Accounting for Taxes on Income: Expert Analysis under AS 22 (Accounting for Taxes on Income) and Ind AS 12 (Income Taxes)
Executive Summary: This article presents an expert-level analysis of accounting for taxes on income, referring to the Indian Accounting Standard AS 22 (Accounting for Taxes on Income) and the corresponding Ind AS 12 (Income Taxes). It discusses the fundamental accounting concepts underlying the standards, the recognition and measurement of current and deferred taxes, the distinction between timing (temporary) differences and permanent differences, and practical implications for preparers, auditors, and users of financial statements. Detailed numerical illustrations are provided to explain the computation, journal entries, presentation and disclosure issues.
1. Introduction
Taxes on income represent one of the most significant items in the financial statements of companies. Accounting for income taxes requires an understanding of both the tax legislation that determines taxable profit and the accounting framework that determines accounting profit. AS 22 and Ind AS 12 establish principles for recognising and measuring the current and deferred tax consequences of transactions and events recognised in the financial statements. While AS 22 is the legacy Indian Accounting Standard, Ind AS 12 aligns closely with IAS 12 and is applicable to entities that have adopted Ind AS. Practitioners must be able to apply both frameworks where relevant, understand the differences in approach, and prepare accurate, transparent, and audit-proof tax accounts and disclosures.
2. Fundamental concepts underlying AS 22 and Ind AS 12
Before engaging with the technical rules, it is essential to recall the fundamental accounting concepts that underpin tax accounting:
– Matching principle: Income taxes are part of the cost of earning accounting profit for a period. To reflect the cause-and-effect relation, expenses (including tax expense) should be matched with the related revenues and recognised in the period to which they relate.
– Prudence / conservatism: Estimates and recognition should err on the side of caution when uncertainty exists — particularly for deferred tax assets (DTAs) where realisation is not virtually certain.
– Substance over form: Accounting reflects the economic substance of transactions; therefore, tax consequences are accounted for based on the underlying economic effects rather than merely the tax legal form.
– Temporality of differences: Differences between taxable income and accounting profit arise due to timing (temporary) differences and permanent differences. Temporary differences lead to deferred tax accounting; permanent differences do not.
– Reliability and faithful representation: Measurements of current and deferred taxes should be based on reliable, verifiable assumptions, including enacted tax rates expected to apply when deferred taxes reverse.
3. Scope and objective of the standards
AS 22: Historically, AS 22 (issued by ICAI) prescribed accounting for taxes on income, focusing on recognition of current tax payable and deferred tax assets and liabilities arising from timing differences. Ind AS 12: Ind AS 12 (converged with IAS 12) sets out principles for recognising and measuring current and deferred tax. Its objective is to prescribe the accounting treatment for tax consequences of:
– Transactions and other events recognised in the financial statements; and
– The amounts to be included in the financial statements for current tax payable and deferred tax assets and liabilities.
Both standards aim to ensure that tax consequences of transactions are recognised in the same period as the transactions themselves and to require disclosures that help users understand the amounts recognised in the financial statements.
4. Current tax — recognition and measurement
Current tax is the amount of income tax payable (or recoverable) in respect of the taxable profit (or tax loss) for a period. Key points:
– Taxable profit is computed in accordance with tax laws and regulations, which may differ from accounting profit.
– Current tax payable (liability) or current tax recoverable (asset) is recognised based on amounts expected to be paid to or recovered from tax authorities, using enacted tax rates and laws at the reporting date.
– Adjustments to current tax for prior periods (e.g., arising from assessments, revisions of returns) are recognised in the period in which they are determined, and typically disclosed separately as prior period tax adjustments.
Journal entry for current tax expense:
1. When tax is payable:
Dr. Income Tax Expense (Profit & Loss) — total tax expense includes current + deferred
Cr. Current Tax Payable (Liability)
2. When tax is recoverable:
Dr. Current Tax Asset (Tax Refund Receivable)
Cr. Income Tax Expense (reduction)
5. Deferred tax — concept and measurement
Deferred tax arises from temporary differences between the carrying amount of assets and liabilities in the financial statements and their tax bases. A temporary difference will result in taxable amounts or deductible amounts in future periods when the carrying amount of the asset or liability is recovered or settled.
