance sheet approach to deferred taxes?
Modern accounting standards adopt the balance sheet approach in determining which differences give rise to deferred tax recognition. Under the balance sheet approach, the difference between the carrying amount of an asset or liability in the financial statements and its tax base (termed a temporary difference) gives rise either to an obligation to pay tax (resulting in a deferred tax liability) or a right to receive a tax benefit (resulting in a deferred tax asset), provided that the accounting recognition criteria are met. In the past, the analysis was based on the income statement approach, which distinguished between “timing differences” (temporary differences that reverse in future periods) and “permanent differences.” However, while timing differences are a subset of temporary differences, temporary differences also include items that are not timing differences. In other words, the set of temporary differences is broader and includes certain items previously defined as permanent differences.
For example, when an asset is revalued for accounting purposes without a corresponding revaluation for tax purposes, the revaluation creates a temporary difference but not a timing difference (since for tax purposes the revaluation was neither recognised in the past nor will it be in the future). Another example is fair value adjustments arising in a business combination accounted for under the acquisition method, which are allocated to identifiable assets and liabilities. Since for tax purposes the values of the acquired company’s assets and liabilities remain unchanged, this difference is temporary but not a timing difference. There is no doubt that the balance sheet approach is more consistent with the Conceptual Framework for Financial Reporting, which requires recognition of assets and liabilities first, with performance (income and expenses) measured as a consequence of the assets and liabilities recognised. The shift to this approach was first implemented in the United States in the early 1990s and was later adopted by the International Accounting Standards Board (IASB).
How are income taxes presented in the financial statements?
In the statement of comprehensive income, income taxes are presented as a separate line item that includes both current taxes and the profit and loss effect of deferred taxes. Current and deferred taxes relating to results of discontinued operations are presented net within that line item.
What is the scope of IAS 12?
IAS 12 provides comprehensive guidance on the accounting treatment of income taxes. The Standard addresses the treatment of current and future tax consequences of the recovery (or settlement) of the carrying amounts of assets and liabilities recognised in the entity’s statement of financial position, as well as the tax effects of transactions and other events of the current period recognised in the financial statements. The Standard also addresses the recognition of deferred tax assets arising from unused tax losses and unused tax credits, the measurement of current and deferred tax assets and liabilities, the presentation of income taxes in the financial statements, and the related disclosure requirements.