 Hello and welcome to the session. This is Professor Farhad and this session would look at AIS 12, which deals with income taxes. This topic is covered in international accounting, the CPA exam, and the ACCA exam. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing, and tax lecture. Please like my YouTube. Click on the like button if you like them, share them, put them in the playlist. Let the world know about them. If you're listening to me now, it means you're benefiting. Share the wealth. Let other people benefit as well. This is my Instagram account. This is my Facebook account, and I do have a website on my website. If you choose to support the channel, please you can do so by making a donation. Also, on my website, I do have offers right now. For example, Becker CPA Review is offering $1,000 off of the Becker Bundle, which is four parts CPA exam. You can have all four parts for $2,987, $1,000 off. It's not only that. Now it's with unlimited access. Unlimited access means you can have the course as long as you need it. This means even if you may not be studying now for the exam, if you are still a college students and you can invest in such a course, it's a good idea for you. Why? Because you can use the thousands of multiple choice questions, more than 2,000, and lectures by qualified Becker faculty to supplement your college studies. Let's go ahead and get started and let's talk about income taxes. Now the first thing I want to do is make a disclosure. Clearly, this complex is topic, quite topic, and I'm going to be covering this topic in maybe 20, 25 minutes. I don't know how long this topic it's going to take us. This is not an intermediate accounting course. What am I trying to say? To explain the topic. So if you're looking to understand income taxes, you have to go to my chapter 19 intermediate accounting. I have nine different lectures. I have nine different lectures over, I would say, three hours plus to understand in accounting for income taxes. This course is international accounting. This course touches upon the differences between US gap and IFRS. But if you really want to learn how we book the entries, what is the third tax asset exactly? What's the third tax liability? How to handle net operating losses? You have to view the lecture. So again, this is not intermediate accounting. And you're going to see in the next few sessions, I'm going to be making this reminders because the next topic will be revenue recognition. And we're going to be covering revenue recognition very briefly while I have 18 different lectures in my intermediate accounting channel. So the reason I'm saying this in case you are like, I'm confused. I really don't know what's going on is because you don't have a good understanding of the accounting for income taxes, which is the third tax asset, the third tax liability income tax refundable current taxes, the third taxes, so on and so forth. Okay. The good news is IS 12 and US gap take a similar approach in accounting for income taxes. That's the good news. So if you go to my channel, you would learn US gap and you should be good to go. And I know many international students, they listen to my recording and they're good to go. They'll be able to understand the material. What does it mean? They use similar approach. It means they use what's called the asset liability approach that recognizes the third tax asset and the third tax liability for temporary differences and operating loss and tax credit carry forward. What does the balance sheet approach means? It means when we're looking to compute the differences between income tax and accounting. Here's what we have to understand. There are two words. Words means two, two separate books. Okay. And we have the tax record and we have the accounting record, at least two, if not more. Now in the US, when we prepare our income tax, we have to follow the internal revenue service, which is a government agency. Now in your country, they follow some other agency, but the IRS is an example. For accounting, we follow US gap. US generally accepted accounting principle. Now, the way we tax things for US gap is different than IFRS. I'll give you an example. Just to illustrate the point, maybe two example. For example, if we rent a building, if we rent a building and we receive, let's assume we receive, we rent a building upfront for five years. That's commercial lease. And we receive upfront for every year, we receive $50,000. $50,000. Now, for tax purposes, what we do is we have $50,000 of income, of taxable income. So we're going to be paying taxes on the $50,000. Let's assume just for this sake of simplicity, 20% rate. So we're going to have to pay $10,000 in taxes. So the whole $50,000 is tax. Now for gap purposes, guess what? This $50,000 will have to be allocated over five years. And for every year, we're only going to be recognizing $10,000 in income. Now $10,000 in income means, let's assume we're dealing with 2019. In 2019, we only have $10,000 in income as far as accounting rules. What happened to the other $40,000? And this is where we have to look at the asset liability approach. For accounting purposes, we're going to have an account receivable, a $40,000. Why? Because we still have to, I'm sorry, I apologize. It's not account receivable. We receive the cash. We have an unearned revenue. We have unearned revenue, a $40,000 by the end of the year, a $40,000. Why $40,000? Because we recognize $10,000 of revenue. We receive the cash. $10,000 was revenue and $40,000 was unearned revenue. Now under the tax rule, we tax the whole thing. So we have no unearned revenue. So