Key definitions:
– Tax base of an asset: The amount attributed to that asset for tax purposes (i.e., the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset).
– Tax base of a liability: Its carrying amount minus any amount deductible for tax purposes in future periods.
– Temporary differences: Differences between carrying amount and tax base that will reverse in the future.
– Deferred tax liability (DTL): Recognised for taxable temporary differences (i.e., when carrying amount>tax base, leading to taxable amounts in future).
– Deferred tax asset (DTA): Recognised for deductible temporary differences (i.e., when tax base>carrying amount, leading to deductible amounts in future), and to the extent future taxable profits are probable (AS 22) or it is probable that sufficient taxable profit will be available (Ind AS 12).
Measurement principles:
– Deferred tax is measured using the tax rates that are expected to apply when the temporary differences reverse, based on tax laws enacted or substantively enacted by the reporting date.
– The measurement is unaffected by future changes in tax rates that are not enacted or substantively enacted by the reporting date.
– Deferred tax balances should reflect the tax consequences that would follow from the manner in which the entity expects, at the reporting date, to recover or settle the carrying amount of its assets and liabilities (Ind AS 12 requires recognition based on expected method of recovery — e.g., sale vs use).
6. Recognition criteria and valuation allowance
– Deferred tax liabilities are recognised in full for all taxable temporary differences except where specific exemptions apply (e.g., initial recognition exemption for goodwill or initial recognition of an asset/liability in a transaction that is not a business combination and at the time of transaction affects neither accounting profit nor taxable profit).
– Deferred tax assets are recognised to the extent that it is probable (AS 22) or it is probable that sufficient taxable profit will be available (Ind AS 12) against which the deductible temporary differences can be utilised.
– Where realisation of a DTA is uncertain, a valuation allowance (or, under Ind AS 12, recognition is limited to the extent of probable future taxable profits) is necessary. Ind AS 12 requires consideration of future reversals of existing taxable temporary differences and tax planning opportunities when assessing recoverability.
– Consideration should be given to the tax planning strategies that the entity can realistically implement to secure tax benefits.
7. Timing (temporary) differences vs Permanent differences — conceptual clarity
– Timing (temporary) differences arise when the tax base of an asset or liability differs from its carrying amount but will reverse in future. Example: different depreciation methods — accounting depreciation on a straight-line basis, tax depreciation accelerated in early years — create a temporary difference.
– Permanent differences arise when certain items of income or expense are either taxable or deductible never, i.e., they will not reverse in future. For instance, penalties and fines are not deductible under tax law and create a permanent difference. Interest on tax-exempt income (certain government bonds) is also a permanent difference.
Why the distinction matters:
– Temporary differences give rise to deferred tax assets or liabilities that affect future periods and must be recognised, measured and disclosed.
– Permanent differences affect only current tax and the effective tax rate (ETR) but do not produce deferred tax entries.
8. Real-life illustration — A detailed numerical example
Consider a manufacturing company (XYZ Ltd.) with the following simplified facts for Year 1 (reporting period):
– Accounting profit before tax (PBT): INR 10,000,000
– Taxable profit (as per tax return): INR 8,000,000
– Applicable corporate tax rate: 25% (for simplicity assume no surcharge/cess)
Differences arise due to:
A. Depreciation: Accounting depreciation (straight-line) = INR 2,000,000; Tax depreciation (accelerated) = INR 3,000,000. (Temporary difference: carrying amount higher than tax base =>future taxable amounts)
B. Provision for warranties: Accounting provision recognised = INR 400,000; tax deduction allowed on actual payment only ->deductible in future when paid (deductible temporary difference)
C. Non-deductible fine: Non-deductible fine expensed in accounting = INR 100,000 (permanent difference)
D. Tax-exempt income: Dividend from certain domestic company fully exempt (or subject to dividend distribution adjustments) = INR 200,000 (permanent difference)
Let us prepare the reconciliation and compute current tax and deferred tax.
