Anticipated and Deferred Corporate Income Tax in Companies' Financial Statements PDF

Anticipated and Deferred
Corporate Income Tax in

Companies' Financial Statements
Anticipated and Deferred
Corporate Income Tax in
Companies' Financial Statements
by
Dr. M. A. van Hoepen
1981
Springer Science+Business Media, B.V.
Distribution in USA and Canada
Kluwer Law and Taxation
190 Old Derby Street
Hingham MA 02043
USA
Cover design: Pieter J. van der Sm an

ISBN 978-94-017-4352-5 ISBN 978-94-017-4350-1 (eBook)
DOI 10.1007/978-94-017-4350-1
© 1981 Springer Science+Business Media Donlrecht

Originally published by Kluwer, Deventer, The Netherlands in 1981
Softcover reprint ofthe hardcover 1st edition 1981
All rights reserved. No part ofthis publication may be reproduced. stored in a retrieval
system, or transmitted in any form by any means, electronic. mechanical. photocopy-
ing, recording or otherwise. without the prior written permission of the publisher.
Contents
PART I. GENERAL ASPECfS OF DEFERRED-TAX ACCOUNTING
1. Background to the problem 3
The aim of this study 3

Some limitations 3
Causes of differences between taxable income and book income 4
Some operational definitions 6
The principle of common basis ('MaBgeblichkeitsgrundsatz') 7
Tax expense or distribution of profit 10
Synopsis of the study 12
Contents chapter 1 16
2. The nature of timing differences and permanent differences 17
Permanent differences, positive and negative 17

Timing differences, positive and negative, originating and reversing 20
Definitions of differences between book income and taxable income 21
Contents chapter 2 24
3. The calculation of timing differences 25
A jungle of methods in deferred-tax accounting 25

Three different methods for the calculation of timing differences 26
Evaluation of the net-change method 33
Evaluation of the static method and the group method 34
Conclusions chapter 3 36
V
CONTENTS
4. The nomenclature and classification of timing differences 37
Nomenclature and classification of timing differences in the P/L-

account 38
Two methods of allocating the tax expense in the income statement 39
Evaluation of the gross and net methods of allocating the tax ex-
pense in the income statement when there are timing differences 43
A sensible solution for the allocation of the tax expense? 44
Conclusion on the allocation of the tax expense in the income
statement 44
Nomenclature and classification of timing differences in the balance
sheet 44
The net-of-tax method in the balance sheet when there are timing
differences 47
5. The valuation of timing differences 54
Part A. Discounted or nominal value 54

One argument for discounting 55
An interlude on non-fully comprehensive tax allocation 58
Another argument for discounting 60
Conclusion on discounting deferred taxes 64
Another solution for the discounting problem 65
An evaluation of the 'liability-in-transit' method 69
Part B. Lower valuation of originating negative timing differences 71

Why the tax effect of negative timing differences does not create
assets 72
On the lower value of the tax effect of negative timing differences 73
Conclusions on the lower valuation of negative timing differences 77
6. Deferred-tax accounting in the case of loss carry-back and carry-

forward 79
Carry-back of losses 79
Carry-forward of losses 81
VI
CONTENTS
Some different views on the accounting treatment of loss carry-

forward 81
Five basic methods of accounting for loss carry-forward 83
A closer look at the basic methods of accounting for loss carry-for-
ward 85
Evaluation of the basic methods of tax-effect accounting in the case
of loss carry-forward 98
7. The offsetting of timing differences 101
The offsetting of timing differences in practice 101

The offsetting of timing differences in certain accounting standards 104
Some theoretical considerations concerning the offsetting of timing
differences 105
Conclusion on the offsetting of positive and negative timing differ-
ences in the balance sheet 107
8. Accounting for permanent differences 108
Part A. Conditional and unconditional differences 110
Part B. When is the tax effect of permanent differences realized? 113
Part C. The disclosure of permanent differences in the PIL-account 119

Book income before tax as a starting point 119
The amount of tax payable as a starting point 120
Objections to the gross and net methods 124
Conclusion on the application of the gross and net methods 126
Tax payable as a starting point and the investment credit 128
Conclusion on the investment credit 130
VII
CONTENTS
9. Summary and conclusions part I 131
Scope of the study 131

Conclusions with regard to the calculation and valuation of income-
differences 133
Conclusions concerning the presentation of income-differences 136
PART II. SOME SPECIAL ASPECTS OF DEFERRED-TAX

ACCOUNTING
10. Timing differences and changes in tax rates 143
Three methods of accounting for rate changes 143

The deferral method 146
The liability method 153
The windfall-solution as a separate method 157
Three combined methods 159
Evaluation of the methods of accounting for rate-changes 164
The case of non-proportional tax rates 165
11. Deferred-tax accounting in group accounts 168
Part A. Deferred-tax accounting in national group accounts 169

A.I. Transfer pricing in national group accounts 169
A.2. The affiliation privilege or participation exemption and
national group accounts 171
A.3. Fiscal consolidation (or fiscal unity) and national group
accounts 176
Part B. Deferred-tax accounting in international group accounts 180

B.I. Transfer pricing in international group accounts 180
B.2. International group accounts and some different methods of
relief from international double taxation 183
• Carry-forward of a foreign loss 186
• 'Carry-forward' of a domestic loss 190
• Carry-back of a foreign loss 192
• 'Carry-back' of a domestic loss 194
VIII
CONTENTS
• Conclusions on tax-effect accounting for different methods of re-

lief from international double taxation when there are losses 196
12. Deferred-tax accounting under the replacement-value theory 201
Part A. l. Tax-effect accounting in the case of a price increase; no backlog

depreciation 202
The unsuitability of the non-inclusive method to the traditional re-
placement-value theory 206
The applicability of the inclusive methods 210
A problem with the reduced version 211
The same problem with the net-of-tax method 212
The applicability of the unreduced version 213
The unreduced version amended 214
Part A. II. Tax-effect accounting and backlog depreciation in the

traditional replacement-value theory 216
Part B. Tax-effect accounting in the traditional replacement-value theory

when prices fall 219
The inclusive method with reduced revaluation in the case of a price
reduction 220
The unreduced version in the case of a price reduction 221
The non-inclusive method in the case of a price reduction 221
Conclusion on tax-effect accounting in the traditional replacement-
value theory when prices fall 224
Part C. The non-inclusive method in the case of loss carry-forward 225

The Van Gelder case 226
Evaluation of the 'Van Gelder' method 232
13. Deferred-tax accounting and inflation accounting 234
Preamble 234
Some preliminary considerations and conclusions 235
Deferred-tax accounting and inflation accounting 236
IX
CONTENTS
Part A. Deferred-tax accounting and adjusted historic cost 239

Al. Adjusted historic cost and the inclusive method with unredu-
ced correction 241
A2. Adjusted historic cost and the inclusive method with reduced
correction 242
A3. Adjusted historic cost and the non-inclusive method 243
Conclusion on deferred-tax accounting and adjusted historic cost 244
Part B. Deferred-tax accounting and current cost 245

B.l. Current-cost accounting and the inclusive method with
unreduced revaluation 245
B.2. Current-cost accounting and the inclusive method with redu-
ced revaluation 246
B.3. Current-cost accounting and the non-inclusive method 247
Conclusion on deferred-tax accounting and current cost 248
Part C. Deferred-tax accounting and simplified current-cost accounting 248

c.l. Simplified current-cost accounting (SSAP 16) and the inclu-
sive method with unreduced current cost reserve 249
C.2. SSAP 16 and the inclusive method with reduced current cost
reserve 250
C.3. SSAP 16 and the non-inclusive method 252
Conclusion on deferred-tax accounting and simplified current-cost
accounting 253
14. Loss carry-over when there are other timing differences 255
Part A. Carry-back and tax-effect accounting for other timing differ-

ences: the A-situations 259
Part B. Carry-forward and tax-effect accounting for other timing differ-

ences: the B-situatians 262
B.a. Full tax benefit is recognized in the loss year; carry-forward
turns out to be possible 262
B.b. Full tax benefit is recognized in the loss year; carry-forward
turns out to be impossible 263
B.c. In principle no tax benefit on account of loss carry-forward is
recognized in the loss year; carry-forward turns out to be possible 264
• Case Bc-I 265
• Case Bc-II 266
x
CONTENTS
• Case Bc-III 268

• The Bc-IV cases 269
• Cases Bc-V and Bc-VI 275
B.d. In principle no tax benefit on account of loss carry-forward is
recognized in the loss year; carry-forward turns out to be impossible 275
Summary of the analysis of loss carry-over when there are other ti-
ming differences 278
• Carry-back and other timing differences: The A-situations 278
• Carry-forward and other timing differences: The B-situations 279
15. Summary and conclusions part II 282
Changes in tax rates 282

Deferred-tax accounting in group accounts 283
Deferred-tax accounting under the replacement-value theory 285
Deferred-tax accounting and inflation accounting 288
Combination of loss carry-over with other timing differences 288
Bibliography 291
XI
Part I
General aspects of deferred-tax accounting

1. Background to the problem
The aim of this study
It might seem superfluous to write a study on the incorporation of deferred and

anticipated income taxes in companies' financial statements, or on tax-effect
accounting. There is a substantial literature on this subject and it might seem
questionable how much scope there is for further work. However, much re-
mains to be done, because a large proportion of the literature, mainly consist-
ing of papers, is very fragmentary and there is no systematic treatment. Even
in more comprehensive studies like the recommendations of professional ac-
countancy bodies (e.g. the U.S. AP.B.-opinion no. 11 of 1967, the British
S.S.AP. no. 11 of 1975 and no. 15 of 1978 and the I.AS.C. International Ac-
counting Standard no. 12 of 1979) or in more extensive studies (partially based
on those recommendations) like Stitt (1976), Black (1966) or Finnie (1973) -
see bibliography -, a systematic treatment is not offered. What is mainly miss-
ing is the discussion of the valuation, nature, nomenclature and classification
of differences between book income and taxable income. Most of the litera-
ture focuses on the calculation side of the problem and on problems arising
when tax rates change. We describe the question at issue briefly as the problem
of deferred taxation!, since this is more important than anticipated taxation.
Some limitations
A delimitation of the problem is necessary in order to get a clear picture of

deferment and anticipation of income taxes in companies' financial state-
ments. The limitations in this study are as follows:
1. The term 'tax allocation' has only occasionally been used in this study, as this term is fre-
quently restricted to the segmentation of the tax burden in consolidated financial statements.
See, inter alia: R. P. Weber: 'The allocation of consolidated federal income tax liabilities with
some related accounting and legal implications', The University of Michigan, Ph.D., 1975.
3
BACKGROUND TO THE PROBLEM
a. The problem is considered only for a company as a going concern, a

usual assumption in financial accounting and as a consequence in tax-effect
accounting as well, the problem of tax-effect accounting being essentially a
matter of inter-period allocation of expenses and revenues and losing its
importance with the liquidation of the company. Of course, the problems
concerned with balance sheets and P/L-accounts are quite different in the
latter situation.
b. The subject of this study is the treatment of deferred and anticipated
corporate income tax in companies' annual accounts; so we are speaking
about the simultaneous fair presentation of income and capital for a compa-
ny (as a going concern). The independent determination of capital value,
that is when the determination of capital value is the only goal of balance
sheet presentation, leads to different opinions and requirements with re-
gard to tax-effect accounting. 2 And the treatment of income tax in the
'Statement of Source and Application of Funds' is not separately analysed.
c. The main starting point of this study has been the Dutch taxation sys-
tem, peculiarities of which are described wherever it is thought necessary
for a proper understanding of the subjects discussed. In order to apply the
conclusions more broadly, other points of reference have been the taxation
systems and accounting standards of the Federal Republic of Germany, the
United Kingdom and the United States of America.
d. Only profits tax is taken into consideration, capital taxes being left out
of account; in so far as they are dealt with, it is only in comparison with
profits tax.
e. The focus of the discussions is on profits taxes levied at a proportional
rate. The problem of non-proportional rates is comparable with that of
changing rates and is dealt with as such.
Causes of differences between taxable income and book income
Deferred-tax accounting is a direct outcome of differences between book in-

come (for publication purposes) and taxable income (in accordance with tax
legislation). Tax legislation itself and rules governing the computation of tax-
able income are often grounded on political considerations, such as a proper
distribution of the tax burden, stimulation or discouragement of investments,
etc.
2. For a good survey of (mainly German) literature see:

• F. Remmlinger: 'Unternehmensbewertung und Ertragssteuern', D.B. 1963. page 1263.
• K. Kolbe: 'Theorie und Praxis des Gesamtwertes und Geschiiftswertes der Unterneh-
mung'. 3rd printing, Dusseldorf, 1967.
• 'Zum Problem der Berucksichtigung der latenten Ertragssteuerbelastung bei der Ver-
mogensermittlung', Institut Finanzen und Steuern, Brief 173. Bonn. 1977.
4
DIFFERENCES BETWEEN TAXABLE AND BOOK INCOME
The aim of published financial statements, is, broadly speaking, to provide

information for a wide range of a company's participators and outsiders, who
have widely differing interests. Differences between book income and taxable
income can thus arise from very different causes; the most frequent differences
are:
a. Differences between what is regarded as the nature of income accord-

ing to fiscal rules and according to accounting standards; for instance, some
expenses, regarded as necessary by the manager of a company, may not be
deductible for taxation purposes.
b. Differences between the method of profit calculation adopted or pre-
scribed for purposes of publication (the published accounts) and that (or
those) prescribed by or acceptable to the fiscal authorities, i.e. different
systems of matching costs and benefits for calculation of taxable income and
book income.
c. Special fiscal rules or tax reliefs or subsidies (like accelerated deprecia-
tion, investment grants and investment allowances) which have nothing to
do with the concept of income or the method of profit calculation, being
special measures of the government aiming at certain goals (like the stimu-
lation of investment or the achievement of a more equal income distribu-
tion).
d. Treatment of losses by the fiscal authorities different from what is con-
sidered allowable in financial accounting.
A more detailed exploration of differences would be of little vahie, primarily

because a rigid scrutiny of the causes of differences between book income and
taxable income is not the aim of this study and would not be essential to a study
of deferred-tax accounting; besides, these causes may differ from country to
country, in line with differences in the taxation system and accounting stand-
ards.
Nevertheless it is a fact that most authors point to the difference between
depreciation methods used for tax purposes and for financial reporting as be-
ing the most frequent cause of differences between book income and taxable
income in their country. A striking case in point is Table 1.1, which shows the
nature of frequently disclosed timing differences (defined in chapter 2 of this
study) giving rise to deferred taxes, for 600 survey companies that form the
basis for the American 'Accounting Trends & Techniques'.
Such a statement of the differences between book income and taxable income
may, of course, be affected by the application of inflation accounting for publi-
cation purposes (see chapter 12 and chapter 13).
5
Table 1.1: Timing differences - Reasons3
Number of companies with fiscal

years
Ending no later than January 31 1976 1975 1974 1973
Depreciation 469 504 477 459

Unremitted earnings 146 156 122 92
Instalment sales 77 68 72 66
Inventory valuation 69 88 56 35
Other employee benefits 67 60 66 50
Pensions 53 55 62 43
Long-term contracts 47 40 35 22
Warranties and guarantees 21 30 26 20
Some operational definitions
Taxable income is defined as: the profit of a company as it is presented to and

accepted by the fiscal authorities.
Book income is defined as: the profit as it is shown in published financial state-
ments which are accompanied by an auditors' certificate unqualified as to the
amount of profit. In that case the amount of profit can be considered to be in
accordance with accounting standards (U.S.A. and U.K.), standards that are
regarded as acceptable in economic and social life (The Netherlands), the
practice and standards of the good businessman (West-Germany) or whatever
may be the rules governing the calculation of income published in financial
statements.
The distinction between the definition of taxable income and book income
means by implication that there can be a difference in amount between the
two. This difference is mostly taken for granted because of the different pur-
poses of calculation of taxable income and book income. Only in the Federal
Republic of Germany (and to a lesser degree in France and Belgium) has there
been a discussion about the principle of a common basis for the annual ac-
3. 'Accounting Trends & Techniques 1977', Table 3-12, page 262. American Institute of
Certified Public Accountants, Inc., New York, 1977.
6
PRINCIPLE OF COMMON BASIS
counts for purposes of both publication and taxation ('der Ma8geblich-

keitsgrundsatz'). 4
The principle of common basis ('Ma8geblichkeitsgrundsatz')
In general terms the principle of common basis means that there is an identity
between the tax balance sheet and the balance sheet for publication purposes
and consequently between taxable income and book income. W. GaiP men-
tions some advantages of the principle of common basis:
a. '... in the case of income derived from trade and industry the regular
commercial balance sheets form the best and safest basis for the assessment
of income tax',
b. ' ... no amounts can in principle be shown on the assets side of the tax
balance sheet which under mercantile law are forbidden from being so
shown' and 'liabilities, the entry of which is obligatory under mercantile
law, must be shown without fail on the tax balance sheet'. This guaran-
tees that' ... the assets shown on the tax balance sheet (are) not lower, nor
the liabilities higher than those shown on the commercial balance sheet' ,
c. '... the valuation rules' designed to protect creditors apply to the tax
balance sheet just as much as to the commercial balance sheet',
d. ' ... there are no differences between the tax balance sheets of the dif-
ferent legal forms, so that the principle of uniformity of taxation - at least
as far as the ascertainment of profits is concerned - is ensured by the
principle of common basis',
e. ' ... the unity of legal discipline would be in danger and a definite safe-
guard from one-sided fiscal interpretations of accounting principles would
be removed if the principle of common basis was not adhered to',
f. '... the fiscal authorities must be shown a limit with respect to ... the
valuation of assets and for guaranteeing that all liabilities are included'.6
4. This principle of common basis in W-Germany is based on section 5, paragraph 1 of the

German Income Tax Law ('Einkommensteuergesetz'), which lays down that every en-
trepreneur who is required by law to keep accounts, and any who volunteer to do so, have to
draw up their balance sheets in accordance with the principles of proper bookkeeping and
preparation of balance sheets (,handelsrechtliche Grundsatzen ordnungsmaBiger Buch-
fiihrung und Bilanzierung').
5. W. Gail: 'Gemeinsamkeiten und Abweichungen zwischen Handels- und Steuerbilanz in
<;Ier Bundesrepublik Deutschland', Journal U.E.C. January 1,1973, page 9 (quoted from the
English translation).
6. The last two arguments are from: 'Translation of the reply by Dr. Winfried Gail,
Heidelberg, to the article by Prof.drs. Burgert on the common features and differences be-
tween commercial balance sheets and balance sheets for taxation purposes in the Nether-
lands', Journal U.E.C., January 1, 1973, page 57.
7
These advantages of the principle of a common basis correspond to those men-

tioned in the Chartered Accountants' Handbook ('Wirtschaftspriifer Hand-
buch'). It should be noted that the first five advantages do not hold true unless
there is a merely formal dependence of the tax balance sheet on the commer-
cial balance sheet. But this formal dependence causes the commercial balance
sheet to be virtually dependent on the tax balance sheet. In W-Germany this
virtual dependence ('umgekehrte Ma8geblichkeit') is even corroborated by
the fact that the tax law provides that the principle of common basis also ap-
plies to tax reliefs (such as accelerated depreciation); in most cases tax relief is
given only if the appropriate entries are also made in drawing up the commer-
cial balance sheet. 7 R. Burgert8 , in discussion with W. Gail argues for a com-
plete seperation between tax balance sheets and commercial balance sheets. In
his opinion:
a. the practical dependence of the commercial balance sheet on the tax

balance sheet' ... (undermines) the main purpose of the commercial balan-
ce sheet ... (The difference in) purposes of tax balance sheet and commer-
cial balance sheet can cause many conflicts'9;
b. the second argument (of Gail) does not hold true, because' ... the tax
payer is attempting to include in the tax balance sheet the least possible as-
sets and the most possible liabilities'.
For a proper understanding of the matter, it should be made clear that the
German 'Ma8geblichkeit' is not so rigid as to require a strict identity between
commercial balance sheet and tax balance sheet. If there were a strict identity,
the problem of deferred taxation would not exist. There is no such identity in
W-Germany; on the contrary, the German Chartered Accountants Handbook
states that, especially for corporations, the tax balance sheet usually differs
7. See: G. W6he: 'Betriebswirtschaftliche Steuerlehre', Frankfurt a.M., 1966, 2nd printing,

Band I, page 223. For this reason it is formally incorrect to speak of a tax balance sheet in W-
Germany, since the tax balance sheet is derived from the commercial balance sheet. It is the
commercial balance sheet, corrected for a few items, that is taken as the tax balance sheet.
8. R. Burgert: 'Gemeinsamkeiten und Abweichungen zwischen Handels- und Steuerbilanz
in den Niederlanden'. Journal U.E.C., January 1, 1973, page 49 and on (quoted from the
English translation).
9. The same argument led the German Tax Reform Committee of 1971 to propose, among
other things, that the rule of common basis be abandoned and an independent tax balance
sheet be introduced. See: 'Gutachten der Steuerreformkommission', 1971 and 'Referen-
tenentwurf eines Einkommensteuergesetzes', Bonn, 1971.
8
PRINCIPLE OF COMMON BASIS
from the commercial balance sheet. 10 Nevertheless the tax effect of these dif-
ferences cannot be disclosed in the published financial statements in Germa-
nyll - at least as far as public companies are concerned - because of the specif-
ic commands and prohibitions regarding the creation of assets and liabilities
under German Company Law. 12
The second argument of Burgert, given above, leads to the way in which
taxes are looked at by companies. As long as a company is trying to maximize
long-term net profit instead of profit before tax l3 , the company does not like
paying tax at all; but if it has to, it will try to pay as late as possible (unless, of
course, an increase in rates is expected).
For the calculation of book income, on the contrary, the company may try to
include as many assets and as few liabilities as possible in the balance sheet.
This different position of the company with respect to the calculation of book
income and taxable income, together with the different purposes of calculation
of the two profit figures (roughly: proper information on the one hand and a
proper basis for allocation of the tax burden on the other) makes the principle
10. The best-known examples of these differences arise because the German Income Tax
Law allows the taxpayer to create several temporary tax-free reserves, that are disallowable
according to the principles of proper bookkeeping and preparation of balance sheets under
company law ('Aktiengesetz'). The 'Riicklage fiir Ersatzbeschaffung' (a temporary tax-free
reserve for procuring replacements, according to Section 35 of the 'Einkommensteuer-Richt-
linien') and the 'Riicklage fur Preissteigerung' (a temporary price-increase reserve, to com-
pensate for sharp fluctuations in prices, according to Section 228 of the 'Einkommensteuer-
Richtlinien') need not be shown in the commercial balance sheet, as stipulated in Section 228
of the 'Einkommensteuer-Richtlinien'.
11. For a more complete analysis of these differences see:
• o. Bahler and P. Scherpf" 'Bilanz und Steuer', Munich, 1971, 7th printing;
• W. Gail: 'Gemeinsamkeiten und Abweichungen ... ' Journal U.E.C.;
• H.I. Gumpel: 'Taxation in the Federal Republic of Germany', 2nd edition; Harvard
Law School, World Tax Series;
• R.I. Niehus: 'Generally accepted accounting principles in Germany and the consistency
and accruals concept', Journal U.E.C., No.3, 1973.
• F. Ziegler: 'Tendenzen zur Wende der Steuerbilanz zur Handelsbilanz', Die steuerliche
Betriebspriifung, Heft 1, 1977.
12. For the same conclusion on deferred-tax accounting under German Company Law see 1.
Schultzke: 'Zur Verrechnung des Ertragssteueraufwandes in der Handelsbilanz', Die
Wirtschaftspriifung, no. 9, May 1974, page 239.
13. During the last few decades, the so-called behaviourists have put forward much criticism
of this neo-c1assical theory of the firm. For a repartation of this criticism in the field of compa-
nies' reactions to taxation, see: P. W. Moerland: 'Firm behaviour under taxation', 's-Graven-
hage, 1978.
9
of common basis inadvisable for a proper financial accounting system. 14 When

the principle of common basis is strictly adhered to, the problem of tax alloca-
tion loses its importance.
Tax expense or distribution of profit
Another problem on which we have to take a position if} advance is whether

the amount oftax paid is to be regarded as an expense or as part ofthe distribu-
tion of profits.
When the amount of tax to be paid on a yearly basis is regarded as part of the
distribution of profits, there is hardly a problem of deferred or anticipated tax-
es at all. In that case the government only takes a part of the profit which can
differ from one year to another depending on the differences between the cal-
culation of taxable and book income. From this point of view the problem of
deferred and anticipated taxes can arise when the company wishes to achieve a
certain equalisation of the amount of profit to be distributed to the govern-
ment. 15 This point of view of the government as a profit-sharing institution will
generally present the following difficulties:
a. There is mostly no direct contribution from the government to the

company, on which the right to share in the profits is based, as it is with
shareholders and employees in Western economic systems;
b. Profit sharing generally means loss sharing as well; the sharing of losses
by the government, however, is in most countries limited;
c. Profit sharing normally imposes on the profit sharer an obligation to
abide by rules in the sense that there is a sharing of business profit; the gov-
ernment, on the contrary, prescribes its own rules for the nature and calcu-
14. A further problem, especially for smaller companies, is whether companies should make
two sets of annual accounts (one for tax and one for publication purposes), or in other words
whether it would be acceptable to present the accounts for tax purposes to the public. I agree
with Sanders and Burgert that for The Netherlands this may be acceptable as long as the com-
pany has not used fiscally allowable valuation systems and tax reliefs in such a way that the
presentation of equity and profit becomes unacceptable for purposes of publication. (P. San-
ders and R. Burgert: 'De jaarrekening nieuwe stijl', Alphen aid Rijn, 1977.)
15. J.P. van Rossem seems to argue, that even when taxes are considered as an appropria-
tion of income rather than an expense, some kind of deferred-tax accounting should remain.
As the amount of tax payable is of a strictly unavoidable nature, only the net profit (after tax)
is at the disposal of those entitled to the proceeds ofthe enterprise apart from the fiscal author-
ities. Van Rossem concludes: 'Even if taxes are considered as being an appropriation of in-
come, rather than a cost, the unavoidable nature of income taxes will be expressed by disclos-
ing the total burden as connected with the result of the period'. J.P. van Rossem: 'Various
concepts to account for income taxes in general purpose financial statements', Working docu-
ments of the 11th International Congress of Accountants, Munich, October 10-14, 1977.
10
TAX EXPENSE OR DISTRIBUTION OF PROFIT
lation of the profit which is to be shared, and these rules do not agree with
the accounting principles adopted by the individual company whose profit it
whishes to share.
Most accounting textbooks follow the neo-classical line of maximization of

long-run after-tax profit within constraints or (as concerns investment decis-
ions) follow the line of maximization of discounted net cash-flow. It can be said
that in the economic and accounting literature of the countries in the Western
economic system the tax-levying government is not regarded as a profit sharer.
Taxes are mostly regarded as an expense, though an expense with some re-
markable characteristics. First, these expenses are not paid for the direct sup-
ply of economic goods to the individual company, so they are not an outlay of
the company arising from the profit motive. It could be argued that the amount
of tax paid is an expense by the company for a sound economic climate, but
then the problem remains that companies which do not need a change in eco-
nomic climate (i.e. those earning a satisfactory income) are 'buying' a change
in economic climate at a considerable price, whereas companies who need a
change in economic climate pay less or even nothing.
Second, the importance of the tax expense depends on the amount of fiscal
profit and so on the amount of the expense. That is the reason why most fiscal
authorities do not accept the income tax as deductible. But this calculation
argument does not preclude treating income taxes as expenses for publication
purposes. It is only if corporate income tax is regarded as an expense that the
problem of deferred taxes arises. As was said earlier, the amount of tax levied
does not depend on book income but on taxable income. The government
prescribes its own rules for the nature and calculation of taxable income. With-
in the limits of those rules, a company trying to maximize a discounted net
cash-flow will try to pay as few taxes as possible and, if it must pay, to do so as
late as possible, i.e. the company will choose those valuation-rules which mini-
mize the discounted taxable income, in order to minimize the discounted tax-
outlay. But valuation-rules selected for their discounted-income-minimizing
qualities will only by chance give a fair presentation of equity and profit for
publication purposes. And if so, a company may simply wish to apply different
accounting standards from those which happen to minimize discounted tax-
able income.
As long as the total taxable income over the lifetime of a company equals the
book income over the lifetime, the total tax expense equals the tax rate times
total book income; but this relation does not necessarily hold for each individ-
ual year; so the yearly tax-payment cannot be treated as an expense for that
year, and must be matched with i"ncome earned in other years.
There are two ways of presenting corporate income tax as an expense in
financial accounts. One can charge the total tax expense to the P/L-account as
a seperate item or one can allocate the tax expense to the cost of goods sold and
11
other cost figures. This problem of tax allocation within the P/L-account for
one year is closely connected with the question whether taxes are passed on to
consumers and others who have dealings with companies.
As this problem of tax shifting is not the subject of the present study and as
the problem of matching the yearly tax expense arises in both cases, income tax
will be treated as a separate item in most of the following examples, for the
sake of simplicity.
Synopsis of the study
a. The aim of this study
This study is aimed at a systematic treatment of deferred taxation in compa-

nies' annual accounts. The general aspects of deferred taxation are treated in
part I, assuming a constant tax rate, the absence of parent/subsidiary relation-
ships, the absence of inflation and assuming to a large extent the absence of
other timing differences in case of loss carry-over. These assumptions have
been dropped one by one in part II of this study, as it were in an order of dimin-
ishing abstraction.
b. The nature of timing differences and the method of calculation
In part I of this study a set of formal definitions has been developed first, argu-
ing from the nature of timing differences and permanent differences. As to the
way in which the tax effect of timing differences can be calculated, only the
static method or individual method appears to be appropriate. Grouping of
timing differences is considered quite normal in the literature, but a satisfacto-
ry grouping has to respond several criteria simultaneously. To avoid the
cumbersome calculations of the static method a grouping of timing differences
according to the cause of origination seems a good starting point.
c. The nomenclature and classification of timing differences
As regards the nomenclature and classification of timing differences, there is a

lot of difference in practice, obviously arising from confusion as to the nature
of timing differences. A special problem in this field is the allocation of the tax
expense in the income statement to different parts of income. This problem
has been treated in chapter 4 for timing differences and in chapter 8 for perma-
nent differences. The conclusion is that if there is a drastic segmentation of the
12
SYNOPSIS OF THE STUDY
income statement, the segmentation must evitably be restricted to gross fig-

ures (before tax).
An apparent misunderstanding of the nature of timing differences causes
the fact that only a few authors have drawn the conclusion, that the amounts of
deferred and anticipated taxes in the balance sheet due to timing differences,
can only be regarded as transitory items, originating because of application of
the matching principle to the PIL-account.
d. The valuation of timing differences
The misunderstanding as to the nature of timing differences causes almost a

jungle of methods and opinions in the field of deferred-tax accounting. Espe-
cially with regard to the valuation of timing differences, there are debates on the
present-value calculation of the tax effect of timing differences, on the ap-
plication of so-called non-fully comprehensive tax allocation and on the non-
asset nature of originating negative timing differences. However, an explicit
treatment of the last problem can only scarcely be found in the literature, proba-
bly because most writers argue for the offsetting of positive and negative timing
differences.
It is argued in this study that the three opinions mentioned above are not in
line with the transitory-nature of deferred (and anticipated) taxes; moreover,
they are not in line with the going-concern and accrual assumptions in financial
accounting.
e. Loss carry-back and carry-forward
Reluctance to show the tax effect of an originating negative timing difference

as an asset in the balance sheet grows when it comes to originating negative
timing differences because of loss carry-forward. Contrary to most of the liter-
ature, only a (prudent) estimate of the tax effect of loss carry-forward is found
to be in line with the facts that the loss causes the tax reduction in later years,
but that the value of the loss carry-forward depends on the amounts of future
taxable income.
Yet another method (assurance beyond any reasonable doubt) is in line with
these facts. However, this rather popular method makes the value of the tax
effect of loss carry-forward dependent on (the relation between taxable in-
come and pre-tax (book-) income in the past.
13
f The offsetting of timing differences
The systematic treatment of deferred-tax accounting gives hardly any opportu-

nity for conclusions on the offsetting of the tax effect of positive and negative
timing differences in the balance sheet, in contrast to the problems mentioned
above. As it is very hard to discover to what extent timing differences are offset
in practice and as the international accounting standards give contrary direc-
tions as to offsetting, chapter 7 undertakes to give some hints ofthis subject.
g. Accounting for permanent differences
Looking to the nature of permanent differences, it could be supposed that pro-

ponents of comprehensive tax allocation will reach the same conclusion about
permanent differences as the advocates of flow-through accounting and sup-
porters of non-fully comprehensive tax allocation.
But this apparent uniformity of opinion is overridden by the conditional
character of many permanent differences. Such is illustrated by the different
methods of accounting for the investment credit. Adherence to the going-con-
cern assumption implies that permanent differences should be treated as per-
manent differences irrespective of their potentially temporal character. Pref-
erence is given to the flow-through method, which is not very popular in The
Netherlands but prevailing in the U. S .A. Moreover, the deferral method is not
compatible with taking tax payable as a starting point for disclosure of the tax
expense in the income statement.
h. Timing differences and changes in tax rates
The first assumption that has been dropped in part II of this study is that of a
constant tax rate. The principle question in this case is to which period the
gains and losses from a change in the rate of tax are to be allocated. Arguing
from the nature of timing differences, that is to say from a proper application
of the matching principle, some evidence can be found in favour of the windfall-
solution. In the windfall-solution, which is very scarcely defended in the litera-
ture, the tax effect of a change in the tax rate is allocated to the period of rate-
change.
i. Deferred-tax accounting in group accounts
The next assumption that has been dropped is that of the absence of parenti
subsidiary relationships. There is not much literature on deferred-tax account-
14
SYNOPSIS OF THE STUDY
ing in group accounts. One of the subjects treated in chapter 11, deferred-tax
accounting in international group accounts for different methods of relief from
international double taxation, is completely unknown in the literature.
j. Deferred-tax accounting under the replacement-value theory
In contravention to the method of diminishing abstraction applied in part II,

deferred-tax accounting under the replacement-value theory has been treated
prior to some of the best-known methods of inflation accounting. The reason for
this deviation is that there has been a rather extensive discussion on deferred-tax
accounting under the replacement-value theory in The Netherlands. The three
methods of deferred-tax accounting under the replacement-value theory that
are discussed have been called the non-inclusive method, the inclusive method
with reduced revaluation and the inclusive method with unreduced revaluation.
The conclusion is that only the inclusive method with unreduced revaluation
offers an appropriate way of deferred-tax accounting under the traditional re-
placement-value theory. This method finds only a limited defense in the litera-
ture, though it finds some application in practice, at least in The Netherlands.
k. Deferred-tax accounting and inflation accounting
After that, these three methods of deferred-tax accounting have been applied
to an adjusted historic cost system according to the British E.D. no. 8, to cur-
rent-cost accounting according to Sandilands and to a simplified current-cost
accounting system according to the British S.S.A.P. no. 16. This may seem a
bit superegatory but, except for Sandilands, none of the propositions on infla-
tion accounting is very distinct about deferred taxation.
The inclusive method with unreduced revaluation, with an unreduced cur-
rent-cost reserve or with an unreduced correction for the diminishing purchas-
ing power of equity is the appropriate method of deferred-tax accounting for
the three types of inflation accounting discussed. As regards current-cost ac-
counting, this conclusion differs from the Sandilands Report, that favours the
inclusive method with reduced revaluation.
I. Loss carry-over when there are other timing differences
Some authors combine their consideration of the accounting treatment of loss

carry-back and loss carry-forward with an analysis of the significance of the
origination and reversal of positive timing differences. Since this does not con-
duce to a clear analysis and since the existence of other timing differences can
15
at best contribute to the probability of reversal of negative timing differences

due to loss carry-forward, loss carry-over has been treated in part I of this
study, as far as possible, under the assumption of the absence of other timing
differences. This assumption has been dropped in chapter 14 of part II.
There is only one author (H.A. Black), who thusfar made a rather profound
analysis of the combination of loss carry-forward and/or carry-back and the
origination or reversal of other timing differences. Although his conclusions
are acceptable, a more general analysis can nevertheless be made. For that
object, 40 cases have been analysed for different methods of accounting for
loss carry-over. This analysis leads to the conclusion that there are only a few
situations in which accounting adjustments of deferred-tax credits or debits
deserve serious consideration.
Contents chapter 1
The aim of this study is to give a systematic analysis of deferred taxation in

companies' annual accounts. The limitations in this study have been revealed.
The most frequent differences between taxable income and book income have
been stated in general. Operational definitions of taxable income and book
income have been given. Some advantages and disadvantages of the principle
of a common basis for taxable income and book income have been discussed.
When the principle of common basis is strictly adhered to, the problem of
deferred taxation loses its importance. It is assumed that the amount of tax
paid is regarded as an expense. When the amount of tax to be paid on a yearly
basis is regarded as part of the distribution of profits, there is hardly any prob-
lem of deferred taxation. Finally a synopsis of the study is given.
16
2. The nature of timing differences and
permanent differences
The disruption of the causal relationship between the amount of tax payable
and book income, in the case of a difference between book income and taxable
income, can be permanent or temporary. This distinction is mostly referred to
as the distinction between permanent differences and timing differences. In
the case of permanent differences it is impossible to restore the causal relation-
ship between book income and the amount of tax payable. So let us first look at
these permanent differences.
Permanent differences, positive and negative
In the case of permanent differences the fiscal authorities are levying tax on a
profit figure which differs from book profit as shown in the annual accounts
without 'correcting' the taxable income in later years. There is a difference
between total income over the lifetime of a company calculated by the compa-
ny and that calculated by the fiscal authorities. In other words, there is a differ-
ence between 'total income' for publication purposes and that for tax pur-
poses. These permanent differences can themselves be of two types.
First, there are those permanent differences for which 'total income for tax
purposes' in only corrected at the moment of termination of a company. An
example of this is that, possibly as a tax incentive, an amount of income can be
retained for tax purposes only, without tax payment for the time being, tax on
it being payable in principle at the end of the lifetime of the company. This
reversal of the difference! is not to be taken into account in the calculation of
1. Sometimes called quasi-permanent differences. See I.P.A. Stitt: 'Practical aspects of

deferred tax accounting', London, 1976, page 4. Stitt mentions two examples of these qua!i- ,
permanent differences in the U.K.:
a. 'Expenses charged to revenue for book purposes, which are disallowed 'for tax pur-
poses, but which may ultimately be allowed as a deduction in computing a chargeable gain
on the disposal of an asset to which they relate - e.g. professional fees incurred in the
acquisition of a company'. _
17
NATURE OF TIMING AND PERMANENT DIFFERENCES
annual book income, because the calculation and presentation of book income
in the financial statements is subject to the going-concern assumption, so that
in the annual accounts it is not permitted to take into account special tax reliefs
related to the liquidation or termination of a company. For this type of perma-
nent differences there is a disruption of the causal relationship between tax
payable and book income for a company as a going concern. A different treat-
ment, however, is necessary for the valuation of a company as a whole, in
which case the reversal of these permanent differences can become part of the
value of the company.
A second type of permanent difference arises when in the calculation of
book income an item is regarded as a cost which is not deductible for tax pur-
poses and is thus regarded as part of taxable income; e.g. certain donations of a
company which are not tax-deductible. This is referred to as a negative perma-
nent difference. A positive permanent difference can arise when an outlay is
regarded as part of profit distribution in the calculation of book income,
whereas the same outlay is regarded as a cost by the tax authorities (as may be
the case with bonus distributions to staff). Such a positive permanent differ-
ence can also arise when under tax law a certain sum can be deducted from
the amount of taxable profit (as is the case with investment allowances). For
this type of permanent differences there is a permanent disruption of the cau-
sal relationship between tax payable and book income; there is a permanent
decrease or increase of the tax burden. It looks as if corporate income tax is
levied at a different rate. In order to restore as far as possible the causal rela-
tionship between book income and tax payable and to give a clear picture of
the components of book income, it seems advisable to show the decrease or
increase of the tax burden separately, mentioning the 'normal' amount of tax
which has a causal relationship with book income, as well as the decrease or
increase. The following example offers an illustration:
--- b. 'Franked investment income', which comprises qualifying distributions received by a

United Kingdom resident company from another United Kingdom resident company, to-
gether with the related tax credit (i.e. the 'Advance Corporation Tax' - A.C.T.) paid on
that distribution by the company making the distribution. Such income is not subject to
corporation tax in the hands of the recipient company in the U. K. and may be passed on as
a dividend to that company's shareholders without any further payment of A.C.T.
These examples of permanent differences, mentioned by Stitt, may reverse before the
end of the lifetime of the company. However, they should usually be treated as permanent
differences as well as those mentioned in the text, because of the going-concern assumption
(see chapter 8).
18
PERMANENT DIFFERENCES, POSITIVE AND NEGATIVE
Example 2.1: Permanent differences create a non-reversing reduction or

increase of the effective tax burden
A bonus distribution (B) to personnel is 10% (b) of after-tax profit; this
bonus distribution is treated as part of profit distribution for publication pur-
poses, whereas the tax authorities regard it as an expense. Book income before
tax and bonus equals taxable income before bonus = I; the tax rate (t) amounts
to 48%. The resulting effective tax rate for this company is 45.38%, being:
t (1·- b)1 100

1-b.t '-1-
as can be seen as follows:

Book income = 1
Taxable income = 1 - B
Bonus = B = b (I - T)
Tax payable = T = t (I - B)
Tax rate times Book income = t . 1
Positive permanent difference (Book income> Taxable income) = 1 - (I - B)
= B = b(1 - T) = b(1 - t)1

1- b .t
Tax effect of permanent difference = t x Positive permanent difference =
t . B = b(1 - t)1 . t
1- b .t
The effective tax rate = T x (100/1)=t x (I - B) x 100/1 =
t .[1 _ b(1 - t)I]. 100 = t(l - b)1 . 100
1 - b·t I 1 - b·t I
which can be shown in the P/L-account as follows:
Tax cost according to

book income: t .1
Tax relief because of
positive permanent difference: t . b(1 - t}1
1- b.t
Tax payable/tax expense: t . (1 - b}1

1- b .t
Further details on accounting for permanent differences are given in chapter 8.
19
Timing differences, positive and negative, originating and reversing
When there are timing differences, the fiscal authorities are levying tax for a
certain year on a profit figure which differs from book income for that year, but
this difference is automatically corrected in later years. In other words, there is
no difference between fiscal 'total income' and business 'total income'; only
the inter-period allocation of costs and revenues to periods differs for the cal-
culation of taxable income compared with that for the calculation of book in-
come. When the fiscal authorities are levying less tax than corresponds to the
causal relationship between tax rate and book income tht:re is a deferred-tax
liability, which results in a higher fiscal profit in later years (a so-called revers-
ing positive timing difference). We can illustrate the latter situation with the
example of accelerated depreciation.
Example 2.2: An originating positive timing difference and its subsequent re-
versal
Suppose that the application of accelerated depreciation is in conflict with
accounting standards, the depreciation in the annual accounts being based on
the straight-line method. For tax purposes it is permitted to compute acceler-
ated depreciation of a third of the purchase price.
Purchase price of a machine is A; salvage value: nil. Economic lifetime (esti-
mated similarly for the published accounts and for tax purposes): n years.
Depreciation for fiscal purposes: one third of the purchase price as initial
depreciation, the remainder being depreciated according to the straight-line
method. Depreciation for calculating book income: straight-line method.
Tax rate: t.
Gross income before tax and depreciation: Yper year (both for tax and pub-
lication purposes). These assumptions give the following picture:
Yr Depr. for Depr. for Taxable income Book income

tax pur- publ. pur- before tax
poses poses
1 [(n+2)A]/3n A/n Y - [(n+2)A]/3n Y - A/n
2 2A/3n A/n Y - (2A/3n) Y - A/n
3 2A/3n A/n Y - (2A/3n) Y - A/n
n 2A/3n A/n Y - (2A/3n) Y - Aln

T A --x-- . n·Y - A n·Y - A
20
DIFFERENCES BETWEEN BOOK AND TAXABLE INCOME
Yr Tax payable Tax expense Tax effect of timing

differences *
1 t . [Y - {(n+2)A}/3n] t· (Y - A/n) t· [{(n-1)A}/3n] or.pos.

2 t . (Y - 2A/3n) t· (Y - Aln) -t . A/3n rev.pos.
3 t . (Y - 2A13n) t· (Y - Aln) -t· A/3n rev.pos.
n t . (Y - 2A/3n) t· (Y - A/n) -t . (Al3n) rev.pos.