for the tax rules, if we look our unearned revenue, if we look under unearned revenue, notice we have zero. We have zero unearned revenue because everything was taxed. Everything was considered income. So the difference between the liability, the book a liability of zero and $40,000, it's what's going to arise to the difference, to the temporary difference. So we look at the asset and the liability. And the same concept would apply if we have an account receivable. If we have an account receivable, basically put, if we provide a service, we debit account receivable. Let me work another example this way since I already opened that Pandora box. So let's just make it clearer. It's easier to just work a similar example. Okay. For account receivable, again, let's look at this. Let's assume we provided $20,000 worth of services. We debit account receivable. We credit revenue, $20,000. So we have the receivable and we have the revenue. Now for tax purposes, under the US code, there is no really no receivable because we did not receive any money. There is no receivable. So I'm just going to do this, just kind of to show you how it works. I'm going to debit account receivable, zero, credit revenue, zero, just to kind of illustrate the point. You don't do that. But the point is notice we have a receivable of zero, a receivable of $20,000. The difference between those two, it's what's going to give us the temporary difference. Now eventually, eventually we're going to receive the cash. As we receive the cash in future years, we're going to receive in $20,000 of cash. When we receive the cash, we debit cash, credit revenue. Here in future years for accounting purposes, when we receive the cash, we debit cash and credit the receivable. Credit the receivable, $20,000 and $20,000. In future years, we're going to have this $20,000 of receivable would reverse. Again, this will create a temporary difference, but it's a reverse. So this is what we meant to say they adopt the asset liability approach. And this is the simplest and the quickest explanation I can give you for this topic. What do you have to do? You have to learn. The assumption is you already have to know it. So differences do exist, but to a great degree, they use the same approach, which is the asset liability approach. And we're going to see the differences later on really quick. The next question we have to discuss is which tax rate do they use? So when you're computing your deferred tax asset, the deferred tax liability, what's the rate? What's the percentage? Because the rate comes with a tax. IAS required that current and deferred taxes must be measured on the basis of the tax law that has been enacted or substantially enacted. Pretty much the same language as USGAP. USGAP, it says been enacted. Now we need to know how do we define been enacted? Now we have to understand it vary from country to country, because how the US passes their law through US Congress could be different than Argentina, could be different than Germany, could be different than France. But the point is the IASB has published guidelines that address the point in time when a tax change is substantially enacted. And when is that enacted? It's when you cannot change the outcome. When the outcome is fixed, when you cannot change the outcome, simply put, when the legislation of power takes action and pass the law, this is when it's enacted. For example, in the US, the point of substantive enactment is when the tax law is passed by US Congress. And USGAP require measurement of income that's using actually enacted tax law and rate. So enacted means they already passed and passed by who? By Congress. So which tax rate to use? To minimize the devil taxation, just because sometimes there is more than one tax rate to minimize the devil taxation of corporate dividend, which is taxes paid by the company, then taxes paid by the shareholder, some countries apply a lower tax rate to profit that are distributed to shareholder than profit that are retained. So in some countries, what happened is you have two different tax rate. One, if you keep the profit, we tax you differently than if you distribute the profit. Okay, so what's going to happen if you're doing business in those countries, you need to know which tax rate are you going to be using when you compute your current and defer taxes because that makes a difference. Example provided actually have example provided specifically in IS 12 indicate that the tax rate that applies to the undistributed profit because usually that's a higher tax should be used to measure the tax expense. Okay, so that's what we're saying. Sometimes there's more than one tax rate. So let's take a look at an example to illustrate how this work. Let's assume a multinational owns a subsidiary in a foreign jurisdiction where income taxes are payable at a higher rate on undistributed profit than distributed profit. Okay, so if the company keeps the money, they will be taxed at a higher rate than if they would have distributed the money. For the first year, the foreign subsidiary has income of 150,000. The foreign subsidiary also has a net taxable temporary difference amounting to 50,000, which is going to give us the third tax slide. But if you don't know what this is, it means we're going to be responsible for paying more taxes down the road. Why are we going to be paying more taxes? Because we're going to be losing a deduction or having more income. So this 50,000, we don't know what it is. It's either we're going to have less expenses in future years or more income as a result of a change in an asset and liability. But