LGS Inc. is a private company. You have recently been hired as the CFO for the company and are currently finalizing

LGS Inc. is a private company. You have recently been hired as the CFO for the company and are currently finalizing the company year-end report for December 31, 2011. The company has an option to follow either IFRS or PE GAAP, and has not yet made the choice. Three situations have arisen affecting the company's reporting of income taxes.

These situations are described below (assume that tax rates are 28%).

1. Shortly after you were hired, you found that a prior period adjustment had been made in 2010, and the future income tax liability account was adjusted through retained earnings as part of this error correction. The difference between the accounting value and the tax value of the related asset is $1 million. Originally, the rate used to record the future income tax liability was 25%. In 2011, the enacted tax rate on this difference is now 28% and therefore an adjustment must be made to the financial tax liability account.

2. The company has land with a building that has been recently appraised at a fair value of $10 million. Currently, the building's carrying value is $6.5 million and its original cost was $8 million. Accumulated capital cost allowance booked to date on the building is $2.3 million. (Ignore the one-time adjustments allowed to property, plant, and equipment for first-time adopters for IFRS or PE GAAP.)

3. LGS bought some equity investments during the year that are not publicly traded for a total cost of $340,000. The company purchased these as an investment to be sold in the near future. Currently, the shares have been valued at December 31, 2010, for $510,000. There were no dividends received on this investment during the year.

Instructions For each of the situations described above, discuss the options for reporting the income tax implications under IFRS and PE GAAP.

(1) An adjustment of $30,000 [$1 million X (28% – 25%)] is required to increase the future income tax liability.  However, there is a difference in how the offsetting amount to this entry is recorded under IFRS and PE GAAP.  Under IFRS, using backward tracing, as the error correction was originally recorded in retained earnings, then the related income tax impact of $30,000 must also be reported against retained earnings.  In contrast, under PE GAAP, the offsetting adjustment would be posted through the current net income. 

(2) Under PE GAAP, the assets are not revalued, (except one time on transition which is being ignored as part of this question).  Consequently, under PE GAAP, the company will not increase the value of the property to its fair value.  Under IFRS, the company has the option to adopt the revaluation method.  Using the revaluation method, the increase in the fair value of $3.5 million (10 million less $6.5 million) is reported as a revaluation surplus.  There is now a total temporary difference of $4.3 million between the accounting value ($10 million) and the tax value $5.7 million ($8 million – $2.3 million) of the asset.  The related tax impact would be to increase the future tax liability by $980,000 ($3.5 million X 28%) and the offsetting entry would be to other comprehensive income.  The total future income tax liability related to this asset would now be: $1,204,000 (10 million - $5.7 million X 28%).  This would have been recorded as follows:

In previous years: ($6.5 million – $5.7 million) X 28% = $224,000

This year’s adjustment: $980,000

Total future income tax liability: $1,204,000

(3) Under PE GAAP, the company has the option to report this equity investment at fair market value through net income or at cost.  The company also has the option to use the taxes payable method or the future income tax method (asset liability method) for reporting income taxes.  Below, these different combinations of alternatives are examined:

 i.    Equity investment at cost and taxes payable method is used:  In this case, there is no impact on the income taxes for the company.  Since LGS has not sold the investment, there are no taxes to be paid.  In addition, since the investment has not been revalued, there is no impact on the accounting income for the year ended December 31, 2011. The tax value and the accounting value of the asset are the same, and there are no reversing differences to recognize.

ii.    Equity investment at cost and the future income tax method is used for taxes.  Under these methods, the investment carrying value remains at $340,000, and no increase in value is reported in the net income.  Also, since the gain is only reported for tax purposes when realized, there is no impact on taxes payable.  As a result, the tax value and accounting value of the asset are the same at $340,000, and there is no future income tax liability.

iii.    Equity investment is adjusted to fair value, and the company uses the taxes payable method.  In this case, the asset would be increased to $510,000, and the resulting holding gain of $170,000 ($510,000 – $340,000) would be reported in net income.  However, since the company has chosen to follow the taxes payable method, only the actual amount of taxes due is recorded as an expense which is not impacted by unrealized holding gains.  There is no future income tax liability that must be reported even though there is a difference between the tax value and the accounting value of the investment.

iv.    Equity investment is adjusted to fair value and the future income tax method is used. In this case, the asset would be increased to $510,000, and the resulting unrealized gain of $170,000 ($510,000 – $340,000) would be reported in net income.  The tax value of the investment is $340,000, the accounting value is $510,000, and therefore there is a temporary difference of $170,000.  At a tax rate of 28%, the future income taxes liability account would be increased by $47,600 ($170,000 X 28%).  This tax impact would also be reported in net income.

Under IFRS, the company must report the investment at fair value, since the investment does not have contractual cash flows.  The company must report this investment as FV through NI since it is held for trading. In this case, the accounting is exactly the same as (iv) above:

In this case, the asset would be increased to $510,000, and the resulting unrealized gain of $170,000 ($510,000 – $340,000) would be reported in net income.  The tax value of the investment is $340,000, the accounting value is $510,000, and therefore there is a temporary difference of $170,000.  At a tax rate of 28%, the future income taxes liability account would be increased by $47,600 ($170,000 X 28%).  This tax impact would also be reported in net income.