Step 1: Reconcile accounting PBT to taxable profit
Accounting PBT 10,000,000
Less: Depreciation difference (Accounting 2,000,000 vs Tax 3,000,000) ->tax lower by 1,000,000 ->reduces taxable profit
Less: Non-deductible fine (add back for taxable profit) +100,000
Less: Tax exempt dividend (deductible from taxable profit) -200,000
Less: Provision for warranty not allowed currently ->add back to taxable profit +400,000 (since deductible later)
Calculation (good practice to show):
Taxable profit = Accounting PBT
– (Accounting Depreciation – Tax Depreciation)
+ Non-deductible items
– Tax-exempt income
+ Non-deductible accruals
Taxable profit = 10,000,000 – (2,000,000 – 3,000,000) + 100,000 – 200,000 + 400,000
= 10,000,000 – (-1,000,000) + 100,000 – 200,000 + 400,000
= 10,000,000 + 1,000,000 + 100,000 – 200,000 + 400,000
= 11,300,000 (This is a stylised arithmetic example; note that earlier we assumed taxable profit 8,000,000 — for demonstration we proceed with internal calculation to illustrate mechanics)
(For consistency and pedagogy the example that follows will rebase so that taxable profit computed equals INR 8,000,000. For demonstration purposes we keep the original given taxable profit of INR 8,000,000 and explain reconciliation adjustments to illustrate temporary vs permanent differences.)
Assume taxable profit per return = INR 8,000,000.
Current tax payable = 8,000,000 * 25% = INR 2,000,000 (Current tax expense)
Step 2: Compute deferred tax from temporary differences
Identify temporary differences and tax bases (simplified):
A. Depreciation temporary difference (Tax base lower by INR 1,000,000 at year-end because tax depreciation higher): Taxable temporary difference = INR 1,000,000 =>Deferred tax liability = 1,000,000 * 25% = INR 250,000
B. Warranty provision: Deductible in future when paid; accounting shows provision of INR 400,000; Tax base less by INR 400,000 =>Deductible temporary difference = INR 400,000 =>Deferred tax asset = 400,000 * 25% = INR 100,000
Net deferred tax = DTL 250,000 – DTA 100,000 = Net DTL INR 150,000
Journal entries at year-end:
– To record current tax payable:
Dr. Income Tax Expense (P&L) INR 2,150,000
Cr. Current Tax Payable (Liability) INR 2,000,000
Cr. Deferred Tax Liability (Net recognised) INR 150,000
Explanatory note: Total tax expense of INR 2,150,000 comprises Current tax INR 2,000,000 and Deferred tax expense (net) INR 150,000 (recognised in P&L because net DTL increased). For presentation, current tax payable is a separate liability and deferred tax is presented as non-current deferred tax liability.
Step 3: Disclosure and reconciliation
Entities should reconcile the effective tax rate (ETR) computed as total tax expense divided by accounting profit before tax. A reconciliation must explain significant permanent differences (fines, tax-exempt income) and differences due to tax rate variations and deferred tax recognition. The impact of permanent differences in the example:
– Non-deductible fine (INR 100,000) increases taxable profit and hence increases current tax but produces no deferred tax effect.
– Tax-exempt dividend (INR 200,000) reduces taxable profit and current tax but produces no deferred tax effect.
9. Illustration of reversal and timing schedule (Five-year projection)
Assume the taxable temporary difference from depreciation reverses evenly over four years; warranty payments expected in year 3 and 4. A reversal schedule is useful for validating recoverability of DTA and for forecasting tax cash flows.
Year 1 (as above): DTL 250,000; DTA 100,000
Year 2: Depreciation difference reduces by INR 250,000 ->deferred tax effect reduces DTL by 62,500
Year 3: Warranty payment INR 200,000 deductible ->DTA utilised by INR 50,000; remaining warranty paid in year 4
By preparing a timetable, chartered accountants can demonstrate the timing of reversals, plan for cash tax payments, and support management’s judgement on the recoverability of DTAs.
10. Permanent differences — examples and accounting consequences
Common permanent differences include:
– Non-deductible expenses: fines, penalties, certain entertainment expenses, provisions disallowed under tax laws.
– Tax-exempt income: dividends under certain sections (historically dividend distribution taxes), certain government incentives that are tax-exempt.
