Main principle of tax effect accounting as per IAS 12:
As the objective paragraph of IAS 12 points out the principle of tax effect accounting in the way that, ‘the principal issue in accounting for income taxes is how to account for the current and future tax consequences of:
(a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an enterprise’s statement of financial position; and
(b) transactions and other events of the current period that are recognised in an enterprise’s financial statements.
IAS 12 adopts the philosophy that, as a general rule, the tax consequences of transactions that occur during a period should be ‘recognised as income or an expense in the net profit or loss for the period’ irrespective of when those tax effects will occur. A transaction may have two tax ‘effects’:
- Tax payable on profit earned for the year may be reduced or increased because the transaction is not taxable or deductible in the current year.
- Future tax payable may be reduced or increased when that transaction becomes taxable or deductible.
If only current tax payable is recorded as an expense the profit for the current year is understated or overstated by the amount of tax (benefit) to be paid or received in future years. Similarly, in the years that the tax or benefit on these transactions is paid or received income tax expense will include amounts relating to prior periods and therefore be understated or overstated.
To illustrate, consider an entity with accrued interest of $12 0000 at balance date. Assuming accrued interest is deductible only when paid, taxable profit will be $12 0000 greater than accounting profit, resulting in $36000 extra tax being paid (assuming a 30% tax rate).
In the next accounting period, the tax deduction for interest paid results in a taxable profit that is $12 0000 lower than the accounting profit. This tax benefit reduces the current tax expense by $36000 although the transaction occurred in the prior year.
To ensure that the tax effect (expense or benefit) of a transaction is recorded in the appropriate period, IAS 12 requires income tax expense to reflect all tax effects of transactions entered into during the year regardless of when the effects occur. Principle of tax effect accounting is demystified in many reference books.