T t· (n·Y - A) t . (n·Y - A) o
• or.pos. means: originating positive timing difference
rev.pos. means: reversing positive timing difterence
The corresponding book entries will be:

Year 1: P/L-account (tax expense) t· (Y - Aln)
Tax payable t·[Y - {(n+2)A}/3n]
Deferred-tax account t·[ {(n-1)A}/3n]
Year 2: P/L-account (yearly tax expense) t· (Y - Aln)
till n Deferred-tax account (rev.pos.) t . (A/3n)
Tax payable t . (Y - 2A/3n)
Unless a company expects a rise in tax rates, it will try to create as much orgi-
nating positive timing differences as possible, in order to maximize the dis-
counted cash-flow after tax.
Definitions of differences between book income and taxable income
When defining timing differences we have to consider:
a. whether they are positive (book income exceeds taxable income) or

negative (taxable income exceeds book income);
b. whether in a certain year they originate or reverse.
The following skeleton is at the basis of the formal definitions of the different
kinds of timing differences:
21
originating in deferral of a
a certain year liability
positive
?ook > !axable
mcome mcome
reversing in a payment of a
timing later year deferred-tax
differences liability
originating in anticipation
negative a certain year - of a tax claim
?ook < !axable
mcome mcome
reversing in a restitution of
later year - an anticipated
tax claim
Likewise, when defining permanent differences, we could consider:
a. whether they are positive (book income exceeds taxable income) or

negative (taxable income exceeds book income);
b. whether, at the end of the lifetime of a company, they reverse or not.
The following skeleton is at the basis of the formal definitions of the different
kinds of permanent differences:
never unconditional
reversing - permanent
positive difference
book > taxable reversing at quasi-
income income the end of a permanent
permanent company's difference
differences lifetime
never unconditional
reversing -- permanent
difference
negative
book < taxable reversing at quasi-
income income the end of a permanent
company's difference
lifetime
22
DIFFERENCES BETWEEN BOOK AND TAXABLE INCOME
The following set of definitions of timing differences is suitable for our pur-
pose:
a. The tax effect of an originating positive timing difference or an origina-

ting deferred-tax liability is an obligation against the fiscal authorities in re-
spect of those parts of book income on which the fiscal authorities are not
levying tax for the time being but will do so before the end of the lifetime of
the company as long as it remains a going concern.
b. The tax effect of a reversing positive timing difference or a reversing
deferred-tax liability for a going concern is a sum of income tax due to the
fiscal authorities in respect of those parts of book income from earlier years
on which the fiscal authorities were not levying tax then.
c. The tax effect of an originating negative timing difference or an origina-
ting anticipated-tax claim is a claim against the fiscal authorities in respect of
those parts of taxable income which are not reckoned to be book income for
the time being but will be reckoned as such before the end of the lifetime of
the company as long as the company remains a going concern.
d. The tax effect of a reversing negative timing difference or a reversing an-
ticipated-tax claim for a going concern is a sum of income tax restored or
cleared by the fiscal authorities in respect of those parts of taxable income
from earlier years which were not reckoned to be book income then but are
so now.
The definitions of permanent differences will now be clear:
e. The tax effect of a positive permanent difference is a sum of income tax

in respect of those parts of book income on which the fiscal authorities are
not levying tax or will do so only at the end of the lifetime of a company. 2
f. The tax effect of a negative permanent difference is a sum of income tax
in respect of those parts of taxable income which will never be reckoned as
book income or will be so reckoned only at the end of the lifetime of the
company.2
2. These quasi-permanent differences, that are included in taxable income only at the end
of the lifetime of a company, are sometimes (and mostly then implicitly) classified as timing
differences. To avoid a violation ofthe going-concern assumption, this classification conforms
with a partial application of tax-effect accounting to timing differences. The tax expense for a
period then excludes the tax effects of certain timing differences when there is reasonable
evidence that these timing differences will not reverse for some considerable period ahead
(see chapter 5). Such can be found inter alia in the International Accounting Standard No. 12:
'Accounting for Taxes on Income' (July 1979). This implies that the term 'quasi-timing differ-
ences' would be a better name for the differences in question. These differences are preferably
to be classified as permanent, as this fully meets the requirements of the going-concern as-
sumption.
23
In this set of definitions the originating/reversing, positive/negative timing dif-

ferences and the positive/negative permanent differences are equal to the tax
effect of the difference multiplied by the tax rate. Of course, special problems
occur if tax rates change over time. These problems will be dealt with in chap-
ter 10.
Contents chapter 2
This chapter offers illustrations of the nature of timing differences and perma-
nent differences. A set of definitions has been developed with regard to:
• the tax effect of originating positive timing differences;

• the tax effect of reversing positive timing differences;
• the tax effect of originating negative timing differences;
• the tax effect of reversing negative timing differences;
• the tax effect of positive permanent differences;
• the tax effect of negative permanent differences.
24
3. The calculation of timing differences
A jungle of methods in deferred-tax accounting
Many methods of calculating the tax effect of timing differences have been
discussed. 1 This is mainly due to the fact that in these methods of calculation
four different problems are often covered, namely:
a. the question whether changes in tax rates are to be taken into consider-
ation;
b. the question whether timing differences should be calculated at their
nominal or their present value;
c. the question whether an originating negative timing difference should
be valued at a lower amount than its nominal or present value, because the
probability of reversal is lower than 100%;
d. the question whether timing differences should be calculated on an indi-
vidual basis, a group basis or in total per period.
The calculation of timing differences when tax rates change will be treated in
chapter 10. Until then it will be assumed that there is no change in tax rates. If
timing differences are calculated at their nominal value, the moment of rever-
sal of timing differences does not influence their amounts (given a constant tax
rate). If it is accepted that there is no reason for a lower-than-nominal valua-
tion of originating negative timing differences, the moment of reversal is not
important either. Both these opinions are subscribed to in this study and their
case will be argued in chapter 5.
1. See e.g.: I.P.A. Stitt: 'Practical aspects of deferred tax accounting', London, 1976, page 22
and following. Stitt distinguishes not less than 16 different methods for the calculation of timing
differences (without taking the application of the discounted value into account).
25
CALCULATION OF TIMING DIFFERENCES
Three different methods for the calculation of timing differences
After the introduction of these simplifications (constant tax rate, nominal

valuation and no special valuation of originating negative timing differences)
there remain only three different methods for the calculation of timing differ-
ences; and the only remaining question of the four mentioned above is d.,
which will be answered in the present chapter. So the choice is between:
• method a: the calculation of timing differences on an individual basis (in

Dutch literature often referred to as the static method)2;
• method b: the calculation of timing differences on a group basis;
• method c: the calculation of timing differences on a net-change basis (in
Dutch literature often referred to as the dynamic method).2
In method a. all differences between the accounts kept for publication pur-
poses and the accounts kept for the calculation of taxable income are analysed
per individual item or transaction. In method b. the same is done but per group
of similar items or transactions. In method c. only the total difference between
taxable income and book income is analysed, i.e. as long as there are no per-
manent differences the amount of the tax expense is calculated directly from
book income.
There is no fundamental difference between these three methods. More-
over, since these methods as such have nothing to do with the valuation of
timing and permanent differences, there is no difference in the total tax effect
of the timing differences calculated under these three methods. This is illus-
trated in the next example:
Example 3.1: The static method, the group method and the dynamic method
illustrated
Taxable income and book income of a company before depreciation of ma-
chinery do not differ from each other for the four years taken into account in
this example.
In order to increase production every year, starting with year 1, a new ma-
chine is bought (at rising prices); for publication purposes the economic life-
time of these machines is estimated to be three years. The fiscal authorities
allow depreciation only over four years, on a straight-line basis, as for book
depreciation. The salvage value of these machines is estimated to be zero. The
calculation of book income and taxable income is as follows:
2. A.L. Brok: 'Latenties terzake van de vennootschapsbelasting', Maandblad voor Accoun-

tancy en Bedrijfshuishoudkunde, June 1964, page 231.
26
METHODS FOR CALCULATION
Book income year 1 year 2 year 3 year 4
• book income before depr. of

machinery 72,000 80,000 90,000 96,000
• cost of machines purchased
(lifetime 3y):
year 1 18,000 \ (6,000) (6,000) (6,000)
year 2 24,000 book (8,000) (8,000) (8,000)
year 3 30,000 depreciation (10,000) (10,000)
year 4 36,000 (12,000)
total depr. of machinery
per year: (6,000) (14,000) (24,000) (30,000)
• book income 66,000 66,000 66,000 66,000
Taxable income year 1 year 2 year 3 year 4
• taxable income before depr.

of machinery 72,000 80,000 90,000 96,000
• cost of machines purchased
(lifetime 4y):
year 1 18,000 (4,500) (4,500) (4,500) (4,500)
year 2 24,000 depr. for (6,000) (6,000) (6,000)
year 3 30,000 tax purp. (7,500) (7,500)
year 4 36,000 (9,000)
total depr. of machinery
per year: (4,500) (10,500) (18,000) (27,000)
• taxable income 67,500 69,500 72,000 69,000
If the tax rate is 50%, the application of these three methods a., b. and c. will
lead to the following calculations:
Method a.: separate computation per individual asset (static method)
year asset depr. book differ- type of the tax eff.

for tax depr. ence difference* of the
purp. diff.
1 mach. 1 4,500 6,000 (1,500) or.neg. tim.diff. (750)
2 mach. 1 4,500 6,000 (1,500) or.neg. tim.diff. (750)

mach. 2 6,000 8,000 (2,000) or.neg. tim.diff. (1,000)
27

for tax depr. ence difference * of the
purp. diff.
3 mach. 1 4,500 6,000 (1,500) or.neg.tim.diff. (750)

mach. 2 6,000 8,000 (2,000) or.neg.tim.diff. (1,000)
mach. 3 7,500 10,000 (2,500) or .neg. tim.diff. (1,250)
4 mach. 1 4,500 0 4,500 rev. neg. tim. diff. 2,250

mach. 4 9,000 12,000 (3,000) Or. neg. tim.diff. (1,500)
Method b.: computation per group of assets (group basis)

(a group being the machines available in one year)

for tax depr. ence difference * of the
purp. diff.
1 mach. 4,500 6,000 (1,500) or. neg. tim.diff. (750)

2 mach. 10,500 14,000 (3,500) or.neg. tim.diff. (1,750)
3 mach. 18,000 24,000 (6,000) or.neg. tim.diff. (3,000)
4 mach. 27,000 30,000 (3,000)** or.neg.tim.diff. (1,500)
Method c.: computations on a net-change basis (dynamic method)
year tax- book differ- type of the timing tax eft.

able income ence differences * of the
income diff.
1 67,500 66,000 (1,500) (or.neg.) or (rev.pos.) (750)

2 69,500 66,000 (3,500) (or.neg.) or (rev.pos.) (1,750)
3 72,000 66,000 (6,000) (or.neg.) or (rev.pos.) (3,000)
4 69,000 66,000 (3,000)** (or.neg.) or (rev.pos.) (1,500)
• Or.neg.tim.diff. means: originating negative timing difference(s); rev.neg.tim.diff. means:

reversing negative timing difference(s) .
•• Note that this (originating negative) timing difference of 3,000 consisted in method a. of a
reversing negative timing difference of 4,500 and originating negative timing differences of
7,500 in total.
28
From this example it can be seen that in method b. (group basis) it is the bal-
ance of timing differences which is calculated per identified group of assets.
That is no problem for the calculation of the tax effect as long as the tax rate
remains the same, since the tax effect of reversing timing differences can be
calculated at the same tax rate as the originating ones. But changes in tax rates
can make the group method a less accurate one than the static method, as will
become clear from chapter 10. As concerns method c. (net-change method) it
is clear, if there are no permanent differences between taxable income and
book income, that it is impossible to say whether a certain difference is on
balance an originating negative one or a reversing positive one (if taxable
income is higher than book income), or an originating positive one or a revers-
ing negative one (if taxable income is lower than book income). This also cre-
ates no calculation problem as long as there are no changes in tax rates. But
changes in tax rates can make the net-change method even less accurate than
the group method, as will be argued in chapter 10.
The existence of permanent differences does not necessarily create a prob-
lem for the application of the net-change method, at least as long as there is
some sort of systematic relationship between the permanent difference and
either book income or taxable income, as is illustrated in the next example:
Example 3.2. part A: The net-change method in the case of permanent differ-
ences
The taxable income and book income of a company before the depreciation
of an office building and a bonus distribution to staff do not differ from each
other for the four years taken into account in this example. The office building
is bought at the start of year 1; its economic lifetime is estimated to be 30 years
and it has no salvage value. For the calculation of taxable income an acceler-
ated depreciation is allowable oftwo-thirds ofthe purchase price of 90,000 Dfl.
The remaining amount is depreciated on a straight-line basis, as is the purchase
price for purposes of publication. Furthermore the company makes a yearly
bonus distribution to staff of 10% of positive book income before tax; the
bonus is treated as part of profit distribution for purposes of publication. This
bonus distribution, however, is tax-deductible. The tax rate is 50% and the
calculation of book income and taxable income is as follows:
Book income/Taxable income year 1 year 2 year 3 year 4
• book income before depr. 65,000 72,000 77,000 79,000

• book depreciation (3,000) (3,000) (3,000) (3,000)
• book income 62,000 69,000 74,000 76,000
• bonus distribution 6,200 6,900 7,400 7,600
29
Book income/Taxable income year 1 year 2 year 3 year 4
• taxable income before depr.

and bonus 65,000 72,000 77,000 79,000
• accelerated depreciation (60,000)
normal depreciation (1,000) (1,000) (1,000) f1,000)
• taxable inc. before bonus 4,000 71,000 76,000 78,000
• bonus distr. to staff (6,200) (6,900) (7,400) (7,600)
• taxable income (2,200) 64,100 68,600 70,400
Method a.: separate computation per individual asset or transaction (static

method)
1. depreciation of office building:
year depr. book differ- type of the tax eff.

for tax depr. ence difference * * of the
purp. diff·
1 61,000* 3,000 58,000 or.pos.tim.diff. 29,000

2 1,000 3,000 (2,000) rev. pos. tim. diff. (1,000)
3 1,000 3,000 (2,000) rev. pos. tim. diff. (1,000)
4 1,000 3,000 (2,000) rev.pos.tim.diff. (1,000)
2. bonus distribution to staff:
year expense book differ- type of the tax eff.

for tax expense ence difference* * of the
purp. diff.
1 6,200 0 6,200 pos. perm.diff. 3,100

2 6,900 0 6,900 pos. perm.diff. 3,450
3 7,400 0 7,400 pos. perm.diff. 3,700
4 7,600 0 7,600 pos. perm.diff. 3,800
30
3. loss carry-forward***:
year taxable taxable in- differ- type of the tax eff.

income come after ence difference ** of the
carry-forw. diff
1 (2,200) 0 (2,200) or. neg.tim.diff. (1,100)

2 64,100 61,900 2,200 rev.neg.tim.diff. 1,100
3 68,600 68,600 0 0
4 70,400 70,400 0 0
4. summary of tax effects:
year tax acc. tax eff tax eff of tax tax

to book of timing permanent expense payable
income differences differences
1 31,000 27,900 3,100 27,900 0

2 34,500 100 3,450 31,050 30,950
3 37,000 (1,000) 3,700 33,300 34,300
4 38,000 (1,000) 3,800 34,200 35,200
• accelerated depreciation 2/3 x 90,000 + normal depreciation (113 x 90,000)/30

•• or.pos.tim.diff. means : originating positive timing difference
rev.pos.tim.diff. means : reversing positive timing difference
or.neg.tim.diff. means : originating negative timing difference
rev.neg.tim.diff. means: reversing negative timing difference
pos.perm.diff. means : positive permanent difference .
••• loss carry-forward is supposed to lead to normal timing differences in this example, for
simplicity. For loss carry-forward, see chapter 6 and chapter 14.
Method b.: computation per group of assets (group basis)
Indentical to method a., because the example consists of only one individual
asset.
Method c.: computation on a net-change basis (dynamic method)
As the bonus distribution is a percentage of book income before tax, otherwise

than in example 2.1, the effective tax rate now becomes t x (1- b) = 0.50 x (1-
0.1) = 0.45.
31
The net-change method can now be applied as follows:
(a) (b) (c) (d) (e) (f)

year taxable income book tax pay- tax resulting tax
after loss income able expense effect of
carry-forward 0.50x(b) 0.45 x (c) timing diff.
(e)-(d)
1 0 62,000 0 27,900 27,900

2 61,900 69,000 30,950 31,050 100
3 68,600 74,000 34,300 33,300 (1,000)
4 70,400 76,000 35,200 34,200 (1,000)
Though there are permanent differences in this case the net-change method
could be applied in this part A of example 3.2. But that possibility disappears
whenever the permanent difference has no systematic relationship with either
book income or taxable income, as is illustrated in part B of this example:
Example 3.2. part B: The net-change method in the case of permanent differ-
ences
All data are the same as for part A, except that a bonus distribution to staff is
tax-deductible only in so far as it does not create a tax loss. The tax-deductible
bonus distribution in year 1 thus becomes 4,000 and the timing difference from
loss carry-forward disappears.
Application of method a. and b. leads to the following results:
year 1 2 3 4
taxable income 0 64,100 68,600 70,400

book income 62,000 69,000 74,000 76,000
tax-deductible bonus 4,000 6,900 7,400 7,600
tax acc. to book income 31,000 34,500 37,000 38,000
tax effect of timing diff. 29,000 (1,000) (1,000) (1,000)
tax effect of perm. diff. 2,000 3,450 3,700 3,800
tax expense 29,000 31,050 33,300 34,200
tax payable 0 32,050 34,300 35,200
The application of the net-change method, however, would lead to the following
incorrect results:
32
EVALUATION OF NET-CHANGE METHOD
(a) (b) (c) (d) (e) (f)

year taxable book tax pay- tax expense resulting tax
income income able 0.45 x (c) effects of tim.
0.50 X (b) differences
(e)-(d)
1 0 62,000 0 27,900 27,900

(correct=29,000)
2 64,100 69,000 32,050 31,050 (1,000)(correct)
3 68,600 74,000 34,300 33,300 (1,000)(correct)
4 70,400 76,000 35,200 34,200 (1,000)( correct)
Evaluation of the net-change method
From examples 3.1 and 3.2 it follows that the applicability of the net-change
method can sometimes be rather limited. First, there is the problem that under
the net-change method all that is apparent is a difference between taxable in-
come and book income; without further analysis of this difference it is impossi-
ble to say whether there is a permanent or a timing difference. As only timing
differences give rise to debits and credits on a deferred-taxation account and
permanent differences do not, the net-change method cannot be applied as
such, when there are permanent differences between book income and taxable
income. Whenever the permanent difference has a systematic relationship
with either book income or taxable income, e.g. the permanent difference is a
fixed amount or a fixed percentage of book income or taxable income, the
applicability of the net -change method on the basis of a calculation of the effec-
tive tax rate-1 is as was shown in part A of example 3.2. Whenever permanent
differences are subject to definite limits, the application of the net-change
method leads to incorrect results, as was shown in part B of example 3.2. In
these cases the net-change method can still be applied, provided that a sepa-
rate file of all permanent differences is kept; this means, however, that the
static method is applied to permanent differences, whereas the net-change
method is applied to the remaining timing difference between book income
and taxable income.
A second problem with the net-change method is that once the difference
between book income and taxable income is split into permanent and timing
differences it is impossible to say whether a positive amount of timing differ-
ences is on balance an originating positive timing difference or a reversing neg-
3. If permanent differences are fixed amounts, the calculation of 'corrected' book income
may be more efficient than the calculation of an effective tax rate, which differs from year to
year.
33
ative timing difference. Likewise it is impossible to distinguish between an

originating negative timing difference (on balance) and a reversing positive
one, as was shown in example 3.1. The reason why the reader could neverthe-
less do so in example 3.1 was that all details necessary for the application of the
static method were given in this example. This creates a serious problem for
those who oppose the offsetting of timing differences (see chapter 7). The sep-
aration of positive and negative timing differences and their subsequent rever-
sals is necessary for the separate presentation of anticipated-tax claims and
deferred-tax liabilities on the balance sheet, because of the different nature of
assets and liabilities. Those who wish to value originating negative timing dif-
ferences at an amount lower than their nominal value because they estimate
the probability of reversal of a negative timing difference to be less than unity
(see part B of chapter 5), are also confronted with serious problems in the ap-
plication of the net-change method.
Apart from the objections to the offsetting of the two kinds of timing differ-
ences, which will be treated in chapter 7, it is clear that a valuation of negative
timing differences below 100%, in the application of the net-change method,
will be possible only if the reversing and originating elements of the timing
difference can be estimated with as much certainty as is necessary for a true
and fair view of the company's financial position. A similar limitation to the
applicability of the net -change method is caused by the fact that the net -change
method as such gives no insight into the expected time of reversal of a timing
difference. The expected time of reversal of timing differences can be ascer-
tained only by analysing per individual item and/or transaction the later 'fiscal
corrections' of income, which restore the causal relationship between tax pay-
able and book income. A certain amount of information in the annual accounts
about the reversal of major timing differences is required to give an insight into
the future liquidity position of the company. 4 This is so even if the present val-
ue method is applied (see part A of chapter 5), because the mere publication of
the discounted value of all timing differences does not say much about the time
of reversal.
Evaluation of the static method and the group method
The three problems with the net-change method, mentioned above, do not
4. The extensive minimum-disclosure requirements concerning the due dates and repayment
terms of (long-term) liabilities, laid down in the company laws and accounting standards of
most countries, contrast sharply with the lack of any explicit requirement for disclosure of that
kind concerning the expected reversal dates of timing differences, either in the company laws
and accounting standards of the countries mentioned in chapter I, or in international account-
ing standards such as the 4th Directive of the European Community or the Standards of the
International Accounting Standards Committee.
34
EVALUATION OF STATIC AND GROUP METHOD
apply to the static method or individual method. As we shall see in chapter 10,
the static method is also the most accurate when tax rates change; but it re-
quires rather detailed calculations. These individual calculations can become
so cumbersome that for practical purposes some grouping of timing differ-
ences is required. This is considered quite normal in the literature. But no crite-
rion for grouping the timing differences is given in the literature. It remains
unclear whether timing differences should be grouped according to their time of
origination, their expected time of reversal, their cause of origination, or their
lifetime, or whether their grouping should follow the grouping of assets and
liabilities in the balance sheet. The examples of grouping oftiming differences in
the literature are mostly groupings of timing differences per type of asset or
liability from which they originate. Stitt has a mixed grouping: 'appropriate
groupings for most companies would be:
1. Buildings These two groupings could be combined but

}greater accuracy is obtained if
2. Plant and equipment they are separated.
3. Items treated as charges for tax purposes.
4. General reserves'.5
This grouping is given without any supporting arguments. It seems as if at-

tempts of grouping are rather haphazard. Looking at the three objections
against the net-change method, we can easily see that:
• for a separation of permanent and timing differences a grouping accord-

ing to the cause of origination is necessary (accelerated depreciation, differ-
ence in acceptance of costs, differences in matching of costs and revenue,
and so on);
• for a separation of positive and negative timing differences a grouping
according to the type of transaction involved is necessary;
• for a separation of timing differences according to the expected time of
reversal, a grouping of timing differences according to that aspect is neces-
sary, (or, what is essentially the same per type of transaction, a grouping of
timing differences according to their time of origination - see year 4 in
example 3.1, method b.).
Only a grouping that simultaneously responds to these three criteria can be

fully satisfactory. This means that from a theoretical point of view the possibili-
ties of grouping timing differences are very limited; even for the machines in
example 3.1 no grouping is possible (see note on method b.). In practice a
proper separation of permanent and timing differences is necessary, of course;
5. Stitt, page 34.
35
but separation of positive and negative differences and separation according to

the expected time of reversal are necessary only in so far as a true and fair view
of the company's financial position is involved. As the degree of offsetting in
the group method is less extensive than in the net-change method, it is easier to
estimate the reversing and originating elements of the timing differences and
the expected time of reversal of timing differences with reasonable certainty.
So a grouping of timing differences according to the cause of origination
seems a good starting point, and further grouping seems to be a matter of esti-
mation of the costs and benefits of information (or application of the 'material-
ity-concept'). Appropriate groupings will thus differ from company to compa-
ny.
Conclusions chapter 3
The static method, the group method and the net-change method mostly do
not calculate different amounts for the tax effect of timing differences. Three
objections against the net-change method have been discussed. These objec-
tions hold true for the group method, albeit to a lesser degree. To avoid the
rather cumbersome calculations of the static method some grouping may be
desirable. A grouping of timing differences according to the cause of origina-
tion seems a good starting point.
36
4. The nomenclature and classification of
timing differences
The treatment of timing differences in financial statements is called by many

different names. M. F. Morley, after an inspection of 300 major British compa-
nies in 1970-1971, concluded that the term 'tax-equalisation' is mostly used in
the U.K. (52%).
Second best in the U.K. was the term 'deferred taxation' (41%). Morley
further states that: ' ... in the U.S.A. and Australia the practice of providing for
deferred taxation is widely referred to as the 'interperiod allocation of corpo-
rate income taxes' or, more simply as 'tax allocation'. The term 'tax-effect ac-
counting' has also been used to refer to the practice under discussion'. 1 The
descriptive caption for the P/L-account mostly used to identify the resulting tax
expense is 'Income Taxes', and 'Deferred Income Taxes' as for the balance
sheef.2 In The Netherlands and Western-Germany the most common term (in
translation) is 'latent tax liability'.3
One might wonder whether we should bother about a name as long as there
is agreement about the method of calculating timing differences. However, it
can be seen from the different terms that there is much confusion about the
nature of what are called timing differences in this study, especially when look-
ing at the following different terms (partially translated) from the literature
studied.
Table 4.1: Some different terms relating to timing differences

Claims and liabilities
tax claims and -liabilities
active and passive latent tax
tax suspense-account
tax equalisation reserve
potential tax-liabilities and -claims
latent tax liabilities, latent tax claims
1. M. F. Morley: 'A defense of deferred taxation provisions', The Accountant's Magazine,

April 1973.
2. 'Accounting Trends & Techniques 1977', page 185 and 262.
3. Translation of 'latente belastingverplichting' and 'latente Ertragssteuerschuld' respectively.
37
NOMENCLATURE AND CLASSIFICATION TIMING DIFFERENCES
deferred tax and prepaid tax

tax-allocation reserve
tax contingency
latent tax
non-payable tax liabilites and non-claimable tax debts
Nomenclature and classification of timing differences in the pfL-account
The amount of tax to be presented in the P/L-account is fairly clear. It is the

amount of book income before tax times the tax rate (at least when there are
no permanent differences). For an insight into the tax effects of timing differ-
ences it is advisable to divide the tax expense into the amount of tax payable
and the tax effect of timing differences. The tax expense to be presented in the
P/L-account thus consists of the elements:
tax payable
+ tax effect of originating positive timing differences
(- reversals)
tax effect of originating negative timing differences
(+ reversals)
+
= tax expense
There is little difficulty in calculating this last amount; it is commonly referred
to as corporation tax or income tax or just tax. The composition of this amount
mentioned above can be given in the P/L-account or in notes. 4 There is a prob-
lem, however, in the presentation ofthe tax expense in the P/L-account, when
the composition of this total amount should be given for the different parts of
4. This composition of the tax expense can be given by way of a note according to the 4th
Directive of the European Community (Section 43, paragraph 1, point 10). Paragraph 53 of
lAS 12 asks for a separate disclosure of 'the relationship between tax expense and accounting
income if not explained by the tax rates effective in the country of the reporting enterprise' ,
obviously by way of a note. As for the U.S.A., Paragraph 60 ofA.P.B. Opinion No. 11 asks
for a disclosure of ... 'the components of income tax expense for the period' ... in 'a) Taxes
estimated to be payable; b) Tax effects of timing differences; c) Tax effects of operating loss-
es'. These components ... 'may be presented as separate items in the income statement or,
alternatively, as combined amounts with disclosure of the components parenthetically or in a
note to the financial statements'. The Dutch 'Committees on Annual Accounts and Report-
ing', on the contrary, are of the opinion that such a disclosure in the income statement lacks
any sense ('Voorontwerp van Beschouwingen naar aanleiding van de wet op de jaarrekening
van ondernemingen', Aflevering 4, paragraph 32; this is a kind of exposure draft on generally
accepted accounting standards but without the same degree of compulsion as in the account-
ing standards of the U.S.A. or Great Britain).
38
METHODS OF ALLOCATING TAX EXPENSE
book income, e.g. for operating income and for extraordinary items. If this is
not done the reader might incorrectly conclude that there is a proportional tax
burden on both components of income.
Most accounting standards require some segmentation of income, some-
times with and sometimes without a corresponding segmentation of the tax ex-
pense. When no segmentation of the tax expense is given, the reader of the
financial statements could easily conclude that the tax effect of the timing dif-
ferences originates proportionally from the different components of income
before tax. But when a segmentation of the tax expense is required it remains
unclear how it should be done. A striking case in point is A.P.B. Opinion no.
11, which states in part: '60. In reporting the results of operations the compo-
nents of income tax expense for the period should be disclosed, for example:
a. taxes estimated to be payable;

b. tax effects of timing differences;
c. tax effects of operating losses.
These amounts should be allocated to a. income before extraordinary items

and b. extraordinary items and may be presented as separate items in the in-
come statement'. But there is hardly any literature available on methods of
allocating the tax expense in question. 5
Probably as a result only a few of the excerpts from the annual accounts of
the survey companies referred to in 'Accounting Trends & Techniques 1977'
offered an analysis of the tax expense in the income statement. But none of
these companies (among others: Exxon Corporation and International Har-
vester) disclosed the method used to arrive at these results.
Two methods of allocating the tax expense in the income statement
I can imagine two different ways to give the allocation on hand in the income
statement, when only the income statements are available:
The gross method: in which all revenue figures are increased by the tax effect
of the originating positive timing differences and lowered by the tax effect of
the originating negative timing differences they gave rise to and in which all
5. The study of R.P. Weber: The allocation of consolidated federal income tax liabilities
with some related accounting and legal implications', concentrates solely on the allocation of
the total tax expense of a concern to the member companies as separate legal (and sometimes
separate fiscal) entities. Some aspects of this problem will be treated in chapter 11.
I.A. Burggraaff analysed a problem quite similar to the one on hand, being the presentation
(and allocation) of the tax expense in the case of permanent differences. See J.A. Burggraaff:
'De presentatie van de belasting naar de winst in de resultatenrekening', Maandblad voor
Accountancy en Bedrijfshuishoudkunde, March 1968.
39
cost figures are increased by the tax effect of the originating negative timing
differences and lowered by the tax effect of the originating positive timing dif-
ferences they gave rise to; in the case of reversing timing differences the
opposite is required;
The net method: in which there is a real division of the tax expense, because
the different parts of income are separately charged for part of the tax expense
in proportion to the amount of tax payable that they gave rise to.
Let us look at an example:
Example 4.1: The gross method and the net method for allocating the tax
expense, illustrated for timing differences
This example contains the fiscal and the published profit and loss accounts
for two successive years. In the two years there are three timing differences,
one in sales, one in cost of goods sold and one in an extraordinary item. The
question at issue is whether the tax burden may be represented by one single
amount (48% of book income before tax), or whether the tax burden should be
distributed between operating income and extraordinary gain and, if so, how
this should be done, taking the three timing differences (lasting only one year)
into account.
A negative timing difference for operating income (consisting of one nega-
tive timing difference for the sales figure and another for the cost-of-goods-
sold figure) originates in year 1 and reverses in year 2; the same thing happens
with an extraordinary gain. The tax-rate is 48%. Taxable income and book
income in these two years are as follows:
Income Statements
Year 1 Year 2 Year 1+2

Tax Publ. Tax Pub!. Tax/publ.
purp. purp. purp. purp. purp.
Sales 10,000 8,000 10,000 12,000 20,000

C.O.G.S.* 8,000 6,400 8,000 9,600 16,000
2,000 1,600 2,000 2,400 -4,000
Sell. + admin. expo 500 500 500 500 1,000
Operating income 1,500 1,100 1,500 1,900 3,000
Extraordinary gain _1,000 500 500 1,000
Tax. or gross inc. 2,500 1,600 1,500 2,400 4,000
Tax payable or
tax expense 1,200 768 720 1,152 1,920
Net income 1,300 832 780 1,248 2,080
• C.O.G.S. = cost of goods sold
40
METHODS OF ALLOCATING TAX EXPENSE
The unallocated tax expense of 768 in year 1 and 1,152 in year 2, consisting for
year 1 of:
tax payable year 1 1,200

tax effect of or.neg.tim.diff. (432)
tax expense year 1 768
and for year 2 of:
tax payable year 2 720

tax effect of rev.neg.tim.diff. 432
tax expense year 2 1,152
suggests that the originating negative timing differences in year 1 originate

proportionally from:
operating income: (1,10011,600) X -432 = -297

and extraordinary gain: (50011,600) X -432 = -135
Likewise it is suggested that the reversing negative timing differences in year 2

originate proportionally from:
operating income: (1,900/2,400) X 432 = 342

and extraordinary gain: (500/2,400) X 432 = 90
So the presentation of an unallocated tax expense in the income statement sug-

gests that different activities contributed in the same proportion to income af-
ter tax as they did to income before tax.
Application of the gross method for allocation of the tax expense gives the
following results;
41
year
PI L-account of' year 1 year 2 1+2
Sales 8,000-0.48x2,000*= 7,040 12,000+0.48x2,000*= 12,960 20,000

C.O.G.S. 6,400-0.48x1,600*= 5,632 9,600+0.48x1,600*= 10,368.16,000
1,408- 2,592' 4,000
Sell.+adm.exp. _ 500 500 1,000
Op.inc. 908 2,092 3,000
Extraordinary
gain 500-0.48x500*= 260 500+0.48x500*= 740 1,000
Gross inc. 1,168 2,832 4,000
Taxexp. (48%) 561 1,359 1,920
Net income 607 1,473 2,080
* These figures represent the amount of the timing differences, not their tax effect.
As the net-method tries to divide the tax expense in proportion to the amount
of tax payable, the determining factor is naturally the contribution to taxable
income. Application of the net method gives as a result:
year
PI L-account of: year 1 year 2 1+2
Sales 8,000 12,000 20,000
C.O.G.S. 6,400 9,600 16,000
1,600 2,400 4,000
Sell.+adm. expo 500 500 1,000
Gross op. income 1,100 1,900 -3,000
Tax on OP.inc.} (1 50012 500)* (1,50011,500)* }
x 768 = ' , 461 x 1,152 = 1,152 1,613
Net op.inc. - 639 748 1,387
Extraord.gain 500 500 1,000
Tax on extra-} (1,000/2,500)* (011,500)*
ord. g. x 768 307 x 1,152 = o 307
Net extraord. gain 193 500 693
Total net income 832 1,248 2,080
* Fractions based on the income statement for tax purposes.
These income statements give a quite different picture of the contribution to
42
EVALUATION OF GROSS AND NET METHODS
net income and so of the tax effect of timing differences. These differences can
be summarized as follows:
~
contribution contribution to net income
to
actlv- gross income without gross net
ities allocation method method
year year year year

1 2 1 2 1 2 1 2
operating
activities 69% 79% 69% 79% 78% 74% 77% 60%
extraordinary
items 31% 21% 31% 21% 22% 26% 23% 40%
Evaluation of the gross and net methods of allocating the tax expense in the in-
come statement when there are timing differences
The objections to the gross method and the net method are:
a. The gross method gives completely fictitious profit and cost figures.
Even the tax expense, although 48% of gross income in the 'traditional
method', is stated to be 561, whereas the tax-authorities claim that 'the right
amount of tax' is 1,200 and the company claims that 'the right amount of
tax' is 768.
b. The net method does not show fictitious profit and cost figures. The tax
expense is just divided between different components of income in propor-
tion to their contribution to taxable income. But the net method may show
very different effective tax burdens, which can range from infinity to zero if
a certain category of income is regarded as being fully realized in one
year for publication purposes and in another for tax purposes.
c. Both the gross and the net method act as if individual revenues result
in taxation and individual costs result in tax reduction; whereas in fact only
positive taxable income (total revenues exceeding total expenses) results in
taxation.
Objection a. fully disqualifies the gross method from use in financial account-
ing. Whether objection b. does the same for the net method depends on the
estimated abilities of the reader of financial statements. It is dubious whether it
43
can be made clear to a majority of these readers, that a category of income (not
exempted from tax) can bear a zero tax expense and that in a following year
there can be a tax expense without a corresponding category of income, as
might happen when a category of income is regarded as fully realized in one
year for publication purposes and in a following year for tax purposes (a posi-
tive timing difference).
A sensible solution for the allocation of the tax expense?
The only sensible solution to the allocation of the tax expense in the income
statement would, of course, be a separate allocation of the amount of tax pay-
able to the different components of income together with a separate allocation
of the tax effect of timing differences to these components. The allocation of
the amount of tax payable poses hardly any problems, at least when the report-
ing entity is identical to the tax-paying entity. The allocation of the amount of
tax payable can mostly be derived from the income statement for tax purposes.
More difficulties may arise in the allocation of the tax effect of timing differ-
ences. This allocation can easily be made for the figures of example 4.1. But if
there is a more drastic segmentation of the income statement this allocation
may soon become too labourious, since it is necessary to analyse how the origi-
nating and reversing timing differences are spread out over the different seg-
mented revenue and expense figures.
Conclusion on the allocation of the tax expense in the income statement
The conclusion is:
• that the net method for allocation of the tax expense can give an accept-
able solution if there is a reasonable degree of continuity in the appearance
of the different components of income and there are relatively small timing
differences;
• that a separate allocation of the amount of tax payable together with a
separate allocation of the tax effect of timing differences gives the only accu-
rate solution, but may be rather labourious;
• that if there is a drastic segmentation of the income statement, the seg-
mentation must inevitably be restricted to gross figures (before tax).
Nomenclature and classification of timing differences in the balance sheet
The classification and especially the nomenclature of corporate income tax in
44
TIMING DIFFERENCES IN BALANCE SHEET
the balance sheet presents quite different problems. There is, of course, no
doubt that the amount of tax to be paid on taxable income (less eventually the
amount already paid in advance) must be presented as a short-term liability.
For permanent differences there is mostly no problem; when they are looked
at as if tax is levied at a different rate at the moment of their origination, they
do not show up in the annual balance sheet for a company as a going concern.
For timing differences, especially for originating positive timing differences,
there are four different opinions about their classification (and nomenclature):
Deferred tax:
a. is a liability, although deferred (defended among others by De Paula6);

b. is a contingency (Finnie 7); is a reserve (SleighS);
c. is a transitory item, to be entered in a suspense account (SleighS and
Koni g9);
d. is imputable to assets and liabilities (mostly referred to as the net-of-
tax-method, defended among others by Moore lO).
The aim of tax-effect accounting in the case of timing differences has been said
to be a restoration of the causal relationship between book income and tax
expense, by showing in the published P/L-account an amount of tax which is
equal to the tax rate multiplied by book income. Under tax-effect accounting
every item in the balance sheet is thus a result of proper matching of cost and
revenues, or a transitory item. It is not a liability (or an asset) in its legal sense;
for an originating negative difference no legal claim will generally arise, only a
conditional right to set off.
So there seems to be a contingent liability, because tax payment to be made
in the future depends upon future tax laws, future tax rates and future net in-
comes. According to Beaton, there is no contingent liability in the sense of' ...
a liability not known at the time of preparation of the accounts, to exist at the
balance sheet date, which (if) it is known might yet come into existence as at
that date as a result of an event in the future'." Given the tax law as at the
6. F.R.M. de Paula: 'The principles of auditing', 13th printing, London, 1965; page 90.
7. 1. Finnie: 'The accounting treatment of deferred taxation', The Accountant's Magazine,
October 1973.
8. c.P. Sleigh: 'Harmonisation of taxable and accounting profits', Journal U.E.C., 1st Janu·
ary 1973, page 63.
9. W. Konig: 'Zur Beriicksichtigung von latenten Ertragssteuerschulden bei der Unterneh-
mensbewertung', Die Wirtschaftspriifung, Jahrgang 28, nr. 14, page 373.
10. c.L. Moore: 'Deferred income tax - Is it a liability?' The New York c.P.A., February
1970, page 130 and following.
11. D. C. Beaton: 'Contingent liabilities - So·called', The Accountant, August 1965, page
238.
45
balance sheet date, there is a liability as the result of an originating positive

timing difference, which is known at the time of preparation of the accounts;
only the amount is uncertain. So on the balance sheet date, given the tax law in
effect on that date, there is no contingent liability, only a provision for a liabili-
ty because the amount of the liability is uncertain, given that future tax rates
and future net income are unknown. The existence of a provision for a liability
(resulting from an originating positive timing difference) is argued in most of
the literature. 12 But this opinion is not in conformity with other valuation rules.
Let us compare this opinion with the valuation of inventories at the lower of
cost-or-market, which rule requires a comparison of cost and market price as
they are on the balance sheet date, that is, regardless of changes in market
price after the balance sheet date. Holding losses because of a fall in market
price after the balance sheet date are not regarded as a loss in the year reported
for, but in the year of the price fall. Like the value of inventories, the amount
of the deferred-tax liability is certain on the balance sheet date.
Changes in tax rates, the occurrence of a tax loss, and changes in tax laws
which influence the amount of the deferred liability, are events of the year of
occurrence and lead to gains or losses in that year; they are extraordinary peri-
od costs or period gains. And by contrast with the case of an originating posi-
tive timing difference (which implies an estimation of future tax rates!) they
lead to an anticipation of future gains. It is, of course, hardly possible to argue
the reserve character of an amount of deferred tax if tax on income is regarded
as an expense. This is obvious for the European use of the term 'Reserve', as
equivalent to 'Earned surplus' or 'Retained earnings'. An amount set aside for
future tax payments due to timing differences doesn't originate from income,
but is part of the calculation of income. In the U.S.A. the term 'Reserve' is
used differently. Accounting Terminology Bulletin No.1 recommends that
the term 'Reserve' be used only to indicate, as an appropriation of retained
earnings, that an undivided portion of the assets is being held or retained for
general or specific purposes. In that case one could argue the reserve character
of an amount of deferred tax if income tax is regarded as an appropriation of
income to the government. The tax effect of originating positive timing differ-
ences, being a future appropriation of income to the government, caused by
12. It is a notable fact that it is the restrictive definition of provisions in the company law of
most countries that precludes the capitalization of the tax effect of negative timing differ-
ences. See inter alia:
• the Dutch Act on Annual Accounts: Section 329, paragraph 2 of Book 2 of the Civil
Code states that the provision for tax shall be disclosed separately. But paragraph 1 of the
same section gives as an (implicit) definition of a provision: 'Any amount on the credit side
of the balance sheet that is intended to be a provision against risks and liabilities the extent
of which is not known when drawing up the balance sheet.'
• A similar implicit exclusion can be found in the 4th Directive of the E.C. in Section
20, paragraph 1 and paragraph 2.
46
NET-OF-TAX METHOD
present events, might be classified in the equity section as a Reserve for

deferred taxation (created out of retained earnings) in that caseY
So the amounts of deferred and anticipated taxes in the balance sheet due to
timing differences can only be regarded as transitory itemsl4, originating be-
cause of the application of the matching principle to the P/L-account. Given
this character of timing differences, the names:
• anticipated (corporate) income tax seem suitable. Also the names:

• non-payable tax-liability
• non-claimable tax-asset
will do, as long as one bears in mind that these items are not liabilities or assets
in the legal sense.
The net-or· tax method in the balance sheet when there are timing differences
The question remains whether these transitory items in the balance sheet can
and/or should be part of the valuation of assets and liabilities: or whether or
not the net-of-tax method can/should be applied. It is surprising that in much
of the literature this so-called net-of-tax method is often mentioned and rapid-
ly rejected (often without much argument)15, whereas I have never seen a de-
fence of its application in full. Only a partial application is supported by a few
authors for certain assets for particular circumstances. One of the examples,
noticed in the literature is c.L. Moore, who argues for an inclusion of the orig-
inating positive timing difference resulting from the fiscal application of accel-
erated depreciation in the valuation of the asset concerned for publication pur-
poses (a net-of-tax depreciation system). A second example was found in the
13. This is probably the type of deferred-tax accounting that Van Rossem refers to, when he
argues, that even when taxes are considered as an appropriation of income rather than an
expense, some kind of deferred-tax accounting should remain. See note 15 on page 10.
14. The opinion that an amount of deferred tax is a transitory item can also be found in
Sleigh and Konig, who both argue for a suspense account. The same opinion, without the need
for a suspense account was found only in: M.l.H. Smeets: 'Overiopende posten en voorzie-
ningen', Weekblad voor Fiscaal Recht, October 1, 1964, page 822.
These transitory items can have a considerable lifetime; sometimes these timing differences
with a considerable lifetime are called quasi-permanent differences, but this name is also used
for permanent differences reversing at the end of the lifetime of a company.
15. A notable exception should be made for: H.A. Black: 'Interperiod allocation of corpo-
rate income taxes', 1966, Accounting Research Study no. 9.
47
Dutch literature: A.L. Brok 16 argues for inclusion of the originating negative
permanent difference resulting from an upward revaluation of an asset which
is not allowed for tax purposes, in the published value of the asset under con-
sideration (a net-of-tax revaluation). The latter opinion will be discussed in
chapter 12, dealing among other things, with permanent differences caused by
the application of the replacement-value theory.
The arguments of C.L. Moore for a net-of-tax depreciation are given only
for depreciable plant. 'Income taxes are costs of operation ... ; income taxes,
along with revenues and other operating costs, determine the flow of benefits
to be derived from an asset' .17 Furtheron the argument continues as follows:
' ... the asset is worth the discounted stream of benefits that it is expected to
produce ... ', and ' ... the pattern of depreciation deductions over the years
should follow the pattern of expected benefits'. 18 Moore himself gives an
example of the application of the net-of-tax method l9 :
Example 4.2: Application of the net-of-tax method to depreciable plant

• A plant costs $ 450,000 and is not expected to have any salvage value at
the end of its estimated useful life of 5 years.
• Cash flow returns before income taxes are estimated at $ 250,000 each
year.
• The sum-of-the-years' -digits method is used to compute tax deprecia-
tion.
• Straight-line depreciation is deducted for financial reporting.
• Income taxes are 40 per cent of net income before taxes.
The tax depreciation is computed for each of the five years along with the tax
effect of these deductions.
Years Cost Depr. Tax Tax re- Bookvalue of

of factor* depr. duction the asset for
asset from tax purp.
depr. ** end-af-year
1 $ 450,000 5/15 $ 150,000 $ 60,000 $ 300,000

2 $ 450,000 4/15 $ 120,000 $ 48,000 $ 180,000
16. A. L. Brok: 'Latenties terzake van de vennootschapsbelasting', Maandblad voor Accoun-

tancy en Bedrijfshuishoudkunde, 1964, page 2311232. In the case of permanent differences
the net-of-tax method is more common, see chapter 8.
17. Moore, page 132.
18. Moore, pages 133 and 134 respectively.
19. Moore, pages 135-137. The column 'book value of the asset, end-of·year' is mine. For
ease of reference this example, although not mine, is numbered consecutively.
48
NET-Of-TAX METHOD
Years Cost Depr. Tax Tax re- Bookvalue of

of factor* depr. duction the asset for
asset from tax purp.
depr. ** end-ot-year
3 $ 450,000 3/15 $ 90,000 $ 36,000 $ 90,000

4 $ 450,000 2115 $ 60,000 $ 24,000 $ 30,000
5 $ 450,000 1115 $ 30,000 $ 12,000 $ 0
• Sum-of-the-years'-digits method
•• Tax rate 40%
• If no liability for deferred taxes is taken into account, Moore gets the
following picture:
Years Income: Income: Income:

Cash flow Taxes Cash flow
before taxes (current) after taxes
1 $ 250,000 $ 40,000 $ 210,000

2 $ 250,000 $ 52,000 $ 198,000
3 $ 250,000 $ 64,000 $ 186,000
4 $ 250,000 $ 76,000 $ 174,000
5 $ 250,000 $ 88,000 $ 162,000
Years Book Net Bookvalue of the.

depreciation income asset end-of-year
1 $ 90,000 $ 120,000 $ 360,000

2 $ 90,000 $ 108,000 $ 270,000
3 $ 90,000 $ 96,000 $ 180,000
4 $ 90,000 $ 84,000 $ 90,000
5 $ 90,000 $ 72,000 $ 0
• If a liability is recognized for deferred taxes, Moore gets the following

picture:
49
Years Income: Non-cash expenses:

Cash flow Depreciation Additional
after taxes (reduced)
tax expense
1 $ 210,000 $ 90,000 $ 24,000

2 $ 198,000 $ 90,000 $ 12,000
3 $ 186,000 $ 90,000 $ 0
4 $ 174,000 $ 90,000 $ (12,000)
5 $ 162,000 $ 90,000 $ (24,000)
Years Net income Liability for Bookvalue of the

deferred asset end-of-year
taxes end-of-
year
1 $ 96,000 $ 24,000 $ 360,000

2 $ 96,000 $ 36,000 $ 270,000
3 $ 96,000 $ 36,000 $ 180,000
4 $ 96,000 $ 24,000 $ 90,000
5 $ 96,000 $ 0 $ 0
• If tax differences are considered to be part of depreciation the net-of-

tax method gives the following results:
Years Cash flow Depreciation related to:

after taxes the usage tax operation
of the plant
1 $ 210,000 $ 90,000 $ 24,000

2 $ 198,000 $ 90,000 $ 12,000
3 $ 186,000 $ 90,000 $ 0
4 $ 174,000 $ 90,000 $ (12,000)
5 $ 162,000 $ 90,000 $ (24,000)
Years Total Net income Bookvalue of the

depreciation asset end-of-year
1 $ 114,000 $ 96,000 $ 336,000

2 $ 102,000 $ 96,000 $ 234,000
50
NET-OF-TAX METHOD
Years Total Net income Bookvalue oj the

depreciation asset end-oj-year
3 $ 90,000 $ 96,000 $ 144,000

4 $ 78,000 $ 96,000 $ 66,000
5 $ 66,000 $ 96,000 $ 0
Moore's example leaves many questions unanswered. First of all, it is not clear
whether or not Moore thinks that his concept should be applied to all assets
(and liabilities) or only to one or a few assets. Application to all assets and
liabilities together with the concept that an ' ... asset is worth the discounted
stream of benefits that it is expected to produce'20, will lead to the application
of the so-called economic concept of profit, under which capital is ... 'a stock of
wealth existing at an instant of time'21, that is the present value of all future
cash-flows, and profit is merely the interest on the capital value. If this were
the case, there would be no depreciation any more, and only actual taxes paid
(based on whatever accounting system) together with other parts of the cash-
flow would be relevant to the value of capital. Valuation of individual assets
and liabilities would then be impossible because the future cash-flows are only
imputable to the whole complex of assets and liabilities, not to individual
items. A theoretical foundation for an application to one asset can be found
only if the asset under consideration is an irreplaceable one, whilst all others
are replaceable. But even then, the value of the irreplaceable asset should be
the present value of the future net cash-flow, and there would be depreciation
only if this present value diminished. But Moore merely mentions a plant with-
out saying anything about its replace ability , and valuation is based on costs. So
the only point remaining is: that depreciable assets (or only depreciable
plant?) should be depreciated in such a way that the pattern of depreciation
deductions over the years follows the pattern of expected benefits. But depre-
ciation under the accounting concept of profit is merely a way of matching
costs and benefits properly, according to a causal relationship, and that is dif-
ferent from simply dividing all costs in proportion to the benefits. Under the
accounting concept of profit the amount of depreciation is not influenced by
the fact that for instance some customers pay rather later than others, which
influences the cash-flow. Likewise the fact that depreciation policy for tax pur-
poses differs from that for publication purposes does not influence the value of
the potential performance of an asset. 22
20. Moore, page 133.

