Reporting the financial performance of a range of entities (C3.2)

F7/FR Exam Deferred Tax Questions:

• Opening Balance: The deferred tax liability presented in the trial balance or draft financial statements is the opening balance. This is your starting point.

• Notes Provide Clues: The notes accompanying the question will contain the information needed to calculate the closing deferred tax liability or the liability's movement (increase/decrease).

• Careful Reading is Crucial: Pay close attention to the wording of the notes. You need to understand precisely what information is being given and how it relates to your deferred tax calculations.

Different Ways Information Might Be Presented (Leading to the Same Result):
The key takeaway is that the exam might give you the information in different formats, but they all lead to the same final deferred tax figures. Here are the common presentations:
Direct Calculation of Closing Liability: The notes might directly provide the information needed to calculate the closing deferred tax liability. For example:

• "A taxable temporary difference of $X exists at the year-end." You would then multiply this by the tax rate to find the closing liability.

Information to Calculate the Change (Movement): The notes might provide the information needed to calculate the change (increase or decrease) in the deferred tax liability during the year. For example:

• "A new temporary difference of $Y arose during the year." You would multiply this by the tax rate to find the change in the liability. You would then add this change to the opening balance to get the closing balance.

Combination of Opening Balance and Change: The notes might give you the opening balance and then provide information that allows you to calculate the change. This is the most common scenario.
Example Illustrating Different Presentations (Simplified):
Assume a tax rate of 25%.
Scenario 1 (Direct Closing Liability): "At the year-end, taxable temporary differences total $1,000."

• Closing Deferred Tax Liability: $1,000 * 25% = $250

Scenario 2 (Change in Liability): "During the year, taxable temporary differences increased by $400. The opening deferred tax liability was $150."

• Change in Deferred Tax Liability: $400 * 25% = $100

• Closing Deferred Tax Liability: $150 (Opening) + $100 (Change) = $250

Scenario 3 (Combination): "The opening deferred tax liability was $150. A new asset was acquired during the year, creating a taxable temporary difference of $400."

• Change in Deferred Tax Liability: $400 * 25% = $100

• Closing Deferred Tax Liability: $150 (Opening) + $100 (Change) = $250

Exam Strategy:

1. Identify the Opening Balance: Look for the deferred tax liability in the trial balance or draft financial statements.

1. Carefully Read the Notes: Determine what information is provided: closing balance, change in balance, or information to calculate the change.

1. Apply the Tax Rate: Multiply the relevant temporary difference (closing balance or change) by the tax rate.

1. Calculate the Closing Balance: If you calculated the change, add it to the opening balance to arrive at the closing balance.

1. Prepare the Journal Entry: Record the movement in the deferred tax liability in the income statement (as part of the tax expense) and the closing balance on the balance sheet.

By understanding these different presentations and practicing exam-style questions, you'll be well-prepared to handle deferred tax in the FR exam.

EXAMPLE 2

The trial balance shows a credit balance of $1,500 in respect of a deferred tax liability.

The notes to the question could contain one of the following sets of information:

At the year-end, the required deferred tax liability is $2,500.

At the year-end, it was determined that an increase in the deferred tax liability of $1,000 was required.

At the year-end, there are taxable temporary differences of $10,000. Tax is charged at a rate of 25%.

During the year, taxable temporary differences increased by $4,000. Tax is charged at a rate of 25%.

Solution:

• Opening Deferred Tax Liability (from Trial Balance): $1,500 (Credit)

Let's analyze each note and how it leads to the correct accounting treatment:

1. "At the year-end, the required deferred tax liability is $2,500."

• This is the most straightforward presentation. It directly gives you the closing deferred tax liability.
• Movement: $2,500 (Closing) - $1,500 (Opening) = $1,000 (Increase)
• Journal Entry:
  • Dr Tax Expense (Income Statement) $1,000
  • Cr Deferred Tax Liability (Balance Sheet) $1,000

2. "At the year-end, it was determined that an increase in the deferred tax liability of $1,000 was required."

• This directly gives you the movement (change) in the deferred tax liability.
• Closing Balance: $1,500 (Opening) + $1,000 (Increase) = $2,500
• Journal Entry:
  • Dr Tax Expense (Income Statement) $1,000
  • Cr Deferred Tax Liability (Balance Sheet) $1,000

3. "At the year-end, there are taxable temporary differences of $10,000. Tax is charged at a rate of 25%."

