What is tax effect accounting?

On the balance sheet of companies, we sometimes see deferred tax assets recorded as assets and deferred tax liabilities as liabilities. Due to the limit of space, I will discuss only deferred tax assets here. In the recent several years, with the lower collectability of these deferred tax assets, companies have disposed of the deferred tax assets, which in many cases place a burden on companies' financial positions.

The amount of profits in business accounting is not necessarily the same as that of taxable income; in fact, there are a number of differences (hereinafter referred to as the "Differences"). Tax effect accounting is the procedure to adjust the Differences in order to reasonably match profits before deducting corporate and other taxes (net income before taxes) under business accounting with corporate taxes and the like. Under business accounting, for example, if a capital loss of 300 yen—which is not acknowledged as an expense under tax law—is recorded and net income before taxes is calculated as 250 yen, with corporate taxes at 40 percent and without applying tax effect, the amount of taxes is 220 yen (= (300 yen + 250 yen) x 0.4), and net income after taxes is 30 yen. If tax effect is applied, the amount of tax adjustments of 120 yen (= 300 yen x 0.4) is deducted from corporate taxes of 220 yen, then, as a result, net income after taxes becomes 150 yen. This amount of tax adjustments of 120 yen is recorded in the balance sheet as deferred tax assets. It should be noted here that the amount of corporate taxes payable is still 220 yen, even if the 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.

Differences as the objects of tax effect and statutory effective tax rates

There are two kinds of Differences between profits under business accounting and taxable income under the Corporation Tax Act; i.e., permanent Differences and temporary Differences. Permanent Differences include those which are recognized as expenses for accounting purposes but are not regarded as such for tax purposes, including entertainment expenses—although it may not be the case for all companies—and those recorded as revenue for accounting purposes but not regarded as such for tax purposes, including dividends income. These differences are called permanent Differences as they will not be dissipated permanently going forward. On the other hand, Differences that have been incurred in the current period but are going to be dissipated in future are called temporary Differences, which are the objects of the tax effect. For example, temporary Differences which incur deferred tax assets correspond to the cases where: losses on the valuation of inventories that are recorded for accounting purposes but denied for tax purposes, and provisions for allowances that are recorded for accounting purposes but denied for tax purposes.

The tax rates that are used in calculating tax effect are called statutory effective tax rates, which are for three taxes: i.e., the income parts of business taxes, local taxes, and income taxes. With the revision of income tax rates and the introduction of the special income tax for reconstruction, in the case of legal entities with the year-end capital of more than 100 million yen, the statutory effective tax rate for the year ended March 2012 was 40.69 percent; 38.01 percent from the one ended March 2013; and is 35.64 percent for the one ended March 2016 and after, as the special income tax for reconstruction is to be abolished.

Collectability of deferred tax assets

A little more difficult question is whether deferred tax assets have the characteristics of assets. Generally speaking, assets are defined as those instruments that will have cash inflows in future. As for the above examples, deferred tax assets are calculated by multiplying the amount of temporary Differences—which is the amount of asset impairment that is recorded as an expense for accounting purposes but is not accepted as such for tax purposes—by the statutory effective tax rate when the temporary Differences are dissipated. The monetary amount means that the amount to be paid in future as tax is paid in the current period in advance; therefore, it shows the saved cash outflow in future. In other words, it can be understood as having the characteristics of assets, because it can be interpreted as the equivalent to cash inflow in future. Accordingly, in order to record deferred tax assets, it is required that there is the sufficiency of securing in future the taxable income that will enable dissipation of temporary Differences and that there is a plan to incur taxable income such as selling the assets at that time. That is to say, future collectability is an issue when recording deferred tax assets. Moreover, it is not a problem if changes in tax rates can be taken into consideration at the time of recording deferred tax assets. If not, however, the amount of deferred tax assets will be revised when the future changes of tax rates become clear.

As a result of incorporating tax effect in the realm of accounting, the amount of assets in balance sheets will decrease with the decrease in the collectability of deferred tax assets, and it will also decrease in response to future decrease of tax rates. Under these circumstances, the disposal of deferred tax assets is being done without any relation to the earnings in the current period.