21. Irving Fisher: The nature of capital and income', New York, 1906.
22. For a similar conclusion see: T. F. Keller: 'Accounting for corporate income taxes', 1961,
page 42.
51
Moreover, in the example given above, the pattern of depreciation deduc-

tions is not at all proportional to the pattern of expected benefits. This can
easily be seen when these patterns are expressed in index form (or average
cash-flow and average depreciation respectively):
years cash-flow depreciation

after tax according to Moore
1 113 127
2 106 113
3 100 100
4 94 94
5 87 73
Apart from the criticism of the opinions and the results of Moore, the analysis
of his example showed that:
Full application of the net-of-tax method is possible (and necessary) only under
the application of the future-orientated economic concept of profit; but then
tax-effect acounting is irrelevant because the only consideration relevant to
taxes is the amount of tax actually payable. The impossibility of saying which
assets and liabilities will give rise to which part of the cash-flow (or book in-
come) makes a valuation of individual assets and liabilities impossible.
Partial application of the net-of-tax method can be theoretically justified only in

the case of one irreplaceable asset, whose value is influenced by all future cash-
flows (including taxes actually payable): because in that case all future cash-
flows can be allocated to that unique irreplaceable asset. The valuation of all
other assets is then on a cost basis (or on a market basis) and certainly not on a
net-of-tax basis; because of the fact that taxes would not be payable without
the presence ofthis irreplaceable asset, all tax-benefits and -charges are imput-
able to this irreplaceable asset.
Partial application of the net-of-tax method to replaceable assets requires arbi-

trary answers to the question which part of the cash-flow (or book income or
just income tax) is imputable to which asset(s). The net-of-tax method in this
case leads to an incorrect valuation of assets (that is, it is not the remaining
income potential of the assets that is valued, but merely costs plus or minus
taxes imputed to other parts of the complex of assets and liabilities). As to the
amount of profit, it makes no difference whether or not the net-of-tax method
is applied in the balance sheet.
52
CONCLUSIONS
The net method for allocation of the tax expense in the income statement can
give an acceptable solution in case of timing differences under certain condi-
tions. A separate allocation is usually rather labourious. If there is a drastic
segmentation in the income statement, the segmentation must inevitably be
restricted to gross figures (before tax).
Under deferred-tax accounting, the deferred and anticipated taxes in the
balance sheet are a result of a proper application of the matching principle to
the P/L-account, and thus transitory items.
Application of the net-of-tax method in the balance sheet when there are
timing differences can be theoretically justified only in the case of one irre-
placeable asset. Partial application of the net-of-tax method to replaceable as-
sets leads to an incorrect valuation of assets.
53
5. The valuation of timing differences
The valuation of deferred and anticipated taxes raises two different questions.
First there is the question of calculating the discounted or the nominal value of
deferred-tax liabilities and anticipated-tax claims. Second there is the question
of whether an anticipated-tax claim should not be valued below its nominal or
discounted value because of the risk that a claim cannot be offset on its reversal
against the amount of tax payable then.
Part A: Discounted or nominal value

The present-value calculation has been advocated by several authors for an
originating positive timing difference. There is no doubt that in the calculation
of capital as such (for capital-tax purposes, for company-valuation etc.) it is the
present value of future tax payments and tax reductions (caused by present
events) which determines the net worth of the company. In that case all differ-
ences between the calculated value of assets and liabilities and the value of the
assets and liabilities for taxation purposes, which lead to future tax payments
or future tax-reductions of whatever type of tax, influence the net worth of a
company at their present value, because essentially the net worth of a company
is the present value of future net cash-flows.! For investment analysis also, it is
the present value of future net cash-flows which counts. 2 But is the application
of a discounting factor to timing differences also logical in external financial
reporting, when it is not the valuation of capital as such that is important, but
the simultaneous fair presentation of capital and results?
1. For an extensive survey of the role of timing differences and permanent differences in
capital valuation: 'Zum Problem der Beriicksichtigung der latenten Ertragssteuerbelastung
bei der Vermogensermittlung'. Institut FSt., Brief 173, Bonn, October 1977.
2. See o.a. B. V. Carsberg: 'Analysis for investment decisions', chapter 9: 'The impact of
taxation', for a good account of the treatment of taxes in investment analysis.
54
DISCOUNTED OR NOMINAL VALUE
One argument for discounting
An apparently strong argument for the present-value calculation is derived

from the fact that postponed tax payments are often never paid at all when
timing differences originate from repetitive transactions. As these timing dif-
ferences are constantly renewed, the tax expense in the income statement can
equal the amount of tax payable if the originating timing differences equal the
reversing timing differences and a constant amount of deferred tax has to be
reported in the balance sheet; they are often referred to as revolving timing
differences. In growing firms the originating timing differences will exceed the
reversing ones. Under a full accrual of deferred taxes, the cumulative amount
of deferred tax in the balance sheet will go on mounting, whilst there may be no
evidence whatsoever that this cumulative amount of deferred tax will ever be
paid in full as long as the company remains in business. Application of the
present-value calculation will lead to a zero value of (part of) these timing dif-
ferences. 3 Bevis4 analysed the actual reversal of positive timing differences in a
real-life instalment-sales company over a 31-year period starting in 1936. This
company computed its income from instalment sales on a collection basis for
tax purposes, while it computed book income on a sales basis. The sales activi-
ties of this company during the 31-year period resulted in originating positive
timing differences for 19 years (per balance, per year) of$ 2,361 in total. There
were 12 years that showed reversing positive timing differences per balance.
'The tax reductions and pay-backs' , as Bevis calls these timing differences, are
summarized as follows:
'Total of tax deductions experienced $ 2,361

Adjustments due to tax rate changes (net) $ 382
'$ 2,743
Pay-backs of taxes $ 655
Net accumulated tax reductions $ 2,088'5
It is the foregoing amount of $ 2,088 which would be charged to income and set
up as a credit in the balance sheet over the years, notwithstanding the fact that
over the 31-year period the reversing positive timing differences (per balance)
amounted to only 28 per cent of the originating positive timing differences ex-
perienced per balance (24 per cent after adjustments for rate changes). Bevis
3. See T.M. Hill and 1. W. Coughlan: 'Tax reductions and tax deferrals', Journal of Busi-
ness (April 1958), esp. page 128. This is the earliest publication found which argues for the
discounting of deferred tax.
4. H. W. Bevis: 'Contingencies and probabilities in financial statements', Journal of Accoun-
tancy, October 1968, page 37-45.
5. Bevis, page 43.
55
VALUATION OF TIMING DIFFERENCES
concludes that it would have been more than sufficient if only 39 per cent of the
tax effect of the originating positive timing differences had been provided for
in order to meet all the reversing positive timing differences during this period
(including the World War II-period). For the post-war period a provision of 17
per cent from the originating positive timing differences would have been suffi-
cient in his opinion.
Bevis's example shows very clearly that the valuation of timing differences is
closely connected to the classification problem. When timing differences (at
least, originating positive timing differences) are regarded as contingencies, as
Bevis considers them to be, then of course the fact that over a 31-year period
only 28% of accumulated deferred tax is really paid, becomes important. For
contingencies, the probability of future payment of originally deferred taxes
has to be estimated, and this influences the value of the 'tax contingency'.
Bevis makes a comparison with a pension plan: 'Renegotiation, income taxes,
law suits, pensions and many other matters present the businessman with ques-
tions of accounting now for transactions or events the precise financial effect of
which will be known only as the future unfolds'. 6
As for pension plans, Bevis argues for the valuation of deferred-tax liabilities
on the basis of an estimation of future payments. Apart from the fact that de-
ferred taxes do not form a contingency (see chapter 4), the comparison with
pension plans is a misleading one. For pension plans, it is possible on the basis
of the law of large numbers to estimate future pension payments by using sta-
tistical death- and life expectations. These future payments are labour costs of
people at present working. As concerns future tax payments caused by present
events, ultimate tax payment is not uncertain at all. Deferred taxes in a going
concern have to be paid eventually, unless the company 'dies' (earning losses
larger than its capital). It is only in the latter case that an element of deferred
tax may never be paid. But the going-concern assumption precludes anticipa-
tion of the end of the company's life. In addition, by contrast with pension
payments, the ultimate payment of taxes depends on the life of a single corpo-
ration.
For pension plans, it is possible to estimate future payments with reasonable
certainty in advance. But in Bevis's example it is only possible to say after a
period of 31 years what percentage of the originating positive timing differ-
ences should have been provided for in order to meet the reversing positive
timing differences. But even this percentage has no predictive value for the
coming years. There is also the problem of how income should be calculated
during the period when the 'stationary' situation has not yet been reached; that
is if the situation has not yet been reached in which 28% of the tax effect of
originating timing differences constitutes a sufficient provision. Actually Bevis
6. Bevis, page 38.
56
suggests carrying 100% of the tax effect of the originating timing differences for
the first year to the deferred-tax account (as a safety factor) and 50% for the next
years until experience indicates that this rate should be modified. In Bevis's
example this rate gradually goes down to 35 %, which can hardly be said to give a
proper matching of costs and benefits.
The problem that deferred taxation will never be paid, and that therefore it
should not be provided for, or should be provided for on a discounted basis, is
more thoroughly analysed by Barton. 7 Instead of analysing on the basis of one
(admittedly real-life) example, Barton analyses a series of hypothetical situa-
tions, in order to find the conditions under which deferred tax is not paid. Bar-
ton's case A is a stationary company with a single fixed asset. Case B involves a
period of growth (in fixed assets) followed by a stationary period. Case C in-
volves a company which ceases to operate and scraps its plant and case D in-
volves negative growth - a rundown of fixed assets. Barton concludes: 'The
only situation in which the initial reduction in taxation leads to an increase in
future taxes occurs for the single investment cycle company, the profitable
company which terminates its operations and realises a taxable profit on the
sale of its assets, and the profitable company which runs down the scale of its
operations. In all other cases - the growth company, the multiple plant com-
pany having a balanced age stock, the company which operates at a loss, and
the company which makes no taxable profit on realisation of its assets - the
deferred taxes are never paid'. 8 Barton believes that the classes of companies
that will never pay their deferred tax predominate and that this fact should be
taken into account in providing for deferred taxes. But the belief that not pay-
ing deferred tax is a normal situation implies that either growth or loss is such a
normal situation that the going-concern concept should be replaced by the as-
sumption of a growing concern or a shrinking concern.
Morlet states (in a reply to Barton's arguments), that the next question is to
look in real life at the numbers of companies falling into each category (payers
and non-payers of deferred taxes). In contrast to Barton he thinks that at least
53% of companies have to reduce their deferred-taxation provision once or
more in a 5-year period. But even if practical research showed that companies
fall only exceptionally into the category of payers of deferred taxes, so that
deferred tax is postponed indefinitely, it should still be provided for. Many
liabilities are in practice indefinitely postponed, though they should clearly be
included as liabilities in the debtor's balance sheet. Black lO makes a compari-
7. A.D. Barton: 'Company income tax and inter-period allocation', Abacus, Vol. 6 no. 1,
September 1970.
8. Barton, page 19-20.
9. M.F. Morley: 'A defence of deferred taxation provisions', The Accountant's Magazine,
April 1973, page 181.
10. H.A. Black: 'Interperiod allocation of corporate income taxes', Accounting Research
Study no. 9, 1966, Chapter 5.
57
son with a clearing bank's aggregate indebtedness to its current account cus-
tomers. But in addition, the same objection against Bevis holds true as for
discounting, namely that it is possible to say whether a certain deferred-tax
liability should not be provided for at the time of origination only when it has
not become payable after a period long enough to make its present value prac-
tically zero.
With an after-tax interest percentage of 5, it takes about a hundred years to
make the present value less than 1% of the original nominal value. The conclu-
sion is that, although there may be companies which will not have to pay (part
of) their deferred taxes in the foreseeable future and may never have to do so,
this is an insufficient reason for valuing deferred taxes on a discounted basis
(falling eventually to zero) because this implies an expectation of future
growth or future losses, which can be justified only a considerable time after
the origination of a positive timing difference which has to be valued now.
An interlude on non-fully comprehensive tax allocation
The argument that some companies do not have to pay (part of) their deferred
taxes in the foreseeable future was found to be an insufficient reason for valu-
ing deferred taxes on a discounted basis. But it is much more customary to use
this argument for a partial application of deferred-tax accounting. Sometimes
this practice is referred to as the 'probability method', by contrast with the
flow-thfC\ugh method or taxes-payable method and with comprehensive tax
allocation.
Under the taxes-payable method or the flow-through method, the tax ex-
pense in respect of the current period is equal to the amount of tax payable.
Support for this method is sometimes based on the view that taxes are a distri-
bution of income rather than an operating expense of the company. 'Other
support for the taxes-payable method may be based on the view that tax effects
of timing differences are part of the tax expense of the period in which they are
part of taxable income. This view is not in accordance with the accrual assump-
tion, which states that revenue and costs are accrued, that is, recognised as
they are earned or incurred (and not as money is received or paid) and record-
ed in the financial statements of the periods to which they relate ... '.11
The term comprehensive tax allocation refers to a full application of
deferred-tax accounting. The tax expense in respect of the current period is
equal to the amount of tax payable plus or minus the tax effect of all timing
differences (at least the positive ones). 12
11. International Accounting Standard No. 12: 'Accounting for Taxes on Income', paragraph
11, London 1979.
12. Even if the tax effect of the negative timing differences is not taken into account in the
calculation of the expense, the term comprehensive tax allocation is still used.
58
Partial application or the probability method13 bears on the situation in which

the tax expense for a period excludes the tax effects of some (positive) timing
differences, ' ... when there is reasonable evidence that those timing differences
will not reverse for some considerable period ... ahead. It is also necessary for
there to be not indication that after this period these timing differences are
likely to reverse' Y
As the main argument for application of the probability method is the same
as the first argument for discounting deferred tax, my objections are identical:
the probability method too introduces a growing-concern assumption into fi-
nancial accounting instead of sticking to the going-concern assumption. The
same conclusion was reached by Herring and Jacobs in their statement: 'that
the argument against comprehensive tax allocation, i.e. that the credit is never
discharged, cannot be sustained' .15 A failure in their analysis is that they only
analysed a number of firms showing increases and decreases of the deferred-
tax account; they did not look for the amount of the increases and decreases.
The re-analysis ofthe Herring-and-Jacobs study by Lantz, Snyir and Williams l6
shows that although evidence can be found to support the argument that cor-
porations can defer taxes indefinitely (which is the main argument against
comprehensive tax allocation), this never resolves the argument about liquida-
tion of the deferred-tax account. 17 The latter problem is a micro-problem,
which 'can only be resolved by examining the behaviour of an individual firm's
deferred-tax account' .18 But it is hard to imagine what predictive value such a
study would have for the non-liquidation of the deferred-tax account of a com-
pany in the future.
13. The term 'partial application' originates from lAS No. 12. The term 'probability method'
originates from the U.K. Statement of Standard Accounting Practice No. 15: 'Accounting for
deferred taxation'.
14. lAS No. 12, paragraph 20.
15. H. C. Herring and F.A. Jacobs: 'The expected behaviour of deferred tax credits', The
Journal of Accountancy, August 1976.
16. K. W. Lantz, A. G. Snyir and J.J. Williams: 'A second look at the expected behaviour of
deferred tax credits', Cost and Management, MarchiApril1978.
17. For a similar earlier discussion of the expected behaviour of deferred taxes, especially on
the requirements which have to be fulfilled for the deferred-tax account never to be dis-
charged under a tax regime of accelerated depreciation, see:
• J.L. Livingstone: 'Accelerated depreciation, cyclical asset expenditures and deferred
taxes', Journal of Accounting Research, 1967, pages 77-94;
• and in: 'Empirical Research in Accounting, Selected Studies', 1967:
- J.L. Livingstone 'Accelerated depreciation and deferred taxes', pages 63-117;
- G.R. Corey: 'Discussion of accelerated depreciation and deferred taxes: an empiri-
cal study of fluctuating asset expenditures', pages 118-123;
- T.R. Dyckman: 'Discussion of accelerated etc.', pages 124-138;
• J.L. Livingstone: 'Accelerated depreciation, tax allocation and cyclical asset expendi-
tures of large manufacturing companies', Journal of Accounting Research, 1969, pages
245-256.
18. Lantz, Snyir and Williams, page 49.
59
Only if an amount of deferred tax is regarded as a contingency, and not as a

transitory-liability, is there any need to estimate future nominal payments of
taxes caused by present events. But 'the behaviour of an individual firm's
deferred-tax account' in the past has no predictive value about the future re-
versal of positive timing differences. Deferred taxes have to be paid eventual-
ly, unless they give rise to a loss for tax purposes that cannot be carried over to
other years.
If it is agreed that taxes on income are expenses, the amounts of tax payable
have to be accrued according to the matching principle. Tax payable is re-
cognised when incurred (irrespective of when it is actually paid). The probabil-
ity method is a violation of:
a. the going-concern assumption: in which ... 'it is assumed that the en-
terprise has neither the intention nor the necessity of liquidation or of cur-
tailing materially the scale of its operations'. 19 If deferred taxes are not ac-
counted for because of expected future losses, the going-concern assump-
tion is dropped only with regard to positive timing differences. If the expec-
tation of future losses raises serious doubts about the validity of the going-
concern assumption, this should have its influence on the valuation of all
assets and liabilities;
b. the matching principle or accrual assumption: as was indicated earlier;
c. the prudence principle: because an amount of tax that with reasonable
certainty will have to be paid eventually in the future is not recognized in the
preparation of financial statements.
An attendant problem in the application of the probability method arises when

timing differences, not accounted for previously, suddenly become likely to
reverse in the near future. The tax effect of these reversing positive timing
differences cannot be charged to the income statement (included in the
amount of tax payable) upon their actual reversal, because they relate to trans-
actions in previous years. This suggests a retroactive adjustment of the year of
origination of these positive timing differences. This problem is identical to
that in case of the actual carry-forward of a loss when no negative timing differ-
ence due to loss carry-forward has been recorded in the loss year. This problem
will be discussed in chapter 6 and chapter 14.
Another argument for discounting
A second argument for valuation of timing differences on a discounted basis
19. lAS No. I: 'Disclosure of Accounting Policies'. paragraph 5.
60
comes from those authors who regard deferred taxes as a normal liability . A
company pays the same total amount of taxes over its entire life, other things
being equal, whether or not it defers taxes through the later recognition of
revenues (or earlier recognition of costs) for tax purposes than for purposes of
financial reporting. The company does not have to pay more taxes because of
the advantage of the delay in tax payment; so a deferred-tax liability is an inter-
est-free loan from the government. Or as Black puts it: 'The government does
not require immediate payment of taxes otherwise due and allows a company
to continue using its own funds, if the company elects to take advantage of
certain provisions of the law. Postponing payment is of value to the company
because the retained funds can be invested profitably. If the taxes were paid
currently, this return would be lost. The loss of return would be a cost of paying
taxes now, and theoretically a current payment would be partly taxes and part-
1y interest. Interest is implicit in postponing tax payments'. 20
From these statements, application of the discounting method follows
quickly and easily. From the fact that deferred taxes are an interest-free loan
from the government, it is concluded that: 'net worth is in fact increased by
using tax methods which defer taxes and this increase in net worth should be
reported in the income statement for the period in which the deferral takes
place'.21 From the fact that deferred taxes yield an implicit interest-rate it is
concluded that: ' ... accounting for deferred tax liabilities on a discounted basis
is more informative than accounting presently accorded to them, provided the
interest expense recognized thereon is disclosed separately. By discounting
deferred tax liabilities, the operational advantages of deferring taxes are dis-
closed separately in the income statement'. 22
After this rather facile demonstration that the discounted value should be
applied, a quarrel begins over the determination of a proper discount rate.
Nurnberg23 mentions several options:
1. a tax penalty rate

2. a tax anticipation note rate
3. internal rate of return
4. cost of alternative debt or equity:
a. the weighted average costs of debt and equity
20. Black, page 84.

21. H. Nurnberg: 'Discounting deferred tax liabilities', The Accounting Review, Vol. XLVII,
no. 4, October 1972, page 659. In the same sense: E.E. Williams and M.e. Findley: 'Dis-
counting deferred tax liabilities: some clarifying comments', Journal of Business Finance and
Accounting, no. 2, 1976, page 121.
22. Nurnberg, page 658.
23. Nurnberg, pages 659-661.
61
b. depending on how creditors and stockholders interpret deferred-tax

liabilities:
• after-tax cost of debt, if the funds are used to retire existing debt
• cost of equity, if the funds are used to retire existing equity
• average overall cost of capital, if the funds are used to retire debt
and equity in the pre-existing ratio;
and concludes that 4b presents a proper discount rate.
Williams and Findlay then ask: ' ... why would management ever want to sub-
stitute the deferred tax liability for a debt source when it would be equally easy
to substitute for equity?'. 24 They conclude that the picture of a deferred-tax
liability is' ... one of 0% nominal, fixed (maximum) dollar return, highly sub-
ordinated (such that the interest would probably be wiped out in liquidation),
non-marketable quasi-debt instrument, the amount of which cannot be direct-
ly controlled by the lender and the repayment of which is somewhat similar to
the interest provisions of an income bond (paid only if earned)'25, and they
conclude in favour of a discount factor at approximately the cost of equity tim-
es (I-r), in which r is the existing tax rate.
Instead of going into detail on a discussion of a proper discount rate let us
take a closer look at the application of the discounting method to external fi-
nancial reporting. When we look at external financial reporting in general, it is
astonishing that an argument over discounting transitory items seems to arise
only for deferred-tax liabilities. That is perhaps because balance sheet
valuations of most liabilities approximate to their present value under current
practice (ignoring changes in the market structure of interest rates). 26 Thus,
'the maturity value of bonded debt, adjusted for unamortized premium or dis-
count, approximates the present value of the nominal interest and principal
payments thereon, provided the effective rate of interest at the date of issu-
ance is the rate of discount used'. 27 Apart from this last opinion of Nurnberg
(which is 'proved' by other examples), it can be said that for most liabilities,
interest expense represents the excess cash-outflows to creditors, and is an in-
curred cost. But unlike other liabilities, the (implicit) interest expense on def-
erred-tax liabilities, being an interest-free loan, is a non-incurred cost, which
might be called an opportunity cost because it will never result in an actual
cash-inflow or cash-outflow. So in the application of the discounting method to
deferred taxes the question becomes' ... whether the inclusion of opportunity
costs in financial reports for external parties is good or bad and in particular,
24. Williams and Findley, page 127.

25. Williams and Findley, page 121.
26. R. T. Sprouse: 'The 'radically' different Principles of Accounting Research Study no. 3':
The Journal of Accountancy, May 1964. pages 64-65.
62
whether discounting deferred-tax liabilities is consistent or inconsistent with

more basic accounting concepts'. 28 The latter question can be answered very
quickly. Application of opportunity costs is a departure from generally accep-
ted accounting principles. As Keller states, it is the incurred cost concept
which is applied in external financial reporting: ' ... the implicit interest charge
is generally thought to be that amount which is added to the price of the good
or service for the privilege of delaying payment. It is not the value of deferral to
the entity, which has delayed payment ... The value of the deferral to the
company permitted to defer its taxes will be reflected in higher earnings to the
stockholders, which in turn will call for a revaluation of the stock equity ... The
tax deferral does not provide for the payment of interest to the government. It
is an interest-free loan by the government to the business in an attempt to en-
courage increased spending on plant assets. No one has yet suggested, and for
a very good reason, that the bond liability is the present value of future pay-
ments discounted at the capital-attracting rate for the particular business. In-
stead the interest rate demanded by the market is used. In the case of the tax
liability the rate is 0 per cent. The present value of an amount due in 12 periods
at 0 per cent interest is the maturity amount'. 29
The first question, whether inclusion of opportunity costs in external finan-
cial reporting is good or bad, can be put differently: is accounting for deferred
taxes on a discounted basis more informative than accounting on a nominal-
value basis? Nurnberg says yes to this question, and so do other advocates of
the discounting method, because the interest savings in deferring taxes are dis-
closed. But it is a disclosure in contradiction to the realization principle. Ap-
plication of the discounting method implies that the whole interest saving from
the interest-free loan by the government is reported in the income statement
for the period in which the deferral takes place, that is, before realization, be-
fore the advantages of not paying interest on a loan are actually received.
However, one could ask why the discounting method as such gives much more
information since it merely discloses an unrealized (partly fictitious) gain. The
conclusion must be that for a fair presentation of capital as such application of
the discounting method can be considered, when the time-value of money has
to be taken into account in the calculation of the net worth of a company. For a
fair presentation of the results application of the discounting method leads to a
deviation from the realization principle and to an improper matching of costs
with revenues; application of the nominal-value method seems far preferable.
The problem is then brought back to the famous question whether a balance
sheet can serve more than one purpose at the same time. This problem is in
Dutch and German literature mostly referred to as the problem of monism

29. T.F. Keller: 'Accounting for Corporate Income Taxes', Michigan Business Studies, 1961,
page 118.
63
versus dualism. The advocates of a monistic balance-sheet theory claim that a

balance sheet can serve only one purpose at a time, i.e. the balance sheet can
give a fair presentation either of capital or of the results. The advocates of a
dualistic balance-sheet theory claim that a single balance sheet can simulta-
neously give a fair presentation of capital and results.
Since in financial accounting a simultaneous fair presentation of capital and
results is required, a dualistic standpoint has been chosen. The accounting con-
cept of profit asks for a presentation of capital and results that is fair and also
conservative, in other words both are subject to the rules of prudence and the
principle of realization together with the matching principle. This seems to
imply that in cases of contradiction between a fair presentation of capital and a
fair presentation of results, it is the presentation of the results that predomina-
tes in drawing up the income statement in present financial accounting. This
means that primacy is granted to the calculation and presentation of income
and that a possibly unfair presentation of capital in the balance sheet is correct-
ed parenthetically, by way of a note or perhaps by adjustments in the balance
sheet instead of the other way round: drawing up the balance sheet and adjust-
ment of the income statement. 30
Conclusion on discounting deferred taxes
The conclusion is that application of the discounting method to deferred taxes

is not advisable because:
a. income calculation has priority over capital calculation in present finan-

cial accounting; the resulting unfair presentation of capital can be corrected
byway of a note or perhaps by way of adjustments in the balance sheet;
b. looking to the way 'normal' loans are treated in financial accounting,
we find no reason for a partial application of the discounting method to an
interest-free loan, when other low-interest-bearing loans are valued at their
maturity value; if valuation on maturity value is regarded as incorrect, it is
confusing to correct the presentation of capital only partially (i.e. only for
deferred taxes);
c. when we look at other assets and liabilities for which application of the
discounting method is current practice in financial accounting, for instance
pension plans, application of the discounting method seems to originate on-
30. An interesting application can be found in The Netherlands. The Dutch 'Committees on
Annual Accounts and Reporting' require disclosure by way of a note of material differences
between the current value and the book value of stock if the base-stock method or the LIFO-
method is used in order to correct the possibly unfair presentation of assets resulting from the
application of these valuation rules ('Richtlijnen voor de jaarrekening' (loose-leaf), De-
venter, 1980, paragraph 1.03.214).
64
ly from the matching principle; but the matching principle leads to the use
of the nominal value for deferred taxes (interest-savings are regarded as
realized during the years of actual tax-deferment);
d. in tax deferral, the market rate of interest is 0%;
e. the mere publication of the discounted value of the tax effect of timing
differences does not disclose anything about the expected time of reversal.
Although the American APB Opinion no. 11 on deferred taxes does not ex-
plicitly preclude the application of discounting deferred taxes, no evidence
could be found of any company discounting the tax effects of timing differ-
ences in the 'Accounting Trends & Techniques 1977'.
Evidence of practical application of discounting could be found only in The
Netherlands. The 'NIVRA-investigation of annual accounts 1977' reveals that
only 86 out of 112 companies stated the method of calculation, although this is
required by law. Of these 86 companies:
74% used the nominal value,

13% used a discounted value,
12 % used a discounted value for long-term deferred tax only,
1% (one company) used a net-of-tax method (probably on a nominal ba-
sis).31
Another solution for the discounting problem
Application of the nominal method gives an unfair presentation of capital. It

was suggested that an adjustment in the balance sheet could be made in order
to correct this, if the correction is not made parenthetically or by way of a note.
An interesting solution for this was suggested (not advocated) by BurggraaffY
He suggested valuing deferred taxes in the balance sheet on a discounted basis,
and creating simultaneously a 'liability-in-transit' for deferred income, consist-
ing of the advantages of having an interest-free loan. This solution is illustrated
in the following example:
Example 5.1: Application of the 'liability-in-transit' method

The data are the same as in example 2.2., but they are irrelevant in this
example. When the following figures are used: book income before tax and
depreciation = Y = 8,000; purchase price of machine = A = 12,000; economic
lifetime = n = 8; tax rate = t = 0.48, the resulting timing differences are:
31. 'Onderzoek laarvers[agen 1977' NIVRA-Geschrift No. 21, Amsterdam, February 1979;
page 59.
32. I.A. Burggraaff: 'Latenties terzake van de vennootschapsbe1asting', Maandblad voor Ac-
countancy en Bedrijfshuishoudkunde, June 1964, page 248.
65
year !iming difterences book inc. tax tax

before expense payable
nature amount tax
1 originating positive 1,680 6,500 3,120 1,440

2 reversing positive 240 6,500 3,120 3,360
The interest rate before tax is 10%33; the interest gain from an interest-free
loan is not liable to taxation; a permanent difference arises, which is shown
'net-of-tax' in this example. So the discounting factor has to be (1 - tax per
guilder) x interest rate = (1 - 0.48) x 10 = 5.2%. This interest factor is applied
in calculating the present value of deferred tax (column 3), the interest gain
(column 4) and deferred interest (column 5) below:
(1) (2) (3)

year nominal value balance of deferred balance of deferred
of tim. diff tax at year-end at tax at year-end at
nominal value present value
1 + 1,680 1,680 240 x a715.2 = 1,378

2 240 1,440 240 x a615.2 = 1,210
3 240 1,200 240 x a515.2 = 1,033
4 240 960 240 x a415.2 = 847
5 240 720 240 x a115.2 = 651
6 240 480 240 x a2i5.2 = 445
7 240 240 240 x a1i5.2 = 228
8 240 0 240 x a0l5.2 = 0
33. Partly in view of the conclusion on discounting and on the 'liability-in-transit' method,
the appropriate discount rate will not be discussed any further. Application of the 'firm's costs
of capital' appeals to me most (see Nurnberg).
66
(4) (5)
year interest gain/expense deferred interest at year-end
1 302 302
2 5.2% x 1,378 = - 72 230
3 5.2% x 1,210 = - 63 167
4 5.2% x 1,033 = - 54 113
5 5.2% x 847 =- 44 69
6 5.2% x 651 =- 34 35
7 5.2% x 445 =- 23 12
8 5.2% x 228 =- 12 o
Using the nominal value the book entries would have been:
year 1: Tax expense 3,120

Deferred tax 1,680
Tax payable 1,440
year 2 - 8: Tax expense

(per year) 3,120
Deferred tax 240
Tax payable 3,360
The net book income would have been: income before tax (6,500 every year)
- tax payable - change in deferred tax = 3,380 for every year, a total of
27,040.
The amount of deferred tax would have decreased by 240 for seven years as
shown in column (2) above.
Using the present value the book entries would have been:
year 1 : Tax expense 3,120

Deferred tax 1,378
Tax payable 1,440
Interest earned
(after tax) 302
67

Deferred tax 240 mut.mut.
Tax payable 3,360 during 7
and Interest expense years
(after tax) 72
Deferred tax 72
Net book income would have been:
year net book inc. interest gain/ net book income

under nominal expense under present value
value
1 3,380 302 3,682

2 3,380 (72) 3,308
3 3,380 (63) 3,317
4 3,380 (54) 3,326
5 3,380 (44) 3,336
6 3,380 (34) 3,346
7 3,380 (23) 3,357
8 3,380 (12) 3,368
27,040
The balance-sheet value of deferred tax would have been as shown in column
(3) above.
Using the 'liability-in-transit' solution the book entries would have been:

Deferred tax 1,378
Deferred interest 302
Tax payable 1,440

Deferred tax mut.mut.
(240 x A715.2) 168 during 7
Deferred interest years
(5.2% x 1,378) 72
Tax payable 3,360
68
The net book income for this method would have been:
year income - tax change change in = net book

before payable in deferred deferred income
tax tax interest
1 6,500 1,440 1,378 302 3,380

2 6,500 3,360 (168) (72) 3,380
3 6,500 3,360 (177) (63) 3,380
4 6,500 3,360 (186) (54) 3,380
5 6,500 3,360 (196) (44) 3,380
6 6,500 3,360 (206) (34) 3,380
7 6,500 3,360 (217) (23) 3,380
8 6,500 3,360 (228) (12) 3,380
27,040
The balance-sheet value of deferred tax would have been as shown in column
(3) and the value of the deferred-interest account would have been as shown in
column (5) above.
Together they present of course the nominal value of the amount of deferred
tax:
year deferred tax + deferred = deferred tax at

at present interest nominal value
value
1 1,378 302 1,680

2 1,210 230 1,440
3 1,033 167 1,200
4 847 113 960
5 651 69 720
6 445 35 480
7 228 12 240
8 0 0 0
An evaluation of the 'liability-in-transit' method
As the only reason for the application of tax-effect accounting is to have a

proper matching of revenues and (tax-)costs, every method in this field has
primarily to be judged by its effect on income (and distribution of income over
the years). As there is no difference in total income under the three valuation
69
methods mentioned above, the only way to judge them is by looking to the
income distribution over the years. The conclusion may then be that the pres-
ent-value method does not result in income smoothing; the present-value
method 'matches' the advantage of having an interest-free loan to the year of
origination of timing differences by :
a. anticipation of the realization of (implicit) interest income and

b. taking higher interest costs in the years that the advantages are higher
(that is when the interest-free loan is higher).
The nominal-value method, together with the 'liability-in-transit' solution

leads to income smoothing: after-tax book income is the same for every year
and the advantage of having an interest-free loan is not reflected in net income.
The only way to reflect in net income the advantage of having a (decreasing)
interest-free loan would be to add the advantage of having this interest-free
loan to net book income. This would result in the following 'net-opportunity-
profit' figures for the data of example 5.1 :
year net book after-tax interest distribution 'net op-

income gain through not of interest portunity
(nominal) paying the remain- gain over profit'
ing deferred-inc. tax the years
at the beginning
of the year
1 3,380 5.2% x 1,920 = 100 22% 3,480

2 3,380 5.2% x 1,680 = 87 19% 3,467
3 3,380 5.2% x 1,440 = 75 17% 3,455
4 3,380 5.2% x 1,200 = 62 14% 3,442
5 3,380 5.2% X 960 = 50 11% 3,430
6 3,380 5.2% x 720 = 37 8% 3,417
7 3,380 5.2% x 480 = 25 6% 3,405
8 3,380 5.2% x 240 = 12 3% 3,392
total 27,040 448 100% 27,488
But this application has no factual basis. So the real problem is not that the
application of the present value gives a fair presentation of capital, whilst the
application of the nominal value gives a fair presentation of income. The real
problem is that a proper allocation over the years of the advantage of having an
interest-free loan can only be attained if this advantage is added to book in-
come (leading to a fair distribution of income over the years, but a wrong total
amount of income). Both the nominal-value method and the present-value
70
LOWER VALUATION OF NEGATIVE DIFFERENCES
method 'misrepresent' this advantage. The nominal-value method allocates

this advantage (implicit in net income) in equal proportions to every year,
whilst the interest-free loan is actually decreasing through the reversal ofposi-
tive timing differences. The present-value method adds the advantage of hav-
ing an interest-free loan completely to the year of origination of positive timing
differences, whilst the advantage of having an interest-free loan lasts till the
complete reversal.
The 'liability-in-transit' method merely tries to solve this controversy by di-
viding an expense figure into an amount representing the present value of the
tax effect of timing differences and an amount representing fictitious interest
costs. It is dubious whether this makes anything clearer to the user of financial
statements. The maximum clarity of financial statements will be attained if the
application of the nominal-value method is accompanied by a note disclosing
the expected reversal years of major timing differences.
Part B: Lower valuation of originating negative timing differ-

ences
A quite different question on the valuation of timing differences concerns ori-
ginating negative timing differences. As Barton says: ' ... the case of 'prepaid
taxes' ... is scarcely mentioned in the literature, notwithstanding that .,.
taxable income can ... substantially exceed ... accounting income ... '.34
The reason why explicit treatment is scarcely found in the literature is proba-
bly that most writers argue for the offsetting of originating positive and nega-
tive timing differences and in most cases a company is trying (and able) to max-
imize the positive timing differences and minimize the negative ones. When
nevertheless the originating negative timing differences are larger than the
originating positive ones there seems to be a reluctance in most of the litera-
ture to show the tax effect of this difference as an asset in the balance sheet. For
instance Hendriksen rejects the tax effect of a negative timing difference as an
asset because it ' ... is not an unconditional right to future benefits and it is not a
claim that would be recognized by the government'. 35
Most writers argue that a distinction must be made between the valuation of
a negative timing difference arising because of a difference between book prof-
it and taxable profit and the valuation of negative timing differences because of
the possibility of offsetting a fiscal loss against positive taxable income in the
future (loss carry-forward).
34. Barton, page 22.

35. E.S. Hendriksen: 'Accounting theory', 3rd edition, Homewood Illinois, 1977, page 370.
71
Partly in imitation of this literature and partly because the conclusions on

the recognition of an asset because of 'normal' negative timing differences will
differ (although only in degree) from the conclusions on the recognition of an
asset as a result ofloss carry-forward, the distinction referred to will be made in
this study as well. Deferred-tax accounting in the case of loss carry-forward
will be analysed in chapter 6. The valuation of the tax effect of 'normal' nega-
tive timing differences will be analysed in this part.
Why the tax effect of negative timing differences does not create assets
Morley36 goes as far as to argue that negative timing differences should be com-
pletely ignored. The assumptions required to show that the tax effect of a nega-
tive timing difference will be a recoverable asset are very different from those
required to show that deferred tax will be payable. Deferred tax will be pay-
able if a company expects to break even over the years, but taking the tax effect
of a negative timing difference as a permissible asset, ' ... involves a degree of
profit forecasting greater than that implied by the going-concern concept'. 36
Morley illustrates his statement with an example, which is reproduced below:
Example 5.2: On the value of the tax effect of negative timing differences
'A company with pre-tax profits (before providing for bad debts) of £ 100 in
19xO decides that a general provision for bad debts of £ 50 is required which
will be disallowed for taxation purposes. However, in 19x1 the company (a
good predictor!) finds that of its debtors as at December 31, 19xO exactly £ 50
turn out to be bad, and are written off against the provision brought forward. If
the company regards prepaid tax 37 as an asset at December 31, 19xO then its
profit and loss account for the year 19xO will be as follows:
Operating profit £ 100

General provision for bad debts 50
£ 50
Corporation tax payable at 40% on
(£ 50 + £ 50) £ 40
Less tax 'prepaid' 40% on £ 50 20
£ 20
Profits after tax £ 30'38
36. Morley, page 182.

37. Morley and many other writers use the term 'prepaid tax' to indicate the tax effect of
negative timing differences. This term causes confusion as the moment of actual payment
depends on the collection policy of the fiscal authorities. For example when there is loss carry-
forward tax is not paid at all, and no amount of tax is so far carried over.
38. Morley, page 182. For ease of reference this example is numbered consecutively.
72
Morley argues for the non-asset nature of originating negative timing differ-
ences by saying that' ... it will be seen that for 'prepaid tax' to be of benefit to a
company and recordable as an asset one must assume that future profits will at
least equal the amount of expense temporarily disallowed for tax purposes
(author: £ 50 in 19x1), and this seems an unwarranted extension of the going-
concern principle'. 36
It is not difficult to find objections to this opinion. First of all, it is not true
that the amount of future profit must at least equal the amount of the originat-
ing negative timing difference. Reversal of an originating negative timing dif-
ference fails to take place in the expected year only if in the year of (full or
partial) reversal there are no reversing positive differences of at least the same
amount, whilst there is a fiscal loss in the year of reversal. A second objection
to the opinion of Morley is that it completely ignores the possibilities of loss
carry-back and carry-forward. It is not true that the amount of profit (minus
reversing positive timing differences) must equal the reversing negative timing
differences; the company must expect to break even only over a period equal
to the sum of the loss carry-back and loss carry-forward periods. If the compa-
ny in example 5.2. earns only a£ 40 operating profit in 19x1, then the reversal of
the originating negative timing difference is completed by:
a. an immediate tax reduction of £ 16, and

b. a new originating negative timing difference of £ 4, due to the right of
loss carry-back or loss carry-forward.
So the realization of the asset represented by the 'tax effect of negative timing
differences' depends on a fiscal break-even (mostly over a considerable peri-
od, especially when the reversing negative timing differences are spread over
several years). Morley's arguments are insufficient to deny the asset-nature of
the tax effect of negative timing differences.
On the lower value of the tax effect of negative timing differences
Most writers think that originating negative timing differences have some val-
ue, but that this value must be measured with prudence. This prudence can
vary in degree:
a. Some writers argue for the neglect of originating negative timing differ-
ences in so far as they cannot be offset against positive timing differences. This
opinion was defended a.o. by De Jong39 and Hendriksen. 35 This seems to be
39. 1. de long: 'Latenties terzake van de vennootschapsbelasting' Maandblad voor Accoun-

tancy en Bedrijfshuishoudkunde 1964, pages 45 and 54.
73
very prudent, because a negative timing difference under the tax law of most
countries grants only a conditional right to clear. But this method is not pru-
dent at all when the reversal of the positive timing differences takes place in a
different year from the reversal of the negative timing differences.
Moreover, this treatment is not only inconsistent with that of positive timing
differences; there is also an inconsistency in the treatment of the originating
negative timing differences themselves, since some of them are valued at their
full nominal (or discounted) value (by offsetting them against positive differ-
ences), whilst others (which of them?) are completely neglected. Moreover,
this treatment can lead to a strong fluctuation in successive net income figures,
depending on the relationship between book income and taxable income.
b. Barton40 mentions that ' ... in those (few) cases where 'prepaid taxes'
are recognized in practice, they are generally offset against the item from
which they arose ... ; the reason ... appears to be the reluctance to show 'pre-
paid tax' as an asset where the 'prepaid tax' exceeds the deferral'. 40 Barton
mentions no writers defending or companies applying this method. It seems to
imply a net-of-tax method (defended only by Moore 41 in the literature) either
for all the negative timing differences or only in so far as the negative timing
differences are larger than the positive ones. The inconsistency is the same as
when negative timing differences are neglected and becomes even more prob-
lematical if the net-of-tax method is applied only when the negative differences
are larger than the positive differences. The valuation of some assets is influ-
enced by the fact that they are thought to have given rise to negative timing
differences, whilst other assets (which are thought to have done the same) are
valued without taking this into account.
c. Most writers argue that the tax effect of a negative timing difference is
a permissible asset if its realization is reasonably certain, at lfast when negative
timing differences are even mentioned. Most professional accountancy bodies
agree with this opinion. 42 Clark 43 mentions, in a comparison between the Eng-
lish and the Australian recommendations, the peculiar change in reasoning
used in the Australian Statements on this subject. In Australia the 1971 State-
40. Barton, page 21 and 22.

41. c.L. Moore: 'Deferred income tax - Is it a liability?', The New York C.P.A., February
1970, page 130 and following. (See chapter 4 for his opinion and objections to his opinion).
42. See inter alia: 'International Accounting Standard 12', paragraph 44: 'The tax effect of
timing differences that result in a debit balance or a debit to the deferred tax balance should
not be carried forward unless there is a reasonable expectation ofrealisation'. However, the
recognition of the tax effect of loss carry-forward requires 'assurance beyond any reasonable
doubt' (paragraph 48).
43. F.L. Clark: 'Deferred tax accounting is still hocus-pocus', The Accountant, November
4th, 1976, pages 523-526.
74
ment D4 asked for 'virtual certainty of realisation' in the presentation of an

asset for the tax effect of negative timing differences. In the 1974 Statement
DS4 this was changed into a 'reasonable expectation of realisation'. Some
companies with future taxation benefits were quick to act and suddenly creat-
ed considerable assets from the tax effect of negative timing differences, even
changing (book) losses into profits. The Australian Accounting Standards
Committee reacted by bringing out a new Statement DS4 in August 1976, stat-
ing that taxation benefits might be raised only when it is 'virtually certain' that
they will be realized, irrespective of whether they arise out ofloss carry-forward
or through the existence of other timing differences; they thus made good the
effect of the application of (new) accounting principles by restoring the former
accounting principles. This third 'type of prudence' is certainly intelligible when
it is put the other way: it would be a serious violation of the realization principle
to capitalize the tax effect of negative timing differences where reversal (realiza-
tion) is reasonably uncertain. So its fairness depends very much on the expla-
nation of 'reasonable certainty'. There is not much literature that explains the
term 'reasonable certainty'.
A very rigid interpretation, if it can be said to be one, has been given by the
Dutch Enterprise Chamber in the Pakhoed case. 44 This judgment of 31 May
1979 bears on the annual accounts of 1977 of Pakhoed Holding N.V. In this
judgment, the Court among other things dealt with the recognition of the tax
effect of a negative timing difference because of a peculiar type of loss carry-
over. A loss because of the liquidation of a subsidiary is, in contrast to other
gains and losses, not exempted from income tax under the affiliation privilege
in The Netherlands. 45 However, this loss is recognized for fiscal purposes only
after the liquidation has been fully settled. Pakhoed Holding in drawing up the
annual accounts 1977 balanced the tax effect of a negative timing difference
because of termination losses on some affiliated companies, for which the liq-
uidation had not yet been completely settled, with the tax effect of existing
positive timing differences. Pakhoed argued that they had so much positive
timing differences at the end of 1977, that it could be readily accepted that the
fiscal profits arising because of the reversal of these positive timing differences
would be more than sufficient to absorb the termination losses on their recog-
nition for fiscal purposes. Moreover, as Pakhoed argued, the company is able
to affect future fiscal profits, by using tax incentives to its own discretion,
therefore it can be taken as certain that future fiscal profits absorb the termina-
44. The Enterprise Chamber at the Amsterdam Court was constituted by the Act on Annual
Accounts in 1971, to enforce, if necessary, the enactments of Company Law through a sen-
tence of the Court.
45. Section 13, paragraph 5 of the Corporate Income Tax Act (Wet Vennootschapsbelasting).
Some further details will be given in chapter 11.
75
tion losses on their recognition for tax purposes. The Enterprise Chamber con-
sidered in its judgment that the existence of positive timing differences and the
possibility of affecting future fiscal profits did not matter, because these facts
did not imply: 'that it can be taken as a fact that future fiscal profits will absorb
the future termination losses. This method of proceeding of Pakhoed is in con-
flict with the prudence principle, that should be considered especially in the
recognition of benefits that may be realized only in the future. It makes no
difference that positive timing differences will reverse in the future as has been
argued by Pakhoed. The effect of this can also be recognized only in the year of
actual reversal, because of the prudence principle'.
According to the Enterprise Chamber, Pakhoed must prepare annual ac-
counts that do not show the fact that the company can pass part of the recorded
termination losses on to the fiscal authorities. The matching principle, even if
negative timing differences are practically certain to be reversed, is overridden
by the prudence principle. It should be noted that the judgment of the Court
does not concern the capitalization of negative timing differences because of
loss carry-forward, but merely negative timing differences as such. This judg-
ment gives the death blow to any capitalization of the tax effect of negative
timing differences. Pakhoed Holding N. V. appealed against this judgment to
the High Court. The High Court, on appeal of Pakhoed, decided in its judg-
ment of 20 March 1980, that the tax effect of negative timing differences can be
capitalized if reversal may be reasonably assumed. It is obvious that reason-
able certainty cannot be interpreted as absolute certainty; but even a less rigid
interpretation might give rise to a serious violation of the matching principle.
When reversal of a negative timing difference cannot take place because there
is a fiscal loss, it is not the existence of negative timing differences that causes
the non-reversal; the cause of non-reversal is that there is not enough profit in
the year of reversal. It will immediately be in conflict with the matching princi-
ple to show the tax effect of an originating negative timing difference by creat-
ing extraordinary costs in the year(s) of origination and (an) extraordinary
gain(s) in the year(s) of reversal.
In the case of negative timing differences there arises a 'conditional right to
clear' in the year of origination of the negative timing difference (however un-
certain this right may be); and when profit in the year of reversal is not enough
to make this reversal possible, there arises an extraordinary loss in the year of
non-reversal, due to the fact that the amount of profit was too low, at least if
carry-back and/or carry-forward of losses is not possible.
Besides the contrariety to the going-concern assumption, Burgert46 , and
46. R. Burgert in his commentaries on the judgment of the Dutch Enterprise Chamber of 31
May 1979 in the Pakhoed case.
P. Sanders and R. Burgert: 'Jaarrekening van ondernemingen, dee I 3, Jurisprudentie',
(loose-leaf), Alphen aid Rijn, 1968, page 225.
76
very properly, points to the fact that a valuation of originating negative timing
differences below their undiscounted nominal value is not in line with the
transitory-nature of the balance-sheet items because of deferred-tax account-
ing.
Conclusions on the lower valuation of negative timing differences
A lower valuation of originating negative timing differences (lower than their

nominal or present value) seems to be reasonable only when:
a. a company is expecting losses and does not foresee making enough

profit during the coming years to make reversal of negative timing differ-
ences possible; depending on the period of loss carry-back and loss carry-
forward, this situation implies in most countries that the going-concern as-
sumption is no longer valid, so that the valuation of all assets and liabilities
(including tax assets and tax liabilities) comes into question;
b. under the circumstances mentioned above, the company expects not to
be able to influence the originating negative timing differences or reversing
positive timing differences so as to make them equal to the reversing nega-
tive timing differences in the year of their reversal.
In this special situation, when both the above-mentioned conditions are ful-
filled, it is conceivable that the matching principle is rejected through a lower
valuation of negative timing differences. But this situation, as was said before,
will mostly be one in which the valuation of all assets and liabilities will be
changed by abandoning the going-concern assumption. No justification for a
lower valuation of negative timing differences as a general rule can be found,
unless there are reasons for abandoning the matching and consistency princi-
ple. A further analysis of the influence of the existence of positive timing dif-
ferences on the going-concern assumption will be given in chapter 6 and chap-
ter 14.
The argument that some companies do not have to pay (part of) their deferred
taxes in the foreseeable future is not only an insufficient argument for valuing
deferred taxes on a discounted basis, but also for a partial application of
deferred-tax accounting (non-fully comprehensive tax allocation).
The fact that deferred taxes are an interest-free loan from the government is
an insufficient argument as well for valuing deferred taxes on a discounted ba-
sis.
77
The 'liability-in-transit' method is, theoretically speaking, a good invention,

but it hardly contributes to maximum clarity of financial statements.
A denial of the asset-nature of negative timing differences, as well as a valu-
ation below their undiscounted nominal value, is not in line with the transitory-
nature of the balance-sheet items because of deferred-tax accounting.
Moreover, this treatment is clearly inconsistent with that for positive timing
differences, as long as the going-concern assumption can be considered justi-
fied.
Apart from loss carry-forward, it is only in rare situations that it is conceiv-
able that the matching principle is rejected through a valuation of negative
timing differences below their undiscounted nominal value.
78
6. Deferred-tax accounting in the case of
loss carry-back and carry-forward
If the accounting entity and the taxable entity are the same and if the tax au-
thorities would immediately refund an amount of money equal to the (taxable)
loss times the current tax rate, loss situations would not raise any special prob-
lems. However, no tax system in the world satisfies these two conditions. Prob-
lems arising from a difference between the accounting entity and the taxable
entity will be dealt with separately in chapter 11. The problem analysed in this
chapter is the accounting treatment of loss carry-over within the same legal,
accounting and fiscal entity, in other words, the accounting treatment of loss
carry-back and loss carry-forward. Some authors combine their consideration
of the accounting treatment of loss carry-back and loss carry-forward with an
analysis of the significance of the origination and reversal of other timing dif-
ferences. Since this does not conduce to a clear analysis and since the existence
of other timing differences can at best contribute to the probability of reversal
of negative timing differences due to loss carry-forward, this simultaneous
treatment is not necessary. The influence of other timing differences will be
dealt with separately, as far as possible, in chapter 14.
Carry-back of losses
Although the right to offset a loss against positive income of the same company
from the past (carry-back) is far from universaP, there is almost universal
agreement on its accounting treatment. Carry-back results either in an imme-
diate refund of tax or in an existing short-term tax liability that disappears or is
reduced. The claim against the tax authorities because of loss carry-back can
1. G. Laule: 'Rapport Generale des consequences des deficits subis dans un pays pour une
entreprise ou des entreprises associees ayant des activites internationales sur I'imposition des
benefices dans d'autres pays', Volume LXIVb of 'Cahiers de droit fiscal international' for the
33rd 'Congres International de Droit Financier et Fiscal', Copenhaque, 1979, page 77. Laule
states that only 6 out of 23 countries (being the country members of the International Fiscal
Association submitting reports on this occasion, offer the possibility of carrying losses back.
These countries are Canada, the Federal Republic of Germany, Great Britain, Japan, The
Netherlands and the U.S.A.
79
LOSS CARRY-BACK AND CARRY-FORWARD
be offset against a current tax liability, as debtor and creditor are the same. If
the claim against the tax authorities because of loss carry-back exceeds current
tax liabilities, the balance can be capitalized as a current asset. The treatment
of loss carry-back in the income statement poses no special problem either. It
appears advisable to disclose the loss and the tax effect of loss carry-back sepa-
rately. This can easily be done by showing a negative amount of tax payable
(which is the amount of tax actually refundable). An illustration of the dis-
closure of the tax effect of loss carry-back follows.
Example 6.1: Disclosure of the tax effect of loss carry-back

The current tax rate is 50%. Book income and taxable income are identical
and have been so in the past. In year 5 a loss of Oft. 1,500 arises, because of a
special write-off of fixed assets (for both accounting and tax purposes). The
loss can be carried back in full.
Balance sheet III year 5
Fixed assets 2,000 Stockholders' equity 1,000

Current assets 500 Tax payable 500
Other debts 1,000
2,500 2,500
Income statement year 5
Operating loss before tax 1,500

Tax payable (carry-back) (750)
Tax effect of t.d. -0-
Tax expense
Net operating loss
Balance sheet 31112 year 5
Fixed assets 500 Stockholders' equity 1,000

Current tax refund 250 Debt 1,000
Other current assets 500
Net loss 750
2,000 2,000
80
CARRY-FORWARD OF LOSSES
There is practically universal agreement on this type of treatment of carry-

back. I.A.S. no. 12: 'Accounting for taxes on income', affords an interesting
illustration of this, when it states in part:
'23. A recovery of taxes through the application of a tax loss to the carry-
back period represents a tax saving that is effectively realised in the period of
loss and is included in net income or net loss in the financial statements for that
period. In determining the amount of saving, appropriate adjustment of exist-
ing deferred tax balances may be necessary ...
37. Taxes on income which were previously paid and are due to be recov-
ered as a result of the application of a tax loss in accordance with paragraph 23
are shown in the balance sheet as a receivable separate from deferred tax
balances' .
The treatment of existing timing differences and timing differences originat-
ing or reversing in the loss year poses hardly any problems; a rather more
complex situation may arise if there is a loss carry-over (carry-back or -for-
ward) and simultaneously timing differences originate or reverse. I.A.S. no.
12 probably refers to this in paragraph 23 (and 49) when speaking of an 'adjust-
ment of existing deferred tax balances'. Chapter 14 will show that no adjust-
ment is necessary; the 'adjustment of existing deferred tax balances' will turn
out to be nothing other than an offset of the tax effect of loss carry-forward (!)
against existing positive timing differences.
Carry-forward of losses
Carry-forward of losses is the possibility of offsetting a loss (for tax purposes)

against positive income (for tax purposes) of the same company during a limit-
ed or unlimited period in the future. In contrast to loss carry-back, the ac-
counting treatment of loss carry-forward has given rise to many differences of
opinion.
Some different views on the accounting treatment of loss carry-forward
The opposing views at once appear from a brief investigation of some leading
accounting standards.
The British S.S.A.P. no. 22 states:

'While trading losses by definition give rise to timing differences, prudence
dictates that they should not be recognized through the deferred taxation ac-
count since there can be no certainty that future profits will be earned of suffi-
cient amount to absorb them.
Credit for the tax effects of a trading loss should therefore only be taken
81
when the loss is utilised for tax purposes, unless there is a credit balance on
deferred taxation account at the time when the loss carry-forward arises. In
such circumstances, credit balances on deferred taxation account should be
released to profit and loss account to the extent of the notional tax relief attrib-
utable to the loss, but not exceeding that part of the deferred taxation account
which represents tax on income which can properly be offset against the loss
for tax purposes. When trading profits are subsequently earned a deferred tax-
ation account balance will require to be reinstated to the extent of the tax relief
resulting from the loss but not exceeding tax on the equivalent amount of tim-
ing differences previously released when the losses were carried forward'. 2
The U.S.A. A.P.B. opinion no. 11 states:

'The tax effects of loss carry-forwards relate to the determination of net in-
come (loss) of the loss periods. However, a significant question generally ex-
ists as to realization of the tax effects of the carry-forwards, since reaiization is
dependent upon future taxable income. Accordingly, the Board has concluded
that the tax benefits of loss carry-forwards should not be recognized until they
are actually realized, except in unusual circumstances when realization is as-
sured beyond any reasonable doubt at the time the loss carry-forwards arise.
When the tax benefits of loss carry-forwards are not recognized until realized
in full or in part in subsequent periods, the tax benefits should be reported in
the results of operations of those periods as extraordinary items'. 3
The I.A.S. Standard no. 12 states:

