Deferred tax is back

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This article was first published in the February 2018 international edition of Accounting and Business magazine.

The central theme of the current work plan of the International Accounting Standards Board (IASB) is ‘Better communication in financial reporting’. In the past few months, this column has considered the varying ways the IASB is applying this – to the disclosure project, the definition of materiality, the format of primary financial statements and the proposed changes to the Conceptual Framework.

In November 2017, the IASB held its annual research forum. Most of the discussion unsurprisingly centred around topics linked to this principle of improved communication. An interesting addition to the research topics was a discussion on deferred tax. This was an unexpected topic, as the IASB has decided not to change IAS 12, Income Taxes, in respect of deferred tax and it sits nowhere in the current work plan.

IAS 12 covers the accounting treatment for both current and deferred tax. Current tax relates to the entries to be made in respect of the estimated tax liability from the current year’s tax return to be filed. Deferred tax arises where there are taxable temporary differences in the carrying amount of an asset or liability in the statement of financial position and its tax base. Therefore deferred tax assets or liabilities are recognised if they represent the future tax consequences of events that are already in existence.

The concept and practical application of deferred tax has been a source of much debate and criticism for many years. Academics Arjan Brouwer and Ewout Naarding produced a research paper at the forum that questions the decision not to re-examine IAS 12, especially in the light of the IASB’s focus on better communication. Here are some of the arguments raised in this discussion and other concerns raised over the treatment of deferred tax.

Consistency in recognition

As deferred tax is defined by looking at the carrying amount of an asset or liability in relation to its tax base. This shows a focus on financial position in the application of deferred tax. Having a financial position focus is consistent with the Conceptual Framework, even though this focus is not always popular, particularly with accounting students, who often struggle with the definitions surrounding which tax base to apply to items.

In addition, it could be questioned whether deferred tax assets and deferred tax liabilities really satisfy the definitions of assets and liabilities. The proposed definitions according to the Conceptual Framework exposure draft are:

• an asset is a present economic resource controlled by the entity as a result of past events
• a liability is a present obligation of the entity to transfer an economic resource as a result of past events.

Cases can be made to show that deferred tax assets and liabilities do meet these definitions, but equally cases could also be made to question whether entities do indeed have present obligations in terms of deferred tax liabilities recognised.

One of the most common deferred tax liabilities arises from the differences between the depreciation charged on a non-current asset compared to the capital allowances given for that asset. In situations where capital allowances exceed the depreciation charged, this will result in a deferred tax liability. The principle behind this is a sound one, as the entity will receive fewer capital allowances in the future, resulting in higher tax charges. This tax will only be payable based on the entity’s future profits, so critics often suggest that there is no present obligation to settle this liability, as the entity may not make any taxable profits.

A much more contentious issue revolves around adjustments to fair value. An entity using either the revaluation model for a non-current asset, or a parent company making fair value adjustments to assets on the acquisition of a subsidiary, may recognise a fair value gain if the asset value increases. This would increase the difference between the carrying amount of the asset and its tax base. A deferred tax liability would therefore be created.

From a matching perspective, this makes sense, as the entity will never be able to recognise the fair value gain recorded without incurring tax on that gain. While this makes sense from a matching perspective, does the entity have a present obligation to transfer an economic resource? If the entity has no intention to sell the asset, it could be argued that it doesn’t.

Instead of showing the deferred tax as a liability, commentators have suggested simply showing the gain net of tax. This would have the effect of only recording the net gain to the entity, and not reflecting a liability. This is currently not in line with the accounting treatments for non-current assets or tax so cannot be done, but it could be argued that as the payment of the liability is very unlikely, the presence of a deferred tax liability may be misleading.

This seems to represent a slight conflict with some key principles in the Conceptual Framework: not to recognise any potential tax impacts on a remeasurement gain would show a gain but omit any potential costs associated with the gain. Recognising a liability with a low probability of any payment may also not represent relevant information.

The Conceptual Framework exposure draft does state that ‘users of financial statements may, in some cases, not find it useful for an entity to recognise assets and liabilities with very low probabilities of inflows and outflows of economic benefits’, which could be argued to be the case here with the deferred tax on revaluation gains.

While the Conceptual Framework does seem to suggest that the recognition of some liabilities with a low probability of outflow is not useful, IAS 12 explicitly states that a deferred tax liability must be recognised for all temporary timing differences. While a deferred tax liability must be recognised wherever the carrying amount exceeds the tax base, a deferred tax asset has a probability criterion attached to it, stating that there must be sufficient projected future taxable profits to be able to recognise the deferred tax asset.

The IASB has already addressed this issue in relation to its work on the Conceptual Framework, stating that there is asymmetric prudence within certain accounting standards, and that this should be allowed to remain.

Consistency in measurement

Many deferred tax items, particularly liabilities, are long term and will be settled in over 12 months. The Conceptual Framework exposure draft states that fair value should reflect the time value of money. Under IAS 12, the discounting of deferred tax items is explicitly prohibited.

The reasoning behind this is because it could be inherently complex to do and may not provide useful information. While this may well be true, it may mean that deferred tax liabilities could be significantly overstated in the financial statements. This also puts IAS 12 in conflict with other standards, such as IAS 37, Provisions, Contingent Liabilities and Contingent Assets, which states that long-term provisions must be discounted to reflect the time value of money.

There is often a weak relationship between deferred tax balances and future cashflows. Deferred tax items are often very long term, or the settlement of the liability may have a very low probability if it arises from fair value gains. In the light of the IASB’s focus on producing more useful information, deferred tax does seem at odds with this approach. It is questionable as to how much value the accounting for and disclosures surrounding deferred tax produces for investors.

When it comes to the information investors regard as useful in relation to tax, it would appear reasonable to assume that most users are more interested in the current tax position and any future cash impacts relating to tax. The current deferred tax disclosures do not show this information clearly. From the deferred tax accounting and disclosures under IAS 12, users would not be able to assess whether there is a future cash impact, the estimated timing of that impact or the likelihood of the event arising.

Some commentators believe that deferred tax accounting isn’t fit for purpose and that it provides limited usefulness. They often argue that users would be more interested in an entity’s tax policies and governance rather than the deferred tax information. Given the IASB’s focus on useful disclosure, the disclosures around tax seem to be an area that could be looked at further.

While the removal of deferred tax is likely to remain wishful thinking for accounts preparers and accounting students everywhere, there are surely enough inconsistencies between IAS 12 and other areas of corporate reporting for the IASB to consider taking action. Maybe the topic’s inclusion within the research forum could lead to just that.

Adam Deller is a financial reporting specialist and lecturer