they told us it's a deferred tax liability. The tax rate paid in the foreign country on undistributed profit is 40,000. The tax rate on, I'm sorry, on distributed profit is 40,000. Undistributed profit is 50,000. Basically, they want, they tax you for half of your mind. This looks like sounds like a European country. Just joking. The tax credit arises when the undistributed profit are later distributed. So after you distribute the profit, guess what's going to happen? They will give you a 10% tax credit because you're supposed to be only taxed at 40%. As of the balance sheet, no distribution of dividend has been proposed or declared. So they have 150,000 of income. Well, guess what? What's going to happen is then in year two, they distribute 75,000. In year two, they distribute the 75,000. So in year one, we have to find the tax, we have to tax you on the 150,000. The 150,000, it's going to be 50%. We have to pay taxes of 75,000. So we're going to debit current tax, current tax expense, credit income taxes payable and to be more specific current. So this is how much you have to pay this year. Well, not 75,000. This is 75,000. So we figured out the current taxes. Now, what we are told in the problem, we are told, and I'm going to highlight it in yellow, we are told that we have a temporary difference of 50,000 that gave us the third tax liability. What does that mean? It means in the future, we're going to be responsible for more taxes. How much taxes we're going to be responsible for? Well, it's going to be an additional 50,000. Additional 50,000 of temporary difference. It means we have to pay 50% taxes on this. It means we are responsible for additional 25,000. We have to book the third tax expense. Notice they're both expenses, one you have to pay now and the other one you have to book for the future 25,000 and the third tax liability of 25,000. Simply put, this is the third or non-current portion. Let's just call it the third portion of taxes. So simply put, my total income tax expense is my deferred component and my current component. So my taxes are in total 75 plus 25 is 100,000. That's my total tax. Part of it, part of it current and part of it is deferred. Now, remember in year two, they paid the dividend. They paid $75,000 in dividend. When you paid the dividend, remember when you paid the dividend, if you paid 75,000, you're going to get 10% tax credit. Why 10% tax credit? Because originally they taxed you at 50%. Then when you distribute, they give you a credit as if you distribute the money initially, which your rate should be 40. Therefore, the difference is 10%. So you have a credit, which is a receivable. Now you're waiting for a receivable of 7,500 and you have what's called, you'd reduce your income tax expense for that year by not 25,000, not 7,500. I'm sorry, 7,500. Yes, 7,500. Sorry. I copied the numbers from the other side. So you have a tax credit or tax receivable of 7,500 and you would reduce your current income tax. Yeah, you'd reduce your current tax income tax expense. So for that year, you reduce your current income tax expense, which is for year two, which will be a reduction to this account, reduction to this account, because what happened is you paid the dividend now. Therefore, your taxes should go down, should go down. Okay. So let's talk a little bit more about recognition of the third tax asset. The IAS 12 require recognition of the third tax asset if the future realization of the tax benefit is probable, where probable is undefined. So they don't tell you what probable is in IAS 12. They tell you if it's probable. They don't really tell you how to compute probability. Now, why is that an issue? What are you saying? When I say I have a deferred tax asset, when you say I'm going to be creating a deferred tax asset, I'm going to be creating a deferred tax asset. That means I'm creating an asset. What does that asset represent? What is the deferred tax asset means? It means in the future, you're going to have a tax savings. Why will you have a tax saving? Why would you have a tax saving in the future? Two reasons you could have a tax savings. You're going to have more expenses for tax purposes, more expenses for tax purposes. That's one reason or less revenue for tax purposes compared to now. Let me just explain this. Okay. You would have the third tax asset because you're either going to have more expenses, more expenses that you could not take now. This year, you cannot take the expense. You're going to take it later or less revenue in the future. You remember the rental example I told you we paid? We paid when we received the $50,000 of rental upfront, we taxed the whole thing. We taxed the whole amount. All in 2019. Now, this money was for five years. So on the next five years, you're supposed to tax 10,000, 10,000, 10,000. You already taxed the whole amount the next four years because 10,000 is considered a year one. So basically in the next four years, you have zero taxes, zero taxes on that 50,000 of revenue because you taxed the whole thing in 2019. So because of that, what you do is you book the third tax asset, but you have to be very careful. The third tax asset means going to give you future savings. Well, if you don't have any taxable income, your future savings should not be there. So you want to make sure when you have the third tax asset, ask yourself, am I going to have taxable income? Because if you're not paying taxes, what good is the savings? Because if your taxes are going to be zero because you have no income, what if I gave you $1 million in savings? Well, I don't have any bill. So you can give me