'However, in rare circumstances, the inclusion of this potential tax saving in
the determination of net income for the period of the loss may be considered
appropriate. If a potential tax saving is to be dealt with in this manner, the
consideration of prudence requires that there is assurance beyond any reason-
able doubt that future taxable income will be sufficient to allow the benefit of
the loss to be realized. For example, the condition of assurance beyond any
reasonable doubt would be satisfied if the following conditions exist:
a. the loss results from an identifiable and non-recurring cause, and

b. a record of profitability by the enterprise has been established over a
long period and is expected to continue'.4
2. Statement of Standard Accounting Practice no. 11: 'Accounting for deferred taxation',
1975. The Institute of Chartered Accountants in England and Wales, paragraphs 19 and 20.
3. Accounting Principles Board Opinion no. 11: 'Accounting for Income Taxes', 1966.
American Institute of Certified Public Accountants.
4. International Accounting Standards Committee: International Accounting Standard no.
12: 'Accounting for Taxes on Income', July 1979, paragraph 25.
82
METHODS FOR CARRY-FORWARD
The Dutch 'Tripartiete overleg' in its 'Voorontwerp van beschouwingen naar

aanleiding van de Wet op de jaarrekening van ondernemingen, Aflevering no.
4' states (in translation): 'In the case of carry-forward there is an anticipated
tax claim, which will only be realized if and in so far as there will be enough
positive taxable income during the carry-forward period. Recognition of this
claim is possible only in exceptional cases'. 5
Other possible (and rather extreme) ways of accounting for loss carry-forward,
are:
• Allocation of the total tax effect of a loss to the loss year, as being con-
sistent with the assumption underlying inter-period income-tax allocation,
that the income tax follows income. Allocating future income-tax reduction
to the carry-forward years would conflict with the principle that the loss
causes the reduction .
• Allocation of the total tax effect of a loss to the carry-forward years, be-
cause the earnings in the carry-forward years give value to the relief carried
forward.
Five basic methods of accounting for loss carry-forward
Five basic methods for the allocation of the tax effect of loss carry-forward can
be distinguished. In a sequence of diminishing prudence, they are:
Method 1
The total tax effect of the loss is allocated to the carry-forward years, because
the earnings which create the real value of the right on carry-forward should
benefit from their tax effect. The tax effect of the loss carry-forward is thus
included in the annual income of the carry-forward years. A complete neglect
of the effect of possible loss carry-forward in the loss year is also defended
because the prudence principle forbids recognition of an asset due to loss car-
ry-forward in the loss year; the tax effect ofloss carry-forward should be credit-
ed to Earned Surplus during the carry-forward years as being a prior-period
adjustment of the loss year. 6
5. Aflevering no. 4, 31 december 1975, paragraph 27. Also published in: 'Richtlijnen voor
de jaarrekening' (loose-leaf), Deventer, 1980.
6. Inter alia the opinion of mr. Wellington in assenting to chapter lOB of Accounting Re-
search Bulletin no. 43: 'Income taxes', AICPA, Committee on Accounting Procedure, 1953.
83
Method 2
The tax effect ofloss carry-forward is allocated to the loss year if and in so far as
the realization of the benefit of the loss carry-forward is 'assured beyond any
reasonable doubt'. The tax effect of the remainder of the loss, if any, for which
carry-forward is not assured beyond any reasonable doubt, is allocated to the
carry-forward years (in case of actual carry-forward) or treated as a prior-peri-
od adjustment.
Method 3
The tax effect of loss carry-forward is allocated to the loss year in so far as this
tax effect is equal to a credit balance on the deferred-tax account. The tax ef-
fect of the remainder of the loss, if any, is allocated to actual carry-forward
years (in the case of actual carry-forward) or treated as a prior-period adjust-
ment.
Method 4
The tax effect of estimated loss carry-forward is allocated to the loss year. The
tax effect of differences between actual carry-forward and estimated carry-for-
ward is allocated to the carry-forward years or treated as a prior-period adjust-
ment of the loss year.
Method 5
The total tax effect of a loss to be carried forward is allocated to the loss year.
When the realization of the benefit of the loss carry-forward turns out to be
impossible an extraordinary loss arises in the last year of the carry-forward
period.
Although these methods do not exclude each other (as a matter of fact, the
combination of methods 2 and 3 occurs rather frequently), they will be dealt
with separately.
84
A closer look at the basic methods of accounting for loss carry-forward
Method 1
The first method (allocation of the tax benefit to the carry-forward years) is,
without doubt, the most prudent one, as it does not anticipate future income.
However, this method is definitely not consistent with the assumption underly-
ing comprehensive tax allocation. It ignores the fact that the loss causes the
reduction; only the value of the right of carry-forward depends on taxable in-
come in future years. This method after all treats the loss carry-forward as a
permanent difference in the years of actual carry-forward: it is therefore sur-
prising that the few advocates of this method7 do not defend the allocation of
the tax effect of loss carry-back to the actual carry-back years. It is difficult to
see why loss carry-forward should be treated as a permanent difference of the
carry-forward years, whereas the tax effect of loss carry-back is recognized in
the loss year; also why the earnings in the carry-forward years do produce the
value of the carry-forward, whereas the earnings in the carry-back period obvi-
ously do not produce the value of the carry-back (by way of a prior-period
adjustment). Method one, by treating the actual carry-forward as a permanent
difference, misstates income, because the loss of one year reduces a (tax-) cost
figure in later years, as is illustrated in the following example:
Example 6.2A: Method one misstates income

The tax-rate is 48% for seven years. Book income before tax equals taxable
income during these years, except for carry-back (over a period of three years)
and for carry-forward (over a period of two years). Application of method one
produces as a result:
7. In The Netherlands among others l. de long: 'Latenties terzake van de vennootschapsbe-

lasting', Maandblad voor Accountancy en Bedrijfshuishoudkunde, Febr. 1964.
In the U.S.A. this method is defended inter alia in A.P.B. no. 43, chapter lOB: 'Accounting
for income taxes', paragraph 17: 'Where tax-payers are permitted to carry-forward losses or
unused excess profits credits, the committee believes that, as a practical matter in the prepara-
tion of annual income statements, the resulting tax reduction should be reflected in the year to
which such losses or unused credits are carried .. .'
85
Year Book income Carry-back Carry-forward

before tax
1 100,000 100,000
2 100,000 100,000
3 100,000 100,000
4 (400,000)
5 (50,000)
6 100,000 100,000
7 100,000 50,000
Total 50,000 300,000 150,000
Year Tax payable Tax expense Net income Reported ef-

or refundable fective tax-
burden
1 48,000 48,000 52,000 48%

2 48,000 48,000 52,000 48%
3 48,000 48,000 52,000 48%
4 (144,000) (144,000) (256,000) 36%
5 0 0 (50,000) 0%
6 0 0 100,000 0%
7 24,000 24,000 76,000 24%
Total 24,000 24,0000 26,000 48%
Method 2
The assessment of method 2 (allocation of the tax benefit to the loss year in so
far as the realization of the benefit of loss carry-forward is assured beyond any
reasonable doubt) depends on the meaning of the term 'assured beyond any
reasonable doubt'. A.P .B. Opinion no. 11 cites, by way of example, some cu-
mulative circumstances under which carry-forwards may be recognized in the
loss year: 'Realization of the tax benefit of a loss carry-forward would appear
to be assured beyond any reasonable doubt' ... when four conditions exist:
a. 'the loss results from an identifiable, isolated and non-recurring cause',

b. 'the company either has been continuously profitable over a long period
or has suffered occasional losses which were more than offset by taxable
income in subsequent years',
86
c. 'future taxable income is virtually certain to be large enough to offset

the loss carry-forward',
d. 'future taxable income ... will occur soon enough to provide realization
during the carry-forward period'. 8
Bevis and Perry, in their interpretation of the Opinion, comment condition

a. as follows: 'The use of the words 'identifiable, isolated and non-recurring'
in the above quotation was intended to rule out recognition of loss carry-for-
wards resulting from generally unsuccessful business operations of an entity.
Thus operating losses resulting because of depressed economic conditions or
because of changes in consumer preferences or in technology do not give rise
to a situation where a future tax benefit may be recognized. Loss carry-for-
wards resulting from the introduction of products or services which have not
achieved sufficient acceptance to produce profits do not qualify for recognition
prior to realization. Such non-recognition of loss carry-forwards applies both
to companies in existence for many years that have moved into a new area of
business and to newly-formed companies in the developmental stage'.9
For the last type of company, the allocation of the tax effect of loss carry-
forward to the loss year might already be precluded by condition b. This inter-
pretation of 'assurance beyond any reasonable doubt' leaves only rather rare
cases in which the tax effect of loss carry-forward may be allocated to the loss
year. That I.A.S. no. 12 is much more explicit in its rigid interpretation of the
term 'assurance beyond any reasonable doubt' might have become clear from
the earlier remark: ' ... The potential tax saving related to a tax loss carry-for-
ward is generally not included in the determination of net income in the period
of the loss ... However, in rare circumstances, the inclusion of this potential tax
saving in the determination of net income for the period of the loss may be
considered appropriate ... '.10
In contrast to method one, method 2 takes as its starting point that in essence
the right to carry a loss forward constitutes a timing difference. Only for the
sake of prudence, the matching principle is overruled by the realization princi-
ple in those cases in which loss carry-forward is not 'assured beyond any rea-
sonable doubt'. This really means that whenever the conditions for 'assurance
beyond any reasonable doubt' are not satisfied, there is an expectation of no
positive (taxable) income during the carry-forward period.
8. Quoted from: D.J. Bevis and R.E. Perry: 'Accounting for Income Taxes, An interpreta-
tion of A.P.B. Opinion no. 11', New York, 1969, page 24. The A.P.B. Opinion mentions only
two conditions, taking the conditions a) and b) and the conditions c) and d) together. It fol-
lows from a literal interpretation of the text that there are really four conditions that must be
satisfied simultaneously.
9. Bevis and Perry, page 24.
10. I.A.S. No. 12, paragraphs 24/25. Emphasis mine.
87
The expectation of uncertain future taxable income, however, is the basis

for not recording a carry-forward benefit in the loss year and that is definitely
not the same expectation as that of no future taxable income (before loss carry-
forward) at all. Thus, for most cases this method will lead to the same misstate-
ment of income in the loss year and the carry-forward years as in method one.
Actual carry-forward of a loss, for which no carry-forward benefit was
recorded in the loss year, is due to the operations in the loss year, being the
reversal of a non-recorded negative timing difference. The misstatement of
income during the carry-forward years can be prevented by treating the revers-
ing negative timing differences as a prior-period adjustment. Application of
this method to the figures of example 6.2 gives the following results, if the real-
ization of the benefit of the carry-forward is not assured beyond any reason-
able doubt:
Example 6.2B: Method two with prior-period adjustments
Year Book income Tax payable Net operating Prior-period

before tax Tax expense income adjustments
1 100,000 48,000 52,000

2 100,000 48,000 52,000
3 100,000 48,000 52,000
4 (400,000) (144,000) (256,000) 48,000
5 (50,000) 0 (50,000) i 24,000
6 100,000 0 100,000 (48,000) i
7 100,000 24,000 76,000 (24,000)
Total 50,000 24,000 26,000 x x
88
Year Net income Ex-post inc. Reported effective tax burden

for the year for the year for the year ex-post
1 52,000 52,000 48% 48%

2 52,000 52,000 48% 48%
3 52,000 52,000 48% 48%
4 (256,000) (208,000) 36% 48%
5 (50,000) (26,000) 0% 48%
6 52,000 52,000 0% --+ 48%* 48%
7 52,000 52,000 24% --+ 48%* 48%
Total (46,000) 26,000 x x
* Note: The first percentage (0% and 24%) me&ns: tax expense as a percentage of book in-
come before tax; the second percentage (48%) gives the tax expense as a percentage of book
income before tax, but after correction for prior-period adjustments applicable to the current
year.
Method 3
Another reason can be found in the literature for assuming that the realization
of the benefit of loss carry-forward is assured beyond any reasonable doubt:
the expected reversal of positive timing differences during the carry-forward
period. ll This reason will be discussed in connection with method three.
At first sight, method 3 seems rather prudent; but in certain circumstances
this may be far from true. The recognition of the tax effect of loss carry-for-
wards as an offset against deferred-tax credits is justified because it would be
unrealistic to require recognition of deferred-tax credits while at the same time
denying recognition of deferred-tax charges in the form of a loss carry-for-
ward. However, when the tax effect of existing positive timing differences has
to cancel out the tax effect of negative timing differences due to loss carry-
forward, it is essential that the positive timing difference to which the credit
balance of the deferred-tax account relates will reverse entirely during the car-
ry-forward period. But even when this last condition is satisfied, method 3 can
11. It is notable that l.A.S. No. 12 actually incorporates two different standpoints. In the
'Explanation-paragraph' 26 it is stated that the existence of positive timing differences may
provide evidence that loss carry-forward is assured beyond any reasonable doubt: 'The exis-
tence of a credit amount in the deferred tax balance may provide evidence that the tax saving
related to a tax loss carry-forward can be realised at least in part ... •. But paragraph 49 adheres
to method 3: ' ... the tax saving relating to a tax loss carry-forward should be included in the
determination of net income for the period of the loss to the extent of the net credits'in the
deferred-tax balance .. .'.
89
give rather strange results as concerns the reported effective tax burden. This
can be illustrated by the application of this method to the figures of example
6.2; taxable income remains the same, but book income before tax now differs
from taxable income.
Example 6.2C: Method three may produce strange results
Year Book inc. Taxable Tax pay- Tax effect of timing

before income able differences
tax
1 125,000 100,000 48,000 or.pos.t.d. 12,000

2 150,000 100,000 48,000 or.pos.t.d. 24,000
3 150,000 100,000 48,000 or.pos.t.d. 24,000
4 (400,000) (400,000) (144,000) or.neg. t.d. (36,000)A
5
6
(50,000)
25,000
(50,000)
100,000 °
°
or. neg. t.d.
reinstatement
rev.pos.t.d.
(24,000)B
48,000 C
(36,000)C
7 50,000 100,000 24,000 reinstatement 12,000 D
rev.pos.t.d. (24,000)D
Total 50,000 50,000 24,000
Year Deferred-tax Tax expense Net income Reported ef-

acc., balance fective tax
at year-end burden
1 cr. 12,000 60,000 65,000 48%

2 cr. 36,000 72,000 78,000 48%
3 cr. 60,000 72,000 78,000 48%
4 cr. 24,000 (180,000) (220,000) (45%)
5
6 °
cr. 12,000
(24,000)
12,000
(26,000)
13,000
(48%)
48%
7
Total
° 12,000
24,000
38,000
26,000
24%
Notes to example 6.2C

A. Year 4: The recognition of a negative timing difference because of loss car-
ry-forward (with a tax effect of 48% of 100,000 = 48,0(0) is restricted to
the expected reversal of positive timing differences during the two year car-
ry-forward period of 75,000, with a tax effect of 48% of 75,000 = 36,000
90
B. Year 5: Tax effect of expected reversal of pos.t.d. during carry-forward pe-

riod = 48% of 125,000 = 60,000
Used as an offset to the year 4-loss: 36,000
Remaining tax effect of rev.pos.t.d. during carry-forward period: 24,000
Tax effect of or.neg.t.d. because of loss carry-forward year 5: 24,000
Balance of deferred-tax account -0-
C. Year 6: Possible reinstatement of deferred-tax account = tax effect of actual

loss carry-forward (see chapter 14) = 48% of 100,000 =
Necessary reinstatement of deferred-tax account = tax effect of positive timing
differences going to reverse: 48% of 125,000 = 60,000
Actual reinstatement of deferred-tax account: 48,000
Tax effect of rev.pos.t.d. year 6: 48% of 75,000 = 36,000
Leaves a reinstatement for year 6 of: 12,000
D. Year 7: Possible reinstatement: 48% of 50,000 = 24,000
Necessary reinstatement = 48% of 50,000 = 24,000
Actual reinstatement of deferred-tax account: 24,000
Reinstatement of year 6: 12,000
Leaves a reinstatement for year 7 of: 12,000
It is noteworthy that in this method the income figures for several years are
influenced by the loss carry-forward. This is so for:
• the loss year(s), when because of loss carry-forward an asset is only par-
tially offset against a credit balance on the deferred-tax account (year 4 in
example 6.2C);
• the year(s) of actual loss carry-forward, when an original net deferred-
tax credit is reinstated;
• the year(s) of reversal of positive timing differences, for which the cred-
it on the deferred-tax account was used as an offset against the tax effect of
the negative timing difference due to loss carry-forward.
This last effect in particular can make method three a rather imprudent one,
because the impossibility of loss carry-forward is reflected solely in the years of
reversal of positive timing differences. And these years can be a considerable
time after the end of the carry-forward period (e.g. positive timing differences
from depreciation of real estate). This effect does not appear in example 6.2C,
because the reversal period and carry-forward period are the same; so it may
best be illustrated by another example:
91
Example 6.3A: Method three has effects a considerable time ahead
Year Book income Taxable Carry-back and Tax payable

before tax income carry-forward
1 175 100 100 48

2 150 100 100 48
3 150 100 100 48
4 (400) (400) 300 (144)
5 (50) (50) 0
6 (25) 75 75 0
7 0 25 25 0
8 75 100 48
9 75 100 48
Total 150 150 400 96
Year Tax effect of Deferred- Tax Net Reported

timing differ- tax ace. expense income effective
ences at year- tax
end burden
1 or.pos.t.d. 36 cr. 36 84 91 48%

2 or.pos.t.d. 24 cr. 60 72 78 48%
3 or.pos.t.d. 24 cr. 84 72 78 48%
4 or.neg.t.d. (48)A cr. 36 (192) (208) (48%)
5 or.neg.t.d. (12)B cr. 24 (12) (38) (24%)
6 rev.pos.t.d. (12)C cr. 12 (12) (13) (48%)
7 -D cr. 12 0 0 0
8 rev.pos.t.d. (6)E cr. 6 42 33 56%
9 rev .pos. t.d. (6)E 0 42 33 56%
Total 96 54 x
Notes to example 6.3A
A. Year 4: The tax loss amounts 400

carry-back 300
possible carry-forward 100
The expected reversal of positive timing differences in year 6 (within the carry-for-
ward period) is 100; so, the full tax effect of loss carry-forward can be offset
against the credit balance in the deferred-tax account.
92
B. Year 5: The whole tax loss of year 5 has to be carried forward; the expected rever-
sal of pos.t.d. during the (two-years) carry-forward period is 125, of which 100 has
already been used as an offset against the loss of year 4; the tax effect of the loss
carry-forward that can still be offset against the credit balance of the deferred-tax
account is 48% of 25 = 12.
C. Year 6: The possible (and necessary) reinstatement of the deferred-tax account
equals the tax effect of actual loss carry-forward 48% of 75 = 36, whereas the tax
effect of reversing positive timing differences in year 6 of 48% of 100 = 48. This
leaves a reversal of 12.
D. Year 7: The possible reinstatement of the deferred-tax account = 48% of 25: 12
tax effect of reversing positive timing differences 48% of 25: 12
leaves a reversal/reinstatement of: 0
E. Years 8 and 9: The credit balance of the deferred-tax account at the end of year 7
(end of the carry-forward period) is 12. This amount of deferred tax must be
amortized equally during years 8 and 9, since positive timing differences reverse in
equal amounts of 25 during these two years.
Example 6.3A illustrates that the reversal years (years 8 and 9) are really
charged for the impossibility of loss carry-forward, which gives an effective tax
burden that is higher than the current rate (56% instead of 48%). The expecta-
tion of reversal of positive timing differences during the carry-forward period
is not the same as the expectation of enough (positive) taxable income during
the carry-forward period to make an actual loss carry-forward possible. The
effect of reversing positive timing differences during the carry-forward period
may really be that the tax loss is not as large as negative book income before
tax!
Method 4
Method 4 enables to take into account the expectation of positive future tax-
able income. The expected reversal of positive timing differences during the
carry-forward period will, without doubt, affect the expectation of positive
taxable income during this period; but this influence does not automatically
lead to an expectation of positive taxable income large enough to carry a loss
forward, as in method three. Method 4 comes very near to method 2 (assur-
ance beyond any reasonable doubt), but its conditions are less rigid than for
method 2. The first two conditions of method 2, at least those stated in A.P.B.
Opinion No. 11, are:
a. the loss results from an identifiable, isolated and non-recurring cause;

and
b. the company either has been continuously profitable over a long period
or has suffered occasional losses which were more than offset by taxable
income in subsequent years.
93
These are also stipulated in method 4, and with good reason. For neither the
cause of a loss nor the profitability of the company in the past can guarantee
the full realization of the benefit of loss carry-forward. Condition b. (positive
taxable income in the past) could have some significance in the case of a rather
long carry-back period, because the latter reduces the amount that remains to
be carried forward. But, although the U.S.A. probably has the longest carry-
back period of any country in the world, it is only three years. Laule 12 states
that only 6 out of 23 countries 13 (Canada, the Federal Republic of Germany,
Great Britain, Japan, The Netherlands and the U.S.A.) provide for the carry-
back oflosses. Apart from the U.S.A. and The Netherlands all these countries
have a carry-back period of only one year. 14 So, the profitability of the
company in the past will in most countries be of no significance to the full real-
ization of the benefit of loss carry-forward.
The length of the carry-forward period varies much more between coun-
tries. The carry-forward period of the 23 countries mentioned above varies
from two years (in Switzerland, depending on federal and cantonal taxes) to an
unlimited carry-forward of losses (in Great Britain, Israel and New Zealand).
What really counts is the length of the carry-forward period.
Refraining from recording an asset because of loss carry-forward, where
there is an unlimited carry-forward period, is in fact the expectation of losses
(in total) in the long run. Except for some rare cases such as non-taxable gov-
ernment subsidies or profitable transactions outside the company attached to
the losses, the expectation of losses in the long run will generally be an induce-
ment to the company to abandon the going-concern assumption. This will
change the valuation of all assets and liabilities and not only the valuation of an
asset because of loss carry-forward. In the case of an unlimited carry-forward
period, normally the full tax effect of loss carry-forward can be recognized in
the loss year, at least when the going-concern assumption remains valid.
However, even if the carry-forward is not unlimited, the non-recognition of
an asset because of loss carry-forward generally testifies that there is a serious
doubt about the validity of the going-concern assumption. Laule states that
only 3 out of the 23 countries (Brazil, Mexico and Switzerland) have a carry-
forward period shorter than five years. The time-horizon for the judgment of
the validity of the going-concern assumption will not be much longer than five
years for many companies. Refraining from the recognition of any asset due to
loss carry-forward then means that no positive taxable income is expected dur-
ing this whole period of five years. Why should the obvious doubt about the
12. Lau/e, page 77.

13. Being the country members of the International Fiscal Association submitting reports on
this occasion.
14. The U.S.A. has a carry-back period of three years, and The Netherlands one of two
years.
94
going-concern assumption in that case work out only in the non-recognition of

a negative timing difference and not in the valuation of other assets and liabili-
ties?
In my opinion only a (prudent and may be conservative) estimate of the pos-
sibilities of realization of the benefit from loss carry-forward and a correspond-
ing recognition of a negative timing difference because of loss carry-forward
are in conformity with the going-concern assumption in financial accounting.
Method 5
Method 5 attributes not only the tax effect of loss carry-back and carry-forward
to the loss year, but so is the tax effect of the full loss, irrespective of a reason-
able expectation of setting off the loss against positive taxable income of other
years. This method does not differ from method 4 either in the case of an un-
limited loss carry-forward or in the case of a reasonable expectation of carrying
the whole loss forward. A difference from method 4 arises in the case of ex-
pected 'loss-evaporation' (the impossibility of carrying the whole loss over).
Method 5 allocates the full tax effect of this 'loss-evaporation' to the last year
in which loss carry-forward would have been possIble under tax law. However,
this last carry-forward year has no relationship to the 'loss-evaporation'. 'Loss-
evaporation' occurs because the total of positive taxable income during the
whole carry-over period is smaller than the tax loss to be carried over. Thus the
last year of possible carry-forward should not bear the full tax effect of the
'loss-evaporation'. Method 5 deliberately misstates the loss in the case of ex-
pected 'loss-evaporation'. Application of method 5 to the figures of example
6.3 would have given the following results:
95
Example 6.3B: Method five deliberately misstates the loss in the case of loss-
evaporation
Year Book income Taxable Carry-back Tax payable

before tax income and carry-
forward
1 175 100 100 48

2 150 100 100 48
3 150 100 100 48
4 (400) (400) 300 (144)
5 (50) (50) 0
6 (25) 75 75 0
7 0 25 25 0
8 75 100 48
9 75 100 48
Total 150 150 400 96
Year Tax effect of timing Deferred- Tax Net Reported

differences tax acc. expo inc. effective
at year- tax
end burden
1 or.pos.t.d. 36 cr. 36 84 91 48%

2 or.pos.t.d. 24 cr. 60 72 78 48%
3 or.pos.t.d. 24 cr. 84 72 78 48%
4 or. neg. t.d. (48)A cr. 36 (192) (208) (48%)
5 or.neg.t.d. (24)B cr. 12 (24) (26) (48%)
6 C cr. 12 0 (25) (0%)
7 max.rev.of.neg. t.d. 12 D cr. 24 12 (12) C\)
8 rev.pos.t.d. (12) cr. 12 36 39 48%

9 rev.pos.t.d. (12) 0 36 39 48%
Total 96 54 x
Notes to example 6.3B

A. Year 4: Tax loss 400
Carry-back 300 -
Possible carry-forward 100; tax effect of carry-forward: 48
96
B. Year 5: Tax loss 50

Carry-back 0
Possible carry-forward 50; tax effect of carry-forward: 24
C. Year 6: Tax effect of reversing pos.t.d.:
[(-25)-75] x 48%: (48)
Tax effect of reversing neg.t.d. from loss carry-forward: 75 x 48%: 36
Tax effect of non-reversing neg.t.d. because of the impossibility of loss carry-for-
ward in year 6:
(100-75) x 48% 12
Change in deferred-tax account 0
D. Year 7: Tax effect of rev.pos.t.d.: (25-0) x 48%: (12)
Tax effect of rev.neg.t.d. from loss carry-forward:
~xa% U
Tax effect of non-reversal of a neg. t.d. because of the impossibility of loss carry-
forward in year 7:
(50-25) x 48%: 12
Credited to deferred-tax account If
Application of method 4 (provided that the company has perfect foresight)

would have led to the results given in example 6.3C.
Example 6.3C: Method four, when the company has perfect foresight
Year Book income Taxable Carry-back and Tax payable

before tax income carry-forward
1 175 100 100 48

2 150 100 100 48
3 150 100 100 48
4 (400) (400) 300 (144)
5 (50) (50) o
6 (25) 75 75 o
7 0 25 25 o
8 75 100 48
9 75 100 48
Total 150 150 400 96
97
Year Tax effect of timing Deferred- Tax Net Reported

differences tax acc. expo inc. effective
at year-end tax burden
1 or.pos.t.d. 36 cr. 36 84 91 48%

2 or.pos.t.d. 24 cr. 60 72 78 48%
3 or. pos. t.d. 24 cr. 84 72 78 48%
4 or.neg.t.d. (36)A cr. 43 (180) (220) (45%)
5 or.neg. t.d. (12)B cr. 36 (12) (38) (24%)
6 rev.pos.t.d. (12)C cr. 24 (12) (13) (48%)
7 D cr. 24 0 0
8 rev.pos.t.d. (12) cr. 12 36 39 48%
9 rev.pos.t.d. (12) 0 36 39 48%
Total 96 54 x
Notes to example 6.3C

A. Year 4: Tax effect of expected carry-forward
possibility: 75 x 48%: (36)
B. Year 5: Tax effect of expected carry-forward
possibility: 25 x 48%: (12)
C. Year 6: Tax effect of rev.pos.t.d.
[(-25)-75) x 48%: (48)
Tax effect rev.neg.t.d. from loss carry-forward: 75 x 48%: 36
Per balance tax effect of rev.pos.t.d.: (12)
D. Year 7: Tax e'ffect of rev.pos.t.d.:
(25-0) x 48%: (12)
Tax effect of rev.neg.t.d. from loss carry-forward: 2S x 48%: 12
Per balance tax effect of rev. pos. t. d. o
Evaluation of the basic methods of tax-effect accounting in the case ofloss carry-
forward
Only method 2 (assurance beyond any reasonable doubt) and method 4 (esti-
mate of the tax effect of loss carry-forward) are in line with the undeniable
facts that the loss causes the tax reduction in later years, but that the value of
the loss carry-forward depends on the amounts of future taxable income. Pru-
dence cannot go so far that a deliberate overstatement of the loss in the loss
year (as is done in method 1 - allocation of the tax benefit to the carry-forward
years) is considered correct. Prudence has been also driven too far in method 2
(assurance beyond any reasonable doubt), since the value of the tax effect of
loss carry-forward has been made dependent on (the relation between taxable
income and pre-tax book-) income in the past. Prudence has been restored to
98
EVALUATION OF METHODS
its right place in the case of a (prudent) estimate of the possible future realiza-
tion of the benefit of carry-forward (method 4). The expected reversal ofposi-
tive timing differences during the carry-forward years (the basis of method 3)
can playa role in the estimation of future positive taxable income, but the re-
versal of positive timing differences does not as such necessarily create positive
taxable income. Method 5 deliberately misstates the value of loss carry-for-
ward in the case of expected 'loss-evaporation'.
In applying method 4 (and method 2 as well) it can occur that the estimated
value of the tax effect of loss carry-forward will not be justified by the realized
amount of positive taxable income during the carry-forward years. Under the
matching principle the loss applies to the loss period and not to the subsequent
period of realization (or non-realization) of the benefits of the carry-forward.
This suggests a retroactive adjustment ofthe accounts as per the end ofthe loss
period. The accounting standards in most countries, however, greatly restrict
these adjustments: ' ... the criteria set forth in APB opinion No.9: 'Reporting
the Results of Operations', greatly restrict prior-period adjustments. One cri-
terion essential to a prior-period adjustment is that such an adjustment not be
attributable to economic events occurring subsequently to the date of the fi,
nancial statements for the period' .15 Since the non-realization of the tax benefit
from the carry-forward of the operating loss is due to subsequent operations,
which were not profitable enough, a prior-period adjustment does not meet
this test. When applicable accounting standards forbid to treat this loss as a
prior-period adjustment, a second-best alternative could be to present this loss
as an extraordinary item in the P/L-account for the year of non-realiiation. 16
Similar considerations apply when the actual loss carry-forward exceeds the
estimated potential of realization. For some examples of the application of pri-
or-period adjustments in the case of loss carry-over, reference is made to ex-
ample 6.2B and to chapter 14.
As concerns the disclosure of a negative timing difference because of loss
carry-forward, it may be sensible to recall that the conditions for reversal of
this negative timing difference differ although only in degree from those for
other negative timing differences.

16. I.A.S. No.8: 'Unusual and Prior Period Items and Changes in Accounting Pplicies' re-
stricts prior-period adjustnents to the case in which ... 'The financial statements of one or
more previous periods were prepared and presented on a wrong or inaccurate basis as a result
of an error or an omission' (paragraph 11; emphasis mine). As a consequence, paragraph 27 of
I.A.S. no. 12 states; 'If the tax saving related to a past tax loss was not included in net income
in the year of the loss, a tax saving later realised by offsetting such a tax loss against taxable
income is included in net income in the period of realisation and disclosed'. I.A.S. 8 leaves
plenty of scope to treat this as an extraordinary item. The Dutch Committees on Annual Ac-
counts and Reporting dislike the presentation as an extraordinary gain in the period of realiza-
tion; they prefer to include this tax-saving in the tax expense of the period of realization
together with separate disclosure in a note.
99
Full reversal of a negative timing difference because of loss carry-forward

takes place only if positive taxable income during the carry-forward period
equals the estimated carry-forward potential. This additional condition 17
should be disclosed either by recognition of this negative timing difference as a
separate asset, or at least by way of a note to the deferred-tax account.
The accounting treatment of loss carry-back poses no special problems. It ap-

pears advisable to disclose the loss and the tax effect of loss carry-back sepa-
rately.
There is a general reluctance to show the tax effect of an originating negative
timing difference due to loss carry-forward as an asset in the balance sheet.
Five basic methods of accounting for loss carry-forward have been discussed.
Contrary to most of the literature, only the method in which the estimated tax
effect of loss carry-forward is allocated to the loss year is found appropriate.
17. As required by paragraph 50 of I.A.S. no. 12.
100
7. The offsetting of timing differences
The opinions about whether or not negative timing differences can be offset
against positive timing differences are closely related to the opinions men-
tioned in chapter 5B about the valuation of negative timing differences. Those
writers advocating a complete neglect of negative timing differences have no
problem with this subject. Those writers advocating neglect or the use of a net-
of-tax method for that part of the negative timing differences that is larger than
the positive ones are, of course, advocating an offsetting oftiming differences.
Tax-effect accounting leads to many questions about the nature of the result-
ing balance-sheet items, as was shown in chapter 4. This fact, together with the
above-mentioned relationship to the valuation of negative timing differences,
is the reason for the treatment of this subject in a separate chapter.
The offsetting of timing differences in practice
Apart from the relationship with some of the opinions mentioned in chapter
5B, the offsetting of positive and negative timing differences concerns the
presentation of information. There is not much theory in this field of the art of
accounting; so at a theoretical level it is hard to express an opinion about the
offsetting of positive and negative timing differences. Besides, an opinion on
the presentation of an item in the annual accounts has to be based on a careful
assessment of users' needs against (possible) theoretical arguments.
Hasselback has done some practical research in the field of the presentation
of income tax in annual reports.! The U.S.A. APB Opinion no. 112 does not
1. I.R. Hasselback: 'An empirical examination of annual report presentation of the corpora-
te income tax expense', The Accounting Review, April 1976. Except for the revolving nature
of timing differences there is not much practical research in the field of tax-effect accounting;
other individual researchers who have done some practical research on this subject are:
• I.F. Finnie: 'The accounting treatment of deferred taxation', The Accountant's Maga-
zine, October 1973;
• M.R. Morley: 'A defense of deferred taxation provisions', The Accountant's Maga-
zine, April 1973;
• V.A. Mallinson: 'The case against full tax-equalisation', Accountancy, November
1972.
Only Hasselback mentions some results relevant to the subject of this chapter.
2. 'Accounting for income taxes' - APB no. 11, American Institute of Certified Public Ac-
countants, 1967.
101
OFFSETIING OF TIMING DIFFERENCES
require separate disclosure of negative and positive timing differences in the

balance sheet (except for those timing differences resulting from any opera-
ting-loss carry-forward). All that is required is disclosure of the component
parts of the income-tax expense for the period; this represents taxes estimated
to be payable currently and the tax effects of timing differences.
Hasselback found that out of 300 corporations listed on the New York and
American Stock Exchanges, for financial years ending between 1 July 1972
and 30 June 1973, 69 corporations did not present information such that both
the 'flow-through' and 'normalized' income-tax rates could be computed.
There was no significant relationship with corporate size, federal income-tax
rate or the presence of a particular independent auditing firm. Hasselback's
conclusion is that already a slight non-adherence to the ' ... required APB
Opinion Income Tax Disclosure Requirements makes prediction of future net
income more difficult. Without the 'required' information, let alone additional
needed information, the determination of the expected future income tax rate
of a corporation becomes a near impossibility'. 3
The main criterion applied by Hasselback was whether the information dis-
closed makes it possible to compute both the 'flow-through' tax rate and the
'normalized' tax rate. The 'normalized' tax rate was defined by Hasselback as:
total income tax pertaining to:
• net income before extraordinary items
• extraordinary items
• prior-period adjustments
divided by the sum of:
• net income after taxes
• extraordinary items net of taxes
• prior-period adjustments net of taxes.
The flow-through' tax rate was defined as:

current income tax pertaining to:
• net income before extraordinary items
• extraordinary items
.• prior-period adjustments
divided by the same denominator as in the 'normalized' tax rate.
This flow-through tax rate is essentially the same as what has been called the
'effective tax rate' in this study (see e.g. example 2.1): being the amount oftax
payable divided by book income before tax. The reason for taking after-tax
book income as the denominator is not explained by Hasselback.
Hasselback's 'normalized' income-tax rate is essentially the reported in-
3. Hasselback, pages 275/276.
102
OFFSETIING IN PRACTICE
come-tax expense divided by book income after tax. If the denominator had
been book income before tax, the 'reported effective tax burden' would have
been calculated as was done inter alia in the examples 6.2 and 6.3.
In the absence of timing differences, the 'normalized' tax rate will equal the
'flow-through' tax rate, so Hasselback's test implies only the separate disclo-
sure of the amount of tax payable, the tax effect of timing differences and the
tax effect of permanent differences, but not the offsetting of positive and nega-
tive timing differences. If Hasselback had tried to predict future 'flow-through'
and 'normalized' tax rates, this test would make it possible to conclude about
the separate disclosure of positive and negative differences (together with dis-
closure of expected reversal dates).
In addition, 'Accounting Trends & Techniques' 19774 hardly allows any con-
clusions to be drawn about the offsetting of the tax effect of timing differences
in the balance sheet. The only thing that may perhaps be concluded is that
some companies do not offset timing differences, since the number of compa-
nies showing debit balances for deferred tax together with the number of com-
panies showing credit balances exceeds the total number of survey companies,
as is illustrated in Tabel 7.1. But even this table should be interpreted with the
utmost caution, since it is impossible to discover to what extent the debit
balances arose from timing differences or from the application of the cost-re-
duction method for permanent differences (see chapter 8).
Table 7.1: 'Accounting Trends & Techniques' suggests that some companies do
not offset negative timing differences against positive timing differences
Source:
Number of companies Year: Accounting
classifying deferred Trends & Tech-
tax as: 1976 1975 1974 1973 niques 1977:
current assets 74 76 68 67 tab. 2-11, p. 122

non-current assets 30 41 39 38 tab. 2-18, p. 151
total assets 104 117 107 105 not recorded
current liabilities 39 60 43 57 tab. 2-24, p. 162
non-current liabilities 466 479 481 488 tab. 2-28, p. 185
total liabilities 505 539 524 545 not recorded
either assets or liab. 609 656 631 650 not recorded

number of survey compo 600 600 600 600 ._-
4. A.I.C.P.A.: 'Accounting Trends & Techniques', New York 1977, thirty-first edition.
103
OFFSETIING OF TIMING DIFFERENCES
The 1977 NIVRA-investigation of 135 companies quoted on the Amsterdam

stock exchange shows that 112 companies had a deferred-tax account. In 25
cases it appeared that companies had offset the tax effect of negative timing
differences against positive timing differences, and 16 companies appeared to
have created an asset due to loss carry-forward. 5
The offsetting of timing differences in certain accounting standards
The international accounting standards give contrary directions as to the

offsetting of timing differences. LA.S. no. 5: 'Information to be disclosed in
financial statements' requires that deferred taxes on the asset side are sepa-
rately disclosed, whilst deferred-tax liabilities should be separately disclosed
only if significant. 6 But LA.S. no. 12: 'Accounting for taxes on income' sug-
gests the offsetting of timing differences in paragraph 21 7 , and requires offset-
ting in paragraph 26 as concerns negative timing differences due to loss carry-
forward. 8
The Fourth Directive of the E.C. on the annual accounts of limited compa-
nies is rather definite on the subject of deferred-tax accounting. It requires the
application of comprehensive tax allocation at least by way of a note. But, un-
fortunately, the Directive is completely silent about negative timing differ-
ences. The tax effect of positive timing differences should be separately dis-
closed as a provision. 91t can hardly be assumed that this provision refers to the
tax effect of the credit balance of positive and negative timing differences,
since Section 7 of the Directive is very definite in forbidding the offsetting of
debit and credit items in the balance sheet. The comprehensive definition of
'transitory items' (Section 18) permits capitalization of the tax effect of nega-
tive timing differences, but it seems to me that the offsetting of positive and
negative timing differences is prohibited by the Directive.
5. NIVRA: 'Onderzoek laarverslagen 1977', Amsterdam, 1979, page 59.

6. I.A.S. 5: 'Information to be disclosed in financial statements', paragraph 12 and para-
graph 15 respectively.
7. I.A.S. 12: 'Accounting for Taxes on Income', paragraph 21: The accounting for timing
differences may result in a debit balance or a debit to the deferred-tax balance ... ' (emphasis
mine).
8. I.A.S. 12, paragraph 26, has this to say about negative timing differences due to loss car-
ry-forward that can be offset against positive timing differences which are expected to reverse
during the carry-forward period: The tax saving as a result of offsetting a tax loss is included in
net income for the period of the loss and the debit is carried forward as part of the deferred tax
credit balance in the balance sheet. The amount of such a debit may be disclosed' (emphasis
mine).
9. Sections 9 and 10 of the Fourth Directive.
104
THEORETICAL CONSIDERATIONS CONCERNING' OFFSETTING
In closing this section, it can be pointed out that the Dutch 'Committees on
Annual Accounts and Reporting' are very definite about the offsetting of ti-
ming differences. They recommend the ofsetting of timing differences in any
event and require a note of disclosure only for negative timing differences due
to loss carry-forward and for the offsetting of timing differences from different
tax entities.lO
Some theoretical considerations concerning the offsetting of timing differences
If timing differences must be so presented that the future effective tax rate can
be predicted, the amounts of positive and negative timing differences (togeth-
er with an indication of the period in which reversal can be expected) must be
given in the annual accounts. These amounts can be presented as separate
items in the balance sheet or combined with disclosure of the component parts
parenthetically or by way of notes.
When positive and negative timing differences are combined, the problem is
how this should be done. McClure 11 , in discussing the sources of the differences
between taxable and book income, mentions as one of the main sources of
these differences the irrelevance of the matching concept to taxation. For the
relationship between fiscal and book income in the U.S.A., he draws the con-
clusion that: ' ... the tax emphasis is on the annual period rather than on the
transaction. The reverse holds true for accounting - the emphasis is on the
transaction rather than on the period' .12 This would imply, in my opinion, that
the tax effect of timing differences, whether negative or positive, can be classi-
fied as period-costs or period-benefits; a combination of positive and negative
'timing differences would then be theoretically defensible if they reversed in
the same future period. An offsetting of positive and negative timing differen-
ces would be possible for those timing differences whose reversal was one year
ahead, two years ahead and so on per year-period.
Other theoretical considerations would prevent any offsetting of timing dif-
ferences. Given the different character of negative and positive timing differ-
ences, all offsets should be prohibited. 13
10, 'Voorontwerp van beschouwingen naar aanleiding van de wet op de jaarrekening van on·
dernemingen', Aflevering 4, page 22.
11. M. T. McClure: 'Diverse tax interpretations of accounting concepts', The Journal of Ac-
countancy, October 1976.
12. McClure, page 72.
13. M.A. van Hoepen: 'Geschilpunten bij de verwerking van latente belastingverhoudingen
in de jaarrekening van ondernemingen', Maandblad voor Accountancy en Bedrijfshuishoud-
kunde, Febr. and March 1973.
105
OFFSETTING OF TIMING DIFFERENCES
From a company's point of view, taxes are 'prepaid' when timing differences
are negative (except in the case of loss carry-forward, when tax is not refund-
ed). When timing differences are positive, taxes are from the company's point
of view deferred. But payment in advance (in this case, payment of taxes) is
something other than payment in arrears (that is, before or after a taxable
event is/was recognized in the annual accounts). Offsetting of assets and liabili-
ties in general is permissible only if they concern the same object of valuation;
in the case of claims and debts (including future tax claims and future tax
debts) clearing in the balance sheet is permissible only if:
a. debtor and creditor are the same, and

b. there is a current account (in which an interest calculation compensates
for differences in due dates).
If there is no such current account between the company and the tax authori-
ties, as is the case in most countries of the Western world, all offsets between
positive and negative timing differences may be regarded as inadmissible.
Furthermore, the common accounting practice of distinguishing between
short-term and long-term liabilities and claims in the balance sheet precludes a
complete offsetting of all timing differences.
Conclusion on the offsetting of positive and negative timing differences in the

balance sheet
On the basis of these theoretical arguments, and the considerations in part B of

chapter 5 (valuation of 'normal' negative timing differences) and chapter 6
(valuation of negative timing differences due to loss carry-forward), the pres-
entation of timing differences should distinguish five items in the balance sheet
(unless the amounts concerned are negligible):
a. negative timing differences due to loss carry-forward;

b. short-term negative timing differences, } other than those due
c. long-term negative timing differences, to loss carry-forward;
d. short-term positive timing differences;
e. long-term positive timing differences.
To simplify the balance sheet, however, the presentation can be restricted to

only two items :
a. the balance of short-term timing differences;

b. the balance of long-term timing differences,
106
CONCLUSION
with disclosure of 'normal' negative timing differences, negative timing differ-

ences due to loss carry-forward and positive timing differences parenthetically
or by way of a note.
In particular, the offsetting of 'normal' short-term negative timing differ-
ences against 'normal' short-term positive timing differences seems permis-
sible because:
• the interest calculation to compensate for differences in due dates, re-

ferred to above, can hardly be regarded as material for short-term timing
differences;
• if the reversal of short-term negative differences cannot be assumed
with reasonable certainty (that is, ifthe company expects that the short-term
negative timing differences will not be compensated through the amount of
tax payable in the future or by way of loss carry-back and/or loss carry-for-
ward), there is no doubt that the going-concern assumption can no longer be
considered justified in those countries that have a rather liberal carry-over
period.
107
8. Accounting for permanent differences
Permanent differences were defined in chapter 2 as differences between book

income and taxable income that will never be regarded as taxable income (pos-
itive permanent differences) or as book income (negative permanent differ-
ences) or will be so only at the end of the lifetime of a company. This means
that permanent differences will in principle never reverse as long as the compa-
ny remains a going concern.
So it seems that proponents of comprehensive tax allocation will reach the
same conclusion about permanent differences as the advocates of flow-
through accounting and supporters of the probability method (or partial-allo-
cation approach). This conclusion is that:
• some differences between book income and taxable income, which con-
stitute negative permanent differences, will give rise to an increase in the
effective tax burden; for instance: when certain donations are regarded as
costs in the calculation of book income, whereas they are disallow able as
deductions in the calculation of taxable income;
• some differences between book income and taxable income, which con-
stitute positive permanent differences, will give rise to a decrease in the
effective tax burden; for instance: when a category of income is exempted
from taxation, as is the case in some countries for dividends and capital gains
derived from an investment in the shares of another company (the so-called
affiliation privilege), or when a reduction in taxable income is not regarded
as a component of book income before tax, as is the case with investment
allowances, which are not deducted in the computation of fiscal book val-
ues.
But a few complicating factors override this apparent uniformity of opinion

concerning permanent differences. First, some timing differences will reverse
only when certain conditions are satisfied, whereas some permanent differ-
ences will be permanent only in particular circumstances. In addition, a second
108
ACCOUNTING FOR PERMANENT DIFFERENCES
distinction is implicitly made by many writers!: the distinction between condi-

tional and unconditional differences. Taking this distinction into consideration
as well, we can list four types of differences:
a. unconditional timing differences; e.g. accelerated depreciation;

b. unconditional permanent differences; e.g. donations not accepted as de-
ductions for the computation of taxable income;
c. conditional timing differences; e.g. 'evaporation' of losses when loss
carry-forward is restricted to a limited period;
d. conditional permanent differences; e.g. a revaluation of assets, which is
not allowed for tax purposes.
The second problem is the moment of realization of permanent differences.

