What is tax effect accounting?

On a company’s balance sheet, deferred tax assets are sometimes recorded as assets and deferred tax liabilities as liabilities. In recent years, because of the lower collectability of deferred tax assets, some companies have disposed of them – this often places a burden on their financial positions.

Tax effect accounting is the procedure to adjust the difference between profits in business accounting and taxable income. This is in order to reasonably match profits before deducting corporate and other taxes.

It can be a maze for financial report preparers and requires input from tax experts, because the laws that underpin tax exposures change constantly.

An example of tax effect accounting

At a small financial firm in Melbourne a capital loss of A$3,000 – which is not acknowledged as an expense under tax law – is recorded, and net income before taxes is calculated at A$2,500.

With corporate taxes at 40% and without applying the tax effect, the amount of taxes is A$2,200 (=(A$3,000 + A$2,500) x 0.4) and net income after taxes is A$300. 

If the tax effect is applied, the amount of tax adjustments of A$1,200 (A$3,000 x 0.4) is deducted from corporate taxes of A$2,200. As a result, net income after taxes becomes A$1,500.

This amount of tax adjustments of A$1,200 is recorded in the balance sheet as deferred tax assets. Note here that the amount of corporate taxes payable is still A$2,200. This is even if tax effect accounting is applied. In other words, the amount of corporate tax adjustments recorded with the application of tax effect accounting is only an accounting treatment.

Tax effect accounting guide

Financial report preparers must involve tax colleagues or tax experts and never assume they have all the information needed. Tax expertise is essential, as is an understanding of how management intends to deal with assets and liabilities.

Follow this tax accounting process:

Step 1: Consider how management intends to realise assets and settle liabilities

Step 2: Work with tax experts to ensure tax bases for all assets are clearly understood

Step 3: Ensure the appropriate accounting base is used for the set of accounts being prepared

Step 4: Calculate temporary differences towards the end of the reporting process to avoid the need to recalculate them

Step 5: Watch out for amounts booked through reserves

Step 6: Tax accounting should follow the accounting treatment of the underlying line item

Tax effect accounting in Australia

As part of the transition to the move to international financial reporting standards (IFRS) in Australia, the reporting of income tax has moved from the income statement method to a balance-based method.

The balance sheet method requires a totally new approach to the computation of income tax expense, resulting in some starkly contrasting tax figures in financial statements compared to the old method. This way makes reported earnings more sensitive to swings in tax expense resulting from large fluctuations in book and tax balances.

This transition in Australia was complicated by its interaction with the new tax consolidation regime. Unlike other countries such as the USA with tax consolidation rules, in Australia the head entity of a consolidated group assumes the entire group’s income tax liability and tax losses. But recognition of the group’s current and deferred tax liabilities in the head entity could have made the head company technically insolvent and contravened IFRS principles.

Therefore, the Urgent Issues Group (UIG) of the Australian Accounting Standards Board (AASB) issued Interpretation 1052 - Tax Consolidation Accounting to provide guidance on the recognition of current and deferred tax balances in a consolidated group and the relevance of Tax Funding Agreements (TFA) and Tax Sharing Agreements (TSA).

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