as much as possible. So you only recognize it when it's realizable. You know you're going to use it. Okay? Under US GAAP, a deferred tax asset must be recognized if the realization is more likely than not. Under US GAAP, they are less stringent, more likely than not. There's a good percent chance then you can do it. They're more liberal. IAS is more stringent. Okay? Let's take a look at an example to show you how it works from a operating loss perspective. During the physical year, December 31st, this company had a not operating loss of $450,000. So the company had a loss. What happened is this, if you have losses this year, you could not use, but you could carry your losses forward because you could carry your losses forward. The loss is going to give you future taxable savings. Basically, the loss is like a deduction for you in the future. This future, the taxable saving, it's going to give you, it's going to give you the rise to the third tax asset, to the third tax asset. So let's take a look at it because the company has experienced some losses in the last several years. It cannot use the NOL carryback. So sometimes you could go back, but they cannot go back because also in prior year, they have losses. So in some countries, they allow you to go back. Now in the US, they don't allow you to go back anymore, but in some countries, they allow you to go back in future years and get a refund. But here they're saying you had losses in future years, in prior years anyway. However, the company has negotiated several new contract and management expect that it's slightly more than 50% that it will likely be able to utilize one third of the net operating loss in future years. Now what happened is the company thinks, guess what? We have new contract, things are looking good, we're going to have some income. Therefore, what's going to happen is we're going to be able to realize, we're going to be able to take advantage of this. Well, the company effective rate is 40%. Now depending on how we define the likelihood, we're assuming it's going to occur, the worth probable, it's going to occur more than 50%. We expect to be able to realize 40% of that $450,000. So we cannot realize the whole thing, but we think 40% of $450,000, it's going to be realizable. Therefore, that's going to translate into $60,000 of the third tax asset. So we book the third tax asset $60,000, credit income tax benefit $60,000. Simply put, we're going to have $60,000 of savings, of tax savings in the future, tax savings in the future, because we have we have a loss that we're carrying over. And this is what the third tax asset is. Basically, again, USGAP and IFRS, they treat it the same way. Go to my intermediate accounting if you don't understand what the computation here. Disclosure real quick. Let's talk about disclosure. IES require extensive disclosure to be made with regard to income taxes, including disclosure of the current and the third tax component. Remember, every time you compute your taxes, you have two taxes. You have the current portion and the third portion. And hopefully you know this. The standard also require an explanation of the relationship between the hypothetical tax expense based on the statutory tax rate and the reported tax expense based on the effective tax rate using one of the two approaches. Simply put, you're going to have a hypothetical tax expense, tax expense, a hypothetical one, and you're going to have the effective one. The effective one is what you actually end up paying. The effective is what did you end up paying? That's the effective. And the tax expense, the hypothetical one is based on the rate. The rate is this much. Well, the rate is this much, but how much did you end up paying? Because there are going to be differences between the tax expense, what the tax rate in a certain country is. For example, in the U.S., just to give you a quick example, right now the tax rate for corporation is 21%. That's the tax rate that's on the books. But when the company actually paid their taxes, they could, what they end up paying, maybe 10%. Maybe 3%. Maybe negative 10%. It means they get a refund. Okay. So the hypothetical rate is 20%. But the effective rate, they get a refund. Why? Because there are other deductions, other things that gave them credit. There are some tax credit that gave them a refund or reduced their tax rate. So this is what we meant by hypothetical tax expense. So as far as IAS concern, you have to reconcile those two. You have to show what is your hypothetical tax expense and what's your actual, what's your effective. There are two ways to build that reconciliation. One is a numerical reconciliation between the tax expense based on the statutory tax rate in the home country. So what's your tax rate in the home country and the tax expense based on the effective rate? What was your actual effective rate? So this is what your rate is, like 20%. But what's your effective? That could be more, it could be higher, it could be higher, it could be lower. Okay. Or you could take, you could do this reconciliation between the tax expense based on the weighted average statutory tax rate across jurisdiction. You might be in many different countries in which the company pay taxes and the tax expense based on the effective rate. Or you could look at the weighted average. So you look at your income from various countries and you compute your weighted average based on the various taxes and you say, this is what it should be, the weighted average, but I actually paid that much. Why would you pay different than the weighted average? Because there are other