Discussion has concentrated on positive permanent differences, such as invest-
ment credits and investments allowances, and most of the arguments used
have recurred later in the discussion of comprehensive tax allocation versus
flow-through accounting. This recurrence is not surprising, because in the
flow-through method (or tax-payable method as it has sometimes been called
later) the tax expense in respect of the current period is taken to be equal to the
amount of tax payable; this view of the amount of tax payable as an expense
inevitably leads to the conclusion that the tax effect of positive permanent dif-
ferences is realized when e.g. the investment credit is granted. The arguments
of those who take the investment credit as a reduction in costs otherwise
chargeable in a larger amount to future accounting periods (mostly referred to
as the cost-reduction method or the deferral method) are very similar to the
arguments of the advocates of comprehensive tax allocation. The comprehen-
sive-tax allocation approach argues that the tax expense in respect of a current
period is equal to the amount of tax payable plus or minus the tax effect of (all)
timing differences; but it will be argued in this chapter that comprehensive tax
allocation does not inevitably signify application of the cost-reduction or de-
ferral method.
The third problem is the impossibility of disclosing the tax effects of perma-
nent differences and timing differences simultaneously in the P/L-account. A
choice has to be made between disclosure in notes of either the tax effects of
permanent differences or the tax effects of timing differences.
1. The same conclusion was found in: P.N. Kruyswijk: 'De behandeling van de ven-
nootschapsbelasting in de boekhouding', unpublished master's thesis at Erasmus Universiteit
Rotterdam, May 1977.
109
Part A. Conditional and unconditional differences
The revolving nature of some timing differences has been used by certain au-
thors to argue for the valuation of deferred and anticipated taxes on a present-
value basis, as was discussed in part A of chapter 5. Others have used the re-
volving nature of some timing differences to argue for the flow-through ap-
proach to deferred taxes. 2
Under certain conditions timing differences can become permanent, so that
comprehensive tax allocation and the flow-through approach give the same
amount of tax expense in the P/L-account as is illustrated in the following ex-
ample.
Example 8.1: If timing differences become permanent, comprehensive tax allo-

cation gives the same result as the flow-through approach
Many examples might be used to illustrate this point; for the sake of simplicity
let us look at instalment sales, which are accounted for on an accrual basis for
the calculation of book income and on an instalment basis for the calculation of
taxable income. Interest and any special costs related to these transactions are
ignored for the sake of simplicity. The sales price on an instalment basis is
Dfl. 90. - per unit and is to be paid in three yearly instalments of Dfl. 30. -, of
which the first is a down-payment at the moment of sale.
Per unit sold this gives the following results:
Year Book inc. Taxable Tax pay- After-tax book inc. on

on accrual inc. on able the basis of
basis instal- (50%) flow-through comprehen-
ment basis accounting sive tax
allocation
1 90 30 15 75 45
2 30 15 (15)
3 30 15 (15)
Total 90 90 45 45 45
As soon as the number of units sold is stable for a period equal to the reversal-
2. Especially: A.D. Barton: 'Company income tax and interperiod allocation', Abacus, vol.
6, no. 1, September 1970; R.I. Chambers: 'Tax allocation and financial reporting', Abacus,
vol. 4, no. 2, December 1968; J. L. Livingstone: 'Accelerated deprecation, tax allocation and
cyclical asset expenditures of large manufacturing companies': Journal of Accounting Re-
search, 1969, pages 245-256.
110
CONDITIONAL AND UNCONDITIONAL DIFFERENCES
period, after-tax book income will be equal for flow-through accounting and
comprehensive tax allocation, as is illustrated in the following table:
Year Number of Pre-tax book Taxable inc. Tax payable

units sold inc. accrual instalment
basis basis
1 5 450 150 75
2 5 450 300 150
3 5 450 450 225
4 5 450 450 225
5 5 450 450 225
6 4 360 420 210
7 5 450 420 210
8 5 450 420 210
9 5 450 450 225
10 5 450 450 225
Year Net book inc. Net book inc. on Deferred-tax acc.

on a flow- a comprehensive at year-end
through basis basis
1 375 225 150

2 300 225 225
3 225 225 225
4 225 225 225
5 225 225 225
6 150 180 195
7 240 225 210
8 240 225 225
9 225 225 225
10 225 225 225
In part A of chapter 5 some objections were made to the present-value ap-

proach to revolving timing differences. But the same objections hold good
against the treatment of revolving timing differences as permanent; it implies
replacing the going-concern concept by a stable-concern concept as well.
Another type of condition which can give timing differences a permanent
character or which can make permanent differences reverse is conditions aris-
ing from provisions of tax law. Examples of this type of conditional difference
were given earlier. Let us look at these examples more closely. An upward
111
revaluation of depreciable assets in the annual accounts, which is not allowed

for tax purposes, creates in principle a series of negative permanent differ-
ences; but an instant reversal takes place on sale of the revalued asset before
the end of its economic lifetime. Carry-forward of losses in principle creates an
originating negative timing difference; but reversal will not take place in so far
as income during the period set for loss carry-forward is smaller than the losses
to be carried forward; thus timing differences become permanent when the
conditions for reversal are not satisfied. An investment credit is in principle a
positive permanent difference; but there will be a partial reversal whenever
the assets are sold before the end of the recapture period stated by law. These
differences would be classified either as permanent or as timing differences
whenever the conditions mentioned were not satisfied; but this implies that the
satisfaction of these conditions (for reversal of permanent differences or non-
reversal of timing differences) is to be regarded as events of the period in which
these conditions are satisfied.
Taking these conditions into account would create an adverse 'principle of
common basis'; the annual accounts would be influenced by future tax events,
which have no causal relationship with the accounting period. E.g. a claim for
loss carry-forward in principle constitutes a negative timing difference. When-
ever the conditions for the realization of this claim are not satisfied, because
income in the period set for loss carry-forward is smaller than the amount of
the loss to be carried forward, a loss of this kind is caused by the limitation of
the loss carry-forward period. According to the matching principle it could be
argued that there is a loss in the period of non-satisfaction of the conditions.
But this is not the main question here; see chapter 12 (revaluation of assets
creates permanent differences) and chapter 6 (loss carry-forward creates a tim-
ing difference) for further objections from the point of view of the matching
principle to a flow-through approach for conditional differences.
The main question here concerns the nature of permanent differences. Can
particular conditions turn timing differences into permanent differences? The
answer, of course, depends on the opinion about the nature oftiming differ-
ences. If an amount of deferred tax is regarded as a contingent liability, the
potentially permanent character of conditional timing differences is relevant
to its valuation. But if the credit side of a balance sheet is regarded as present-
ing the current position of a company's source of funds, then the potential fu-
ture reversal of a permanent difference and the potentially permanent charac-
ter of a timing difference at some time in the future are completely irrelevant.
When deferred taxes are regarded as transitory items, the only relevant ques-
tion is whether a deferral (or anticipation) of taxes is a significant enough
source offunds (or claim) to be disclosed in the balance sheet. If it is significant
enough, disclosure should take place irrespective of the possible future devel-
112
MOMENT OF REALIZATION
opment of this source. 3 The conclusion about conditional differences is two-

fold:
• Adherence to the going-concern assumption implies that conditional

timing differences should be treated as timing differences irrespective of
their potentially permanent character. The controversy between flow-
through approach, comprehensive tax allocation and partial tax allocation
remains in this case, although these methods may lead to the same results for
the computation of after-tax book income.
• A proper allocation of costs and revenues to periods and the 'source of
funds' character of the balance sheet imply that conditional permanent dif-
ferences should be treated as permanent differences, irrespective of the pos-
sibility of their reversal in the future if certain conditions are satisfied. Flow-
through approach, comprehensive tax allocation and partial tax allocation
lead to the same conclusion; there is an increase or a decrease in the effec-
tive tax burden.
Part B. When is the tax effect of permanent differences realized?
There is little doubt about the moment of realization of the tax effect of nega-
tive permanent differences. In most cases the concept of prudence implies that
the increase in the effective tax burden is regarded as realized when the
amount of tax payable exceeds the current tax rate times pre-tax book income.
Sometimes this treatment of negative permanent differences is accompanied
by a provision for future negative permanent differences which unjustly over-
rules the matching principle and the going-concern assumption, as will be
explained in chapter 12 (revaluation of assets).
The question to be treated here is whether flow-through approach, compre-
hensive tax allocation and partial tax allocation will always lead to the same
figures for book income if there are permanent differences. Although these
methods come to the same conclusion as to the nature of permanent differ-
ences (an increase or decrease in the effective tax burden), there is a difference
between the flow-through approach and comprehensive tax allocation in the
computation of income if there are positive permanent differences. This is best
illustrated by accounting for investment credits.
3. See: D.F. Hawkins: 'Controversial accounting changes', Harvard Business Review,

March/April1968, page 20 and following. Hawkins applies this funds-approach to explain a
number of items appearing on balance sheets, for which traditional accounting concepts pro-
vide no adequate answers; in addition to deferred taxes, these are self-insurance reserves
charged to earnings, deferred profits on sale-and-leaseback arrangements and various other
items in the deferred-income category that represent funds received but not yet earned.
113
Let US take as an example an investment credit equal to a certain percentage

of investment in depreciable assets. The amount available in anyone year is
used to reduce the amount of taxable income for that year, but it is not deduct-
ed from the book value of the assets in the tax balance sheet. In these condi-
tions the investment credit leads to a definitive reduction of income tax pay-
able, that is, a positive permanent difference. An investment credit once al-
lowed may be subject to recapture in circumstances set out in the tax law; this
makes the difference between book income and taxable income a conditional
positive permanent one; the conditions for recapture should mostly not be tak-
en into account4, for reasons discussed in part A of this chapter.
The reasoning about the accounting treatment of the investment credit is
very similar to the reasoning in the flow-through approach and the comprehen-
sive-tax-allocation approach for the treatment of timing differences; there has
been discussion between defenders of the last two methods in most countries
only after disputes on the accounting treatment of the investment credit.
Three common ideas about the nature of the investment credit are:
a. the investment credit is a subsidy by way of contribution to capital;

b. the investment credit is a reduction in taxes otherwise charged on the
income of the year in which the credit arises;
c. the investment credit is a reduction in costs otherwise chargeable in a
larger amount to future accounting periods. s
The flow-through approach, arguing with regard to timing differences that the
amount of tax expense should be limited to the tax payments actually assessed
for the period, is closely related to both method a. (subsidy by way of a contri-
bution to capital) and method b. (tax reduction). The difference between
method a. and method b. lies not so much in the nature of the permanent dif-
ference, but rather in the controversy between an all-inclusive income state-
ment and the current-operating-performance type of income statement.
The comprehensive-tax-allocation approach, with takes the standpoint of
the matching principle, argues with regard to timing differences that the tax
expense should be recorded in the same period in which the related revenue
and expense items are recognized; as such it is closely related to method c.
(cost-reduction or deferral approach).
In its original support of the deferral approach (method c), the former
American Accounting Principles Board (A.P.B. No.2, 1963) rejected the
4. The conditions for recapture of the investment credit are to be taken into account only if
'disinvestment' is intended to take place in the period set for recapture, that is, whenever the
estimated economic lifetime of an asset is shorter than the recapture period defined by law.
5. See: 'Accounting for the investment credit', A.P.B. opinions No.2 and No.4, Journal of
Accountancy, Febr. 1963, resp. May 1964.
114
flow-through approach (methods a and b) principally on the ground that the

credit does not conduce to the integrity of the income figure if income can be
increased simply by buying an asset. In A.P.B. opinion No.4 of 1964, this point
of view was changed, merely because a significant number of companies had
treated the investment credit as an increase in net income of the year in which
the credit arose, and so the tax-reduction method (method b) was accepted by
the AP.B. The flow-through approach seems to have gained in popularity in
the U.S.A since, as Table 8.1. shows.
Table 8.1: Accounting for the investment credit in 600 U.S. companies6
Method/year 1976 1975 1974 1973
Flow-through method 502 518 504 496

Deferral method 76 60 72 78
No reference to investment credit 22 22 24 26
Total companies 600 600 600 600
In the opinion of many people, the A.P.B. took a step backwards in accepting
the flow-through method, since the acceptance of both cost-reduction and tax-
reduction method makes the company's income figure much more a function
of accounting decisions. When the flow-through method is rejected for timing
differences (as it was by the AP.B.) there seems to be no logic in accepting it
for permanent differences. When income taxes are regarded as an expense,
then the matching principle applies as much to the tax effect of timing differ-
ences (leading to comprehensive tax allocation) as to the tax effect of perma-
nent differences. 7 Moreover, method b. (tax reduction) is thought to overesti-
mate the amount of income in the year the investment credit is granted, and
method a. leads to an underestimation of earning power, as is illustrated in the
following example.
Example 8.2: Accounting for the investment credit; three methods compared
The investment credit is 10% of an investment and is not subject to recap-
ture. At the start of year 1 Dfl. 1,000 is invested in an asset with an economic
lifetime of 5 years; depreciation is on the straight-line basis. Book income after
depreciation (of Ofl. 200 per year) but without the investment credit is Dfl. 300
per year. These figures lead to the following results:
6. A.I.C.P.A.: 'Accounting Trends & Techniques 1977', Table 3-13, page 269.
7. The matching pricipie may imply a matching of negative permanent differences as well.
115
Year Book Investment Taxable Tax Book inc. atJer tax:

inc. credit income payable Method
a. b. c.
sub- tax cost
sidy red. red.
1 300 100 200 100 150 200 160

2 300 300 150 150 150 160
3 300 300 150 150 150 160
4 300 300 150 150 150 160
5 300 300 150 150 150 160
If after-tax book income is fully distributed each year and the rate of return is
computed as a percentage of capital at year-end after profit distribution, the
results of the three methods are:
Capital at year-end Effective tax burden

a. b. c. a. b. c.
Yea; subsidy tax cost subsidy tax cost
to reduction reduction to reduction reduction
capital capital
1 1,050 1,000 950 50% 33.33% 48.39%
2-5 1,050 1,000 950 50% 50% 48.39%
Book income after tax Rate of return

a. b. c. a. b. c.
Year subsidy tax cost subsidy tax cost
to reduction reduction to reduction reduction
capital capital
1 150 200 160 14.29% 20% 16.84%
2-5 150 150 160 14.29% 15% 16.84%
So the cost-reduction method, that corresponds to the comprehensive-tax-al-

location method for the treatment of timing differences, gives an acceptable
income- and capital figure.
116
However, the cost-reduction method, being essentially a net-of-tax method,

does not disclose the tax effect of the investment credit. This tax effect is treat-
ed as a reduction in the net amount at which the acquired asset is stated, as if
the investment credit was a property of the acquired asset itself.8 A change in
the investment-credit regime would lead to different values of otherwise iden-
tical assets. To overcome this asset-presentation problem, the investment
credit can be treated as deferred income, which is amortized during the pro-
ductive life of the acquired asset. If the tax effect of the investment credit were
deducted from the book value of the asset, the P/L-account in example 8.2
would be:
The PI L-account in the cost-reduction method, if the investment credit is deduct-

ed from the bookvalue of an asset
Income before depreciation

and tax 500
Depreciation effective tax rate:
(1,000 - 0.50 x 100)/5 190 150/(1/100 x 310) = 48.39%
Book income 310 rate of return:
Tax expense 150 160/(1/100 x 950) = 16.84%
Book income after tax 160
And if the tax effect of the investment credit is treated as deferred income, the
P/L-account becomes:
The PI L-account under the cost-reduction method, if the investment credit is

treated as deferred income
Income before depreciation

and tax 500
Depreciation (1,000/5) 200 effective tax rate:
Gross operating income 300 150/(1/100 x 310) = 48.39%
Realized deferred income rate of return:
(0.50 x 100)/5 10 160/(1/100 x 1,000)= 16%
Book income 310
Tax expense 150
Book income after tax 160
8. This quality of the cost-reduction method results in its non-applicability if an investment

credit (or any other type of investment incentive that creates a permanent difference) has no
causal relationship with the investment in a certain asset. This applies inter alia to several
investment incentives in the Netherlands given under the 'Law on the Investment Account' of
1978. See: M.A. van Hoepen: 'WIR en laarrekening', Economisch-Statistische Berichten, 4
April 1979, page 353.
117
It appears from a study ofKuijl and Van Dijk9 , that this last method (treatment
as deferred income) has been applied in 47% of the 108 companies (quoted on
the Amsterdam stock exchange) that formed part of their investigation. Their
investigation of the accounting treatment of the Dutch investment premiums
of the 'Law on the Investment Account' (Wet Investeringsrekening - or WIR
- a 'credit against tax') can be summarized as in Table 8.2:
Table 8.2: Accounting for the WIR-premiums in 108 Dutch companies
Method Frequency of occurrence
• deduction from book value of as-

sets 19%
• deferred income subject to con- deferral
tingencies
• deferred income subject to liabil-
41 %} d. eferred method: 66%
Income: 47%
ities 6%
I
• subsidy by way of contribution to
capital 1%
• income in the year in which flow-thmugh method, 4%
the credit arises 3%
• no reference to WIR-premium 21%
• other methods 9%
100%
However, the presentation of the effective tax burden is stated falsely in the
cost-reduction method both when an investment credit is deducted from the
book value of an asset and when, an investment credit is treated as deferred
income. Gross income during the lifetime of the asset in example 8.2 is : 5 x
300 = 1,500; the amount of tax payable during these years is 100 + 4 x 150 =
700. So, the effective tax burden is in fact 46.67% instead of the 48.39% calcu-
lated for every year in both applications of the cost-reduction method. This is
the third problem mentioned in a nutshell at the start of this chapter; it will be
treated now separately in part C.
9. J.G. Kuij/ and H. van Dijk: 'WIR en Jaarrekening', Maandblad voor Accountancy en
Bedrijfshuishoudkunde, November 1979, page 497 and following.
118
DISCLOSURE OF PERMANENT DIFFERENCES
Part C. The disclosure of permanent differences In the P/L-

account
The amount of the tax expense on a comprehensive-allocation basis and the
disclosure of the tax expense in the P/L-account can be approached from two
different starting points. The tax expense equals the amount of tax payable
plus or minus the tax effect of timing differences; but the tax expense also
equals the tax rate times book income before tax plus or minus the tax effect of
permanent differences. This can be outlined as follows:
Tax payable
+ tax effect of originating positive timing differences

tax effect of reversing positive timing differences
tax effect of originating negative timing differences
+ tax effect of reversing negative timing differences
TAX EXPENSE
+ tax effect of positive permanent differences

tax effect of negative permanent differences
Tax rate x Book income before tax
It is clearly impossible to disclose the tax effect of both timing differences and
permanent differences simultaneously in the P/L-account itself, otherwise
than parenthetically or by way of a note.
Book income before tax as a starting point
It has been shown in chapter 4 that if book income before tax is taken as a
starting point for the calculation of the tax expense (and so a disclosure of per-
manent differences is given in the income statement), the reader may conclude
that the tax effect of timing differences originates in the same proportion from
the different parts of income as the contribution of these different parts of in-
come to book income before tax. The gross method and the net method of
avoiding this possibly false impression have been analysed in -chapter 4.
A much smaller problem when book income is taken as a starting point
might arise if an item is regarded as income (or cost) for taxation purposes
while it is added to (or subtracted from) Earned surplus as an extraordinary
119
item for publication purposes. If in the P/L-account for publication purposes

the amount of tax must show a causal relationship with book income, it is ne-
cessary to reduce (or to increase) Earned surplus by the amount of tax related
to the extraordinary gain (or loss).
The amount of tax payable as a starting point
If the starting point for the calculation of the tax expense is not book income,
but the amount of tax payable, a quite different problem may arise. As only the
tax effect of timing differences is disclosed in the income statement and not the
tax effect of permanent differences, the reader might easily conclude that the
effective tax burden is the same for different parts of income. This is illustrated
in example 8.3.
Example 8.3: Disclosure of the tax expense, starting from the amount of tax
payable, using the gross method and the net method
The income statements of the year 19xO are the following:
---~-------------
PI L-account for publication PI L-account for tax purposes:

purposes:
------ - - -
Sales 1,000 Sales 900

Cost of goods sold 800 Cost of goods sold 750
Gross profit-margin 200 Gross profit-margin 150
Inc. from non-consol-
idated subsidiaries 100
Extraordinary income 100 Extraordinary income 100
Gross income 250
Book inc. before tax 400 Bonus distribution - 30
Investment credit - 20
Tax payable 96 Taxable income 200
Tax effect of t.d. 24
Tax expense 120 Tax rate 0.48

Net income 280 Tax payable 96
The differences between these income statements can be explained as follows:
120
Book income before tax 400

• Originating positive timing differences:
- Gross profit-margin recognized later for tax
purposes - 50
• Positive permanent differences:
Income from non-consolidated subsidiaries not
taxed because of affiliation privilege - 100
Bonus distribution to personnel not deducted
from book income before tax but deductible for
tax purposes 30
Investment credit * attributable to year 19xO 20
- 200
Taxable income 200
• For the sake of simplicity the investment credit is regarded as attributable to one year.
The income statement for publication purposes suggests that the different
parts of profit contribute in the same proportion to book income before tax as
they do to net income, that is:
income from sales: 50%

income from subsidiaries: 25%
extraordinary income: 25%
BurggraafflO suggested two methods of presenting the real tax burden for the
different parts of profit, which were introduced in chapter 4 as the gross meth-
od and the net method. Application of these methods to the figures given
above, gives rise to the following results:
a. The gross method
All revenue figures are increased by the related positive permanent differ-
ences, and the related negative permanent differences are deducted; for cost
figures the opposite is done. Thus in consequence, the amount of the tax
10. I.A. Burggraaff: 'De presentatie van de belasting naar de winst in de resultatenrekening',
Maandblad voor Accountancy en Bedrijfshuishoudkunde, March 1968, page 168 and follow-
ing.
121
expense to be disclosed will be equal to book income times the tax rate; at least
this is so when all permanent differences can be related to one category of
income (which is not so for the bonus distribution in this example).
PI L-account based on the gross method
Sales 1,000
Cost of goods sold (800 - investment credit of 20) 780
Gross profit-margin 220
Income from non-consolidated subsidiaries:
100 x [1 + t/(l-t)] 192
Extraordinary income 100
Tax expense 232
Net income 280
The tax expense is calculated as follows:

Non-imputable permanent differences (bonus) 30
'Corrected' book income 482
Tax expense in 'gross-income statement':
0.48 x 482 = 232
added to income from subsidiaries 92

added to income from sales 20
imputed permanent differences: 112
Tax expense in traditional income statement 120
b. The net method
The different elements of profit are charged separately with the related ele-
ments of the effective tax burden (on a comprehensive-allocation basis). The
bonus distribution to personnel is supposed to have been paid out of income
from sales.
122
PI L-account based on the net method
Sales 1,000
Cost of goods sold 800
Tax payable on income from sales 48
Tax effect of tim. diff. related to sales 24
Tax expense related to income from sales 72
Net income from sales 128
Income from subsidiaries 100

Tax payable on income from subsidiaries 0
Tax effect of timing differences 0
Tax expense related to inc. from subsidiaries 0
Net income from subsidiaries 100
Extraordinary income 100

Tax payable on extraordinary income 48
Tax expense related to extraordinary income 48
Extraordinary income after tax 52
Total net income 280
The tax expense can be calculated as follows:
Source of income Amount Tax Tax Timing Tax

rate expense diff. payable

investment credit - 20
bonus distribution - 30
Corrected profit-margin 150 0.48 72 24 48
Income from subsidiaries 100 0 o o o
Extraordinary income 100 0.48 48 o 48
Total 350 120 24 96
These three P/L-accounts give a different picture of the contribution of the

different elements of income to net income, and thus a different picture with
regard to the tax effect of permanent differences, as is summarized in the fol-
lowing table:
123
contribution contribution to net income
I~
ele- bution to book according to:
ments income traditional 'gross- 'net-inc.
of before tax inc. state- inc. state- state
income ment ment' ment'*
Sales 50% 50% 43% 46%

Subsidiaries 25% 25% 37% 36%
IExtraordinary 25% 25% 20% 18%
• The contribution of sales to net income is slightly overstated in the net method and as a
result the contributions of subsidiaries and extraordinary income are slightly understated, be-
cause the bonus distribution to personnel was fully imputed to income from sales.
Objections to the gross and net methods
The objections to the gross and net methods resemble the objections to the
application of these methods to timing differences (as was discussed in chapter
4). But let us look at these objections more closely now ll , and especially at
objections to the net method.
Although the gross method gives a reliable picture of the contribution of
different activities to net income, it gives completely fictitious profit and cost
figures as far as permanent differences are involved. Furthermore, the effec-
tive tax burden presented is false. On the basis of comprehensive tax account-
ing, the effective tax burden in example 8.3 is [1201 (1/100 x 400)]= 30%,
whereas the effective tax burden in the gross method is presented as [2321 (11
100 x 512)] = 45%. These two objections in themselves make the gross meth-
od unsuitable for application to financial accounting.
The net method does not present fictitious profit and cost figures and it even
gives an opportunity to show the tax effect of timing differences per category of
income, as was illustrated in the P/L-account based on the net method in exam-
ple 8.3. But this net method poses certain difficulties:
a. First, some figures in the income statement are presented net of tax,
whereas others are not. Full application of the net method would, like
the gross method, lead to fictitious figures. Because the effective tax burden
on sales income in example 8.3 is [72 1 (11100 x 200)] = 36%, full ap-
plication of the net method would give a different income statement.
11. These objections are partially quoted from Burggraa//, pages 172 and 173.
124
PIL-account of example 8.3 in the case offull application of the net method
(abbreviated)
Sales [1,000 x (1 - 0.36)] 640

Cost of goods sold [800x(1 - 0.36)] 512
Net income from subsidiaries 100
Extraordinary income net of tax 52
Net income 280
b. The total amount of the tax expense is not disclosed in the P/L-account;
disclosure by way of a note will be necessary if it is thought worthwhile to
show the total amount of this cost category.
c. It may be acceptable for the users of the annual accounts that income
figures are reduced by their related tax burden; but a reduction of cost fig-
ures by their related tax savings may be less acceptable.
d. Application of the net method gives problems when a negative taxable
income appears, which cannot be offset through loss carry-back. If in exam-
ple 8.3, there had been an extraordinary loss of 250 instead of a gain of 100,
all other things being equal, the traditional accounting and the fiscal income
statement would have been:
Traditional income statement* Fiscal income statement
Gross income from sales 200 Sales income 150

Income from subsidiaries 100 Extraordinary loss - 250
Extraordinary loss - 250 Investment credit and
bonus - 50
Book income before tax Taxable income - 150
Tax payable o Tax payable o

Tax effect tim.diff. 24
Tax expense 24
Net income 26
• The tax effect of the originating negative timing difference because of loss carry-for-
ward is not taken into account in this income statement.
125
Application of the net method would have given the following rather pecu-
liar resu1t1 2 :
PI L-account based on the net method in the case of fiscal loss
Gross income from sales 200

Tax payable on sales income (!) 48
Tax expense related to income from sales 72
Income from subsidiaries 100
Extraordinary loss - 250
Tax recoverable from loss carry-back __0
Extraordinary loss net of tax - 250
Net income - 22
e. Since income tax is treated in the net method as if individual revenues

create an obligation to pay taxes and individual cost items create an imme-
diate tax reduction, it is necessary in the net method to allocate all perma-
nent differences (and timing differences if disclosed per category of in-
come) to one or other of the different categories of income. In example 8.3
the bonus distribution was supposed to be fully imputable to sales income;
but as a matter of fact the decrease in the effective tax burden, because
bonusdistributions to personnel are tax-deductible, should be allocated to
all categories of income.
Conclusion on the application of the gross and net methods
Before a choice can be made between the methods described, a choice must
first be made of the starting point for calculating the amount of the tax expense
in the P/L-account. In the literature this starting point is, mostly implicitly, the
amount of tax payable, in which case the tax effect of timing differences can be
disclosed in the income statement itself. At first sight this choice is not very
logical. Since the income statement already gives the book income before tax,
taking this as the starting point seems far preferable; in that case the tax effect
of permanent differences can be disclosed in the income statement itself,
whereas material timing differences can be disclosed by way of notes.
A justification found in the literature for choosing tax payable as the starting
12. This problem does not exist in the case an originating negative timing difference due to
loss carry-forward is taken into account. The traditional income statement and the income
statement according to the net method would then both have given a net income of 98.
126
point concerns the difference in origin of permanent differences and timing

differences. In most countries, permanent differences are generally caused by
special reliefs in tax law. So, permanent differences can hardly be influenced
by management. By contrast, most timing differences are caused by the
attempts of management to postpone tax payments. If these rather tentative
conclusions about the causes of permanent and timing differences are right,
there is no doubt that taking book income before tax as a starting point, with
disclosure of the tax effect of permanent differences in the income statement,
reflects management policies less than does the alternative option. Taking tax
payable as a starting point, with disclosure of the tax effect of timing differ-
ences in the income statement, gives this income statement much more the
character of a flow-of-funds statement, because it can be explicitly disclosed
how many interest-free loans were acquired by tax-deferral, and how many
interest-free loans expired through the reversal of deferred taxes. The starting
point of tax payable gives the income statement much more of an accounting
character.
But taking tax payable as a starting point, with disclosure of the tax effect of
timing differences in the income statement, will lead to the conclusion that the
effective tax burden is the same for different categories of income. There are
three ways of avoiding this suggestion. In addition to the gross method and the
net method there is the possibility of disclosing the tax effect of permanent
differences by way of notes in such a way that it is made clear to which category
of income the permanent differences are related, if any.
The gross method, giving fictitious figures and a false effective tax burden, is
unsuitable for financial accounting. Disclosure of the tax effect of permanent
differences by way of notes to a traditional P/L-account, although suitable,
may have a practical disadvantage; it can be rather confusing if there are differ-
ent types of material permanent differences; the information is spread all over
the annual statements. Some objections can be made to the net method, but
none of these make the net method completely unsuitable for financial ac-
counting, Subject to the condition that the amount of net income mu;;t equal
the amount of net income in the traditional income statement (see objection d.
to the net method), this method has its merits when applied with care (see
objection a. to the net method). If the income statement is more than an enu-
meration of cost-categories, the net method can disclose the effective tax bur-
den per category of income. And it is even possible to disclose the tax effect of
timing differences which are related to a disclosed category of income, as was
illustrated in example 8.3. To overcome the problem of the allocation of all
permanent differences to one category of income, disclosure of the effective
tax burden per category of income could be restricted to one or a few categor-
ies to which material permanent differences are related.
127
Tax payable as a starting point and the investment credit
Taking tax payable as a starting point for calculation of the tax expense and for
disclosure of the tax effect of timing differences in the P/L-account is fully com-
patible with use of the tax-reduction method in accounting for the investment
credit. The question when the positive permanent difference due to the invest-
ment credit is realized does not come up for discussion in the tax-reduction
method; it is thought to be realized whenever the investment credit is actually
granted either by reduction of taxable income (in the case of a credit against
income) or by reduction of the amount of tax payable or refund of tax (in the
case of a credit against tax). If the company at present expects that there will be
disinvestment before the end of the recapture period of the investment credit,
a provision must be made (and charged to the P/L-account in the year that the
investment credit has been granted) to avoid overestimation of income in the
year that this credit resulted in tax reduction. The tax effect of the investment
credit can be disclosed by way of a note to the amount of tax payable.
It is only when the investment credit is regarded as a property of the ac-
quired asset, that the matching principle becomes important and the deferral
method comes into the picture. It is out of place to discuss in this study whether
an investment credit can be regarded as a property of an acquired asset. This
depends on a variety of circumstances, such as:
• whether the investment credit is a 'credit against income' (only effective

in case of positive taxable income and its tax effect depending on the appli-
cable tax rate) or a 'credit against tax' (independent of taxable income and
of the applicable tax rate);
• whether the investment credit is the same for all tax payers and for all
regions of a country;
• the relationship between the recapture period and the economic lifetime
of an asset;
• whether there exists a causal relationship between the amount of the in-
vestment credit and the amount of investment in assets; etc.
In other words: the question whether it is permissible to accept the matching

principle for timing differences (leading to comprehensive tax allocation) and
to accept simultaneously the flow-through method for permanent differences,
such as an investment credit, depends solely on the character of the permanent
difference; this question cannot be solved through reasoning by analogy.
In any case, the analysis of 'the gross method and the net method in part C of
this chapter has shown that the false statement of the effective tax burden un-
der the deferral method or cost-reduction method of accounting for the invest-
ment credit can be avoided in two ways.
It is obvious that the deduction of the investment credit from the book value
128
of assets is similar to the application of the gross method. The only difference is
that under this cost-reduction method it is the tax effect of the (realized) per-
manent difference that is deducted from the book value of the assets, whereas
under the gross method it is the permanent difference as such that is deducted.
Application of the gross method to the figures of examples 8.2 gives as a resuit:
PI L-account years 1 to 5; deferral method by way of deduction from the book

value of an asset under the gross method
Income before depreciation: 500

Depreciation [(1,000 - 100) 15] 180
Book income 320
Tax payable 160
Tax effect of timing differences o
Tax expense 160
Net income 160
But the gross method is not compatible with taking tax payable as a starting
point for disclosure of the tax expense; it merely leads to the restoration of the
causal relationship between book income and tax expense. However, the
amount of tax payable is stated falsely in every year.
Treatment of the investment credit as deferred income is rather similar to
the application of the net method. Application of the net method to the figures
of example 8.2 gives the following result:
PI L-account years 1 to 5; deferral method by way of a separate item as deferred

income under the net method
Income before depreciation 500

Depreciation (1,000/5) 200
Gross operating income 300
Tax payable on gross operating income 150
Tax expense related to gross op. income 150
Net operating income 150
Extraordinary income:
Deferred investment credit net of tax 10
Total net income 160
The net method also leads to the restoration of a causal relationship between
129
income and tax expense; but the amount of tax payable is stated falsely in year
1 (150 instead of 100).
Conclusion on the investment credit
The conclusion is that if tax payable is taken as the starting point for the calcu-
lation of the tax expense and if disclosure of the tax effect of timing differences
in the P/L-account is preferred to disclosure of the tax effect of permanent
differences in the P/L-account, and if simultaneously the deferral method is
applied in accounting for the investment credit, a misleading income statement
is unavoidable. Deferral of the tax effect of the investment credit is simply not
compatible with taking tax payable as the starting point for disclosure of the
tax expense. Moreover, only the tax-reduction method of flow-through ap-
proach is applicable if the investment credit has no causal relationship with the
investment in certain assets.
Conditional timing differences should be treated as timing differences ir-

respective of their potentially permanent character. Conditional permanent
differences should be treated as permanent differences irrespective of the pos-
sibility of their reversal in the future if certain conditions are satisfied.
The cost-reduction method in accounting for the investment credit gives an
acceptable income- and capital figure. However, the tax effect of the invest-
ment credit is treated as if this credit was a property of the acquired asset itself
and this method gives a false presentation of the effective tax burden.
Taking tax payable as a starting point for disclosure of the tax expense in the
income statement will lead to the conclusion that the effective tax burden is the
same for different categories of income. There are three ways of avoiding this
suggestion. The gross method is unsuitable for financial accounting. The net
method has its merits when applied with care. Otherwise, only note-disclosure
on the tax effect of permanent differences per category of income can be given
if tax payable is chosen as a starting point
Only the tax-reduction method or flow-through method of accounting for
the investment credit is in line with taking tax payable as a starting point for
disclosure of the tax expense in the income statement. This method is the only
appropriate way of accounting for the investment credit if there is no causal
relationship between the tax effect of the investment credit with the invest-
ment in certain assets.
130
9. Summary and conclusions part I
Scope of the study
1. The assumptions of part I
In the first part of this study of the treatment of deferred and anticipated in-
come tax in companies' annual accounts, deferred taxes were dealt with for a
single company (not a member of a group of companies) as a going concern,
assuming a constant tax rate, the absence of inflation and assuming to a large
extent the absence of other timing differences in case of loss carry-over.
2. Presentation of income dominates
It was supposed that in financial accounting, which looks for a simultaneous

fair presentation of income as well as capital, it is the proper presentation of
income which is given primary attention if there is a conflict between a proper
presentation of income and of capital. Some practical evidence for this presup-
position can be found in inventory-valuation rules and depreciation systems.
3. Influence of tax system
The Dutch income-tax system for the taxation of company profits was the
model for consideration in the first part of this study. Because a serious effort
was made not to draw any conclusion based on the specific character of the
Dutch taxation system, the conclusions and considerations of part I hold true
outside the borders of the Dutch tax jurisdiction.
4. No common basis for taxable income and book income - reasons for
differences
It was supposed that taxable income is computed independently of book in-

come; if there is an absolute 'principle of common basis' there can be no differ-
131
SUMMARY AND CONCLUSIONS PART I
ences between taxable income and book income and the problem of deferred
taxes (and anticipated taxes) loses its importance.
If the principle of common basis is not adhered to absolutely, differences
between taxable and book income may arise from all sorts of causes. The main
cause of these differences originates mostly in differences between the objec-
tives of the computation of book income for publication purposes and the ob-
jectives of the calculation of taxable income. The objectives of the computa-
tion of taxable income, as a fair division of the tax burden among taxpayers,
and the objectives pursued by the regulatory functions of a tax levy, may con-
flict with the existence of opportunities for the taxpayer to reduce the amount
of his taxable income. More precisely, the differences between taxable income
and book income are mainly the result of:
• differences concerning the concept of 'total income' over the lifetime of

a company;
• differences concerning the concept of period-income;
• special rules or reliefs for the computation of taxable income, which
have nothing to do with the concept of income, but originate from the regu-
latory functions of taxation;
• special rules for the computation of taxable income, which have nothing
to do with the concept of income, but which are set to make tax collection
easier or more certain.
5. Profits tax as an expense or as distribution of income
These differences are unimportant when tax payments are not regarded as an
expense but as a distribution of income. In the latter case the problem of tax
deferral loses its importance too. As a matter of fact this view has been taken
by those supporting the flow-through method. In this method the yearly tax
expense is regarded as the amount of the tax payments actually assessed for the
period. Some authors argue that, even when tax payments are regarded as an
income distribution by the company, tax-effect accounting does not lose its
importance: some degree oftax-effect accounting remains necessary to express
the unavoidable nature of income taxes (as opposed to other types of income
distribution) .
When income tax is regarded as an expense, the matching principle requires
a recording of this tax expense in the same period in which the related revenue
and expense items are recognized; thus if there are material differences be-
tween taxable income and book income, the so-called comprehensive-tax-allo-
cation approach becomes unavoidable.
132
CALCULATION AND VALUATION
Conclusions with regard to the calculation and valuation ofincome-ditTerences
1. Categories of differences
Differences between (pre-tax) book income and taxable income can be classi-
fied into different categories for comprehensive-tax-allocation purposes:
1. Depending on the relationship between taxable income and book in-

come:
• POSITIVE: if book income exceeds taxable income,
• NEGATIVE: if taxable income exceeds book income.
2. Depending on the persistence of the differences:
• PERMANENT: if the difference is never taken into account in the
computation of taxable income or will be so only at the end of the lifetime
of the company,
• TIMING: if the difference exists only for a period shorter than the
lifetime of the company; i.e. items which are taxed, or allowed as a de-
duction, in a period other than that in which they are recorded for the
computation of book income, but before the end of the lifetime of the
company.
3. Depending on the time of recognition of timing differences:
• ORIGINATING timing differences: the deferral or anticipation of
tax begins,
• REVERSING timing differences: the deferral or anticipation of tax
comes to an end.
4. The distinction between:
• CONDITIONAL differences: i.e. timing differences which under cer-
tain conditions can take on a permanent character, or permanent differ-
ences which under certain conditions may reverse, and
• UNCONDITIONAL differences,
was thought irrelevant because of the matching principle and the going-con-
cern assumption.
2. Partial tax allocation; contingencies or transitory items?
Partial tax allocation, in which only those timing differences are taken into
account which reverse within a foreseeable period, can be justified only if
deferred taxes are regarded as contingencies: but to classify an amount of
deferred tax as a contingency is to replace the going-concern assumption with
an assumption of indefinite growth. In the present state of the art of financial
accounting, timing differences, or rather the tax effect of timing differences,
133
can only be regarded as transitory items, i.e. interest-free loans from or to the
government. Partial tax allocation, which is not taken into account apart from
these differences because of the materiality concept, is in conflict with the go-
ing-concern assumption.
3. Loss carry-back
The offset of a loss against positive income of the same company from the past
(loss carry-back) is rather simple, when there are timing differences.
In the absence of other timing differences, a negative amount of tax payable
can be shown in the P/L-account, being the tax effect of actual loss carry-back.
As for presentation in the balance sheet, the claim against the tax authorities
due to loss carry-back can either be offset against a current tax liability, or
classified as a current asset, or both, depending on the actual treatment by the
fiscal authorities of this claim.
4. Loss carry-forward
The accounting treatment of loss carry-forward shows many more conflicting

opinions than loss carry-back. Five basic methods for the allocation of the tax
effect of loss carry-forward have been distinguished. Only two of these meth-
ods treat the loss carry-forward as a timing difference, albeit a conditional one.
These methods are those in which the tax effect of loss carry-forward is allocat-
ed to the loss year in so far as the realization of the benefit of the carry-forward
is assured beyond any reasonable doubt, and the one in which the tax effect of
estimated realization of the benefit of loss carry-forward is allocated to the loss
year. Only these methods are in line with the undeniable fact that loss carry-
forward constitutes a timing difference, because the loss causes the tax
reduction in later years; only the value of the right of loss carry-forward de-
pends on future taxable income. As for the method of 'assurance beyond any
reasonable doubt', the degree of recognition of the tax effect of loss carry-
forward depends on the cause of the loss as well as on the profitability of the
company in the past. But neither the cause of a loss, nor the profitability of the
company in the past, can guarantee a full realization of the tax benefits of a loss
carry-forward.
The cause of the loss and the profit of the company in the past may have an
influence on the estimate of future taxable income (during the carry-forward
years), or may even induce the abandonment of the going-concern assump-
tion. But neither positive income in the past, nor the cause of an incurred loss,
in itself influences the value of the tax effect of the right of loss carry-forward;
and this influence is certainly not as automatic as is suggested by the criteria of
134
CALCULATION AND VALUATION
the method of 'assurance beyond any reasonable doubt'.

An additional problem for the 'estimation method' mentioned above (and
for the 'assurance method' as well) can occur if the estimated value of the bene-
fits of the tax effect of loss carry-forward will not be justified by the amount of
realized positive taxable income during the carry-forward years. Then the ac-
tual benefits of the loss carry-forward turn out to be smaller (or larger) than
the estimated benefits. Under the matching principle this difference (loss or
gain) applies to the loss period and not to the subsequent carry-forward peri-
od. A retroactive adjustment of the accounts as per the end of the loss period,
which this consideration suggests, may be hampered by the hesitation to
accept prior-period adjustments inherent in the accounting standards of most
countries. As second-best alternative such a loss could be presented as an
extraordinary debit in the year of non-realization of the benefits of loss carry-
forward (the last carry-forward year) and a gain as an extraordinary credit as
soon and in so far as the actual benefits from loss carry-forward exceed the
estimated carry-forward potential.
5. Present value vs. nominal value
The resemblance of deferred taxes to an interest-free loan is an insufficient

reason for valuing the tax effect of timing differences on the basis of their pres-
ent value; this would introduce the opportunity-cost principle into financial
accounting, which goes beyond the present state of the art. The revolving na-
ture of some timing differences was also found to be an insufficient argument
for computing the tax effect of timing differences on a present-value basis. De-
spite an improper presentation of capital, the nominal-value method was
found to be the only one in accordance with accounting standards.
6. On the asset-nature of negative timing differences
The combined effect of matching principle and going-concern assumption pre-

vents a valuation of (per balance) originating negative timing differences be-
low their un discounted nominal value; the same conclusion follows if the aim
of the income statement is regarded as a presentation of flows of funds.
7. Static method preferred
As for the way in which the tax effect of timing differences can be calculated, a
calculation per individual transaction (the static method), was (because it re-
quires a proper segregation of permanent and timing differences) inevitably
135
found to make a separate disclosure of positive and negative timing differences

possible and to give some insight into the expected time ofreversal. However,
the offsetting of short-term timing differences raises few objections, at least
when there is good reason for the going-concern assumption.
Conclusions concerning the presentation of income-differences
The above mentioned discussion of the offsetting of timing differences for pub-
lication purposes brings us into the area of the presentation of the tax effect of
timing differences in the annual accounts. Apart from the minimum disclosure
requirements embodied in company law or in the specific accounting standards
in each country, disclosure of information in the annual accounts is mainly a
matter of weighing the costs and benefits of information. Thus, conclusions on
the presentation of the tax effect of timing differences and permanent differ-
ences in the annual accounts can only be tentative ones. These tentative con-
clusions on the disclosure of the tax effect of income differences are treated
rather more elaborately in this chapter, because they are mentioned through-
out the first part of the study.
1. Disclosure of the tax effect of PERMANENT DIFFERENCES IN THE

BALANCE SHEET
a. Unconditional permanent differences
The tax effect of unconditional permanent differences is not represented in the

balance sheet, at least when the permanent differences are recognized at the
time of their origination.
b. Reversal of conditional permanent differences
The tax effect of a possible reversal of conditional permanent differences

should not be disclosed in the balance sheet because it does not constitute a
contingency.
c. Positive permanent differences not recorded in the period of origination
Positive permanent differences for which the tax effect is recorded in a period
other than the period of the origination of these permanent differences can
136
PRESENTATION OF INCOME DIFFERENCES
give rise to deferred income figures in the balance sheet, as can happen with an
investment credit.
d. Net-of-tax valuation of assets rejected
On theoretical grounds, a separate deferred item of income in the balance

sheet is preferable to a net-of-tax valuation of assets.
2. Disclosure of the tax effect of PERMANENT DIFFERENCES IN THE

INCOME STATEMENT
a. Influence of performances asked from the annual accounts
Because of the performances asked from the annual accounts it does not seem
advisable to disclose the tax effect of permanent differences in the income
statement.
b. Tax payable as a starting point
If the amount of tax payable is chosen as a starting point for the calculation and
disclosure of the tax expense, the tax effect of timing differences can be dis-
closed in the income statement. The tax effect of material permanent differ-
ences can then be disclosed by way of a note.
c. Net method vs. gross method
The disclosure of a normalized tax rate per category of income (the net meth-
od) has its own merits and can be an alternative to the disclosure of the tax
effect of permanent differences by way of a note. However, if taking tax
payable as a starting point for calculation of the tax expense in the P/L-account
is combined with application of the deferral method of accounting for the tax
effect of permanent differences, a misleading income statement will result in
any case. The traditional income statement will present an incorrect effective
tax burden; the income statement under the gross method will permanently
show an incorrect amount of tax payable and the net method will do so in the
year of origination of the permanent difference.
137
3. Disclosure of the tax effect of TIMING DIFFERENCES IN THE BAL-

ANCESHEET
a. Transitory items
In conformity with the aim of comprehensive tax allocation and on the analogy
of the valuation rules for other assets and liabilities, the tax effects of timing
differences in the balance sheet can be regarded as transitory items.
b. Net-of-tax method in the balance sheet
Deduction or addition of these tax effects from or to the related assets (net-of-
tax method in the balance sheet) was found to be a partial application of the
economic concept of profit and as such incompatible with accounting stand-
ards.
c. Offsetting of timing differences
Some arguments can be found that prevent the offsetting of the tax effect of
positive and negative timing differences in the balance sheet. Without this
offsetting, and quite apart from a separate disclosure in the balance sheet of a
negative timing difference due to loss carry-forward, at least four elements of
the tax effect of timing differences appear in the balance sheet (if material),
being the tax effect of either short-term or long-term, and either positive or
negative, timing differences. However, the offsetting of short-term negative
and short-term positive, timing differences can hardly be objected to as long as
the going-concern assumption is soundly based.
4. Disclosure of the tax effect of TIMING DIFFERENCES IN THE IN-

COME STATEMENT
a. Tax payable as a starting point
As a starting point for the disclosure of the tax expense in the income state-
ment, the amount of tax payable has been chosen. Thus the tax effect of timing
differences can be disclosed in the income statement itself.
138
PRESENTATION OF INCOME DIFFERENCES
b. Separate disclosure of positive and negative timing differences
By analogy with the disclosure of the tax effect of timing differences in the
balance sheet, a separate disclosure of the tax effect of positive and negative
timing differences seems desirable; this separate disclosure gives a 'flow-of-
funds-character' to the income statement.
c. Importance of the net method
The use of the net method for the disclosure of the tax effect of permanent
differences in the income statement leaves the opportunity to disclose the tax
effect of timing differences per category of income; thus, for different categor-
ies of income both a 'normalized' and 'flow-through' tax rate can be calculated.
139
Part II
Some special aspects of deferred-tax ac-

counting
10. Timing differences and changes in tax
rates
Three methods of accounting for rate-changes
The problems arising in deferred-tax accounting when tax rates change are
comprehensively treated in the American literature. They are already men-
tioned in the earliest American publications on tax-effect accounting, being
Accounting Research Bulletin no. 23: 'Accounting for income taxes' of 1944
and Accounting Series Releases no. 53: 'In the matter of 'charges in lieu of
taxes' and 'Provisions for income taxes' in the Profit and Loss Statement' of
1945. It might be interesting for accounting historians to investigate the cause
of this early treatment of rate changes in the U.S.A.t, where changes in tax
rates do not seem to have occurred more frequently than in other countries.
Three methods for the treatment of timing differences when tax rates
1. Other publications, treating the problem of rate-changes are, inter alia:

• C. Blough: 'Reserve provisions net of taxes', Journal of Accountancy, June 1948.
• M. Moonitz: 'Income taxes in financial statements', The Accounting Review, April
1957.
• T.F. Keller: 'Accounting for corporate income taxes', 1961.
• G.K. Carr: 'Accounting for income taxes', Canadian Chartered Accountant, Oct.
1963.
• L. G. McPherson: 'Capital allowances and income taxes', Canadian Chartered Accoun-
tant, Dec. 1954.
• E.L. Hicks: 'Income tax allocation', Financial Executive, Oct. 1963.
• E.S. Hendriksen: 'The treatment of income taxes by the 1957 AAA Statement', The
Accounting Review, April 1958.
• W. Powell: 'Accounting principles and income-tax allocation', New York CPA, Jan.
1959.
• P. Grady: 'Tax effect accounting when basic federal income tax rate changes', Journal
of Accountancy, April 1964.
• R.E. Perry: 'Comprehensive income tax allocation', Journal of Accountancy, Febr.
1966.
• H.J. Shield: 'Allocation of income taxes', Journal of Accountancy, April 1957.
• H.A. Black: 'Interperiod allocation of income taxes', 1966, ARS no. 9.
• D.J. Bevis and R.E. Perry: 'Accounting for income taxes. An interpretation of APB
opinion no. 11', 1969.
143
TIMING DIFFERENCES AND CHANGES IN TAX RATES
change are almost invariably mentioned in the literature, albeit under differ-
ent names:
a. the deferral method, or deferred-credit approach or deferred-concept;

b. the liability method, or estimated-liability approach or accrual-concept;
c. the net-of-tax method.
It is astonishing to find the net-of-tax concept among these methods. The net-
of-tax concept (analysed in chapter 4) has as such nothing to do with the
treatment of timing differences when tax rates change. The reason for treating
the net-of-tax method under the heading of rate changes may be that the case
for the other two methods (deferral method and liability method) is often de-
rived from the nature of timing differences, as follows:
a. In the deferred-concept '... deferred taxation balances represent

deferred revenue or expenditure (and not amounts due by or to the compa-
ny)'.2 The deferred-concept emphasizes the effect of timing differences on
income of the period in which they originate. 'The income tax expense is a
function of pre-tax income (excluding permanent differences between ac-
counting and taxable income) unless the expense is affected by amounts
deferred previously at other than current rates. The primary purpose is to
match the income tax expense with the items which cause a tax effect'. 3 Be-
cause of this characteristic of timing differences, subsequent changes in tax
rates (after the origination of the timing differences) give no reason for ad-
justments. The emphasis is on the correctness of income for the period in
which timing differences have originated.
b. In the liability method, the tax effect of timing differences is regarded as
an amount of tax ultimately due by or to the company. The liability-concept
looks on tax allocation as accruing income-tax expense as a function of pre-
tax income (again excluding permanent differences between accounting
and taxable income, as has been done throughout this chapter). So the esti-
mated amounts of future tax liabilities and prepaid taxes are computed at
the tax rate expected to be in effect in the future periods in which the timing
differences are expected to reverse. The emphasis is on the correctness of
income for the period in which timing differences will reverse.
c. The net-of-tax concept is based on the idea that taxability and tax
deductibility are factors in the valuation of individual assets and liabilities.
Black says, on the subject of the applicable rate: ' ... in theory, the concept
depends on anticipating the future tax rates over the life of the asset at the
2. EDll: 'Accounting for deferred taxation', The Accountant, 3rd May 1973, page 603.
3. Black, page 13.
144
ACCOUNTING FOR RATE-CHANGES
time of its acquisition.'4 Thus the net-of-tax concept would produce the
same net income as would the liability-concept. But, according to Black: ' ...
in practice, however, the amortization of cost attributed to the loss of tax
deductibility is recorded at the rate in effect when the timing difference ori-
ginates'.4 The net-of-tax concept thus results in the same net income as the
deferred-concept.
The description of the net-of-tax method already demonstrates that it is not a

method for the treatment of timing differences when tax rates change. Black
too concludes, as was done in chapter 4, that the case for the net-of-tax method
is mainly based on its application to accelerated depreciation for tax purposes.
In chapter 4 it was concluded that the net-of-tax concept can be applied only to
one irreplaceable asset. It is only for an irreplaceable asset that the obligation
to make future tax payments is contingent upon the conversion of that asset
and the asset valuation depends on future tax payments. When tax rates
change, the net-of-tax method leads to the same results as either the liability
method or the deferral method.
Four groups of opinions about the classification or the nature of timing differ-
ences have been mentioned in chapter 4; the relationship that is assumed in the
literature between the nature of timing differences and the appropriate way of
accounting for them when tax rates change is as follows:
Nature of Acc. method Appli- Emphasis on

timing when tax cable tax the correct-
differences rates change rate ness of
a. (Assets or) liabilities Liability Expected Balance

method tax rate sheet
1). Contingency Liability Expected Balance
method tax rate sheet
c. Transitory items Deferral Current Income
method tax rate statement
r.
d. Imputable to assets Net-of-tax Unclear Income
and liabilities method statement
and Balance
sheet
However, the relation between the appropriate method of accounting for tim-
ing differences when tax rates change and the nature of timing differences is
much more complicated. I will give the conclusion of this chapter first.
4. Black, page 23.
145
Only the liability method and the deferral method have something akin with
changes in the income-tax rate.
The proponents of the liability method reproach the proponents of the de-
ferral method the mismatching of tax expenses. It is indeed possible in the de-
ferral method that over a great number of years the reported tax expense does
not equal book income times current tax rate, as will be illustrated in this chap-
ter. But a similar kind of 'mismatching' occurs when the liability method in the
years of origination of timing differences is applied. The proponents of the
deferral method pride themselves on the simplicity of their method: no adjust-
ments are necessary when tax rates change. But this simplicity is contradicted
by the inevitable assumptions about the flow-through of timing differences, as
will be discussed in this chapter.
Neither the deferral method nor the liability method are satisfactory ac-
counting methods when tax rates change. A satisfactory method must consist
of a valuation of the tax effect of timing differences at the tax rate in effect at
the moment of their origination and of a subsequent adjustment at the mo-
ments of the changes in the rate. This last method, sometimes called the 'wind-
fall-solution', has been treated as a special interpretation of the liability meth-
od. However, it should be regarded as a separate method, because the basic
principle that the tax effect of timing differences should be calculated at an
estimated future tax rate, is abandoned in the windfall-solution.
There have been several proposals to combine the liability method and the
deferral method. Three of the best-known proposals are discussed at the end
of this chapter. But, as the liability method and the deferral method, these
combined methods ignore the fact that gains and losses caused by changes of
the tax rate are brought about by the rate change itself, and that these gains
and losses have to be allocated to the period of the rate change in accordance
with the matching principle.
The deferral method
Under this method, a change in the tax rate does not force an adjustment of the
tax effect of existing timing differences. Consequently, the gain or loss due to
the rate change is recognized only on the moment of the reversal of the timing
difference concerned.
The advocates of the deferral method regard its simplicity as a great advan-
tage: ' ... the deferred method is considered to be preferable to the liability
method because ... (it) ... has the practical advantage that it neither requires
assumptions as to future tax rates or the imposition of new taxes, nor does it
require adjustments of balance sheet deferred tax accounts when tax rates
146
THE DEFERRAL METHOD
change or new taxes are imposed'. 5 However, it should be considered that the
reported tax expense over the whole lifetime of a company cannot possibly be
larger or smaller than actual tax-payments.
In other words, an under- or overstatement of total income over the years
will result if the tax effect of reversing timing differences is calculated using the
tax rate in effect on the moment of origination of these differences. This is
illustrated in example 10.1.
Example 10.1: An improper application of the deferral method
Calculation of income in year 1 2 3 1 till

3
• Calculation of taxable income:

Income before tax and a
special cost item 2,000 2,000 2,000 6,000
Special cost item recognized
for tax purposes only 500 500 - 1,000
Taxable income 1,500 1,500 2,000 5,000
Tax rate 50% 45% 40% -
Tax payable 750 675 800 2,225
Net income after tax 750 825 1,200 2,775
• Calculation of accounting income:

Income before tax and special
cost item 2,000 2,000 2,000 6,000
Special cost item recognized for
accounting purposes only - - 1,000 1,000
Pre-tax accounting income 2,000 2,000 1,000 5,000
Tax payable 750 675 800 2.225
Tax effect of originating! 500x50% 500x45% (looO)x
reversing positive timing = = 40%=
differences 250 225 (400) 75
Tax expense 1,000 900 400 2,300
Net accounting income 1,000 1,100 600 2,700
147
However, the tax effect of the reversing positive timing difference in year 3
in the example is not 40% of 1,000 but 475, being the sum of the tax effects of
the originating positive timing differences of years 1 and 2.
So it will be necessary in applying the deferral method to record every
individual timing difference together with the tax rate at which it was calcula-
ted at the time of its origination. The records become even more complicated if
timing differences that have originated over several years (and at different tax
rates) reverse little by little. In that case assumptions have to be made as to
which part of the timing difference is considered to reverse first; an arbitrary
flow-assumption will be necessary in order to relate the reversing timing differ-
ences to the corresponding originating differences.
I.P.A. Stitt6 distinguishes six ways in which the tax effect of timing differences
can be calculated under the deferral method:
1. Separate computation for every timing difference.