• This provides information to calculate the closing deferred tax liability.
• Closing Balance: $10,000 (Taxable Temporary Differences) * 25% (Tax Rate) = $2,500
• Movement: $2,500 (Closing) - $1,500 (Opening) = $1,000 (Increase)
• Journal Entry:
  • Dr Tax Expense (Income Statement) $1,000
  • Cr Deferred Tax Liability (Balance Sheet) $1,000

4. "During the year, taxable temporary differences increased by $4,000. Tax is charged at a rate of 25%."

• This provides information to calculate the movement (change) in the deferred tax liability.
• Movement: $4,000 (Increase in Taxable Temporary Differences) * 25% (Tax Rate) = $1,000 (Increase)
• Closing Balance: $1,500 (Opening) + $1,000 (Increase) = $2,500
• Journal Entry:
  • Dr Tax Expense (Income Statement) $1,000
  • Cr Deferred Tax Liability (Balance Sheet) $1,000

Summary:

As you can see, all four scenarios lead to the same result: a closing deferred tax liability of $2,500 and a $1,000 increase in the liability during the year. The only difference is how the information is presented.

Key Exam Technique:

1. Identify the Opening Balance: Always start by finding the opening deferred tax liability in the trial balance.
2. Determine What Information is Given: Carefully read the notes to understand if you're given:
   • The closing balance is directly.
   • The change (movement) directly.
   • Information to calculate the closing balance (e.g., year-end temporary differences).
   • Information to calculate the change (e.g., increase/decrease in temporary differences during the year).
3. Calculate the Missing Piece: If you have the opening balance and the closing balance, calculate the change. If you have the opening balance and the change, calculate the closing balance.
4. Apply the Tax Rate: If you're given temporary differences, multiply them by the tax rate to get the deferred tax liability or the movement.
5. Make the Journal Entry: Remember the double entry: Dr Tax Expense, Cr Deferred Tax Liability (for an increase) or the reverse (for a decrease).

Example: Non-Current Asset Depreciation, Revaluation, Capital Allowance, and Deferred Tax Impact

Scenario:

A company acquires a machine for $100,000 on January 1, Year 1. The machine has a useful life of 5 years and no residual value. The company depreciates the machine using the straight-line method for accounting purposes and claims capital allowances (tax depreciation) at 20% per annum on a reducing balance basis for tax purposes. The company's income tax rate is 30%.

Year 1:

• Accounting Depreciation: $100,000 / 5 years = $20,000

• Capital Allowance: $100,000 * 20% = $20,000

• Deferred Tax: No deferred tax arises as accounting depreciation and capital allowance are equal.

Year 2:

• Accounting Depreciation: $20,000

• Capital Allowance: ($100,000 - $20,000) * 20% = $16,000

• Deferred Tax Liability: ($20,000 - $16,000) * 30% = $1,200

Year 3:

• Accounting Depreciation: $20,000

• Capital Allowance: ($100,000 - $20,000 - $16,000) * 20% = $12,800

• Deferred Tax Liability: ($20,000 - $12,800) * 30% = $2,160

Year 4:

• Accounting Depreciation: $20,000

• Capital Allowance: ($100,000 - $20,000 - $16,000 - $12,800) * 20% = $10,240

• Deferred Tax Liability: ($20,000 - $10,240) * 30% = $2,928

Year 5:

• Accounting Depreciation: $20,000

• Capital Allowance: ($100,000 - $20,000 - $16,000 - $12,800 - $10,240) * 20% = $8,192

• Deferred Tax Liability: ($20,000 - $8,192) * 30% = $3,542.40

Revaluation at the end of Year 5:

Assume the machine is revalued to $50,000 at the end of Year 5. The revaluation surplus is $30,000 ($50,000 - $20,000 carrying amount). This revaluation creates a taxable temporary difference as the tax base remains unchanged.

• Deferred Tax Liability: $30,000 * 30% = $9,000

Overall Deferred Tax Liability:

• Year 2: $1,200

• Year 3: $2,160

• Year 4: $2,928

• Year 5: $3,542.40 + $9,000 = $12,542.40

Note:

• The deferred tax liability will be reversed over the remaining useful life of the asset as the accounting depreciation will be lower than the capital allowance.

• The revaluation surplus is recognized in equity and will be taxed when the asset is sold or disposed of.  

• 
  

• This example illustrates the basic concepts of deferred tax accounting. The actual calculations may be more complex depending on the specific circumstances and tax regulations.

Key Takeaways:

1. Depreciation and capital allowances can create timing differences that result in deferred tax liabilities or assets.  

2. Revaluations of non-current assets can also create deferred tax liabilities.  

3. Deferred tax liabilities and assets are recognized on the balance sheet and represent the future tax consequences of timing differences.  

4. Proper accounting for deferred taxes is important for accurate financial reporting.