– Tax credits that reduce tax payable but are not recognised as an asset under accounting rules until realised.
Accounting consequences:
– Permanent differences affect only the current tax computation and the effective tax rate (ETR).
– They should be disclosed in the tax reconciliation (PBT to tax expense) and considered when explaining ETR variances to stakeholders.
Example: If a company has accounting PBT of INR 1,000,000 and a non-deductible expense of INR 50,000, then taxable profit increases by INR 50,000, creating additional current tax of INR 12,500 at 25% rate. No deferred tax arises.
11. Presentation, classification and disclosure requirements
AS 22 and Ind AS 12 require a range of disclosures designed to help users understand the tax positions:
– Components of tax expense: current tax and deferred tax, with separate disclosure of tax relating to discontinued operations if any.
– Reconciliation of accounting profit to taxable profit and reconciliation of tax at applicable rate to tax expense (ETR reconciliation) showing the impact of permanent differences, tax rate differences, and recognition of DTAs/DTLs.
– Movement in deferred tax balances during the reporting period (opening balance, credit/(charge) to P&L, credit/(charge) to OCI, business combinations, exchange differences, and closing balance).
– Details of unrecognised deferred tax assets and reasons for non-recognition.
– Disclosure of tax contingencies and uncertain tax positions, if any, with an explanation of their nature and potential financial effect.
– Under Ind AS 12, disclosure of the amount of deferred tax recognised in OCI and directly in equity is required.
– The classification of current tax for presentation on the face of balance sheet and statement of financial position: current tax is typically a current liability or asset; deferred tax is presented as non-current under Ind AS 12 and AS 22 in many jurisdictions (Ind AS requires deferred tax as non-current).
12. Measurement complexities and judgement areas
Chartered accountants will face judgment in many areas:
– Determining tax bases for complex instruments (leases, financial instruments, derivatives) and consolidation entries.
– Determining the expected manner of recovery for assets — whether through use or sale — and the tax consequences: Ind AS 12 requires consideration of expected method (sale vs use) because tax base may differ notably for assets held for sale.
– Assessing the probability of future taxable profits for recognition of DTAs: projections, sensitivity analysis, and tax planning strategies must be documented.
– Business combinations: recognising deferred tax in a business combination requires allocation and assessment of temporary differences arising on acquisition; deferred tax consequences of goodwill and bargain purchase must be assessed.
– Uncertain tax positions and tax litigation: recognition of liabilities for uncertain tax positions requires evaluation of likelihood of outflow and measurement at expected value or most likely amount in jurisdictions permitting that approach.
– Impact of tax rate changes: Entities must apply enacted or substantively enacted tax rates at reporting date, and changes in rate require remeasurement of all deferred taxes.
13. Transitional provisions and differences between AS 22 and Ind AS 12
Differences exist between AS 22 (legacy Indian standard) and Ind AS 12; key contrasts include:
– Ind AS 12 is closely aligned to IAS 12 and contains specific guidance on measurement and presentation that may differ in detail from AS 22. For example, Ind AS 12 emphasises non-current presentation of deferred tax and requires measurement based on expected recovery method for assets.
– Transition to Ind AS requires entities to reassess deferred taxes at the date of transition and apply transitional reliefs where available. Adjustments arising from the transition often impact opening retained earnings.
– Ind AS 12 provides more detailed guidance on recognition exemptions (initial recognition exemption) and the treatment of deferred tax on investments in subsidiaries, associates and interests in joint ventures where the timing of reversal can be controlled and it is probable that reversal will not occur in the foreseeable future.
14. Practical tips for practitioners (audit and compliance focus)
– Reconcile tax returns to accounting records every year and maintain working papers that explain reconciling items, the nature of differences (temporary vs permanent), and supporting tax computations.
– Maintain schedules of temporary differences by major category (property, plant and equipment, provisions, employee benefits, tax losses, carry forward items).
– Document management assumptions about future taxable profits and tax planning strategies used to support recognition of deferred tax assets.
– Regularly review deferred tax balances for recoverability, especially when performance deteriorates or when there are significant carry-forward tax losses.
– Consider tax risks and uncertain tax positions early; where necessary, consult tax counsel and ref
Author Bio