2. Separate computation for each group of timing differences, taking only
the tax effect on the net originating or reversing difference for each group
(net change method by group); for the net reversing differences (per group)
the tax effect is computed on one of the following two bases:
a. FIFO-basis: based on the assumption that the oldest net originating
difference will reverse first.
b. moving average rate: based on the assumption that the balances in
the deferred-tax account represent 'pools' of timing differences, the
identity of individual items having been lost.
3. Separate computation for each group of timing differences but dealing
separately with the originating and reversing timing differences in each
group; the tax effect of all reversing timing differences is computed using
either:
a. FIFO-basis
b. moving average rate.
6. I. P.A. Slitt: 'Practical aspects of deferred tax accounting. A working guide to SSAP's 8
and 11', London 1976, page 22 and following. However, Stitt gives no criterion for the group-
ing of timing differences as for method 2 (net change method by group) and method 3 (sepa-
rate computation for each group). The grouping of timing differences. which Stitt uses in his
examples is given without any supporting argumenh, as was stated in chapter 4 of this study.
148
THE DEFERRAL METHOD
4. Net-change method; all timing differences are aggregated to determine

whether there is a net originating or a net reversing timing difference; for a
net reversing timing difference the tax effect is computed using:
a. FIFO-basis
b. moving average rate
5. A simplified version of the net-change method. Under methods 1 to 4,
the calculation basis was the tax rate in force for the period of origination,
either for the individual originating timing difference (method 1), or the net
(or all originating) timing differences of several different groups of timing
differences (methods 2 and 3) or the total net originating timing difference
(method 4). In the British Exposure Draft no. 117 a method was pre-
sented which was called 'a practical expedient of the net change method', in
which all timing differences, whether originating or reversing are put to-
gether and dealt with at the rate of tax in force for the present period. So an
individual timing difference is computed at the rate of tax in force in the
period of origination but withdrawal from the deferred-tax account is at the
rate of tax in force in the period of reversal.
6. The base-stock method. 'Under the 'the base-stock' method, it is as-
sumed that the timing differences consist of a fixed amount and a fluctuat-
ing amount. The fixed amount is retained in the balance sheet at a fixed rate
of tax. The fluctuating amount is dealt with in accordance to one of the oth-
er methods outlined above'. 8
Bevis and Perrys use another classification of the methods mentioned above.
They call methods 2,3 and 4 (net-change method per group, separate compu-
tations per group and the net-change method) 'gross-change methods', where-
as they call method 5 (practical expedient of the net-change method) 'the net-
change method'.
Method 1 (separate computation for individual timing differences) cannot
always be applied without further assumptions. If timing differences originate
over several years (e.g. accelerated depreciation) and at different tax rates,
then, as for the other methods, a flow-assumption will be necessary if the r;!-
versal of these timing differences does not take place in a single year.
In method 5 (practical expedient of the net-change method) one single com-
putation is made at the current tax rate. This could ultimately result in a total
tax expense that exceeds the cumulative actual tax payments during the same
years. For this reason, an additional condition is generally posed for the appli-
7. E.D. 11: 'Accounting for deferred taxation'. Accounting Standards Steering Committee
of the Institute of Chartered Accountants in England and Wales (London, 3rd May 1973). In
the resulting S. S.A. P. 11 this practical expedient was no longer mentioned. It is not, of course,
mentioned either in S.S.A.P. no. 15, in which the probability method was introduced.
8. Stitt, page 40.
149
cation of this method. In the British ED 11, this condition was expressed as
follows: 'This method may result in reversals at a higher rate of taxation than
those at which originating timing differences were recorded. This must never
be allowed to cause an existing credit balance on deferred taxation account to
be converted into a debit balance and in such case no more than the release of
the credit balance can take place' 9. This method can lead to an improper
matching as well as an improper presentation of capital as illustrated by the
example appended to this Exposure Draft lO :
Example 10.2: Application of a 'practical expecient of the net-change method'

(ED 11)
Year Current Tax effect of timing Machine Machine Deferred-

tax differences A B tax acc.
rate
1 50% Mach. A purchased for 10,000

Fiscal depreciation * 8,000
Accounting depr. ** 2,500
Timing differences 5,500
Tax effect of net pas.
tim. diff.: 50%
of 5,500 cr. 2,750
Balance of deferred-
tax acc. at year-end cr. 2,750
2 53% Mach. B purchased for 20,000

Fiscal depreciation 500 20,000
Accounting depr. 2,500 5,000
Timing differences (2,000) 15,000
Tax eff. of net pas.
t.d.: 53% of 13,000 cr. 6,890
9. The Accountant, May 3rd, 1973, page 603.

10. The Accountant, May 3rd, 1973, pages 606/607. Example not repeated verbatim.
150
THE DEFERRAL METHOD
Year Current Tax effect of timing Machine Machine Deferred-

tax differences A B tax acc.
rate
3 53% Fiscal depreciation

Accounting depr.
Timing differences
375
2,500
(2,125)
°
5,000
(5,000)
Tax eff. of net neg.
t.d.: 53% of 7,125 db. 3,776
4 50% Fiscal depreciation

Accounting depr.
Timing differences
281
2,500
(2,219)
°
5,000
(5,000)
Tax eff. of net.neg.
t.d.: 50% of 7,219 db. 3,610
° °
5 50% Fiscal depreciation 211
Accounting depr. 5,000
Timing differences 211 (5,000)
Tax eff. of net neg.
t.d.: 50% of 4,789 =
2,395
Release of the credit-
balance restricted to: db. 2,254
Balance of deferred-tax
acc. at year-end Nil
Total fiscal depreciation 9,367 20,000

Total accounting depreciation 10,000 20,000
• Fiscal depreciation: Machine A: 8,000 in year 1 and 25% of bookvalue in later years; Ma-
chine B: 20,000 in year 2.
** Accounting depreciation: 25% of purchase prices.
The balance of the deferred-tax account at the end of year 5 is nil, whereas for
the calculation of taxable income a depreciation of (10,000 - 8,000 - 500 -
375 - 281 - 211) = 633 will still be allowed during the coming years. The tax
effect of this remaining net negative timing difference is at the curre.nt rate:
151
50% of 633 = 317. Both income and capital are misstated from year 5 onwards
until the end of the (fiscal) lifetime of machine A.
It is not only method 5 that leads to an improper matching of cost and reve-
nues; all the other methods of applying the deferral method do so. The
mismatching does not occur in the period of origination of timing differences
but in the future periods of their reversal. The periods of reversal bear the full
effect of rate-changes between the period of origination and the period of re-
versal of timing differences. The reported tax expense in the reversal period
does not show a functional relationship with pre-tax accounting income, al-
though there are no permanent differences. This type of 'mismatching' lasts
longer in so far as the period of subsequent reversal after a rate-change lasts
longer. In general, the type of 'mismatching' under the deferral method is:
On the reversal If the tax The reported effective tax

of a: rate has: burden in the years of re-
versal will be:
Positive timing risen higher} than the current

difference fallen lower tax rate
I
Negative timing risen lower than the current
difference fallen higher } tax rate
The case of a fall in the tax rate and a positive timing difference will be illustrat-
ed in example 10.3, where the liability method and the deferral method are
compared.
Proponents of the deferral method emphasize the income statement as the
most important part of the accounts. 'The matching of the deferred-concept is
difficult to criticize if it is conceded that current tax effects on income are the
only consideration and that the future may be ignored. The period of the tim-
ing difference and the period of its reversal are assumed to be essentially unre-
lated. (But) if this interpretation is accepted, the question of why defer at all
remains' .11
The matching principle implies that the revenues recognized in a year are
offset against the corresponding costs, including tax cost in the case of compre-
hensive tax allocation. Let us consider an originating negative timing differ-
ence and a subsequent rate-increase. From a strict accounting point of view, an
amount of income of the size of the negative timing difference should be taxed
later and thus at a higher rate. Actually, this amount of income was taxed earli-
11. Black, page 50.
152
THE LIABILITY METHOD
er and at a lower rate. The gain resulting from the rate-increase cannot be re-
cognized in the year of origination of the timing difference (even if the rate-
increase was predictable), because the income statement for the period of ori-
gination of the timing difference using the lower current tax rate was correct;
that is the main argument in favour of the deferral method. But, according to
the matching principle, the gain from the rate-increase cannot be recognized in
the reversal period either, since this gain is not related at all to the revenues
recognized during the reversal years.
If income tax is regarded as a cost factor, the allocation of income tax must
follow the matching-procedure. This implies that the amount of tax costs to be
matched against revenue equals the current tax rate times pre-tax accounting
income. Gains or losses from rate-changes are neither functionally related
with income of the year of origination of timing differences, nor with income of
the year of reversal of timing differences. The cause of these gains and losses
lies in nothing else than in the rate-change, and thus these gains and losses
should be accounted for in the year of the rate-change.
The liability method
'Let tax follow the income'12 is the leading principle underlying the liability
method. Since all differences between the amount of reported tax costs and the
amount of taxes actually payable for the period are categorized as either tax
postponements or tax prepayments, the tax expense should be provided for at
rates expected to apply when the tax will be paid.
The proponents of the liability method emphasize the correct matching of
tax expenses: 'An important consideration in evaluating the liability method is
its effect on the determination of periodic net income. When the tax effect of a
timing difference is a balance sheet credit, the liability method measures up
well. It consistently follows the idea that 'the income tax follows the income'.
The income tax expense accrued represents the taxes on income components
at the rates expected to apply when the tax is paid. The income tax expense is
therefore directly related to the pretax accounting income' .13
However, recognition of gains and losses in the year of origination of timing
differences disregards the fact that these gains and losses are not in any way
related to the origination of timing differences. The liability method disregards
the fact that pre-tax accounting income in years of origination of timing differ-
ences is thought to be the correct income-figure for the year on which the tax
burden should be based. Thus the liability method leads to a 'mismatching' in
12. M. Moonitz, 'Income taxes in financial statements', The Accounting Review, April 1957,
page 183.
13. Black. page 47.
153
the years of origination of timing differences, as is shown in the example 10.3.

In general, the 'mismatching' under the liability method is:
On the origination If the tax The reported effective tax

of a: rate will: burden in the years of
origination will be:
Positive timing rise higher than the current

difference fall lower } tax rate
Negative timing rise lower than the current

difference fall higher } tax rate
Example 10.3: 'Mismatching' in liability- and deferral methods
Year 1 2 3 4 5

revenue item 1,000 1,000 1,000 1,000 1,000
Special revenue item recognized
for tax purposes only 200 200 200
Taxable income 1,000 1,000 1,200 1,200 1,200
Taxe rate 50% 50% 30% 30% 30%
Tax payable 500 500 360 360 360
Net income after tax (on
fiscal basis) 500 500 840 840 840
Liability method
revenue item 1,000 1,000 1,000 1,000 1,000
Special revenue item recognized
for accounting purposes only 200 200 200
Pre-tax accounting income 1,200 1,200 1,200 1,000 1,000
Tax payable 500 500 360 360 360
Tax effect of tim.diff.
(expected rate on reversal) 60 60 {60) {60)
Tax expense 560 560 360 300 300
Net income according to
liability method 640 640 840 700 700
154
THE LIABILITY METHOD
Deferral method
Pre-tax accounting income
(as above) 1,200 1,200 1,200 1,000 1,000
Tax payable 500 500 360 360 360
(current rate on origination) 100 100 (100} (100}
Tax expense 600 600 360 260 260
Net income according to
deferral method 600 600 840 740 740
The reported effective tax burden under both methods is:
year current pre-tax Liability method Deftrral method

inc. tax acc. reported effective reported effective
rate income tax expo tax burden tax expo tax burden
1 50% 1,200 560 46 2/ 3 % 600 50%

2 50% 1,200 560 46 2/ 3% 600 50%
3 30% 1,200 360 30% 360 30%
4 30% 1,000 300 30% 260 26%
5 30% 1,000 300 30% 260 26%
One well-known argument against the liability method is that deferred taxes
are not liabilities because there is no legally enforceable obligation to pay at
the moment. This argument can hardly be taken seriously in accounting, be-
cause in accounting the identification of a specific legal person to whom the
obligation runs is not necessary for the recognition of a liabilityI4, as can be
seen from the estimated liabilities for all types of contingencies.
Another well-known argument against the liability method is that it requires
estimates of future tax rates (often a considerable time ahead). This argument
likewise can hardly be taken seriously from a theoretical point of view. The
valuation of various assets and liabilities requires all kinds of estimates. 'The
need for estimates is characteristic of many liabilities, and difficulties in the
case of taxes are no more insurmountable than in others'. 15
However, the estimate of future tax rates may create a serious practical
problem; that is why some authors say' ... that the only reasonable assumption
about future tax rates is that the current rate will continue' .16
14. See among others: P. Grady: 'Inventory of generally accepted accounting principles for
business enterprises', Accounting Research Study no. 7, 1965, pages 28-30.
15. Black, page 46.
16. Black, page 22.
155
Thus the tax effect of originating timing differences is calculated on the basis
of the current tax rate and the existing balance of the deffered-tax account is
only revalued at the moment the rate changes. The result for net income and
effective tax burden, using the figures of example 10.3, then will be:
Year 1 2 3 4 5
Pre-tax accounting income 1,200 1,200 1,200 1,000 1,000

Tax payable 500 500 360 360 360
Tax effect of timing diff.
(current rate) 100 100 (60} {60}
Tax expense 600 600 360 300 300
Net operating income 600 600 840 700 700
Extraordinary gain:
effect of tax-rate decrease
on timing differences 80
Net income for the year 600 600 920 700 700
Current income-tax rate 50% 50% 30% 30% 30%

Reported effective tax
burden 50% 50% 30%or 30% 30%
23 1/3%*
• 30% in a current-operating-performance type of income statement and 23 1/)% in an all-

inclusive income statement
The above method has been treated as an interpretation of the liability meth-
od.17 It has been called 'the windfall-solution' by T.F. Keller: 'A change in tax
rates produces a windfall loss (or gain) because the tax liability which accrues
at the new rate when the revenue is earned is satisfied by the payment at the old
rate' .18 However, this method can hardly be presented as a special interpreta-
tion of the liability method, because the basic principle that the tax effect of
timing differences should be calculated at an estimated future rate is aban-
doned in the windfall-solution. Even if a change in the tax rate is certain, the
windfall-solution does neither recognize the gain or loss from the rate-change
in the years of origination of timing differences (as under the liability method),
nor in the years of reversal of timing differences (as under the deferral meth-
od), but in the year of rate-change itself.
17. Black, page 58.

18. T.F. Keller, 'Accounting for corporate income taxes', 1961. pages 121-124. Although
Black scorns the windfall-solution (Black: page 59). it forms the basis of all his examples of the
liability method.
156
WINDFALL-METHOD AS SEPARATE METHOD
The advantages of the liability method mentioned by its advocates are most-
ly based on the windfall-solution. See inter alia G. Hope: 'The most obvious
reason for this (= the use of the liability method) must be the simplicity of the
annual calculation, but additionally there is much to be said for measuring the
amount of deferred taxation at the latest known rates of corporation tax. The
deferred taxation would then reflect the position which would exist if all the tim-
ing differences were eliminated at the balance sheet date'.19
However, the liablity method in fact does not measure the deferred tax at
the late~t known tax rate, and therefore does not reflect the position which
would exist if all timing differences were eliminated at the balance sheet date,
if a rate change is certain. It may be that' ... ordinarily, the only reasonable
assumption about future tax rates is that the current rate will continue. (But)
... if a rate change is known or reasonably certain when the tax effect is first
recorded, however, the anticipated rate is used' ... 20 in the liability method. A
change in the tax rate that can be known in advance or is reasonably certain
does not create a windfall gain or loss under the liability method. The win~fall
solution recognizes all gains and losses from a rate-change, having a causal
relationship with the year of change in that year itself, independent of whether
the rate-change could be foreseen or was reasonably certain or not.
The windfall-solution as a separate method
The main argument against the 'windfall-solution' is that if the balance on the
deferred-tax account is calculated at the latest known tax rate, abnormal
charges or credits against profits on account of the changes in rates could arise.
For instance Stitt, when showing in an example an application ofthe 'windfall-
solution' for a three-year period, with different tax rates for every year, states:
'It will be noted that in each year, other than the first, the tax charge is not
book profit times tax rate for the year. The reason for the difference is the fact
that the ,accumulated timing differences brought forward from the previous
year must be adjusted to the new tax rate'.2l
However, this criticism is an argument with implications for the liability
method and the deferral method as well. If the main criterion for a choice be-
tween the liability, deferral and windfall methods is to be the number of years
in which the tax charge in the income statement equals book income times tax
rate for the year, it is as well to note that the liability method does not meet this
test in the years of origination of timing differences and the deferral method
19. G. Hope, 'Problems of timing differences', Accountancy Age, May 1973, Emphasis
mine.
20. Black, page 22.
21. Stitt, page 18.
157
does not do so in the years of reversal of timing differences. The criterion for a
choice between these three methods would then simply depend on an estimate
of the frequency with which three types of events will occur:
• origination of timing differences before the rate-change and subsequent

reversal at once after the rate-change; if the frequency is low the deferral
method is the most appropriate;
• origination of timing differences in one year and reversal after the rate-
change little by little; if the frequency is low the liability method is the most
appropriate;
• changes in tax rates; if the frequency is low the windfall-solution is the
most appropriate method.
However, this can hardly be a main criterion for the choice between these
methods. The main question is with which period the gains and losses due to
rate-changes have a causal relationship. If this period is the period of the origi-
nation of timing differences, then the liability method is the most appropriate,
since it recognizes in principle the gains and losses of timing differences as part
of the tax expense in the years of origination of the timing differences.
When there is a causal relation with the year(s) of reversal oftiming differ-
ences, the deferral method would be the most appropriate, since the gains and
losses from rate-changes are recognized, as part of the tax expense, in the
year(s) of reversal. If it is thought suitable to attribute a causal relation with the
year of rate-change, the windfall-solution is the most appropriate method. In
this case it is quite correct that the tax charge in the year of rate-change' ... is
not book profit times tax rate for the year'. 21 However, the effects of the rate-
change are not necessarily to be recognized as part of the tax expense for the
year. A distortion caused by the correction can be overcome' ... if the adjust-
ment for the change in rate of corporation tax is shown in the profit and loss
account either:
a. as an extraordinary item
b. as an adjustment to earnings retained for the year or
c. as an adjustment to the balance of profit brought forward ... '.22
The first of these options, mentioned by Hope, appears to be the most suit-
able. The treatment as an extraordinary item clearly recognizes the fact that
these gains and losses are brought about by the rate-change itself. Any associa-
tion with income of other years, as might occur in the second and third options,
can thus be prevented.
22. Hope, Accountancy Age, 25 May 1973.
158
THREE COMBINED METHODS
Three combined methods
There have been several proposals to combine the liability method (generally
interpreted as the windfall-solution) and the deferral method. The best-known
proposals are discussed briefly in this section.
a. First there is a proposal for combination of the deferral and the liability
method from P. Grady. Grady wants to use the deferral method for timing
differences that' ... have a long term effect, involve repetitive as distinguished
from isolated transactions and are of such a nature that it is possible to estab-
lish a known amount by which taxes for the year were reduced or increased
because of accounting for the item one way in the books and another way in the
tax return'. 23
The liability method, on the other hand, appears to Grady to be appropriate
for those timing differences' ... which may not cover long periods, do not nec-
essarily involve repetitive transactions, may be susceptible of fairly accurate
estimates and (where) the tax effect represents an estimate of future effect
rather than being currently determinable'. 23
Grady analyses five situations, four of which meet the criteria set for the use
of the deferral method. Only in one situation is the liablity method in his opin-
ion the most appropriate. This situation covers: 'expenses or losses provided
for in the accounts in advance of their deductibility for tax purposes'. 23
Grady's decision on the applicability of the deferral and liability methods
seems inconsistent. Why should long-term liabilities (and claims) be regarded
as 'deferred credits' while short-term liabilities should be regarded as 'estimat-
ed liabilities'? How long must the long-term effect of timing differences be for
their tax effect to be regarded, not as an 'estimated liablity', but as a 'deferred
credit'?
Apart from this inconsistency, Grady's proposal leaves much unclear. Sup-
pose that a number of positive timing differences have not been adjusted after
a rate-increase in the past, because their tax effect had to be categorized as
'deferred credits'. It is not clear in which period the loss due to the rate-in-
crease should be recognized; it may be done either in the years when these
timing differences reverse, or in the year(s) when the tax effect ofthese timing
differences can no longer be regarded as 'deferred credits' but must be regard-
ed as 'estimated liablities' because their reversal has come so near.
Moreover, why should the tax effect of timing differences, that are expected
to reverse in the near future, be valued using the liability method, thus recog-
nizing the effects of a rate-change in the year of origination of timing differ-
ences (or in the year of rate-change)? As the tax effect of timing differences
23. Grady, 'Tax effect accounting ... ', page 26 and following. This article was also published
in: 'Inventory of generally accepted accounting principles .. .', page 117 and following.
159
that are expected to reverse in the long run is valued using the deferral method,
thus recognizing the effects of a rate-change in the distant future (that is, upon
reversal). The logic of this method is far from evident.
The main argument Grady uses to defend his proposal is that in the long run
the tax rate is much more uncertain than in the short run. However, this is a
false argument, because the degree of uncertainty about the future tax rate
does not vary with the length of the expected reversal period. This uncertainty
depends on whether tax is either prepaid or deferred. For an originating nega-
tive timing difference, the amount of prepaid tax is elear, because it is the origi-
nating negative timing difference times the current tax rate. This amount of
prepaid tax does not change according to whether the reversal is expected to
occur sooner or later and does not change if tax rates change in the future.
b. A second proposal to combine the deferral and liability approaches is
based on the criterion of whether the tax charge has been definitely deter-
mined or not. This proposal was made by R. E. Perry. 24 Perry distinguishes
four different situations:
Situation as described by Example Appropriate method ac-
Perry: cording to Perry
I. Prepaid income tax Revenue item in- Deferral method, because

(originating nega- eluded in taxable the tax charge has al-
tive timing differ- inc.earlier than in ready been definitely
ence) acc.inc. determined
II. Deferred income tax Expense item in- Deferral method, because
credit (originating eluded in taxable the tax credit has already
positive timing dif- inc. earlier than in been definitely determi-
ference) acc.inc. ned
III. Deferred tax lia- Revenue item in- Liability method, because
bility (originating eluded in acc.inc. the amount of the inc. tax
positive timing dif- earlier than in charge has not been defi-
ference) taxable income nitely assessed
IV. Future income tax Expense item in- Liability method, because
benefit( originating eluded in acc.inc. the amount of the inc.
negative timing dif- earlier than in tax credit has not been
ference) taxable income definitely assessed
24. Perry, pages 23-32.
160
Perry's proposal is clearly' ... based on a fallacy - the proposition that because
an item has been reported in a tax return, the tax effect has been definitely
determined. Some timing differences result from a deduction that first reduces
the taxes paid and later its absence increases the taxes paid. The argument
overlooks this 'see-saw' effect'. 25
Black, when illustrating Perry's argument for the case of accelerated depre-
ciation (Perry's case II), remarks quite rightly: 'Accelerated depreciation ...
reduces the tax paid currently because the deduction for tax purposes exceeds
the expense in the income statement. At a later date, the reverse occurs, and
tax payments increase. The reversal is as much a part of the tax effect as the
original tax reduction. If they are not completely compensatory, the pre-
cedence of one or the other must ... not be settled merely on the basis of which
event occurred first'. 25
c. A third proposal to combine the deferral and liability approaches origi-

nates from H.A. Black. Unlike Perry, Black explicitly applies the criterion of
whether the income tax is prepaid or deferred from an accounting point of
view.
Black also describes four situations; these cases are exactly the same as those
mentioned by Perry. The methods appropriate to rate-changes according to
Black (and Perry) are:
The situation described by Appropri- The situation de- Appropri-

Perry ate method scribed by Black ate method
according according
to Perry to Black
I. Prepaid income Deferral Rev. or gains Deferral

tax (or.neg.t.d.) method taxed before- method
earned (C)
II. Deferred income Deferral Tax deduction Liability

tax credit method before recording method *
(or. pos. t.d.) expo (D)
III. Deferred income Liability Revenues or- Liability

tax liability method gains taxed after method*
(or. pos. t.d.) accrual (A)
25. Black. page 61. Table continued on p. 162.
161
The situation described by Appropri- The situation de- Appropri-

Perry ate method scribed by Black ate method
according according
to Perry to Black
IV. Future income Liability Expenses ac- Deferral

tax. benefit method crued before tax method
(or. neg.t.d.) deductible (B)
• Interpreted as the windfall-solution.
Black's proposal is a straightforward application of the liability approach (in-

terpreted as the windfall-solution) when there are positive timing differences
and a straightforward application of the deferral approach when there are neg-
ative timing differences. Since Black interprets the liability approach here as
the windfall-solution and since the windfall-solution is the only method that
does not jeopardize the matching principle, negative timing differences are of
especial interest. Black gives two arguments for the use of the deferral method
in case B (Expenses accrued before tax deductible). These arguments are simi-
lar to those given in case C. Concentrating on case B, these two arguments are:
1. 'The timing of the expense charge depends on the anticipation of tax-

able income. The entire amount of tax paid is an expense of the period of pay-
ment unless a portion applies to future periods. Applicability of the tax effect
of the timing difference to future periods depends on whether tax payments
are likely to be reduced because the item is deductible when paid, which, in
turn, depends primarily on the existence of sufficient taxable income in the
later period'. 26
This argument concerns the timing (or matching) of prepaid tax. The future
benefits ofthe prepayment oftax have to be recognized in the reversal periods.
As such this argument is an argument for the application of comprehensive tax
allocation. Under both the liability method and the windfall-solution, the ben-
efit of prepayment of tax is recognized in the reversal period. This argument
does not imply that the recognition of the benefit of prepayment of tax should
be stated at the old tax rate that was in effect when the tax was prepaid (or the
negative timing difference originated).
Why should the uncertainty about future reversal of negative timing differ-
ences be expressed only if the tax rate changes (a rate-decrease in Black's ex-
26. Black, page 79.
162
ample)? The reversal of negative timing differences still depends on the exis-
tence of sufficient taxable income even if the tax rate remains the same. Uncer-
tainty about the effective reversal of negative differences may be an argument
for a lower valuation of negative timing differences, as has been discussed in
part B of chapter 5. The conclusion may be repeated: Uncertainty about the
reversal of negative timing differences, can under the going-concern assump-
tion be expressed in a lower valuation only in rather exceptional situations. We
can now add to this conclusion, that such a recognition of uncertainty definite-
ly cannot depend on the casual occurrence of a change in the rate of tax.
Moreover, Black illustrates the use of the deferral method when there are
negative differences only with examples of a fall in the tax rate. Did he not
notice that use of the deferral method for negative timing differences results in
a lower effective tax burden in the years of reversal if the tax rate rises? In his
concern about the uncertainty of the future reversal of negative timing differ-
ences, Black implicitly appeals to the prudence principle. But prudence is ab-
sent when he applies the deferral method to negative timing differences when
tax rates increase.
2. Black's second argument concerns the amount of the tax expense: 'The
amount of the expense depends on the tax already paid ... , interperiod income
tax allocation is a process of matching tax payments with periods to which they
apply rather than with the periods in which they are paid. The tax payments set
the limit on tax expenses; over the life of a business the tax expenses can be
neither more nor less than tax payments'.26
It is noteworthy that both the liability method and the deferral methdd meet
this test. So this can hardly be an argument for the use of the deferral method
when there are negative timing differences. In this argument Black clearly
overlooks the arguments he used to reject Perry's proposal. There is a 'see-
saw' effect for negative timing differences as well as for positive timing differ-
ences. Paraphrasing Black's words, it can be said, that: this method is clearly
based on a fallacy - the proposition that because an item has been reported in
a tax return, the tax effect has been definitely determined. Some timing differ-
ences result from the absence of a cost item, that first increases the taxes paid
and later its presence reduces the taxes to be paid. The origination is as much
part of the tax effect as the subsequent reversal.
Black's arguments for the application of the deferral method in case C (Reve-
nues or gains taxed before earned) are similar to those mentioned above for his
case B. Therefore they need not being discussed. Black's arguments for the use
of the liability method when there are positive timing differences are similar to
26. Black, page 79.
163
those given earlier (under the description of the deferral method) in favour of
the windfall-solution (which solution is, however, rejected by Black).
Evaluation of the methods of accounting for rate-changes
Generally three methods are mentioned for the treatment of timing differ-
ences when tax rates change:
• the liability method;

• the deferral method;
• the net-of-tax method.
Only the liability method and the deferral method are relevant to changes in
the income-tax rate. The proponents of the liability method reproach the pro-
ponents of the deferral method with the mismatching of tax expenses. It is in-
deed possible that over a great number of years the reported tax expense does
not equal book income times current tax rate. But the same kind of 'mismatch-
ing' occurs when the liability method in the years of origination of timing dif-
ferences is applied.
The proponents of the deferral method pride themselves on the simplicity of
their method: no adjustments are necessary when tax rates change. But this
simplicity is contradicted by the inevitable assumptions about the flow-
through of timing differences.
All three of the combined methods analysed implicitly appeal to the pru-
dence principle, but none of the proponents of these methods (Grady, Perry
and Black) has shown why this prudence is necessary only iftax rates change.
The principle question is to which period the gains and losses from a change
in the rate of tax are to be allocated. Proponents of the deferral method argue
that allocation to the period of origination of timing differences is not correct,
because the income statement prepared at the current rate was correct. Propo-
nents of the liability method argue that allocation to the period of reversal of
timing differences is not correct, because 'tax should follow the income'.
The recognition of gains and losses from tax-rate changes is a problem of
matching. The matching principle includes three elements:
• allocation of revenues to periods;

• allocation of expenses to revenues;
• allocation to periods of those expenses that cannot be allocated to reve-
nue.
Comprehensive tax allocation appeals to the second element of the matching
principle. Gains and losses caused by rate-changes, however, can neither be
allocated to the revenues of the period of origination of timing differences (as
164
CASE OF NON-PROPORTIONAL TAX RATES
proponents of the deferral method have argued), nor to the period of reversal
of timing differences (as proponents of the liability method have argued).
These gains and losses are brought about by the rate-change itself; in accor-
dance with the third element of the matching principle, they have to be allocat-
ed to the period of the ratechange. This method, sometimes called the 'wind-
fall-solution', has three advantages:
• no arbitrary flow assumptions are required concerning the reversal of

timing differences;
• the effect of rate-changes can be calculated simply by using the balance
of the deferred-tax account;
• the reported tax charge in years of origination and of reversal of timing
differences equals pre-tax accounting income times the current tax rate,
which is the main goal of comprehensive tax allocation.
A distorting effect in the year of rate-change, inter alia, can be prevented, at

least as far as net operating income is concerned, by presenting the gains and
losses from rate-changes as extraordinary items.27 Nearly all the arguments
presented in favour of the liability method are essentially arguments in favour
of this windfall-solution.
The case of non-proportional tax rates
So far we have taken into consideration only a flat-rate income tax. If an in-
come tax is levied at graduated rates, there may be changes in the rate each
year, which have three consequences for the calculation of the tax effect of
timing differences:
a. The tax effect of timing differences can no longer be calculated as the

timing difference times the tax rate; the tax effect of a timing difference
being the difference between tax payable and an amount of tax that would
be payable if pre-tax accounting income were taken as the tax base.
b. If the rate-structure remains unchanged, the yearly tax rate depends
solely on the amount of taxable income; this implies the need for a yearly
adjustment of the tax effect of timing differences under the liability- and the
windfall-solutions.
c. Even if differences between accounting income and taxable income con-
sist only of timing differences, and the rate-structure remains unchanged, a
27. The British S.S.A.P. no. 15 requires a separate disclosure of the effects of rate changes
as part of the taxation charge for the period. This is certainly understandable, given that under
the probability method, as defended in this statement, the taxation charge for the period does
not show a causal relationship with book income before tax even if there are no permanent
differences.
165
permanent increase or decrease in the effective tax burden may result from
the progressive rate-structure.
A yeady adjustment of the tax effect of timing differences hardly seems to be

feasible, since the necessity for this adjustment does not arise from rate-
changes but depends on changes in the amount of taxable income only.
Given the size of the companies liable to income tax with a progressive rate
and their legal form (in most countries generally small privately owned compa-
nies), fully comprehensive tax allocation will hardly be appropriate. These
companies, or rather their owners, may even regard income tax not as a cost
factor but rather as an enforced expenditure of private income. Nevertheless,
it may be useful to this kind of companies, or rather to their owners, to get
some notion about the amounts of income involved in tax deferral because of
tax reliefs (e.g. investment allowances). The rule of common basis (the identi-
ty of the annual accounts for tax purposes and for publication purposes) must
be commented upon more favourable than for companies liable to a flat-rate
(corporate) income tax; the use of fully comprehensive tax allocation can hard-
ly be expected from small privately owned companies that are liable to income
tax with a progressive rate, for reasons mentioned above. A practical solution
could be to allow the identity of the annual accounts for tax and for publication
purposes and to require additional note-disclosure to the accounts for publica-
tion purposes on the amounts of major tax reliefs (either timing differences or
permanent differences). 28
The net-of-tax metho~, almost invariably mentioned in the literature in this

context, is not relevant to changes in the tax rate.
The deferral method in case of rate-changes gives a wrong allocation of the
tax expense over the years. It makes arbitrary flow-assumptions necessary, if
timing differences that have originated over several years (and at different tax
rates) reverse little by little.
The liability method, in its original version, disregards the fact that pre-tax
book income in the year of origination of timing differences is thought to be the
28. This 'moderate type of tax allocation' (adverse rule of common basis plus additional
note-disclosure on major tax reliefs) has been allowed even to big public companies in the 4th
Directive of the E.C. (Section 43, paragraph 10, 4th Directive). However, the country mem-
bers of the E.C. can decide that small and medium sized companies (as defined in the 4th
Directive) are allowed to omit even this note-disclosure in published financial statements
(Section 47, paragraphs 2 and 3, 4th Directive).
166
CONCLUSIONS CHAPTER 10
correct income-figure for that year, on which the tax burden should be based.
Only the windfall-solution, that allocates the tax effect of the rate-change to
the year of rate-change itself, is in accordance with the matching principle.
All three of the combined methods analysed implicitly appeal to the pru-
dence principle, but none of the proponents of these methods (Grady, Perry
and Black) has shown why this prudence is necessary only if tax rates change.
A 'moderate type of tax allocation' seems more appropriate for companies
liable to income tax levied at graduated rates.
167
11. Deferred-tax accounting in group ac-
counts
The problem of deferred-tax accounting in group accounts is essentially the

problem of a difference between the accounting entity and the tax entity.
When this difference results from consolidation for publication purposes,
while this consolidation is not performed (or not permitted) in the calculation
of taxable income, transfer pricing appears. Although the calculation of the
tax effect of different transfer-pricing systems may be rather complicated in
practice, it does not pose any special problem in tax-effect accounting. The
intercompany transactions, eliminated in the calculation of consolidated ac-
counting income for a group, but recognized in the calculation of the taxable
income of the different taxpaying members of the group, lead to (usually nega-
tive) timing differences. At least, only timing differences will appear if all the
taxpaying members are liable to the same tax system, that is to say, for national
groups of companies.
In tht;! absence of any relief for the parent company, there will be national
double taxation on account of the earnings of its subsidiaries. This double taxa-
tion constitutes a negative permanent difference for the group accounts, origi-
nating on consolidation. The most common types of relief from this national
double taxation are the affiliation privilege or participation exemption and the
option of fiscal consolidation or fiscal unity. The appropriate method of tax-
effect accounting will be discussed subsequently. As for the affiliation privi-
lege, complications seem to arise when the loss of a subsidiary is set off against
positive income of other members of the group, while the tax administration
levies tax on the separate members of the group; for tax purposes, the loss
member has to rely on carry-back and/or carry-forward. Of course, this consti-
tutes a problem even if there is no affiliation privilege; but for brevity it will be
discussed only for the case where an affiliation privilege forms part of the tax
system. If there is grouping for tax purposes, no tax-allocation questions seem
to arise since the tax entity (the group) is identical to the accounting entity.
However, if consolidation is allowed for tax purposes when there is less than
100% participation, it has to be decided which member of the group should
receive the benefit of different kinds of tax relief. This case is known as 'allo-
cating tax advantages among affiliates' and it is really a matter of valuation of
minority interests. For brevity, the discussion will be confined to the situation
168
NATIONAL GROUP ACCOUNTS
where there is grouping for tax purposes and a loss of one member of the group
is set off against positive income of other members. But it should be borne in
mind that this problem can arise in a number of other situations.
When the tax authorities tax a domestic parent company on its world-wide
income (country-of-residence principle) and the tax authorities abroad tax the
income from a foreign subsidiary or permanent establishment on the basis of a
source-country principle, there is again a difference between the accounting
entity (the group for purposes of consolidated accounts) and the tax entity
(several firms overlapping for tax purposes). The transfer-pricing problem for
this international group of companies is much more complicated than for a
national group. Apart from the timing differences originating in the consoli-
dated accounts because intercompany profits will be realized only on sale to
outsiders, permanent differences can originate in an international group of
companies because the different tax-levying authorities may not use the same
transfer price or if they do so group income may be taxed at different rates.
In the absence of any relief for the parent company, it will be subject to
international double taxation because of the earnings of its subsidiaries or per-
manent establishments abroad. This double taxation constitutes a negative
permanent difference for the group accounts, originating on consolidation, as
was the case for national groups. However, there is a wider range of methods
for granting relief from international double taxation. Four basic methods of
relieving international double taxation will be discussed below, mainly in
terms of loss-situations.
Part A. Deferred-tax accounting in national group accounts
A.1. Transfer pricing in national group accounts
For intercompany transactions between members of a group of companies it is

common accounting practice to eliminate the intercompany profit in the con-
solidated accounts. If the tax rate for the group members is the same, then,
since the transfer price will usually not be corrected, only a timing difference
originates if tax is levied from these group members as separate tax entities.
This timing difference is usually a negative one, since the sales proceeds will be
regarded as realized for the consolidated accounts only on sale to outside par-
ties. Transfer pricing in national group accounts does not pose any special
problems for tax-effect accounting. However, it should be realized that the
timing differences arising from intercompany transactions will appear only in
the group accounts, not in the accounts of the individual members of the
group. This is illustrated in example 11.1.
169
DEFERRED-TAX ACCOUNTING IN GROUP ACCOUNTS
Example 11-1: Transfer pricing in national group accounts

Company A starts business with a stock of goods valued at 80, and its equity
is also 80. Company B, a fellow member of the group, has cash of 100 and
equity of 100. In year t\ company A sells its stock of goods to company B for
100. In year t2 company B sells the same goods to outside parties for 120. The
transfer price of 100 for the intercompany transaction between A and B is ac-
cepted for tax purposes. The tax rate is 50%. The calculation of taxable income
and tax payable, if companies A and B are taxed individually and the income
statement for publication purposes are:
Income statements for tax purposes:
Company CompanyA Company B

period t, t2 t] t2
Sales 100 0 0 120

COGS 80 0 0 100
Taxable income 20 0 0 20
Tax payable 10 0 0 10
Net income 10 0 0 10
Income statements for publication purposes:
Company Company A Company B A+B

consolidated
period t, t2 t, t2 t, t2
Sales 100 0 0 120 0 120

COGS 80 0 0 100 0 80
Book income before tax 20 0 0 20 0 40
Tax payable 10 0 0 10 10 10
Tax effect of tim.diff. 0 0 0 0 (10) 10
Tax expense 10 0 0 10 0 20
Net income 10 0 0 10 0 20
So the tax effect of timing differences resulting from intercompany transac-

tions will be recorded only in the consolidated accounts. The balance sheets for
publication purposes, the mutual financial relationship being disregarded are:
170
Balance sheets for publication purposes:
Company Company A Company B A+B

consolidated
period to t] t2 to t] t2 to t] t2
Stock of goods 80 0 0 0 100 0 80 80 0

Cash 0 100 100 100 0 120 100 100 220
Tax effect of
neg. tim.diff. 0 0 0 0 0 0 0 10 0
80 100 100 100 100 120 180 190 220
Equity 80 80 80 100 100 100 180 180 180
Inc. (accumulated) 0 10 10 0 0 10 0 0 20
Tax payable
(accumulated) 0 10 10 0 0 10 0 10 20
80 100 100 100 100 120 180 190 220
A.2. The affiliation privilege or p~rticipation exemption and national group ac-
counts
The affiliation privilege, as it is known in several countries, applies where a

company holds shares in another company which constitutes a certain mini-
mum-percentage of the paid-in capital of that other company. The general ef-
fect of the affiliation privilege is that the recipient company will not be liable to
corporate income tax on the dividends (and possibly other income) it has
received from the other company. These dividends (and other income if ap-
plicable) constitute exempted income for the parent company. That is why the
affiliation privilege is also called 'participation exemption'. However, the term
'affiliation privilege' is preferred as the noun 'participation' implies majority
shareholding, but the affiliation privilege in most countries applies also to mi-
nority shareholding. Thus the affiliation privilege is very similar to the franked
investment income in the U. K., at least in case of national group accounts.
The existence of an affiliation privilege may give rise to a number of timing
differences and permanent differences, but no special theoretical problems are
involved, as long as the subsidiaries do not produce a negative taxable income.
However, tax-effect accounting may become rather complicated in practice,
especially when the affiliation privilege applies to income from subsidiaries
abroad (see part B of this chapter for the exemption method).
Intercompany transactions may raise timing differences, as was mentioned
in part A.L of this chapter. When no consolidated annual accounts are pub-
lished, the income transferred by a subsidiary to the parent company under the
affiliation privilege constitutes exempted income for the parent company;
171
however, reporting the effective tax burden for different elements of income
has been treated in chapter 8.
When consolidated annual accounts are published, timing differences and
permanent differences may arise from the consolidation, if it is desired that the
shareholders' equity of the parent company equals that in the consolidated bal-
ance sheet. An example of a permanent difference arising on consolidation is
the application of the purchasing method of consolidation (merger by pur-
chase of shares). If the purchase price of the subsidiary exceeds the fair value
of its net assets, an amount of goodwill appears in the consolidated balance
sheet. For accounting purposes this goodwill can be written off on the evidence
of decline in value or it may be amortized by charges to group income. As this
goodwill can usually not be written off for tax purposes of the parent company,
there is a negative permanent difference, existing only in the consolidated ac-
counts. But, again, the treatment of the tax effect of this permanent difference
(resulting from the consolidation procedure and the type of merger and not
from the affiliation privilege) constitutes no problem that has not been treated
earlier in this study.
The occurrence of a loss under the operation of the affiliation privilege poses
no new problems either. The recognition of a decline in the value of a subsidi-
ary in the annual accounts of the parent company, that is exempted from the
calculation of taxable income through the operation of the affiliation privilege,
results in the familiar event of reporting the effective tax burden for different
elements of the income of the parent company.
Complications seem to arise when a loss of a subsidiary is set off against
positive income of other members of the group in the consolidated accounts,
whereas the tax administration levies tax from the separate members of the
group; for tax purposes the loss member has to rely on carry-back and/or carry-
forward. Yet no accounting adjustments are necessary if the valuation of the
minority shareholding, if any, is consistently based on the after-tax income of
the subsidiaries.
This conclusion does not change if the loss is compensated by carry-back of
carry-forward; nor is it influenced by the recognition or non-recognition of an
originating negative timing difference because of the possibility of loss carry-
forward. This may be explained by the following example:
Example 11.2
a. Affiliation privilege; offset of a loss of a subsidiary in the consolidated

annual accounts; loss carry-back by individual loss-member; purchasing
method of consolidation
Parent owns 70% of subsidiary; full consolidation; no intercompany transac-
tions; the purchase price of the subsidiary was equal to the fair value of the net
assets of the subsidiary (no goodwill).
172
Income statements year 1 and year 2:
Year Company PIL-acc. PIL-acc. Consolidated

Parent cy. Subs. PIL-acc.
1 Operating income 100 100 200

Tax payable (48%) 48 48 96
Tax effect of t.d. 0 0 0
Tax expense 48 48 96
52 52 104
Net increase in the
fair value of net
assets of subs. *: 36.4
Minority interest: 15.6
Net income 88.4 52 88.4
2 Operating income 100 (50) 50

Tax payable (48%) 48 (24) 24
Tax expense 48 (24) 24
52 (26) 26
Net decrease in the
fair value of net
assets of subs. *: (18.2)
Minority interest: (7.8)
Net income 33.8 (26) 33.8
* Exempted from income tax.
b. Same facts as a. except that the loss of the subsidiary is carried forward
and an originating negative timing difference on account or loss carry-for-
ward is recognized


Tax payable (48%) 48 0 48
Tax effect of t.d. 0 (24) (24)
Tax expense 48 (24) 24
52 (26) 26
Income statement continued on p. 174.
173

Net decrease in the

fair value of net
assets of subs. *: (18.2)
Minority interest: (7.8)
Net income 33.8 (26) 33.8

Tax payable (48%) 48 24 72
Tax expense 48 48 %
52 52 104
Net increase in the
fair value of net
Minority interest: 15.6
Net income 88.4 52 88.4
• Exempted from income tax.
c. Same facts as b. except that no originating negative timing difference on

account of loss carry-forward is recognized


Tax payable (48%) 48 0 48
I Tax expense 48 0 48
52 (50) 2
Net decrease in the
fair value of net
assets of subs. *: (35)
Minority interest: (15)
Net income 17 (50) 17
174
Year Company PI L-acc. PI L-acc. Consolidated


Tax payable (48%) 48 24 72
Tax effect of t.d. 0 o o
Tax expense 48 24 72
52 76 128
Net increase in the
fair value of net
Minority 'interest: 22.8
Net income 105.2 76 105.2
• Exempted from income tax.
A special problem may arise if the affiliation privilege does not exempt all
gains and losses from the participation. As an example of this we may take the
te1"mination loss in Dutch tax law, which is exempted from the affiliation privi-
lege if the termination occurs in certain specified circumstances: 'If the (subsi-
diary) is terminated by the dissolution of the company in which the participa-
tion is held and by the total distribution ofthe proceeds ofthe liquidation, then
a deduction is allowed for the amount by which the 'amount sacrificed'l to ac-
quire the participation exceeds the liquidation (proceeds)'. 2
If an amount is paid for goodwill on the acquisition of the subsidiary, which
is terminated with a loss later on, then the annual accounts of the parent com-
pany will show a bigger loss than that shown in the consolidated accounts. This
is illustrated in the following example:
Example 11.3: Termination loss exempted from the affiliation privilege

Parent company P owns a 100% of the shares of two subsidiaries (Sl and
S2); both subsidiaries are valued at their acquisition price. For subsidiary Sl a
considerable amount has been paid for goodwill. In year t2 Sl is terminated;
the net assets of Sl are sold for Dfl. 900. No intercompany transactions or
mutual dividend payments have ever taken place. For the sake of simplicity it
is supposed that the consolidated accounts are prepared using the pooling
method of consolidation (merger by exchange of shares).
1. The 'amount sacrifi<:ed' does not mean book value or acquisition price. It means the
amount initially paid for the shares of the subsidiary, adjusted by additional capital subscribed
and distributions paid out of retained earnings present at the time of acquisition.
2. 1. Mittendorff 'Netherlands: The affiliation privilege" European Taxation, nr. 3, March
1977, page 85.
175
Balance sheet P year t1 Balance sheet P year t2

Assets 500 Total 1,500 Assets 500 Total 1,000
S1 500 equity equity
S2 500 S2 500
1,500 I300 1,000 1,000
Balance sheet Sl year t1 S1: terminated in year t2

Assets 1,000 Total eq. 100
Debt 900
1,000 1,000
Balance sheet S2 year t1 Balance sheet S2 year t2

Assets 500 ITotal eq. 500 Assets I
500 Total eq. 500
500 500 500 500
The parent company reports a loss of 500; this loss is exempted from the affilia-
tion privilege, so that it can be carried back and/or forward for the calculation
of the taxable income of the parent company. The loss reported in the consoli-
dated accounts is only Oft. 100, which is the loss on the sale of the assets of
company S1:
Cons. Bal. sheet P/Sl/S2 yr. t1 Cons. Bal. sheet P/S2 yr. t2
Assets 2,000 Total eq. 1,100 Assets 1,000 Total eq. 1,000
Debt 900
2,000 1,000
The difference between these losses constitutes a positive permanent differ-

ence for the group, existing in the consolidated accounts only.
A.3. Fiscal consolidation (or fiscal unity) and national group accounts
Where the tax authorities have allowed consolidation for tax purposes (or fis-
cal unity), no tax-allocation problems seem to arise. The accounting entity and
the fiscal entity are the same. The transfer-pricing problem loses its impor-
tance, at least for unsegmented consolidated financial statements. Even the
occurrence of a loss for a member of the fiscal group apparently poses no prob-
lems in the field of tax-effect accounting. All companies involved in the group-
ing for tax purposes will be taxed as if all subsidiaries had been merged with the
parent company. Losses of one company are immediately set off against posi-
tive income from the other companies. A net operating loss deducted within
the carry-over period, whether on an accounting or a fiscal basis, causes no
permanent or timing difference.
176
However, if a loss of one member of the fiscal group is set off against positive
income of other members, it has to be decided which member of the group
should receive the tax benefit from the net operating loss. 'Allocating tax ad-
vantages among affiliates' is well-known in the U.S.A., since consolidation for
tax purposes is permitted there when the participation is less than 100%. If the
participation is 100%, the allocation of the tax benefit of the offset of the loss
does not matter; it becomes important only when the level of participation is
less than 100%: the problem is essentially a matter of the valuation of minority
interests, at least where the subsidiaries have the same residence as the parent
company. A similar problem of 'allocating tax advantages among affiliates'
arises from different methods of relief from international double taxation even
if the affiliates are 100%-owned (see part B of this chapter). There are three
basic methods of allocating the tax advantage of a loss offset:
'1. Allocate all of the tax benefit from the net operating loss to the loss
member.
2. Divide the tax benefit among the producer of the loss and the users of
the loss.
3. Give all of the tax benefit to the profit members'.3
Note that the situation meant here is not technically the same as the situation
described in example 11.2 for the affiliation privilege; for, in this situation the
offset of the loss is recognized by the tax authorities also, and not only in the
consolidated accounts. The following illustrates the type of situation we have
in mind:
Example 11.4: 'Allocating tax advantages among affiliates'