credits and deductions that may or may not take, may or may not be factored into your tax computation. And the best way to kind of just give you a sense of this is to look at an example. Let's take a look at this company, it's a British company, Tesco PLC and look at their tax rate. Their tax rate is 20%. So their tax, their tax rate is 20%. Okay. And they pay 29 million. That's the tax rate. However, total income tax charge for the year is 87 million. So hold on a second. How did they go from 20 million, 20% which gave them, let me just do this computation real quick just to show you where the numbers are coming from. So if we take profit before taxes, which is 145 million times 0.2 and that's going to give us 29. So this is where the 29 came from. It's it's their profit times 20%. This is what the, that's what the rate in the UK. But what the company ended up paying is 87 million. Now, why did they end up paying 87 million? Look, there are reconciliation. They're showing you, why did we pay more? Why did we pay more? Well, one major reason is there's this 82 million here. And if you look in the notes of the financial statement for this company, this was basically a penalty against this company, a tax penalty for false or misleading financial statement. So that's why they have, they had to pay more taxes. And as a result, they end up paying 87. That's that, that's not the only reconciliation. Look, they have also some credit property item tax on a different basis to accounting entries. And they have other taxes too. But overall, they end up paying more taxes. Therefore the effective rate was 60%. Although the home rate is 20%, not the home rate, the country rate, the country rate for such corporation is 20%. For just for the sake of just to tell you how crazy this is, let's look at 2016, the prior period, the rate was 20.1. But as a result of certain adjustment, the company got a credit. Basically, the government sent them a check for 54 million. And their effective rate was negative. Notice here it's negative 26.6. Simply put, the company will have to show what was the tax rate in that home country. And what's, what did we actually end up paying? This is what went by the reconciliation. And this is using this, this method, basically looking at the home country tax rate versus the effective rate. Another way to do it, the way Nestle did it is basically looking at the weighted average applicable tax rate. And they don't give us the percentage here. But based on that percentage, this is how much taxes they should pay plus or minus the adjustments, which is mostly plus, plus, plus more taxes, they end up paying this much. Okay. So just the way they compute it, it doesn't matter. Tomato, tomato, it's just, it's a different way of computing that reconciliation. But you have to show those two figures. How much I would have paid under the applicable tax rate? Because we have here, we have many jurisdiction. That's why they use the weighted average. And how much I end up paying? Show me the difference. So show me the difference. Why did that difference occur? If we look in here, just kind of show you those are two major reasons. One is change in tax rate, there was change in tax rate, and withholding tax levied on transfer of income. Again, that could be anything. You need a tax expert to explain this for you. Okay. And the prior year, they had a big tax credit prior year taxes. So they get a refund from the government here in 2015. Okay. Just this is what I understand prior year tax. Okay. Compared to us gap, let's just take a look at few more things. Temporary difference. There are certain temporary difference that are unknown under us gap. One of the temporary difference is reevaluation of property, plant and equipment. And we talked about this in IS16 under us gap. We don't have such such a temporary difference because we don't revalue property, plant and equipment. So although they use the same method, but there are certain things that under IFRS may be different under us gap, certain rules, other rules, how we determine the impairment and the amount of the impairment loss is different between IFRS and us gap. However, for presentation purposes, and this is the good news, it used to be different. Now it's easy for IS one presentation of financial statements stipulate that the third taxes may not be classified as current asset or current liabilities only noncurrent. So the question is, how should we present current, the third tax asset and the third tax liability? The answer is easy, noncurrent. It used to be very complicated for us gap. There used to be some current, some noncurrent, and you have to determine based on the status of the asset or the liability. Now it's easy for both us gap and IFRS, and this is part of the convergence. They report, they net them out and they report net noncurrent asset and not net noncurrent liability. So you cannot have current, you cannot have current. And basically that's it for this session. Again, if you feel you are short change, it's, I don't know how long it's gonna, how long the session took, but if you really want to understand accounting for income taxes, you need to spend three to four hours listening to my lecture to have a good understanding. This is an overview. This is not an intermediate accounting course. The assumption is you took your intermediate accounting, and this is just to give you an overview of the difference. If you happen to visit my website for additional lectures or my YouTube, please consider donating. If you're studying for your CPA exam, as always, study hard. It's worth it. Good luck.