Question

Why are tax effect entries sometimes necessary in making consolidation worksheet adjustments? Explain this in detail for the year ending 30 June 2017 using the following example:

Apple Ltd owns all the share capital of Pear Ltd. The income tax rate is 30%. On 30 June 2017, Apple Ltd sold a motor vehicle to Pear Ltd for $15 000. The motor vehicle had a carrying amount to Apple Ltd of $12 000.

Answer 1

Giving effect to tax entries become imperative as the reporting principles for (Generally Accepted Accounting Principles) GAAP and Tax Law differ. The amount of taxes to be paid for a period is governed by tax law, and not by GAAP. Income Tax as reported in the books of account, is sometimes different, from the amount of tax due. GAAP applies the accrual basis of accounting in valuing the income tax cost and related ending balances of tax assets and liabilities for the period. Income tax expense is recognized when it is incurred, irrespective of whether a payment has actually been made to the Internal Revenue Service ( IRS). The process of recognizing income tax expense and associated deferred tax accounts is referred to as "Interperiod Alllocation".

"Interperiod Tax Allocation is defined as "the process of measuring and recognizing the total income tax consequences of transactions throughout the year." Only temporary differences and net operating loss carry forwards enter into this calculation.

"Interperiod Tax Allocation gives rise to deferred tax accounts because the total tax consequence of the period's transactions is not equal to the current income tax liability." The current tax liability, measured at the current tax rate, measures only part of the total liability. There are additional tax consequences in the future on account of transactions that have occurred as at the balance sheet date. Hence the need for deferred tax accounts.

Deferred tax accounts are measured at the future enacted tax rate. Deferred tax accounts are raised when a temporary difference arises because the tax base of an asset of an asset or liability differs from the carrying amount.

Deferred Tax Liability refers to the recognized tax effect of future taxable temporary differences. These differences are on account of transactions that have occurred as of the balance sheet date, and are expected to increase future taxable income relative to pre-tax accounting income.

On the other hand, a Deferred Tax Asset relates to the recognized effect of future deductible temporary differences. In this case, the differences that have occurred as of the balance sheet date, and are expected to result in an decrease to the future taxable income relative to pre-tax accounting income.

Consolidating adjustments result in changing the carrying amounts of assets and liabilities. When this occurs a temporary difference arises, as there is no change to the tax base. In these situations, tax effect entries are required, as they are needed for raise deferred tax assets and liabilities.

In the given problem , the Consolidation Worksheet will show a Credit adjustment of $ 3,000 ( $ 15,000 - $ 12,000) to Fixed Assets - Motor Vehicles account, as the cost to the Apple Ltd is different from its sbsidiary, Pears Ltd.

In the books of Pear Ltd (Subsidiary), the Motor Vehicle is carried at $ 15,000, and has a tax base of $ 15,000 resulting in no temporray difference.

From the Apple Ltd Group's point of view, however, the Motor Vehicle has a carrying amount of $ 12,000, resulting in a temporary difference of $ 3,000. As a consequence, a deferred tax asset exists for Apple Ltd, on account of the expected future deduction being more than the assessable amount.

This has no effect on the tax payable in the current period.