'It is assumed that for each of two years P has $ 100,000 of ordinary taxable
income. Additionally, Shad $ 60,000 of ordinary taxable income in the first
year, but a $ 30,000 net operating loss in the second year. T incurs a $ 10,000
operating loss during the first year, and in the second year it earns $ 80,000 in
ordinary income. Under these circumstances IP* would pay $ 96,000 in taxes
for the two years, whereas IS* would be assessed $ 14,000 and IT* $ 33,600.
This would give a total independent company tax of $ 144,000 for the two year
period. Of this total, $ 76,800 would be paid in year one, the remaining
$ 67,200 in year two. The corresponding consolidated tax would also be
$ 144,000, but it would be paid in two equal instalments of $ 72,000 per year.
The difference in the payment pattern is caused by deducting T's $ 10,000 net
3. D.L. Crumbley: 'Factors in choosing a method of allocating tax advantages among affili-
ates', The Journal of Taxation, June 1969, page 347.
177
operating loss in different years, depending on whether T is an independent

corporation or a member of a consolidating group'.4
* Note: IP, IS and IT mean company P, S or T taxed as an independent company.
The results of the taxation of each company separately by comparison with the
taxation of the group as a single entity can be summarized as follows:
Entity lndep. lndep. lndep. Total of Consol-

camp. P. camp. S camp. T indep. idated
companies
Year one:
oper.inc.: 100,000 60,000 (10,000) 150,000 150,000
tax. inc.: 100,000 60,000 no carry- 160,000 150,000
back:
Year two:
oper.inc.: 100,000 (30,000)
°
80,000 150,000 150,000
tax. inc.: 100,000 carry- carry- 140,000 150,000
back: forward:
r (30,000) 70,000
Tax payable (48%)
year one:
year two:
total
48,000
48,000
96,000
28,800
(14,400)
14,400
°
33,600
33,600
76,800
67,200
144,000
72,000
72,000
144,000
Allocation method 1 (tax benefit allocated to loss member) yields the follow-
ing results:
Tax cost for: P S T Consolidated
year one: 48,000 28,800 (4,800) 72,000

year two·: 48,000 (14,400) 38,400 72,000
total 96,000 14,400 33,600 144,000
Allocation method 2 (tax benefit allocated to the producers and users of the
loss) can yield different results, depending on the exact allocation rules. One
possibility is a method described in the U.S.A.-Regulations as Modification
4. R.P. Weber: The allocation of consolidated federal income tax liabilities with some relat-
ed accounting and legal implications', Dissertation at The University of Michigan, 1975; page
146.
178
one. 5 In this 'modification', the total tax allocated to each member is compared
with the member's separate return tax, ' ... if the total separate return tax of all
members ... exceeds the consolidated tax liability of the group for the same
years, then each affiliate's allocation of the consolidated tax is limited to the
total of its separate return taxes ... If any member's total allocation of the con-
solidated tax is in excess of its separate return tax ... the difference is: .,. reap-
portioned among the other members of the group in direct proportion to the
amount by which separate-return-tax totals exceed their allocable tax .. .'. 5
This modification of allocation method 2 leads to the following results:
Tax cost for: p s T Consolidated
year one: 45,000 27,000 o 72,000

year two: 51,000 (12,600) 33,600 72,000
total 96,000 14,400 33,600 144,000
Allocation method 3 (tax benefit allocated to profit members) gives the follow-
ing results:
Tax cost for: p s T Consolidated
year one: 45,000 27,000 o 72,000

year two: 40,000 o 32,000 72,000
total 85,000 27,000 32,000 144,000
It is clear that method 3 harms the interests of the minority shareholders of

loss-companies (company S in this example), since the possible tax benefit
from loss carry-back and carry-forward as an independent company is entirely
withheld. Method 2 (as interpreted in 'modification one') compensates the
loss-member for the use of its deduction only if it would have used this deduc-
tion on a separate-return basis (as an independent company T in this example).
A problem with method 2 is the allocation of the tax burden over the years; for
companies P and S (the 'users' of T's loss) and their possible minority share-
holders the allocation of the tax burden to years one and two has no relation-
ship with the current tax rate times their individual income, nor with the
5. U.S. Treasury Department. Internal Revenue Service: Regulations, Section 1.1502-33 (d)
(2) (i). A second possibility, _called Modification two, is described in the Regulations on In-
come-tax, Section 1. 1502-33 (d) (ii) and leads to the same results as allocation method
one.
It is surprising to find this subject dealt with in the Internal Revenue Service Regulations and
not primarily in the S.E.C.-Regulations or Statements of the F.A.S.B. The I.R.S. tries to
defend the interests of minority shareholders by tax legislation; the Revenue Service is not
interested in the allocation method used to establish the amount of tax levied from the group.
179
amount of tax that would have been paid on a separate-return basis. What has
been taken from (the minority shareholders of) company T has been given to
(the shareholders of) company S.
Method 1 gives an ideal allocation of the tax burden among the members of
the fiscal group. In the case of a successful loss carry-over on a separate-return
basis, method 2 gives the same total of allocated tax over the years, but in
method 1 the loss member gets the tax benefit of the deduction in the loss year,
even if it would never have benefited from the loss on a separate-return basis
by individual loss carry-over. The consolidation of accounts for tax purposes
can be of benefit to the group, but it can be of benefit to the minority sha-
reholders as well. The allocation of the tax burden over the years in method 1
expresses the benefit to the minority shareholders in the fiscal merger
(grouping for tax purposes): a possible automatic offset of losses.
Part B. Deferred-tax accounting in international group accounts
B.1. Transfer pricing in international group accounts
The tax-effect-accounting aspects of transfer pricing in international group ac-

counts do not differ essentially from those in national group accounts. Of
course, there is the problem of currency-translation; but that does not, as a
matter of fact, change the appropriate method of tax-effect accounting. Nor
does a difference in tax rates between the different countries of residence of
the group companies, as will be shown in example 11.5. A difference in tax
rates does not create a permanent difference in the sense of a permanent dif-
ference between the accounting income of the group and the aggregate taxable
income of the group-members. However, because of these different tax rates,
the effective tax burden as expressed in the consolidated accounts differs from
the actual tax rate in the country of residence of the parent company. So it can
be concluded that there is a permanent difference for the consolidated ac-
counts only, as shown in example 11.5. However, if the transfer prices set for
international intercompany transactions by the tax authorities in one country
are not accepted by the tax authorities of another country, 'real' permanent
differences arise both in the annual accounts of the company resident in the
transfer-price-correcting country and in the consolidated accounts. So, tax-ef-
fect accounting for international groups of companies may become rather
complicated in practice, although it gives rise to scarcely any special difficul-
ties.
180
INTERNATIONAL GROUP ACCOUNTS
Example 11.5: Transfer pricing in international group accounts

Company A resident in country A starts business with a stock of goods val-
ued at 80A; its equity is also 80A. Company B, its fellow group-member, resi-
dent in country B, has cash of 1,000B and equity of 1,OOOB. In yeart t1 company
A sells its stock of goods to company B for 100A; company B has changed its
cash of 1,000B for 100A in order to pay for this purchase. In year t2 company B
sells the entire stock of goods to outside parties for 1,200B cash. The transfer
price of 100A for the intercompany transaction is not accepted by the tax auth-
orities of country B; their figure is 800 B. The tax rate in country A is 50%, and
the tax-rate in country B is 30%. The exchange rates at the balance-sheet dates
are:
31/12 to : 1A = 5B
31/12 t\ : 1A = lOB
31/12 t2 : 1A = 15B
For the sake of simplicity it is supposed that currency translation for the con-
solidated accounts is performed entirely at closing rates and that the effects of
currency translation are booked directly to equity.
The calculation of taxable income and tax payable, if companies A and Bare
taxed individually, is:
Income statements for tax purposes:
Company Company A Company B

tax rate 50% 30%
period t1 t2 t1 t2
Sales 100A 0 0 1200B

COGS 80A 0 0 800B
Taxable income 20A 0 0 400B

Tax payable lOA 0 0 120B
Net income lOA 0 0 280B
181
The individual income statements for publication purposes will be:
Company Company A Company B I A + B 'Consolidated'

tax rate 50% 30% -
period t} t2 t} t2 t} t2
Sales lOOA 0 0 1200B 0 1200B

COGS 80A 0 0 lOOOB 0 1000B-20A
Book income bef.tax 20A 0 0 200B 0 20A+200B
Tax payable lOA 0 0 120B lOA 120B
Tax eff. of tim.diff 0 0 0 0 (lOA) lOA
Tax expense* lOA 0 0 120B 0 lOA + 120B
Net income lOA 0 0 80B 0 lOA + 80B
• being:
tax rate x book inc. 110A o 0 60B 0 lOA +60B
tax eff. of perm.diff. 0 o 0 60B 0 60B
Tax expense lOA o 0 120B 0 lOA + 120B
So there is a negative timing difference of 20A (tax effect lOA), to be found in

the consolidated annual accounts only, because of an intercompany profit of
20A, that is eliminated on consolidation.
In addition there is a negative permanent difference of 200B (tax effect 60B)
in both the annual accounts of company B and in the consolidated accounts
because of the corrected transfer price.
Currency-translation does not itself give rise to timing differences and per-
manent differences, as is shown in the following tables, which give the consoli-
dated income statements and balance sheets in A -currency and B-currency.
Translation at the closing rate.
182
Company A+B 'con- A+B in A+B in

solidated'
currency in original A-currency B-currency
currencies
year t] t2 I t] t2 t] t2
Sales 0 l200B 0 SOA 0 l200B

COGS 0 1000B- 20A 0 462/3 A 0 700B
Book inc.bef.tax -0 20A+200B 0 331/3 A 0 SOOB
Tax payable lOA l20B lOA SA lOOB l20B
Tax eff. of t.d. (lOA) lOA (lOAl lOA (lOOB) lSOB
Tax expense* 0 lOA+120B 0 lSA 0 270B
Net income r 0 lOA + SOB 0 lSI/3 A 0 230B
• being:
tax rate x book inc. 0 lOA+60B 0 14A 0 210B
tax eff. of perm. diff. 0 60B 0 4A 0 60B
Tax expense 0 lOA + 120B 0 18A 0 270B
Eff. tax burden 54% 54%
The consolidated accounts, expressed in B-currency, now show a tax effect of

negative timing differences of 100B, originating in year t1 (closing rate
lA=lOB), because company A's book income of20A is eliminated in the con-
solidation procedure. This timing difference reverses in year t2 with a tax effect
of lSOB (closing rate lA=lSB) on the sale of the goods to outside parties.
There is in addition a negative permanent difference of200B (with a tax effect
of 60B) that is also to be found in company B's annual accounts, because the
tax authorities of country B corrected the transfer price from 100A= lOOOB in
year t1 to SOOB.
Moreover, if the tax rate of country B is taken as a standard tax-rate (30%),
there is a special type of negative 'permanent difference', because consolidat-
ed income has in part been taxed at SO%. If the tax rate of country A were
taken as a standard tax-rate, this special type of 'permanent difference' exist-
ing in the annual accounts only would of course have been positive.
B.2. International group accounts and some different methods of relief from
international double taxation
If the tax authorities tax a domestic parent company on its world-wide income
(country-of-residence principle) and the tax authorities abroad tax the income
from a foreign subsidiary or permanent establishment on the basis of a source-
lS3
country principle, there is again a difference between accounting entity (the

group if the accounts are consolidated for publication purposes) and tax entity
(several overlapping taxpayers).
The international double taxation that results for the multinational concern
is reduced or neutralized by different methods of relief from international dou-
ble taxation. There are four basic methods of relief from international double
taxation:
a. The exemption method. Under this system the profit is taxed in only
one of the states concerned and is exempted from tax in the other.
b. The deduction method. Under this system the foreign tax is allowed as a
deduction from the profit liable to tax in the state of residence.
c. The credit method. Under this system the tax paid in one state is allow-
ed as a credit against tax-liability in the other state. Thus the difference
from the deduction method is that under this system the foreign tax is a
credit against a tax-liability, whereas under the deduction method the for-
eign tax is deducted from the tax base."
d. The proportional method or method of exemption with progression. This
system is essentially an exemption system, but one with a reservation for the
domestic progressive tax rate. 'The broad effect of the system of exemption
with progression is that although the foreign source income is exempt from
taxation, in the destination country that foreign source income is aggregat-
ed with the taxpayer's other income for the purpose of calculating the pro-
gressive rates applicable to his domestic income in the destination coun-
try' .7
Although corporate income tax is not levied at progressive rates in most coun-
tries, the proportional method will nevertheless be discussed in this context.
6. There are four different applications of the credit method:

• the full-credit method: foreign tax is allowed as a credit against the domestic tax liabili-
ty to any level; if the foreign tax exceeds the amount of domestic tax, the excess of the
foreign tax is refunded by the domestic tax authorities;
• the ordinary-credit method: foreign tax is allowed as a credit against the domestic tax
liability up to the domestic tax burden on foreign income;
• the tax sparing credit: the state of residence gives a tax credit for foreign tax, that is
temporarily not levied (for instance because of a 'tax-holiday');
• the matching credit: the state of residence gives a tax credit for a fictitious amount of
foreign tax, regardless of the amount of foreign tax actually payable.
Attention is confined to the ordinary-credit method in this study, as being the most usual
credit method. Moreover, the other credit methods pose no special problems in tax-effect
accounting.
7. f.D.R. Adams and 1. Whalley: 'The international taxation of multinational enterprises',
London 1977, page 46.
184
The reason for this is that it is generally believed and assumed in the literatureS
that the proportional method produces the same results as a straightforward
exemption method when there is a flat rate of tax. That this is certainly not true
in loss-situations will become clear from example 11.6. If there are no losses,
these methods of relief from international double taxation may give rise to sev-
eral types of timing differences and permanent differences. Timing differences
may arise because intercompany profits are not eliminated; the transfer price
(and thus the calculation of taxable income and thus the relief from interna-
tional double taxation) is usually based on the fiction of 'a distinct and separate
enterprise engaged in the same or similar activities under the same or similar
conditions and dealing wholly independently with the enterprise of which it is a
permanent establishment ... '9; that is, the arm's-length principle. Although
the calculation of the tax effect of different transfer-pricing systems may be
very complicated in practice 10, the transfer-pricing problem, as was noticed
earlier, does not create any special difficulties in the field of comprehensive tax
allocation.
Permanent differences in the consolidated annual accounts may arise when
there are no losses, because of a difference between the tax rates and because
several methods of relief from international double taxation do not fully elimi-
nate the double taxation. Again, the calculation of these effects may be rather
complicated in practice; but it introduces no new elements into our subject, it
is just a matter of presentation of the effective tax burden on different ele-
ments of income. If the loss of a foreign subsidiary or permanent establishment
is set off against positive income of the parent company in the annual accounts
of the group, or vice versa, the different methods of relief from international
double taxation have a different effect, because apart from the fact that the
loss-company requires its own loss carry-over (there is no international group-
ing for tax purposes), the relief from international double taxation is based on
a different amount of income (or tax) from the consolidated income statement.
In order to investigate the tax effect of loss-offset between a domestic parent
company (liable to tax on its world-wide income on the basis of the country-of-
residence principle) and a foreign subsidiary or permanent establishment (li-
able to tax on its own income as a distinct and separate enterprise on the basis
of the source-country principle), the following example has been prepared:
Example 11.6: Relief from international double taxation and loss carry-over
A domestic parent company is liable to tax on its world-wide income at a rate
B. See inter alia: Adams and Whalley, page lOB.

9. O.E.C.D.: 'Draft double taxation convention on income and capital', 1976, section 7,
paragraph 2.
10. See inter alia: H. C. Verlage: 'Transfer pricing for multinational enterprises', Rotterdam,
1975.
185
of 48%. This world-wide income includes the profits of a 100%-owned foreign

subsidiary (or permanent establishment). The income of the foreign subsidiary
(or permanent establishment) is taxed in the source country at a tax rate of
48%, as if it were a distinct and separate enterprise. No intercompany transac-
tions, mutual dividend payments etc. are involved in this case. The exchange
rate = 1 : 1. The tax effect of loss carry-back and loss carry-forward in parent
company and subsidiary (or p.e.) is analysed for four different methods of re-
lief from international double taxation. The loss of one company is fully offset
against positive income of the other company in the consolidated annual state-
ments. No timing differences or permanent differences exist or originate dur-
ing the years analysed in this example; it is supposed that an originating nega-
tive timing difference on account of possible loss carry-forward is recognized in
the loss year Y
Carry-forward of a foreign loss
We first analyse the tax effect of the carry-forward of a foreign loss:
Example 11.6a: Carry-forward of a foreign loss
The income figures involved are:
Foreign Domestic inc. Consolidated

income of parent income
company
year one (20,000) 60,000 40,000

year two 70,000 30,000 100,000
Application of the four basic methods of relief from international double taxa-
tion gives the following results:
11. The recognition of an originating negative timing difference on account of loss carry-for-
ward was discussed in chapter 6; its recognition in the loss-year is assumed here for the sake of
simplicity. The conclusions on the different methods of relief from international double taxa-
tion as such do not change upon the non-recognition of this timing difference, except for the
deduction method and the credit method in the case ofthe carry-forward of a foreign loss (see
example 11.6a).
186
Carry-forward of a fo- Foreign Parent Consolidated

reign loss subs. company
(or p.e.)
I Exemption method
year one: indiv. inc. (20,000) 60,000 40,000
tax base 0 60,000
-- -
tax payable 0 28,800 28,800
tax eff. of tim.diff.
from loss carry-f.w. (9,600) 0 (9,600)
tax expense (9,600) 28,800 19,200 (48%)
\
year two: indiv.inc. 70,000 30,000 100,000

tax base (including
carry-forward) 50,000 30,000 -
tax payable 24,000 14,400 38,400
tax effect of tim.
diff. (rev.neg. t.d.) 9,600 0 9,600
tax expense 33,600 14,400 48,000 (48%)
II Deduction method
year one: indiv.inc. (20,000) 60,000 40,000
tax base 0 40,000 --
-
tax payable 0 19,200 19,200
tax-effect of or.neg. t.d. (9,600) 0 (9,600)
tax expense (9,600) 19,200 9,600 (24%)

tax base (inc!.
carry-forward) 50,000 76,000 -
tax payable 24,006 36,480 60,480
tax effect of rev. neg. t.d. 9,600 0 9,600
tax expense 33,600 36,480 70,080 (70%)
III Ordinary-credit
method
year one: indiv.inc. (20,000) 60,000 40,000
tax base
tax payable before credit °
°
40,000 I -- -
19,200 -
tax credit - _0_ ---
tax payable after credit 0 19,200 19,200
tax effect of or.neg. t.d. (9,600) 0 (9,600)
tax expense (9,600) 19,200 9,600 (24%)
Table continued on p. 188.
187
Carry-forward of a fo- Foreign Parent Consolidated

reign loss subs. company
I
year two: indiv. inc. 70,000 30,000 100,000
tax base (incl.
carry-forward) 50,000 100,000
tax payable before credit 24,000 48,000
tax credit 24,000
tax payable after credit 24,000 24,000 48,000
tax effect of rev. neg. t.d. 9,600 0 9,600
tax expense 33,600 24,000 57,600 (58%)
IV Proportional method
year one: indiv. inc. (20,000) 60,000 40,000
tax base 0 40,000
tax payable:before;exempt. 0 19,200
exemption (0/40,000)
x 19,200
tax payable after exempt.
tax effect of or. neg.t.d.
0
(9,600) 0
°
19,200 19,200
(9,600)
tax expense (9,600) 19,200 9,600 (24%)

tax base (incl.
carry-forward) 50,000 80,000
tax payablebefore,exempt. 24,000 38,400
exemption (50,000-
20,(00):80,000 x 38,400 14,400
tax payable after exempt. 24,000 24,000 48,000
tax effect of rev. neg.t.d.
tax expense
9,600
33,600 °
24,000
9,600
57,600 (58%)
Comments on example 11. 6a: Carry-forward of a foreign loss
The offset in the consolidated accounts of a foreign loss which is carried for-
ward for tax purposes in the foreign subsidiary or permanent establishment,
does not require accounting adjustments in the consolidated statements if the
parent company is relieved from international double taxation by the exemp-
188
tion method,12 There are two events in this case that call for special attention,
but neither is specific to the exemption method. One is a possible difference
between foreign and domestic tax rates; there is then a question of how to pres-
ent the effective tax burden on domestic and foreign income in the consolidat-
ed statements. This question has already been discussed in chapters 4 and 8 for
timing differences and permanent differences respectively. The other is
whether an originating negative timing difference on account of loss carry-for-
ward should be recognized in the loss year; this problem was discussed in chap-
ter 6.
The use of the deduction method in this example indicates that this method
does not give full relief from international double taxation. Even if the same
tax rate applies in the foreign and home countries, the total tax burden for the
group will depend on the distribution of foreign and domestic income. The
recognition of a negative timing difference on account of loss carry-forward in
the foreign subsidiary is in consequence incorrect. The foreign tax payable
merely reduces the tax base for the parent company and thus for the group.
When no foreign tax is paid because of loss carry-forward, the tax base is not
reduced. Thus, the presentation of the tax burden for the group will be im-
proved by the non-recognition in the consolidated accounts of a negative tim-
ing difference on account of loss carry-forward:
Foreign subs. Parent compo Consolidated
year one
domestic income (20,000) (60,000) 40,000
tax expense 0* 19,200* 19,200 (48%)
year two
domestic income 70,000 30,000 100,000
tax expense 24,000* 36,480* 60,480 (60%)
• Note: For the appropriate 'allocation of tax advantages among affiliates', see part A.3 of
this chapter: Fiscal consolidation. This problem is not discussed separately here.
The recognition of a negative timing difference on account of loss carry-for-

ward in a foreign subsidiary also leads to an improper matching of the tax bur-
den under the credit method. The basic idea of the credit method is that the
parent company should be liable to tax on its world-wide income at the tax rate
12. Note that the situation discussed in part A.2 of this chapter (the affiliation privilege) is
nothing other than a form of the exemption method, if the affiliation privilege is applicable to
the income from foreign subsidiaries.
189
charged in the home country (the country of residence of the parent company).
There is no loss carry-forward for this world-wide income, since negative (for-
eign or domestic) income is automatically offset against positive income.
Apart from the allocation of tax advantages among affiliates, the presentation
of the effective tax burden for the group is improved by the non-recognition of
a negative timing difference on account of loss carry-forward in the foreign
subsidiary (or permanent establishment):
Foreign subs. Parent compo Consolidated
year one
domestic income (20,000) 60,000 40,000
tax expense 0* 19,200* 19,200 (48%)
year two
domestic income 70,000 30,000 100,000
tax expense 24,000* 24,000* 48,000 (48%)
* Note: For the allocation of the tax expense among the affiliates, sce part A.3 of this chap-
ter.
It is noteworthy that the proportional method 13 does not lead to the same re-
sults as the straightforward exemption method. This belies the assumption in
the literature that the proportional method under a flat rate of tax has the same
effect as the exemption method. The proportional method, on the contrary,
has the same effect in this case as the (ordinary-) credit method, because there
is no difference between the foreign and domestic tax rate (both are 48%). As
for the credit method and the deduction method, the recognition of a negative
timing difference in the consolidated annual accounts on account of loss carry-
forward in the foreign subsidiary seems incorrect.
'Carry-forward' of a domestic loss
A quite different situation exists in the case of the 'carry-forward' of a domestic

loss. The word 'carry-forward' has been put in inverted commas, because the
actual carry-forward of the domestic loss of the parent company takes place
only under the exemption method. The figures used to analyse this situation
are:
13. In the Netherlands based on The Royal Decree on Relief from international double
taxation, 165, section 3, paragraph 3.
190
Example 1l.6b: 'Carry-forward' of a domestic loss

income of parent compo income
year one 60,000 (20,000) 40,000

year two 30,000 70,000 100,000
The four basic methods of relief from international double taxation give the
following results:
Relief from international Foreign Parent Consolidated

double taxation: subs. (or company
p.e.)
I Exemption method
year one tax expense 28,800 (9,600) 19,200 (48%)
year two tax expense 14,400 33,600 48,000 (48%)
II Deduction method
year one tax expense 28,800 5,376 34,176 (85%)
III Ordinary-credit method

year one tax expense 28,800 0 28,800 (72%)
Comments on example 1l.6b: 'Carry-forward' of a domestic loss
By contrast with the situation described in example 11.6a (carry-forward of a

foreign loss), in this situation (carry-forward of a domestic loss) no attual car-
ry-forward takes place in principle, since the parent company is taxed on its
(positive) world-wide income. So, there is no reason whatsoever for recogniz-
ing a negative timing difference in the consolidated annual accounts. Recog-
nizing a negative timing difference can only occur if the parent company has a
claim against the domestic tax authorities; this may happen under:
• the exemption method: the parent company claims the carry-forward of

191
its domestic loss, its tax effect being: domestic loss times domestic tax rate;
• the proportional method: if the parent company has the right to carry
forward an unused exemption of foreign income (as was assumed here), the
tax effect of this claim equals the unused foreign income times the foreign
tax rate l4 ;
• the credit method: if the parent company has the right to carry forward
an unused credit, the tax effect of this claim equals the foreign tax actually
paid minus domestic tax payable before deduction of the credit (the actual
tax credit granted). Note that this situation is not the same as under the full-
credit method, since under the full-credit method the domestic tax authori-
ties would refund Dfl. 9,600 in year one in this example.
The negative timing difference under the exemption method is a timing differ-
ence because of the possibility of carrying forward the domestic loss of the
parent company; its recognition in the loss year was discussed in chapter 6. But
the carry-forward of an unused credit and the carry-forward of an unused ex-
emption under the proportional method depend as much on positive future
domestic income as does the carry-forward of a domestic loss. That is why the
recognition of a negative timing difference in the loss year on account of an
unused credit or an unused exemption will not be discussed separately; the
considerations are the same as for a normal loss carry-forward.
Carry-back of a foreign loss
A third possible situation, namely the carry-back of a net operating loss of a

foreign subsidiary and its offset against domestic net operating income of the
parent company in the consolidated financial statements, poses no special
problems for comprehensive tax allocation in the consolidated financial state-
ments; a possible exception may be a specific application of the proportional
method:
Example 1l.6c: Carry-back of foreign loss

income of parent income
company
year one 70,000 30,000 100,000

year two (20,000) 60,000 40,000
14. Carry-forward of an unused exemption under the proportional method is allowed in The
Netherlands on the basis of The Royal Decree on Relief from international double taxation,
1965, section 3, paragraph 2.
192
The four basic methods of relief from international double taxation would pro-
duce the following results:

double taxation: subs. (or company
p.e.)
I Exemption method
year two tax expense (9,600) 28,800 19,200 (48%)
II Deduction method

Comments on example 11.6c: Carry-back of a foreign loss
• Certain applications of the deduction method in the residence country

of the parent company may induce the parent company to regard the foreign
tax refund on account of loss carry-back as taxable income for the parent
company. Tax payable for the parent company in year two would become:
48% of (40,000 + 9,600) = 23,808; the effective tax burden for the concern
would become 36%.
• As under the deduction method, it would be possible for the tax autori-
ties in the country of residence to regard the foreign tax refund on account of
loss carry-back as taxable income for the parent company under the credit
method; this might happen as a complement to the carry-forward of an
unused credit. The implications for the amount of tax payable and the effec-
tive tax burden would be the same as for the deduction method.
• The Outch version of the proportional method 13 would not compute a
tax base of Oft. 40,000 (world-wide income in year two), but a tax base of
Oft. 60,000 (positive domestic income); it would simultaneously grant a
right to carry forward (over six years) an unused exemption of Oft. 20,000
(namely the foreign loss carry-back). If a negative timing difference on
account of the carry-forward of this unused exemption is recognized in the
193
loss year, the amount of the tax expense and the effective tax burden for the
group will not change. But it is notable that carry-back of a (foreign) loss
may give rise to an originating negative timing difference for the group.
• It is noteworthy that once again the proportional method under a flat
rate of tax does not lead to the same results as the exemption method. The
proportional method and even the credit method are much more favourable
to the group in this case than the exemption method.
'Carry-back' of a domestic loss
A fourth possibility to be analysed is the 'carry-back' of a domestic loss of the

parent company, when this loss is set off against positive foreign income of a
subsidiary (or permanent establishment) in the consolidated financial state-
ments. As in example 11.6b there is an actual loss carry-back only under the
exemption method, because under the other methods of relief from interna-
tional double taxation the parent company is liable to tax on its positive world-
wide income. Although carry-back will not normally give rise to timing differ-
ences, in this particular case a negative timing difference may arise under the
credit method and the proportional method because of a possible carry-for-
ward of an unused credit and an unused exemption respectively, as is shown in
the following example:
Example 1l.6d: 'Carry-back' of a domestic loss

income of parent cy. income
year one 30,000 70,000 100,000

year two 60,000 (20,000) 40,000
The four basic methods of relief from international double taxation would
produce the following results:

double taxation subs. (or company
p.e.)
I Exemption method
year two tax expense 28,800 (9,600) 19,200 (48%)
194

p.e.)
II Deduction method

year two tax expense 28,800 0 28,800 (72%)
year two tax expense 28,800 0 28,800 (72%)
The credit method with carry-forward of unused credits and the proportional
method with carry-forward of an unused exemption would produce the follow-
ing results:

p.e.)
III' Ordinary-credit method

with carry-forward of an
unus~d credit
year two indiv. income 60,000 (20,000) 40,000
tax base 60,000 40,000 -
tax payable before credit 28,800 19,200 -
tax credit - 19,200 -
(max.)
tax payable after credit 28,800 0 28,800
tax effect carry-forward
unused credit - (9,600)* (9,600)
year two tax expense 28,800 (9,600) 19,200 (48%)
195

double taxation subs. company
(or p.e.)
IV' Proportional method with

carry-forward of an
unused exemption
year two indiv. income 60,000 (20,000) 40,000
tax base 60,000 40,000
tax payable before
exemption 28,800 19,200
tax exemption 19,200
(max.)
tax payable after
exemption 28,800 0 28,800
tax effect carry-forward
unused exemption (9,600)** (9,600) (48%)
• 19,200 - 28,800 = (9,600) .

•• 20,000/40,000 x 19,200 = (9,600).
Comments on example 1l.6d: 'Carry-back' of domestic loss
This is another situation in which the offset of a domestic loss may give rise to
an originating negative timing difference, in the case of a possible carry-for-
ward of an unused credit or an unused exemption in the credit method and the
proportional method respectively. The reversal of this negative timing differ-
ence (originating in the loss year) again depends on positive future income of
the parent company; again the considerations on recognition of this timing dif-
ference are the same as for a normal loss carry-forward.
Conclusions on tax-effect accounting for different methods of relief from inter-

national double taxation when there are losses
The appropriate method of tax-effect accounting when a foreign loss is set off
against positive domestic income or when a domestic loss is set off against posi-
tive foreign income in the consolidated financial statements, but not for tax
purposes (there is no international group for tax purposes), has been analysed
for different methods of relief from international double taxation. Originating
negative timing differences arise in several cases summarized in tables 11.1 and
11.2 for carry-back and carry-forward respectively. The considerations
196
affecting the recognition of the tax effect of these timing differences are the
same as those affecting the recognition of the tax effect ofloss carry-forward.
Table 11.1: Tax-effect accounting under different methods ofrelieffrom inter-

national double taxation; summarizing example 11.6 for carry-back situations
Loss-situation The loss of one company is set off

involved against positive income of another
Method company
of relief
from internatio- Carry-back of Carry-back of do-
nal double taxation foreign loss of mestic loss of
applicable in the country subsidiary or parent company
of residence of the parent permanent estab-
company lishment
a. Exemption method No timing diff. No timing diff.

arises arises
b. Deduction method No timing diff. No timing diff.

arises arises
c. Credit method No timing diff. A negative t.d.

arises arises if an un-
used credit can be
carried forward
d. Proportional method A negative t.d. A negative t.d.

arises in the arises if an un-
Dutch version of used exemption can
of the propor- be carried forward
tional method
197
Table 11.2: Tax-effect accounting under different metbods ofrelieffrom inter-

national double taxation; summarizing example 11.6 for carry-f. w. situations
Loss-situation The loss of one company is set off

involved against positive income of another
Method company.
of relief
from internatio- Carry-forward of Carry-forward of
nal double taxation foreign loss of domestic loss of
applicable in the country subsidiary or parent company
of residence of the parent permanent estab-
company lishment
a. Exemption method The tax effect of The tax effect of
oLneg.t.d. on oLneg. t.d. on
account of loss account of loss
carry-f.w. carry-f.w.
= foreign = domestic
tax rate x tax rate x do-
foreign loss mestic loss
b. Deduction method Recognition of No timing differ-
tax effect of ence arises
loss carry-f. w.
in consolidated
financial state-
ments is incorrect
c. Credit method Recognition of A negative timing
tax eff. of loss difference arises if an
carry-f.w. in unused credit can
consolidated be carried forward
financial state-
ments is incorrect
d. Proportionial method Recognition of A negative timing
tax eff. of loss difference arises
carry-f.w. in if an unused ex-
consolidated emption can be
financial state- carried forward
ments does not ac-
cord with the ef-
fects of the pro-
portional method
198
Intercompany transactions between companies of a national group give rise to

(usually negative) timing differences in the group accounts only.
If transfer prices set for international intercompany transactions by the tax
authorities of one country are not accepted by the tax authorities of another
country, permanent differences arise in the group accounts as well as in the
annual accounts of the group-member resident in the transfer-price-correcting
country.
If there is a difference in tax rate between the different countries of resi-
dence of the members of the group, the effective tax burden shown in the
group accounts differs from the tax rate in the country of residence of the par-
ent company. The conclusion is that there is a special type of permanent differ-
ence in this case, to be found in the group accounts only.
Timing differences and permanent differences in the group accounts may
arise from the consolidation-procedure itself, as has briefly been illustrated
when discussing the affiliation privilege. But, these differences do not consti-
tute a problem in deferred-tax accounting that has not been treated in part I of
this study.
The affiliation privilege prevents special problems in deferred-tax account-
ing, if all gains and losses from the subsidiary are exempted from tax in the
hands of the parent company. This exemption, of course, gives rise to a perma-
nent difference in the annual accounts of the parent company.
If not all gains and losses are exempted under the affiliation privilege, per-
manent differences may arise in the group accounts only, as has been illustrat-
ed by the example of the Dutch relief for the termination loss of a subsidiary.
'Allocating tax advantages among affiliates' is not a problem of deferred-tax
accounting but of valuation of minority interests. The method, which allocates
the benefit of loss-offset in the group accounts to the loss member, was found
to be most appropriate.
The conclusions on deferred-tax accounting for different methods of relief
from international double taxation are hard to be recapitulated briefly; they
are summarized in tables 11.1 and 11.2 on the preceding pages.
199
12. Deferred-tax accounting under the re-
placement-value theory
In the Dutch literature on deferred taxes, the problem of the presentation of

income taxes in the case of a revaluation of assets is perhaps the question most
discussed in this field. A traditional and rather widespread view was that where
the value at which an asset is stated in the accounts is written up on a revalua-
tion, provision should be made for the tax rate times the amount of the revalu-
ation in order to present a fair estimate of value. Since the publication of this
opinion by a study-committee of the Dutch Institute of Accountants l in 1962,
there has been much discussion in the Dutch literature on the 'Reserve for
future taxation on account of revaluation' as the amount of deferred tax arising
on an upward revaluation of assets was called by this study-committee.
The treatment of (corporate) income tax on the revaluation of assets has
never been solved satisfactorily. In most English literature also, it is regarded
as normal accounting practice to make provisions for deferred tax arising on a
revaluation of assets.2 In this chapter the treatment of income tax under the
traditional replacement-value theory when there is an upward revaluation of
assets will be analysed. Second, the case of a downward revaluation of assets
will be briefly discussed. Finally, there will be a treatment of the relationship
between deferred-tax accounting, replacement-value accounting and loss car-
ry-forward.
The traditional replacement-value theory dealt with in this chapter has been
1. 'De vraagstukken welke samenhangen met de invloed van de latente belastingverhoudin-

gen op de jaarrekening van de naamloze vennootschap', De Accountant, Sept. 1962, page 40
and following.
2. See inter alia : A. Goudeket: 'Application of replacement value theory', Journal of
Accountancy, July 1960, pp. 36-47; P.R.A. Kirkman: 'Accounting under inflationary con-
ditions', London, 1974; R.J. Pickerill: 'Accounting for deferred taxation. ED 11 Hocus-
pocus', The Accountant, July 19th, 1973; 'Inflation Accounting, Report of the Inflation
Accounting Committee' (Chairman: R.E.P. Sandilands), London, June 1975; 'Guidance
Manual on current cost accounting', The Inflation Accounting Steering Group, London, 1976.
201
REPLACEMENT-VALUE THEORY
represented by the accounting theory mainly formulated by Th. Limperg. 3

Fundamental to this theory is what has been called: 'the theory of the coordi-
nated value definitions.' The value of an asset is the lower of its replacement
value and its realizable value. The replacement value is the specific price of a
commodity on the purchase-market (less an amount of depreciation, in the
case of depreciable assets, that recognizes the fact that a true replacement
would not be a new asset, but one that has the same remaining useful life ). The
realizable value is the higher of direct realizable value and the indirect realiz-
able value. The direct realizable value of an asset is the actual price on the
selling market, the net cash proceeds that would be received if the asset was
sold now. The indirect realizable value of an asset is the present value of future
cash flows to be derived from that asset.
An apparent difficulty arises in determining the indirect realizable value of a
single asset which forms part of a group of complementary assets (and liabili-
ties). But this problem is considered to be solved in a simple way: as long as an
asset is indispensable in a production process which yields a profit, the indirect
realizable value is assumed to be higher than the replacement value and so the
value is the replacement value.
If an increase in the replacement value occurs, the appropriate asset-
account is debited to bring it up to the current replacement value, at least as
long as the replacement value remains lower than the realizable value (either
indirect realizable value or direct realizable value); the necessary contra-entry
is made against the Revaluation surplus. This capital increase is not regarded
as (distributable, income; it is said that attached to it is an obligation to re-
place. If this capital increase were distributed, the possibility of physical
capital maintenance would be endangered.
Part A.I: Tax-effect accounting in the case of a price increase; no

backlog depreciation
The revaluation of fixed assets because of a specific price increase of these
assets raises the famous problem of backlog depreciation. Backlog deprecia-
3. See the following for a more elaborate treatment of this theory in English, than can be
given in this study, in addition to the literature mentioned in the former note:
• M. Backer: 'Valuation reporting in The Netherlands: a real-life example', The Finan-
cial Executive, January 1973;
• W. van Bruinessen : 'Bases of accounting other than historical cost', Working docu-
ments of the 10th International Congress of Accountants, 1972;
• R. Burgert: 'Reservations about replacement value accounting in The Netherlands',
Abacus, December 1972;
• G. Holmes: 'Replacement value accounting', Accountancy, March 1972;
• I. Kleerekoper: 'Some aspects of accounting and auditing in The Netherlands', The
Accountant's Magazine, October, 1959.
202
ACCOUNTING IN CASE OF PRICE INCREASE
tion will be left out of consideration for the present by assuming that the price
of an asset increases only once, immediately after the purchase. Then this
method is consistent with the original replacement-value theory as originally
formulated by Limperg, who only later introduced the notion of maintenance
of 'normal stocks' into his theory. This original replacement-value theory is
identical to the current-cost-accounting system described by the British Infla-
tion Accounting Committee in 1975, in its publication known as The Sandi-
lands Report. However, Sandilands does not pretend to give a value theory; it
is a pure inflation-accounting system aimed at excluding holding gains from
profit. As a consequence Sandilands does not argue from a 'theory of coordi-
nated value definitions'. The value concepts used by Sandilands are neverthe-
less quite similar to those used by Limperg. Instead of replacement value, San-
dilands uses the term current value and instead of the terms direct realizable
value and indirect realizable value the terms net realizable value, respectively
use value are applied. The Sandilands-terminology will be used mainly in this
chapter.
The assumption that the price of an asset increases only once, immediately
after the purchase, results in a simplification that does not limit the conclu-
sions, because the same conclusions are reached if backlog depreciation is
charged against the Revaluation surplus instead of current income.
If the income calculation for tax purposes is strictly based on historic costs
and the annual accounts are based on the replacement-value theory, a specific
price increase will lead to different book values and different amounts of in-
come.
There are many different opinions on the question of how to account for the
tax effect of these differences. Let us look at the following very simple example
in order to show the following basic methods of tax-effect accounting:
1. the inclusive method with reduced revaluation;

2. the non-inclusive method;
3. the inclusive method with unreduced revaluation.
Example 12.1: Different methods of tax-effect accounting under the original re-
placement-value theory when there is a price increase
On the 1st January of year 1 a machine is bought for Dfl. 1,000. This ma-
chine forms the only physical asset of the company; its estimated economic
lifetime is 10 years (both for fiscal and publication purposes). On the 2nd of
January of year 1, there is a specific price increase of20%. Income before de-
preciation and tax is Dfl. 300 a year for ten years, both for publication and for
tax purposes. The annual accounts are based on the traditional replacement-
value theory, whereas the calculation of fiscal income is strictly based on his-
toric costs. The tax rate is 48%. In the absence of taxation, the appropriate
book entries would be:
203
REPLACEMENT-VALVE THEORY
• on the revaluation: • Machines 200.-

Revaluation surpl. 200.-
• and on annual depreciation: • P/L-account
(machine-cost) 120. -
Accumulated depr. 120.-
If taxation is levied on the basis of historic cost, it is the traditional view that
because of the future permanent differences between depreciation for tax pur-
poses and that for accounting purposes a contingency reserve should becreat-
ed for the difference between taxable income and book income on successive
realization of the asset at its current value. 4
This opinion, which has been called 'the inclusive method with reduced re-
valuation' in this study, leads to the following book entries:
• on the revaluation: • Machines 200.-

Deferred tax on
revaluation 96.-
• annual depreciation: • P/L-account
(machine cost) 120.-
• annual tax expense: • P/L-account (tax
expense) 96.-
Tax payable
[0.48 x (300-100)] 96.-
• annual reversal of the tax ef- • Deferred tax on
fect of a difference in in- revaluation 9.6
come on successive realiza- Revaluation surplus 9.6
tion of the revalued asset:
A number of other methods have been proposed ever since; the most import-
ant, at least in its application in Dutch practice, takes as its starting point that in
the absence of permanent differences other than those arising from revalua-
tion of assets, the current tax rate times book income can be regarded as the
proper tax expense; the appropriate book entries are:
• on the revaluation: • Machine 200.-

Deferred taxes 96.-
4. This opinion can be found inter alia in the Report of the Dutch Institute (1962) and the
Sandilands report (1975).
204

• annual tax expense: • P/L-account [0.48 x
(300-120) ] 86.4
Deferred taxes 9.6
Tax payable 96.-
This method, which has been called a 'non-inclusive method'5 in this study
(since part of the amount of tax payable is never charged to the income state-
ment), has found wide application in The Netherlands. The NIVRA-investiga-
tion of annual accounts 1977 reveals that 64% (34 companies) of those compa-
nies that showed a Revaluation surplus (53 out of 135 companies) did make a
provision for deferred taxes on account of revaluation at the charge of this
Revaluation surplus. But only 6% (2 companies) out of the above-mentioned
64% of companies gradually added back the tax effect of the future negative
permanent differences (due to the lower fiscal depreciation) to the Revalua-
tion surplus (the 'inclusive method with reduced revaluation'); whilst 94% (32
companies) of these companies applied this 'non-inclusive method'. 6
Yet another method, and the third to be analysed here, may be called an
inclusive method. As under the inclusive method with reduced revaluation,
the tax effect of future negative permanent differences due to a lower fiscal
depreciation is ultimately charged to future income but, by contrast with the
version with reduced revaluation, this method has been called the 'inclusive
method with unreduced revaluation' in this study. 7 The appropriate book entri-
es are:
• on the revaluation : • Machines 200.-

• annual tax expense : • P/L-account (tax
expense) 86.4
Deferred taxes 9.6
Tax payable 96.-
5. Introduced and defended among others by: W.F. Nederstigt: 'Latente belastingschulden
in de jaarrekening in verband met de vervangingswaarde', Vaga-berichten, April 1952. Bur-
gert has called this method 'the half-way application of the replacement-value theory'.
6. 'Onderzoek Jaarvers[agen 1977', NIVRA-Geschrift nr. 21, Amsterdam, February 1979.
Note 7, p. 206.
205
• annual extraordinary tax ex- • P/L-account

pense: (extraordinary tax
expense) 9.6
Deferred taxes 9.6
A number of other methods has been proposed in this field. All these methods
can be grouped from two different viewpoints, as in Table 12.1.
The results of these methods, when applied to figures of example 12.1 are
summarized in Table 12.2.
Only the first three methods of this table, the reduced and the unreduced
version ofthe inclusive method and the non-inclusive method, will be analysed
in this chapter, because they have the broadest practical or theoretical sup-
port. The reader can easily complete the analysis with the same arguments as
will be given below.
The unsuitability of the non-inclusive method to the traditional replacement-

value theory
It is clear that no timing difference arises on a revaluation of assets. The differ-

ence between book depreciation (on a current-value basis) and fiscal deprecia-
tion (on a historic-cost basis) will never be corrected in the future. There is a
permanent relative increase in the tax burden for the rest of the economic life
of the revalued asset. The only question is how this increase in the tax burden,
being a permanent difference, should be treated in the annual accounts.
7. This unreduced version was introduced in The Netherlands by: l. de long, 1964; it has
found its advocates in The Netherlands with R. Burgert: 'Vervangingswaarde blijft, doch toe-
passing verandert', Maandblad voor Accountancy en Bedrijfshuishoudkunde, November
1975, and M.A. van Hoepen: 'Geschilpunten bij de verwerking van latente belastin-
gverhoudingen in de jaarrekening van ondernemingen', Maandblad voor Accountancy en Be-
drijfshuishoudkunde, March/April1973. In the U.K. this method has been defended by R.J.
Pickerill, 1973.
The Dutch Enterprise Chamber, in its judgment of 16 March 1978, decided in the case of the
annual accounts of Koninklijke Scholten Honig N. V. (KSH) inter alia that: 'A revaluation
based on the (increased) current value of fixed assets, as applied by KSH, represents an adj-
ustments of shareholders' equity. It has neither been alleged nor has it appeared to the Court,
that a system, in which the tax effect of an upward revaluation is not recorded, has found
material application in practice' (translation mine). One might wonder whether the Court
introduced another condition to be satisfied by valuation standards in The Netherlands, in
addition of their acceptability in economic and social life prescribed by law. The findings of the
NIVRA-investigation 1977 (36% did not take the tax effect of an upward revaluation into
account) seem in any case to contradict this conception of the Enterprise Chamber.
206
Table 12.1: Different methods of tax-effect accounting under the traditional re-
placement-value theory when there is a price increase, grouped from two differ-
ent viewpoints
l. Is provision made for future tax payments?
1. Provision is made, the contra-entry being:

a. Revaluation surplus (the non-inclu.sive method)
b. Earned surplus
c. Income in the year of revaluation
2. No provision is made; but as concerns capital presentation:

a. A deferred liability is presented as part of the equity (the inclusive
method with reduced revaluation)
b. A deferred liability appears to be a hidden reserve (a net-of-tax re-
valuationS)
c. No deferred liability is presented (the inclusive method with unre-
duced revaluation)
II. Future tax on account of lower fiscal depreciation is charged to:·
1. Income or capital increase from the past, being:

a. Retained earnings
b. Revaluation surplus (the non-inclusive method)
2. Income for the year of revaluation:

a. As an extraordinary item in the P/L-account
b. As part of the normal tax expense (not treated)
3. Future income in the year of actual tax payment:

a. As part of the normal tax expense (the inclusive method with re-
duced revaluation)
b. As an extraordinary item (the inclusive method with unreduced re-
valuation)
c. As part of (future) income distribution
-----
8. This is the net-of-tax valuation of assets referred to in chapter 4. It has been defended in
The Netherlands by A.L. Brok: Latenties terzake van de vennootschapsbeIasting', Maand-
blad voor Accountancy en Bedrijfshuishoudkunde, June 1964. For its application see the last
column but one in Table 12.2.
207
IV
§6 Table 12.2: Different methods of tax-effect accounting under the traditional re-
placement-value theory in the case of a price increase, illustrated for the figures
of example 12.1
Inclusive methods Non-inclusive Other methods:

accountmg are a
~'ff'CI reduced unreduced method
combination 12 a 12 c II a I I_c lIb 12 b II a
Book of' II 3-a II3b II I b II 2 a III a II 3 a II 3 c
entries: deb. cr. deb. cr. deb. cr. deb. cr. deb. cr. deb. cr. deb. cr.
~
'"CI
On revaluation:
Machines 200 200 200 200 200 104 200 r;
(")
Revaluation surplus 104 200 104 200 200 104 ttl
104 a::
Deferred tax (on rev a!. ) 96 96 96 ttl
On annual depreciation: ~
120 <:
P/L-account (mach. cost) 120 120 120 120 120 ;I>
t"'
Accumulated depreciation 120 120 120 120 120 120 110.4 120 C
ttl
Revaluation surplus 1 9.6
On annual tax cost: 5!
P/L-account (tax expense) 96 86.4 86.4 86.4 86.4 96 86.4 tl
Deferred tax 9.6 9.6 9.6 9.6 9.6 ~
Tax payable 96 96 96 96 96 96 96
Special entries: yearly: yearly: - once: once: - yearly:
Earned surplus 96
P/L-account (extraor-
dinary items) 9.6 96 ...
Deferred tax 9.6 9.6 96 96
Revaluation surplus 1 9.6 9.6
Net accounting income p.yr.: 84 84 93.6 (2.4) 93.6 84 93.6
I
• Referring to table 12.1.
When the tax effect of the difference between fiscal and book depreciation is
charged to equity, as is the case in the non-inclusive method, the difference is
treated as if the revaluation as such leads to an increase in the tax burden. But
it is not the revaluation that gives rise to a relative increase in the tax burden; it
is the future difference between book depreciation and fiscal depreciation that
does so. This can easily be seen when we look at those fixed assets which are
not depreciated. If there is an upward revaluation of land, no difference arises
between book income and taxable income, at least as long as the land is not
sold.
Apart from the fact that it is not the revaluation of assets which causes the
difference between taxable income and book income, but the use of these as-
sets (if the assets are depreciable) and/or their sale, this non-inclusive method
is also incompatible with the maintenance objective of the traditional replace-
ment value theory: at the end of the economic lifetime of the revalued asset,
the balance of the Revaluation surplus is not enough to allow identical replace-
ment of the worn-out asset at the increased price.
The aim of the traditional replacement-value theory is (or has been) to cal-
culate the amount of income that can be distributed while physical capital is
fully maintained. 9 But if after-tax book income calculated by the non-inclusive
method (93.6) had been distributed to the owners, the resulting balance sheets
would have been:
Balance sheet 1st Jan. year t} Balance sheet 2nd. Jan. year t2
I
Machine 1,000 Equity 1,000 Machine I
1,200 Equity 1,000
Reval. surpl. 104
Deferred tax 96
1,200 i,200
9. Although the goal of the traditional replacement-value theory cannot be said to be

physical capital-maintenance, its goal being the 'maintenance of capital that creates income'
(Limperg), the term 'physical capital-maintenance' is used here for the sake of simplicity. In
the absence of economic obsolescense the effect of the two goals is the same and economic
obsolescense as such does not change the appropriate treatment of the tax effect of the rev-
aluation of assets.
209
Balance sheet 31st December year tlO
Machine 1,200 Equity 1,000

