On January 1, 2018 Megamart L.td had a credit balance on its deferred tax account of $3,000,000 all in respect of the difference between depreciation and capital allowances. During the year the following transactions took place: 1. $50 million was charged against profit in respect of depreciation. The tax computation showed capital allowances of $60 million. 2. During the year Megamart Ltd incurred and paid development costs of $400,000 which it has capitalised. Development costs are an allowable expense for tax purposes in the period in which they are paid. None of the expenditure was amortised at the year end. 3. Interest receivable of $56,000 was reflected in profit. However, only $40,000 of interest was actually received during the year. Interest is not taxed until it is received. 4. Interest payable of $38,000 was treated as an expense for the period. However, only $21,000 of interest was actually paid during the year. Interest is not an allowable expense for tax purposes until it is paid. 5. Megamart Ltd is an unregulated company in Jamaica with an applicable tax rate of 25%. The firm has a right of offset between its deferred tax liabilities and its deferred tax assets. Required i) Calculate the temporary differences and the effect on the deferred tax account for the year ended 31 December 2018; and (4 marks) ii) Present the deferred tax account for the period ended 31 December 2018. (2 marks) iii) Briefly discuss the nature and purpose of deferred taxation. (2 marks)
i) Calculate the temporary differences and the effect on the deferred tax account for the year ended 31 December 2018:
Temporary difference from depreciation and capital allowances:
Depreciation charged against profit: $50,000,000
Capital allowances per tax computation: $60,000,000
Temporary difference: $60,000,000 - $50,000,000 = $10,000,000
Effect on deferred tax account:
Credit balance on deferred tax account (January 1, 2018): $3,000,000
Temporary difference: $10,000,000
Deferred tax liability: $10,000,000 * 25% = $2,500,000
Deferred tax account (December 31, 2018): $3,000,000 + $2,500,000 = $5,500,000
ii) Present the deferred tax account for the period ended 31 December 2018:
Deferred tax account (January 1, 2018): $3,000,000
Deferred tax liability (December 31, 2018): $2,500,000
Net deferred tax asset/(liability): $3,000,000 - $2,500,000 = $500,000
iii) Briefly discuss the nature and purpose of deferred taxation:
Deferred taxation is a concept used in financial accounting which recognizes the impact of temporary differences between the carrying amount of assets and liabilities for book purposes and their tax base. Temporary differences arise when there are differences between the timing of recognition of gains, losses, revenues, or expenses in the financial statements and their recognition for tax purposes.
The purpose of deferred taxation is to ensure that financial statements accurately represent a company's financial position, performance, and cash flows by accounting for the timing differences in the recognition of taxable income and tax expense. It recognizes the fact that some items will result in taxable income or tax deductions in future periods, allowing for the recognition of deferred tax assets or liabilities.
Deferred taxation allows for the recognition of the tax impact of these timing differences, ensuring that tax is paid or deducted in the appropriate period. It helps to eliminate distortions in financial reporting by matching tax expenses with the revenues or expenses that gave rise to them.
In the case of Megamart Ltd, the deferred tax account reflects the temporary difference between depreciation and capital allowances, resulting in a deferred tax liability. This recognizes that the tax deduction for capital allowances will be higher than the depreciation charged against profit, leading to higher taxable income in future periods.
To calculate the temporary differences and the effect on the deferred tax account for the year ended 31 December 2018, we need to consider the following transactions:
1. Depreciation and capital allowances:
- Megamart Ltd charged $50 million against profit for depreciation.
- The tax computation showed capital allowances of $60 million.
The temporary difference is calculated as the difference between the tax base and the carrying value of the asset (depreciation expense). In this case, the temporary difference is $10 million ($60 million - $50 million).
The effect on the deferred tax account is calculated as the temporary difference multiplied by the applicable tax rate. In this case, the effect on the deferred tax account is $2.5 million ($10 million * 25%).
2. Development costs:
- Megamart Ltd incurred and paid development costs of $400,000, which were capitalized.
- Development costs are allowable expenses for tax purposes in the period they are paid.
There is no temporary difference in this case because the tax base (development costs) is equal to the carrying value (capitalized amount).
Therefore, there is no effect on the deferred tax account in this case.
3. Interest receivable:
- Megamart Ltd reflected interest receivable of $56,000 in profit.
- However, only $40,000 of interest was actually received during the year.
The temporary difference is calculated as the difference between the tax base (interest received) and the carrying value (interest reflected in profit). In this case, the temporary difference is $16,000 ($40,000 - $56,000).
The effect on the deferred tax account is calculated as the temporary difference multiplied by the applicable tax rate. In this case, the effect on the deferred tax account is $4,000 ($16,000 * 25%).
4. Interest payable:
- Megamart Ltd treated interest payable of $38,000 as an expense for the period.
- However, only $21,000 of interest was actually paid during the year.
The temporary difference is calculated as the difference between the tax base (interest paid) and the carrying value (interest treated as an expense). In this case, the temporary difference is $17,000 ($21,000 - $38,000).
The effect on the deferred tax account is calculated as the temporary difference multiplied by the applicable tax rate. In this case, the effect on the deferred tax account is $4,250 ($17,000 * 25%).
Overall, the total effect on the deferred tax account for the year ended 31 December 2018 is the sum of the effects calculated above: $2.5 million + $4,000 + $4,250 = $10,750,000.
To present the deferred tax account for the period ended 31 December 2018:
Deferred Tax Account:
Credit balance as at 1 January 2018: $3,000,000
Effect on deferred tax account for the year: $10,750,000
Balance as at 31 December 2018: $13,750,000 (credit balance)
The nature and purpose of deferred taxation refers to the concept of recognizing and accounting for tax effects of temporary differences between the carrying values of assets and liabilities for financial reporting purposes and their tax bases.
Deferred taxation is used to account for the timing differences that arise from recognizing expenses, incomes, assets, and liabilities differently for financial reporting purposes and tax purposes. The purpose is to match the recognition of tax liability or asset with the related temporary difference that is expected to reverse in the future.
It ensures that financial statements accurately reflect the current and future tax consequences of transactions and events and helps in providing a more accurate picture of a company's financial position and performance.