Acc. depreciation 1,200 Revaluation surplus 104
o
Cash inflows: lOx300= 3,000
Cash outflows:
• tax payments lOx96= 960 (960)
• income distribution
lOx93.6= 936 (960)
Cash balance 1,104
1,104 1,104
But yet another objection can be raised against the non-inclusive method, na-
mely that it does not charge to the P/L-account the full amount of tax payable
over the entire lifetime of the revalued asset. It was argued in chapter 8, that
the matching principle applies to permanent differences as well as to timing
differences. Proper matching implies that, within the limits of prudence, real-
ized revenues are matched against the expense that were incurred to create the
revenues reported in the P/L-account.
This implies that only when a 'holding gain' is realized and reported in the
income statement, be it by sale of an asset (realization of the net realizable
value) or by depreciation (that is, partial realization of the use value), are the
expenses matched against this holding gain. These expenses are either the full
replacement value of an asset (in the case of realization of the net realizable
value of an asset, that is, on sale of the asset itself), or part of the replacement
value (that is, the annual depreciation in the case of realization of the use value
of the asset, by the sale of the goods it produces), plus the relevant tax ex-
penses. These tax expenses are either tax on the full holding gain (realization
ofthe net realizable value) or tax on part of the holding gain, that is, the annual
extra-depreciation (in the case of realization of the use value).
The applicability of the inclusive methods
Our conclusion is thus that a satisfactory solution for the problem of tax-effect
accounting under the traditional replacement-value theory can be found only
among those methods that make no provision for future tax payments (catego-
ry 1-2 in Table 12.1) and that charge to future income the tax effect of future
permanent differences due to revaluation (category 11-3 in Table 12.1). Both
versions (with reduced and with unreduced revaluation) of the inclusive meth-
od fall into these categories.
210
A problem with the reduced version
The inclusive method with reduced revaluation, in which the income tax bear-
ing on the revaluation is charged to the P/L·account little by little has been
called in Dutch literature by the Gallo-Germanism: 'peu a peu Versteu-
erung' . 10 The amount of deferred tax created in this method is not a usual
amount of deferred tax like that created for timing differences. This can be
seen from the manner of its creation: it is charged to the Revaluation surplus
instead of income; and from the manner of its discharge: it is added to the
Revaluation surplus. The amount of deferred tax produced under this method
is not a normal transitory item for timing differences: it does not relate to the
annual negative permanent difference between book depreciation (on the cur-
rent -value basis) and fiscal depreciation (on the historic-cost basis). The
increase in the tax burden resulting from these negative permanent differences
is already charged to the PIL-account, since the amount of tax cost (96 in
example 12.1) is already higher than the current tax rate times pre-tax book
income (0.48 x 180 = 86.4).
The study-committee of the Dutch Institute, referred to above, thought it
necessary to create an amount of deferred tax arising on an upward revaluation
as part of the equity, in order to present a fair estimate of capital; they called
this amount of deferred tax (in translation): 'a (specific) Reserve for future
taxes on account of Revaluation'. The British Sandilands Report was much
more explicit in stating the character of this amount of deferred tax, by saying
that: 'when fixed assets are revalued it is normal accounting practice to make
provision for the tax charge which would arise if the assets were sold at the
valuation shown in the balance sheet', and: ' ... the sums in (this) deferred tax
account do not form part of the shareholders' funds and are therefore not avail-
able for distribution'. 11
But this 'Reserve for future taxes ... ' will in most cases show a fictitious
amount of tax, since in the traditional replacement-value theory (as in most
other income-theories) the valuation shown in the balance sheet will only ex-
ceptionally equal the value at which an asset can be sold (that is, the net realiz-
able value). In addition, the inclusive method with reduced revaluation antici-
pates a future uncertain event (that is, the sale of an asset before the end of its
economic life), which has no relation to the present. At the moment of revalu-
ation the company does not intend to sell the asset before the end of its eco-
nomic life; otherwise the company would have to reestimate the economic life
of the asset and probably its salvage value. Note that it is never the increase of
the replacement value which impels the company to sell an asset; an increase in
10. J. Vos: 'Veryangingswaarde blijft, doch toepassing verandert', Philips Administration

Review, Dec. 1972.
11. 'Inflation accounting', 1975, page 209, par. 694. Emphasis mine.
211
the replacement value can only make a future replacement economically un-
justified. Only a decrease in the use value of an asset can impel a company to
realize its net realizable value, when its use value falls below its net realizable
value, and this can induce a company to sell an asset before the end of its (origi-
nally) estimated economic liftetime. But the sale of an asset is never initiated
by changes in the replacement value. So, as long as the value of an asset is
shown in the balance sheet at its replacement value, the company does not
intend to sell the asset according to the traditional replacement-value theory.
Whether the amount of deferred tax in this reduced version is regarded as
part of shareholders' funds (the Dutch study-committee) or definitely not as
part of shareholders' funds (the British Sandilands Report) is not crucial. Any
amount of deferred tax entered in the books on a revaluation of an asset is a
denial of the going-concern assumption. The going-concern assumption im-
plies that the sale of an asset before the end of its estimated economic lifetime
is not taken into account in balance-sheet presentation. As Grady writes: 'Go-
ing concern implied indefinite continuance of the accounting entity under
scrutiny. Indefinite continuance means that the business will not be liquidated
within a span of time necessary to carry out present contractual commitments,
or to use up assets according to the plans and expectations presently held. 12
If the amount of deferred tax in the reduced version is regarded as part of
shareholders' funds (the Dutch committee), a division of the equity is given in
the balance sheet, which is in conflict with the going-concern assumption. If
this amount of deferred tax is not regarded as part of shareholders' funds (the
Sandilands Report), there is a serious underestimation of equity.
The same problem with the net-or-tax method
The same conclusion as for the inclusive method with reduced revaluation can
be drawn for the net-of-tax method mentioned earlier. The amount of tax, sub-
tracted from the replacement value of an asset in this net-of-tax method, has
only by coincidence anything to do with the amount of tax that would be pay-
able on the sale of an asset at its net realizable value. The valuation of assets
anticipates a future uncertain event, which has no causal relationship with the
revaluation but only with the event itself (that is, the sale of an asset before the
end of its estimated economic life). Thus, this 'net-of-tax replacement value' is
in conflict with the going-concern assumption as well.
12. P. Grady: 'Inventory of generally accepted accounting principles for business enterpris-
es', Accounting Research Study No.7, New York, AICPA, 1965, page 28. Emphasis mine.
See also: International Accounting Standard no. 4: 'Depreciation Accounting' paragraph 16,
for the same amplification of the going-concern assumption.
212
The applicability of the unreduced version
It is only the inclusive method with unreduced revaluation that violates neither
the matching principle nor the going-concern assumption and that can meet
the aim of the traditional replacement-value theory. But some confusion is
caused by the presentation of the tax effect of the annual negative permanent
differences between book depreciation and fiscal depreciation (9.6 in example
12.1) as amounts of deferred tax. Disclosure of the tax effect of permanent
differences can be effected in two ways as has been shown in part C of chapter
8. If book income before tax is taken as the starting point for the disclosure of
the amount of the tax expense, the book entries for example 12.1 become:
• on revaluation: • Machines 200.-

Revaluation surplus 200.-
• on depreciation: • P/L-account (machine
cost) 120.-
• on tax expense: • P/L-account (tax on book
income 86.4
P/L-account (neg. perm.diff.
because of depreciation) 9.6
Tax payable 96.-
In a P/L-account that does not start from cost-categories, this disclosure con-
cerning tax cost can be given either by way of a note or by a parenthetical divi-
sion of the amount of tax payable in the income statement.
213
The unreduced version amended
In another context Burgert13 has proposed to split the Revaluation surplus into
a part that has already been taxed and a part which remains to be taxed. Apply-
ing this method would give the following book entries for the figures of exam-
ple 12.1:
• on revaluation: • Machines 200.-

Revalution surplus (still
to be taxed)14 200.-
• on depreciation: • P/L-account (machine cost) 120.-
Accumulated depreciation 120.-
• on tax expense: • P/L-account (tax expense)
• (tax expense based on
book income 86.4
• additional tax expense
due to rep!. value 96.-
theory) 9.6
Tax payable 96.-
• special entries: • Revaluation surplus (still
to be taxed)14 20.-
Revaluation surplus (al-
ready taxed)l4 20.-
The right-hand sides of the balance sheets will become:
B.S. 111 tJ B.S. 211 t, B.S. 31112 t,
... Equity 1,000 ... Equity 1,000 ... Equity 1,000

Rev. Surplus Rev. surplus
to be taxed 200 to be taxed 180
Rev. surplus
already taxed 20
13. R. Burgert: 'Vervangingswaarde blijft. doch toe passing verandcrt', Maandblad voor
Accountancy en Bcdrijfshuishoudkunde. Nov. 1975, pages 460-475.
14. Burgeri uses the term 'Unrealized. untaxed increase of the current value' and 'Tax on re-
alized increase of the current value' instead of 'Revaluation surplus' and 'Tax effect of nega-
tive permanent differences' respectively. He uses these terms (in translation) in another ap-
plication of current-cost accounting; that is why I did not adopt these terms in this application
under the traditional replacement-value theory. The application of the ideas of Burgert to the
traditional replacement-value theory is entirely mine.
214
It should be noted that although the reduced version was supported in the Brit-
ish Sandilands Report, the Exposure Draft 18 (,Current Cost Accounting' of
November 1976) based on the Sandi lands Report, but taking into account the
comments on that report by the Consultative Committee of Accountancy Bod-
ies and other representative bodies, moved towards the unreduced version.
The arguments for this change of opinion, although partially similar to those
given in this study (the reduced version violates both the going-concern as-
sumption and the maintenance aim of the replacement-value theory), are
mainly derived from the application of the so-called probability-method (see
part A chapter 5). But the conclusion is the same: 'The revaluation of assets
may give rise to subsequent tax liabilities on their disposal only in the following
case:
a' when a revaluation surplus is realised; and

b. when the surplus is a taxable amount; and
c. when no roll over relief is claimed.
Consequently if it is intended to continue to use an asset until the end of its

useful life a liability to tax will arise on disposal only if roll over relief is not
claimed in respect of any capital gain arising on the ultimate sale proceeds ... It
is considered unnecessary therefore to provide for any deferred tax in respect
of revaluation surpluses ... '.15
15. D. Gilbert : The Inflation Accounting Steering Group's Guidance Manual on Current
Cost Accounting', Croydon/London, 1976, pages 175/176.
215
Part A.II: Tax-effect accounting and backlog depreciation in the

traditional replacement-value theory
Although this study does not intend to treat the replacement-value theory as
such, it is necessary to treat one aspect of the theory in particular, namely
backlog depreciation.
Backlog depreciation did not originally form part of Limperg's traditional
replacement-value theory, but its maintenance aim was soon extended from
physical capital-maintenance of the existing stock towards physical capital-
maintenance of normal stock. In order to create full physical capital-mainte-
nance on an increase in the replacement value of an asset (its use value still
being higher than both its net realizable value and its replacement value), it is
not only the holding gain on the book value of an asset which cannot be regard-
ed as (distributable) income: the price increase on past depreciation must be
retained as well. And indeed, if a company whishes to raise finance in the form
of equity16, full physical capital-maintenance is possible only if backlog depre-
ciation is regarded as a loss, as is illustrated in the following example.
Example 12.2: On the tax effect of backlog depreciation

The figures are the same as in example 12.1, except for the date of the price
increase, that now occurs on the 1st of January year t5'
From year t\ till t4 the book entries will be:
• on depreciation: P/L-account (machine cost) 100.-

• on tax expense: P/L-account (tax expense) 96.-
Tax payable 96.-
Without backlog depreciation the book entries on account of revaluation, us-
ing the unreduced version, become:
• on revaluation: Machines (1,000 x 0.20) 200.-

Accumulated depreciation
(400 x 0.20) 80.-
Revaluation surplus (600 x 0.20) 120.-
and from year t5 till year tlO:
16. Financing a company with borrowed capital is one of the reasons for regarding backlog
depreciation as unnecessary, at least partly. Other reasons are: investment of the cash inflow
in assets that are not necessary for operating purposes; and above all the cyclical asset expend-
itures which makes the annual depreciation on a current-cost basis equal to the reinvestment
for a stable concern, irrespective of the changes in the replacement value.
216
BACKLOG DEPRECIATION
• on depreciation: P/L-account (machine cost) 120.-

• on tax expense: P/L-account (tax expense)
• (tax expense based on
book income) 86.4\
• (additional tax expo 96.-
on account of repl.-
value theory 9.6
Tax effect of timing
differences
Tax payable 96.-
Atthe end of year tlO the balance sheet ofthis single-asset company will be:
Balance sheet as per 31112 tlO
Machines 1,200 Equity 1,000

Acc. depreciation Reval. surplus 120
(4x 100+80+6x 120) 1,200
0
Cash inflow:
lOx300 = 3,000
Cash outflows:
• tax payments :
lOx96 = - 960
• profit distribution:
4x (300-100-96)
6x (300-120-96) } - 920
1,120
1,120 1,120
Full physical capital maintenance would have required a capital of 1,20,0 at the
end of year tw. Physical capital-maintenance in this situation is possible only if
the increase in accumulated depreciation is regarded as a loss. According to
Limperg, the backlog depreciation could be charged to Earned surplus be-
cause of the extraordinary character of this loss. If there is no ,Earned surplus
or if net Earned surplus is not sufficient, the backlog depreciation will have to
be charged (in part) to the P/L-account, in the year of revaluation, since there
can be no (distributable) income before physical capital-maintenance is as-
sured.
If the backlog depreciation is charged to Earned surplus, there is no tax
problem, since retained earnings have already been taxed. There is a problem
217
for the traditional replacement-value theory since the (specific) physical pur-
chasing power of Earned surplus will have to be maintained as well as the other
parts of the owner's equity; but that goes beyond the scope of this study. The
appropriate book entry for revaluation, when the backlog depreciation is
charged to Earned surplus, becomes:
Machines 200.-
Earned surplus 80.-
Revaluation surplus (still to be taxed) 120.-
Revaluation surplus (already taxed) 80.-
Where the backlog depreciation is charged to the P/L-account, a normal nega-

tive permanent difference arises, because backlog depreciation can never be
accepted by the fiscal authorities since the calculation of taxable income is sup-
posed to be based on historic cost. If the amount of tax payable is taken as the
starting point in disclosing the tax expense in the P/L-account the appropriate
book entry in the year of revaluation could be:
P/L-account (tax expense)

• based on book income 48.-
• additional tax expense due to the
application of the replacement-value 9.6 96.-
theory
• additional tax expense due to non-
acceptance of backlog depreciation 38.4
Tax effect of timing differences
Tax payable 96.-
and for years t6 to tlO:
P/L-account (tax expense)

• based on book income
• additional tax expense due to the 86.41 96.-
application of the replacement-value
theory 9.6
Tax payable 96.-
218
ACCOUNTING WHEN PRICES FALL
Part B : Tax effect accounting in the traditional replacement-

value theory when prices fall
Tax-effect accounting in the traditional replacement-value theory when prices
fall is a much more complicated subject, because the case of a price reduction is
only very briefly treated in the literature and the tax effect of this price reduc-
tion has never been treated.
The treatment of a reduction of the replacement value in the traditional re-
placement-value theory is less easy to understand because of what has been
called the 'double bottom'17 of the replacement-value theory. Limperg has
stated that the holding-loss arising from a price reduction should be regarded
as an immediate loss to the company, probably in order to create a nominal
capital-maintenance when prices are falling. This twofold maintenance aim
(namely physical capital-maintenance when prices are rising and nominal
capital-maintenance when prices are falling) is the 'double bottom' of
Limperg's income-theory, since nominal capital-maintenance does not follow
from his postulates. Despite Limperg's statement that a decrease in the re-
placement value of an asset should be regarded as an immediate loss, he sub-
tracted this holding-loss from the balance of the Revaluation surplus. Only if
the Revaluation surplus showed an insufficient credit-balance or no credit-bal-
ance at all, was the holding loss charged (fully or in part) to the P/L-account.
Thus there would be nominal capital-maintenance only if the holding-loss was
immediately charged to the P/L-account.
A treatment analogous to that for backlog depreciation when prices are ris-
ing has never been defended in the traditional replacement-value theory for
the case of falling prices; the reason is clearly that physical capital-mainte-
nance is no problem when prices are falling. The only thing that counts when
prices are falling is nominal capital-maintenance; the introduction of a kind of
'negative backlog depreciation' or 'backlog appreciation' would not influence
the nominal capital-maintenance. 18 If the holding-loss due to the price reduc-
tion is not charged to the P/L-account there will not be full nominal capital-
maintenance; but the degree of nominal capital-maintenance is higher in so far
as the price reduction occurs later. If the holding-loss is charged to the P/L-
account and a hypothetical backlog appreciation is added to Earned surplus,
then, of course, there will be more than nominal capital-maintenance. We now
turn to the appropriate method of tax-effect accounting under the traditional
17. H.C van Straaten: 'Inhoud en grenzen van het winstbegrip', 1957.
18. Only Burgert, to the best of my knowledge, has pointed out that 'backlog appreciation'
follows strictly from the traditional replacement-value theory. See: R. Burgert: 'Be-
drijfseconomisch aanvaardbare grondslagen voor de gepubliceerde jaarrekening', De Ac-
countant, Sept. 1967.
219
replacement-value theory when prices fall; only the three methods analysed in
the case of a price increase will be treated.
The inclusive method with reduced revaluation in the case of a price reduction
Under this reduced version it should be borne in mind that the future negative
permanent difference arising on the sale of an asset before the end of its eco-
nomic life after an upward revaluation (the tax effect of which has been provid-
ed for by way of a 'Reserve for future taxation due to revaluation ') diminishes
as a result of a price reduction, since this potential difference between taxable
income and book income on the sale of the asset before the end of its economic
life diminishes. So the holding-loss due to a price reduction must probably be
charged proportionately to the Revaluation surplus and to the 'Reserve for
future taxation on account of revaluation'; at least this is supposed since ac-
counting for the tax effect of a price reduction under the replacement-value
theory has never been treated in the literature, as was noted above.
An apparent difficulty for the reduced version arises if the replacement val-
ue of an asset becomes lower than its original historic cost. In that case a future
positive (!) permanent difference will arise if the asset is sold before the end of
its economic life. Capitalization of this possible future positive permanent dif-
ference under the reduced version would be a violation of the matching princi-
ple and the going-concern assumption just as the 'Reserve for future taxation
on account of revaluation' was in the case of a price increase. Moreover, since
in this case an uncertain future positive permanent difference may arise, such a
capitalization would be against the realization principle. So, I suppose that this
possible future permanent difference will not be capitalized under the reduced
version.
If the balance of the Revaluation surplus (plus the balance of the 'Reserve
for future taxation on account of revaluation') is not enough to bear the hold-
ing-loss due to the price reduction, this holding-loss, or at least part of it, is
consequently charged to the P/L-account. If this holding-loss is not accepted
for tax purposes, book income before tax and taxable income will differ in the
year of the price reduction, and a negative permanent difference arises.
Apart from these two permanent differences, there will be annual perma-
nent differences between depreciation for publication purposes and deprecia-
tion for tax purposes. These differences either decrease the annual negative
permanent differences if the asset was revalued because of a price increase
earlier and/or they create annual positive permanent differences (when the re-
placement value of an asset falls below its original historic cost).
220
The unreduced version in the case of a price reduction
The inclusive method with unreduced revaluation creates no problems addi-

tional to those of the reduced version. As for the annual differences between
book depreciation and fiscal depreciation, the appropriate treatment is the
same as under the reduced version. The tax effect of a downward revaluation is
not recorded at the moment of revaluation as is the tax effect of an upward
revaluation.
The non-inclusive method in the case of a price reduction
The non-inclusive method aims to charge the income statement for a tax
expense that equals book income times the current tax rate (at least in the
absence of permanent differences other than those due to revaluation).-This
means that if a price reduction follows a price increase, the resulting holding-
loss can be charged against the Revaluation surplus and also against the
amount of deferred tax that was provided for on the upward revaluation and
has not yet been substracted from the amount of tax payable in the P/L-
account and will no longer have to be charged to the P/L-account in order to
have a tax expense equal to book income times the current tax rate. Just as in
the inclusive method with reduced revaluation, the holding-loss due to a price
reduction can be charged proportionately to the Revaluation surplus and to
the provision for deferred tax entered on an upward revaluation.
But if the replacement value of an asset falls below its original historic cost,
the non-inclusive method requires the capitalization of the future positive per-
manent differences between depreciation for book purposes and depreciation
for tax purposes in the balance sheet, when this holding-loss is not accepted for
tax purposes. Otherwise it will be impossible to charge future P/L-accounts for
a tax expense that equals book income times the current tax rate. This is illus-
trated in the following example.
Example 12.3 : Two methods of tax-effect accounting under the replacement-

value theory when prices are falling
The data are the same as for examples 12.1 and 12.2, except for the price
increase and the price reduction. Two cases are analysed in this example:
Case I: after a price increase of Dfl. 200 on the 2nd of January year t),
the price of the machine goes down by Dfl. 100 on the 3 rd of January
year t l ;
Case II: after a price increase of Dfl. 200 on the 2nd of January year t),
the price of the machine goes down by Dfl. 400 on the 3 rd of January
year t l .
221
The income statement for year t1 and the balance sheet at the end of year t 1, for
the non-inclusive method and for the inclusive method with reduced revalua-
tion are:
PI L-account year t/:
Ater P i of 200 Case I: P ~ 100 Case II: p ~ 400

there follows:
Method applied: Inclusive Non-inclu- Inclusive Non-inclu-

Reduced sive Reduced sive
reval. method reval. method
Inc. before depr. and

tax 300 300 300 300
Depreciation 110 110 KO KO
Holding loss - - 200 200
Book inc. before tax 190 190 20 20
Tax expense 96 91.2 96 9.6
Net income I 94 9R.K I (76) 10.4
Balance sheet on 31112 year t]:
After P i of 200 Case I: P ~ 100 Case II: P ~ 400

there follows:

Reduced sil'e Reduced sive
reval. method reval. method
Machine 990 990 720 720

Ace. Cash flow 300 300 300 300
'Anticipated tax' - - - ~6.4
1,290 1,290 1,020 - - 1,106.4
Shareholders ,--. 1,000 1,000 1,000 1.000
equity
Revaluation surpl. 56.R 52 - -
Earned surpl. 94 9K.R (76) 10.4

Deferred tax
I 43.2 43.2 - -
Ace. Tax payable 96 96 Y6 96
1,290 1,290 1,020 1,106.4
222
The income statement for year t2 and the balance sheet at the end of year t2 , for
the non-inclusive method and for the inclusive method with reduced revalua-
tion are:
PI L-account year t2:
After P i of 200 Case I : P of 100 t Case II: P t 400

in year t/ in year t/ in year t/

Reduced sive Reduced sive
reva!. method reval. method
Inc. before depr.

and tax 300 300 300 300
Depreciation 110 110 80 80
Book income
before tax 190 190 220 220
Tax expense 96 91.2 96 105.6
Net income 94 I 98.8 124 114.4
Balance sheet on 31112 year t2:
After P i of 200 I Case I: P t of 100 Case II: P ~ 400

in year t/ in year t/ in year t/
Method applied: Inclusive lfVon-inclu- Inclusive Non-inclu-

Reduced ~ive Reduced sive
reval. '(11ethod reval. method
Machine 880 880 640 640

Acc. Cash flow 600 ~OO 600 600
'Anticipated tax' I 1,480
- -
1,480
-
1,240
76.8
1,316.8
Shareholder's
equity 1,000 1,000 1,000 1,000
Revaluation surpl. 61.6 52 - -
~
Earned surplus 188 197.6 48 124.8
Deferred tax 38.4 38.4 - -
Acc.Tax payable 192 192 192 192
1,480 ,
1,480 ! 1,240- 1,316.8
223
Conclusion on tax-effect accounting in the traditional replacement-value theory

when prices fall
If the holding-loss due to a price reduction is accepted for tax purposes,

deferred-tax accounting does not come up for discussion, as there are no dif-
ferences between taxable income and book income.
If the holding-loss due to a price reduction is not accepted for tax purposes, a
distinction must be made between two cases. First, the case in which the hold-
ing-loss because of the price reduction can be charged against the Revaluation
surplus (case I in example 12.3). Second, the case in which the Revaluation
surplus shows an insufficient credit-balance or no credit-balance at all (case II
in example 12.3).
For the inclusive method with reduced revaluation in case I, it is no more
than plain logic to charge the holding-loss because of the price reduction pro-
portionately to the Revaluation surplus and a remaining credit-balance on the
'Reserve for future taxation because of revaluation', as the difference between
taxable income and book income on successive realization of the asset at its
current value diminishes. The same applies to the non-inclusive method, as
(part of) the credit-balance of the deferred-tax account is no longer needed to
charge the income statement for a tax expense that equals book income times
the current tax rate. The ultimate result is the same as if there had been only
one price increase that was confined to the balance of the original price in-
crease and the later price reduction. This can be illustrated by the balance
sheets as per the end of year tlO for case I of example 12.3:
Balance sheet 31112 t/O in case 1:
Method applied Inclusive NOll-inclusive
Machine
Accumulated Cash flow °
3,000
0
3,000
3,000 3,000
Shareholder's equity 1,000 1,000
Revaluation surplus 100 52
Earned surplus 940 988
Accumulated Tax payable 960 960
3,000 3,000
As a matter of facf, the objections to the inclusive method with reduced revalu-
ation and to the non-inclusive method hold true for the price reduction in case
I.
224
NON-INCLUSIVE METHOD AND LOSS CARRY-FORWARD
In case II there is a permanent relative decrease in the tax burden for the rest
of the economic life of the revalued asset, reflected in future positive perma-
nent differences between taxable income and book income on successive reali-
zation of the asset at its current value. Contrary to the treatment of the nega-
tive permanent differences in case of a price increase, it has been supposed that
these (per balance) positive permanent differences are not capitalized under
the inclusive method with reduced revaluation. Then the result of this method
is the same as for the inclusive method with unreduced revaluation.
The non-inclusive method ultimately calculates the same amount of income
in case of a price reduction (per balance) as do both versions of the inclusive
method. The balance sheet at the end of year tlO for case II of example 12.3 for
all three methods will be:
Balance sheet 31112 tlO case 11; inclusive and non-inclusive
Machine o
Accumulated Cash flow 3,000
3,000
Shareholder's equity 1,000
Earned surplus 1,040
Accumulated Tax payable 960
3,000
However, the non-inclusive method requires the capitalization of the tax effect
of the future positive permanent differences on successive realization of the
asset at its current value (being (200-20) x 0.48 = 86.4 at the end of year tl in
case II). The non-inclusive method misallocates the tax effect of the price re-
duction, as it is not the downward-revaluation that gives rise to a relative de-
crease in the tax burden it is the future difference between book depreciation
and fiscal depreciation that does so.
Part C: The non-inclusive method in the case of loss carry-for-

ward
In part B it was shown that the application of the non-inclusive method in the
case of a price reduction may result in capitalization of anticipated future posi-
tive permanent differences, essentially because in this method permanent dif-
ferences are treated as if they were timing differences. Yet another incongruity
of the non-inclusive method may arise from the fact that permanent differenc-
es are treated as if they were timing differences. After an upward revaluation
of assets, the deferred-tax account in the non-inclusive method consists nor-
225
mally of the tax effect of positive timing differences and the tax effect of future
negative permanent differences. If the tax effect of loss carry-forward is subse-
quently recognized in the loss year in so far as this tax effect is equal to the
credit-balance of the deferred-tax account that will reverse during the carry-
forward period, these future negative permanent differences are also taken
into account.
The Van Gelder case
This combination of methods was applied in the annual accounts 1976 of the
Dutch company Van Gelder Papier N. V. This company offset the tax effect of
negative timing differences due to loss carry-forward against a credit-balance
in the deferred-tax account in so far as the reversal was certain. In the opinion
of Van Gelder Papier N . V.: 'this certainty exists for taxes that would be pay-
able on the difference between depreciation for fiscal purposes and accounting
depreciation during the six-year carry-forward period: if there are losses, they
will be directly and automatically compensated. A consequence of this method
is that the deferred-tax account has to be reinstated at the charge ofthe income
statement, as soon as profit reappears' .IY
Chapter 6 (method 3 in chapter 6) discussed the peculiar effects of the meth-
od in which the tax effect of the benefit of loss carry-forward is allocated to the
loss year in so far as this tax effect equals that part of the credit-balance on the
deferred-tax account that will reverse or can be reversed within the period dur-
ing which the loss can be claimed as a tax benefit. Its consequence is that 'loss-
evaporation' (the impossibility of actual loss carry-forward) is reflected solely
in the years of reversal of positive timing differences, as has been shown in
example 6.3A. But when this method is combined with the non-inclusive
method, the tax effect of loss carry-forward recognized in the loss year includes
not only the tax effect of reversing positive timing differences during the carry-
forward period but also the tax effect of the anticipated future negative perma-
nent differences that will arise during the carry-forward period. The conse-
quence of the 'Van Gelder' method is that loss-evaporation is reflected in the
tax expense for the rest of the economic life of a revalued asset.
But even in the absence of loss-evaporation, this 'Van Gelder' method may
produce some peculair consequences, because:
• The tax effect of loss carry-forward docs not fully affect either after-tax
income in the actual carry-forward years or after-tax income in the year that
a loss arises. The matching of the tax effect of loss carry-forward depends on
the necessary reinstatement of the deferred-tax account.
19. Annual accounts 1976 of Van Gelder Papier N. V, page 28. Translation mine.
226
• As a consequence, the disclosed effective tax burden does not show a

causal relationship either with book income before tax or with the extent of
actual loss carry-forward during the actual carry-forward years.
• Future negative permanent differences are certain to absorb reversing
negative timing differences only if it is certain that fiscal profits during the
whole carry-over period exceed the loss once suffered. Future negative per-
manent differences may only lessen negative fiscal income.
• In so far as there is a balance of the tax effect of future negative perma-
nent differences on the deferred-tax account, there will be a 'direct and au-
tomatic loss-compensation' only if book income is negative while fiscal in-
come is positive.
• If the reinstatement of the deferred-tax account must come after the ac-
tual loss carry-forward, an (after-tax) accounting loss must be disclosed
where actual loss carry-forward in any year is smaller than the necessary
reinstatement of the deferred-tax account, in spite of the fact that book in-
come before tax is positive.
These effects of the' Van Gelder' method are illustrated in the following exam-
ple.
Example 12.4: The non-inclusive method in the case of loss carry-forward

The purchase price of a machine on the 1st of January year t) is Dfl. 1,000.
Its estimated economic lifetime (both for publication purposes and for tax pur-
poses) is 10 years. Salvage value: nil. For tax purposes, accelerated deprecia-
tion is allowed of 20% of the purchase price in year t); the remainder is de-
preciated on a straight-line basis. The tax rate is 48%. There are no provisions
for carry-back; the carry-forward period is six years.
For publication purposes depreciation is also on a straight-line basis. On the
2nd of January year t 1, the replacement value of the machine increases by 20%.
For publication purposes the company uses the 'Van Gelder' method. Income
before depreciation and tax (both for publication and for tax purposes) is:
Year: 1-10 1 2 3 4 5 6 7 8 9 10
Inc. before depr. 1,700 300 200 100 (100) (100) 100 120 180450 450
and tax:
227
Taxable income and tax payable during these years will be:
Year: 1-10 1 2 3 4 5 6 7 8 9 10
Inc. before depr.

and tax 1,700 300 200 100 (100) (100) 100 120 180 450 450
Depreciation 1,000 280 80 80 80 80 80 80 80 80 80
Income 700 20 120 20 (180) (180) 20 40 100 370 370
Loss to be
carried forward 180 360 340 300 200
(accumulated)
Actual carry-forw 20 40 100 200
Taxable income 700 20 120 20 0 0 0 0 0 170 370
Tax payable 336 9.6 57.6 9.6 0 () 0 () 0 81.6 177.6
Using the 'Van Gelder' method, the income statements for publication purposes are:
Year: /-10 1 2 3 4 5 6 7 8 9 10
Inc. before depr.

and tax 1,700 300 200 100 (100) (100) 100 120 180 450 450
Depreciation 1,200 120 120 120 120 120 120 120 120 120 120
Book inc. before
tax 500 180 80 (20) (220) (220) (20) 0 60 330 330
Tall payable 336 96 57.6 9.6 0 () 0 0 0 81.6 177.6
Tax eff. of tim.
diff. 0 86.4 (9.6) (9.6) (52.8) (14.4) 0 0 14.4 (4.8) (9.6)
Tax eff. of re-
valuation (96) (9.6) (9.6) (9.6) (52.8) (14.4) 0 0 14.4 (4.8) (9.6)
Tax expense 240 86.4 38.4 (9.6) (105.6) (28.8) 0 0 28.8 72 158.4
Net income 260 93.6 41.6 (1O.4} {114.4} (IY1.2) (20) 0 31.2 258 171.6
Effective tax
burden 48% 48% 48% 48':{ 48 rlr 13o/r 0% =-- 48% 22% 48%
228
And some of the resulting balance sheets at year-end under the 'Van Gelder'
method will be:
Balance sheet per:* 211 31112 31112 31112 31112

t] t] t3 t4 t5
Machine 1,200 1,080 840 720 600

Acc.Cash-flow 0 300 600 500 400
Acc. Loss 0 0 10.4 124.8 316
1,200 1,380 1,450.4 1,344.8 1,316
Shareholders' equity 1,000 1,000 1,000 1,000 1,000
Revaluation surplus 104 104 104 104 104
Earned surplus 0 93.6 135.2 135.2 135.2
Deferr. } perm.diff. 96 86.4 67.2 14.4 0
tax tim.diff. 0 86.4 67.2 14.4 0
Acc. tax payable 0 9.6 76.8 76.8 76.8
1,200 1,380 1,450.4 1,344.8 1,316
• The balance sheet per 31112 t, has not been reproduced in order to save space.
Balance sheet per: 31112 31112 31112 31112 31112

t6 t7 t8 t9 tlO
Machine 480. 360 240 120 0

Acc. Cash-flow 500 620 800 1,250 1,700
Acc. Loss 336 336 304.8 46.8 0
1,316 1,316 1,344.8 1,416.8 1,700
Shareholders' equity 1,000 1,000 1,000 1,000 1,000

Revaluation surplus- 104 104 104 104 104
Earned surplus 135.2 135.2 135.2 135.2 260
Deferr. } perm. diff. 0 0 14.4 9.6 0
tax tim.diff. 0 0 14.4 9.6 0
Acc. tax payable 76.8 76.8 76.8 158.4 336
1,316 1,316 1,344.8 1,416.8 1,700
229
The tax expense can be explained as follows:
• tax payable year 4: o

• maximum loss carry-forward to be recognized in the loss years:
(6 carry-forward years + the loss year are 7 years) x (20
tim.diff. + 20 perm. diff.) x 0.48 = 134.4
• necessary loss carry-forward to be recognized
(220) x 0.48 = 105.6
Tax expense year 4 (105.6)
• tax payable year 5 o

• maximum loss carry-forward to be recognized in'the loss years:
7 x 40 x 0.48 = 134.4
• already recognized in year 4 105.6
• possible carry-forward to be recognized in year 5 28.8
• necessary loss carry-forward to be recognized:
(220) x 0.48 = 105.6
• tax payable year 8 o

• necessary reinstatement of deferred-tax account:
(20 perm. diff. + 20 tim. diff.) x 2 years x 0.48 38.4
• possible reinstatement: book income times tax rate:
60 x 0.48 = 28.8
Tax expense year 81Actual reinstatement 28.8
• necessary credit-balance of deferred-tax account at the end of

year 9 : (20 perm. diff. + 20 tim. diff.) x 1 year x 0.48 = 19.2
• actual credit-balance end of year 8 28.8
• possible reversal of timing and permanent differences (9.6)
• tax payable year 9 81.6
Tax expense year 9 7'2
Note that it is assumed here that the reinstatement of the deferred-tax account
starts on the appearance of positive book income before tax. If the reinstate-
ment of the deferred-tax account has to come after actual loss carry-forward,
an infinitely large effective tax burden might have to be disclosed in the income
statement, as has been shown in chapter 6.
The Dutch Enterprise Chamber in judging the annual accounts 1976 of Van
Gelder N.V. considered in its judgment of7 February 1980, that the recogni-
tion of the tax effect of loss carry-forward, in so far as it can be offset against
that part of the deferred-tax account that consists of anticipated negative per-
230
manent differences due to revaluation, involves recognition of a gain in the

present at the charge of an increasing tax burden in the future on the future
reinstatement of these anticipated negative permanent differences. So, ac-
cording to the Dutch Enterprise Chamber, the tax effect of loss carry-forward
cannot be offset against that part of the deferred-tax account that consists of
permanent differences that will arise during the carry-forward period. 'Bur-
gert 20 , and very properly, points to the fact that the tax effect of permanent
differences should never be admitted as a credit to income because of the viola-
tion of the realization principle. The appropriate income statements for
example 12.4 can be at best as follows:
Year: 1 2 3 4 5 6 7 8 9 10
Book inc. before tax 180 80 (20) (220) (220) (20) 0 60 330 330
Tax payable 9.6 57.6 9.6 0 0 0 0 0 81.6 In.6
Tax effect of tim. diff. 86.4 (9.6) (9.6) (67.2) 0 0 0 19.2 (9.6) (9.6)
Tax effect of pe rm. d iff. ~(9,...,.6,-'-)~(9___. 6,-'-)~(9;--;.6*")~(9/"".6",)_-;(",9',,6)\---7;(9".6",)....,.(9"',,,6):-,(,,9,,,,6)~(9,,',,6)~(9,;-.6,,)
Tax expense 86.4 38.4 (9.6) (76.8) (9.6) (9.6) (9.6) 9.6 62.4 158.4
Net income 93.6 41.6 (10.4) (143.2) (210.4) (10.4) 9.6 50.4 267.6 171.6
Effective tax burden 48% 48% 48% 35% 4% 48% - 16% 19% 48%
The tax expense can be explained as follows:
• tax payable year 4: o

• maximum loss carry-forward to be recognized in the loss year
+ 6 carry-forward years: 7 years x 20 x 0.48 (67.2)
• tax effect of negative permanent diff. due to revaluation (9.6)
• Tax payable year 8 o

• necessary reinstatement of deferred-tax account:
20 tim. diff. x 2 years x 0.48 19.2
• tax effect of neg. perm. diff. due to revaluation (9.6)
Tax expense year 8 9.6
However, the Enterprise Chamber decided that Van Gelder N.V. was not
even permitted to offset the tax effect of loss carry-forward against the positive
timing differences that were going to reverse during the carry-forward period,
because of ' ... the circumstances in which Van Gelder finds itself ... ' (the com-
20. R. Burgert in his commentaries on the judgment of the Dutch Enterprise Chamber of 7
February 1980 in the Van Gelder case. P. Sanders and R. Burgert: 'Jaarrekening van
ondernemingen, dee I 3. Jurisprudentie', (loose-leaf), Alphen aan den Rijn, 1968, pages 386
en 387.
231
pany was making rather severe losses). This is completely in line with the con-
clusion in chapter 6, namely that the reversal of positive timing differences
during the carry-forward period does not guarantee the occurrence ofthe posi-
tive taxable income required for loss carry-forward. Applied to example 12.4,
the appropriate income statements from year 4 onwards, become:
Year: 4 5 6 7 8 9 10
Book inc. before tax (220) (220) (20) 0 60 330 330

Tax payable: 0 0 0 0 0 81.6 177.6
Tax effect of tim.diff. (9.6) (9.6) (9.6) (9.6) (9.6) (9.6) (9.6)
Tax effect of perm.diff. (9.6) (9.6) (9.6) (9.6) (9.6) (9.6) (9.6)
Tax expense (19.2) (19.2) (19.2) (19.2) (19.2) 62.4 158.4
Net income (200.8) (200.8) (0.8) 19.2 79.2 267.6 171.6
Effective tax burden 9% 9% 96% - (32%) 19% 48%
Evaluation of the 'Van Gelder' method
The judgment of the Dutch Enterprise Chamber on the treatment of loss car-
ry-forward in the annual accounts of Van Gelder contains two elements. First,
the question whether the tax effect of loss carry-forward can be allocated to the
loss year is so far as it can be offset against the positive timing differences that
will reverse in the carry-forward period. Second, the question whether the tax
effect of loss carry-forward can be allocated to the loss year in so far as it can be
offset against future negative permanent differences because of revaluation
that are anticipated in the non-inclusive method.
The first question is not relevant to the non-inclusive method. This question
has been treated in chapter 6 and chapter 14. However, it is a notable fact, that
the Enterprise Chamber obviously changed its opinion on the asset-nature of
negative timing differences. In the Pakhoed-case (see chapter 5), the En-
terprise Chamber considered that a negative timing difference could never be
capitalized because of the violation of the prudence principle. But in the Van
Gelder-case it considered that Van Gelder could not be permitted to offset the
tax effect of loss carry-forward against positive timing differences merely be-
cause of ' ... the circumstances in which Van Gelder finds itself .. .'.
Allocation of the tax effect of loss carry-forward to the loss year in so far as it
can be offset against the future negative permanent differences because of re-
valuation which are anticipated in the non-inclusive method has been rejected
by the Enterprise Chamber with good reason. Putting aside the objections to
the reinstatement of these anticipated future negative permanent differences,
the Van Gelder method is in direct conflict with the realization principle. This
amount of deferred tax under the non-inclusive method is caused by a revalua-
tion of assets. Considered by itself this amount of deferred tax is an anticipa-
232
CONCLUSIONS
tion of future negative permanent differences in direct conflict with the realiza-
tion principle. In addition to this, these permanent differences are of no signifi-
cance whatever for the likelihood of positive taxable income during the carry-
forward period. However, Burgert20 notices with good reason that the main
argument of the Enterprise Chamber to reprobate the Van Gelder-method
(that is: 'the circumstances in which Van Gelder finds itself') is only sufficient
to reject the offset of negative timing differences because of loss carry-forward
against positive timing differences; a judgment as a matter of principle, against
the use of the anticipated future positive permanent differences of the non-
inclusive method as an offset to the tax effect ofloss carry-forward, would have
been more proper.
The inclusive method with unreduced revaluation is the only appropriate

method of deferred-tax accounting under the replacement-value theory in case
of a price increase. This method has only scarcely been defended in the litera-
ture, but it has found a much wider application in practice, at least in The Neth-
erlands (36%, that is 19 out of 53 companies, as the NIVRA investigation sug-
gests).
In order to disclose what part of the Revaluation surplus has already been
realized (and taxed), the Revaluation surplus itself can be split into a part that
has already been taxed and a part that remains to be taxed in the future (Bur-
gert's amendment).
Where backlog depreciation is charged to the P/L-account, a normal nega-
tive permanent difference arises, because the backlog depreciation will not be
accepted for tax purposes, since the calculation of taxable income is supposed
to be based on historic cost.
If the holding-loss because of a price reduction is accepted for tax purposes,
deferred-tax accounting does not come up for discussion.
If the holding-loss because of a price reduction is not accepted for tax pur-
poses and it can be charged to the Revaluation surplus, it is again the inclusive
method with unreduced revaluation that constitutes the appropriate way of
deferred-tax accounting.
Where this holding-loss is charged to the P/L-account both the reduced and
unreduced versions of the inclusive method produce the same results. The
non-inclusive method in this case anticipates future positive permanent differ-
ences, which violates the realization principle.
The anticipated future positive permanent differences of the non-inclusive
method cannot be used to offset the tax effect of loss carry-forward.
233
13. Deferred-tax accounting and inflation
accounting
Preamble
Although the traditional replacement-value theory cannot be regarded as a

method of inflation accounting, at least not in its original version, the views
and conclusions of chapter 12 provide a good basis for the examination of
deferred-tax accounting under some other methods of inflation accounting.
Only some of the best-known methods of inflation accounting will be exa-
mined in this chapter. As a matter of fact, this examination is not aimed at
showing all the ins and outs of inflation accounting, but at finding the appropri-
ate method of tax-effect accounting when different methods of inflation ac-
counting are used for published financial statements.
As the chief features of most methods of inflation accounting so far known
came under review in the U. K. rather recently, the different methods of infla-
tion accounting that will be treated here in the light of the British proposals,
are:
a. Adjusted Historic Cost, as proposed in the U.K. in Exposure Draft no.

8: 'Accounting for changes in the purchasing power of money' (1973) and in
Provisional Statement of Standard Accounting Practice no. 7: 'Accounting
for changes in the purchasing power of money' (1974).
b. Current-Cost Accounting, as proposed by the Sandilands Reportl in
1975.
c. Simplified Current-Cost Accounting with a gearing adjustment, as pro-
posed in the U.K. in the so-called Hyde-Guidelines 2 (1977) and in Exposure
Draft no. 24: 'Current Cost Accounting' (1979) and most recently in State-
ment of Standard Accounting Practice no. 16: 'Current Cost Accounting'
(April 1980).
1. 'Inflation accounting: Report of the Inflation Accounting Committee', London, 1975.

Exposure Draft no. 18: 'Current Cost Accounting' of 1977 will be left out of account as this
Exposure Draft was entirely based on the Sandilands recommendations.
2. 'Inflation Accounting: an Interim Recommendation', November 1977.
234
PRELIMINARY CONSIDERATIONS AND CONCLUSIONS
Some preliminary considerations and conclusions
As was said earlier, the conclusions on the appropriate method of deferred-tax

accounting for the traditional replacement-value theory provide a sound basis
for consideration of the appropriate method of deferred-tax accounting under
other methods of inflation accounting. It is even possible to draw some conclu-
sions in advance. For, as long as the calculation of taxable income is based on
an unadjusted historic-cost system, whereas the calculation of accounting in-
come is based on some system of inflation accounting with a maintenance con-
cept different from that of a strict historic-cost system, only permanent differ-
ences between accounting income and taxable income will arise. When infla-
tion is taken into account only in determining the company's profit-distri-
bution policy, no deferred-tax problem will arise, since there will be no differ-
ence between taxable income and accounting income. If some relief for infla-
tion is granted in the method of calculating taxable income, only timing differ-
ences between taxable income and accounting income will arise. These timing
differences, such as roll-over relief for the book profit on sale of fixed assets or
the applicability of a LIFO rule of inventory valuation, pose no special prob-
lems. So we can safely argue in this chapter from a calculation of taxable
income on an unadjusted historic-cost basis and a calculation of accounting
income (before tax) that is based on some inflation-accounting system, leading
to permanent differences.
For the traditional replacement-value theory, is has been argued in chapter
12 that the non-inclusive method (in which the tax effect of the revaluation is
charged to equity) is incompatible with the aim ofthe traditional replacement-
value theory: full physical capital-maintenance. However, this argument loses
its significance whenever a different maintenance concept is adopted. The oth-
er arguments against the non-inclusive method were that:
• (part of) tax costs are charged to equity while the related revenues are
geared to the P/L-account;
• (part of) tax costs are charged to equity while the related revenues have
not yet been realized.
These two arguments are independent of the maintenance concept adopted

and remain valid and are therefore an important topic for consideration in this
chapter. The permanent difference is created, not by the difference in valua-
tion of assets between the tax balance sheet and the published balance sheet,
but by the usage or sale of assets. Thus the tax effect of these permanent differ-
ences must be allocated to the year in which the holding-gains are realized by
the use or sale of revalued assets. In the inclusive method with reduced revalu-
ation, the tax effect of the permanent difference is properly charged to the
235
DEFERRED-TAX AND INFLATION ACCOUNTING
income statement in the year in which the holding-gains are realized. The main
argument raised against this reduced version in chapter 12 was independent of
the maintenance concept adopted. This method was found to be a denial of the
going-concern assumption, as far as a provision is created (and charged to
equity) or a division of equity is effected that anticipates a future uncertain
event, namely the sale of an asset at the valuation shown in the balance sheet,
whilst the valuation shown in the balance sheet will only exceptionally equal
the sales value of assets.
So it looks as if the inclusive method with unreduced revaluation is m.m. the
only applicable method in case of inflation accounting. And so itis, as will be
shown in a subsequent example. For, the unreduced version, where the tax
effect of a revaluation is allocated to the year(s) of actual realization of the
holding-gains of revalued assets, does not anticipate a future uncertain event
(the sale of an asset at the valuation shown in the balance sheet). So this meth-
od does not violate either the matching principle or the going-concern assump-
tion. But a problem with this method is that it is unclear what part of the Re-
valuation surplus, or Current-cost reserve or a Correction for the diminishing
purchasing power of equity has already been realized (and taxed!). That is why
Burgert3 amended this method in his proposal to split the Revaluation surplus
into a part that has already been realized (and taxed !) and a part that has still
to be realized and that will be taxed on its future realization.
This amendment is m.m. equally applicable outside the sphere of the tradi-
tional replacement-value theory for the different types of inflation accounting
to be discussed in the subsequent example.
Deferred-tax accounting and inflation accounting
To illustrate the tenability of the foregoing preliminary conclusions only one

basic example will be used throughout this chapter.
Example 13.1: Three methods of inflation accounting and three methods of

deferred-tax accounting4
A trading company, selling only one type of product A, starts business on 1
January 1979. Its opening balance sheet is:
3. R. Burgert: 'Vervangingswaarde blijft, doch toepassing verandert', Maandblad voor Ac-

countancy en Bedrijfshuishoudkunde, Nov. 1975.
4. The basic figures in this example, with some slight modifications, are taken from a one-
day course on Inflation accounting, 2 September 1977, Erasmus Universiteit Rotterdam (un-
published) .
236
Balance sheet III 1979
Cash Oft. 100,000 Owners' equity Oft. 60,000

Bank loan Oft. 40,000
Oft. 100,000 Oft. 100,000
This company's activities during 1979 are as summarized below. Taxable in-
come is calculated on a historic-cost basis using the fist-in-first-out (FIFO) sys-
tem. The tax rate is 48%.
Tax will be payable not before 1980. Purchases are made for cash, but the
trade-credit offered for sales is three months. It is supposed for simplicity that
no other expenses are incurred and that the bank loan is interest-free.
Sales prices, purchase prices and the consumers' price index change sudd-
enly at the start of every quarter, and then remain stable during the rest of the
quarter.
Quarter of 1979 I 11
Purchases of A in kg. 5,000 kg. 5,000 kg.

Sales of A in kg. 2,000 kg.
Current value per kg. Oft. 8.- Oft. 9.-
Sales price per kg. Dft. 10.5 Oft. 11.5
Consumer-price index 80 100
Stock (end of quarter) 5,000 kg. 8,000 kg.
Cash (end of quarter) Oft. 60,000 Oft. 15,000
Accounts receivable (end
of quarter Oft. Oft. 23,000
Purchases of A in Ofl. Oft. 40,000 Of). 45,000
Sales of A in Ofl. Oft. 23,000
Quarter of 1979 III IV
Purchases of A in kg.
Sales of A in kg. 1,000 kg. 3,000 kg.
Current value per kg. Oft. 9.- Oft. 11. -
Sales price per kg. Oft. 11.5 Of). 14.-
Consumer-price index 120 150
Stock (end of quarter) 7,000 kg 4,000 kg.
Cash (end of quarter) Oft. 38,000 Oft. 49,500
Accounts receivable (end
of quarter) Oft. 11,500 Oft. 42,000
Purchases of A in Oft.
Sales of A in Of). Ofl. 11,500 Of). 42,000
237
From these facts, taxable income can be calculated as follows:
Sales: (2,000 x I1.S) + (1,000 x I1.S) + (3,000 x 14): 76,000

COGS: (2,000 x 8) + (1,000 x 8) + (2,000 x 8 + 1,000 x 9): 49,000
Taxable income (FIFO-basis) 27,SOO
Tax payable: 48% x 27,SOO 13,200
Net income after tax (FIFO-basis) 14,300
The balance sheet at the end of the year on the FIFO-basis will be:
Balance sheet 31112 1979 (for tax purposes)
Cash 49,SOO Owners' equity 60,000

Accounts receivable 42,000 Income for the year 14,300
Stock of goods Bank loan 40,000
(4,000 kg x 9): 36,000 Tax payable 13,200
127,SOO 127,SOO
Now, our first aim is to show that not every inventory-valuation system for
publication purposes that differs from that for tax purposes leads to permanent
differences. Permanent differences will arise only if the maintenance concept
adopted for the published financial statements differs from that adopted for
the calculation of taxable income (in this case a historic-cost system or nominal
capital-maintenance) .
When, for instance, a last-in-first-out (LIFO) system of historic cost is used
for publication purposes, only timing differences between taxable income and
accounting income will arise. For, taxable income (based on FIFO) would
equal accounting income (based on LIFO) after the sale of the total stock of
product A. Income statement and balance sheet for publication purposes on a
LIFO-basis are (in the case of fully comprehensive tax-allocation):
Income statement 1979 all a LIFO-basis (for publication purposes)
Sales: (2,000 x I1.S) + (1,000 x I1.S) + (3,000 x 14): 76,SOO

COGS: (2,000 x 9) + (1,000 x 9) + (2,000 x 9 + 1,000 x 8): 53,000
Book income before tax 23,500
Tax payable 13,200
Tax effect of or.neg. Ld.: 0.48 x (2,000 x
+ 1,000 x 1 + 2,000 x I): (2.400)
Tax effect of rev.neg.t.d.: 0.48 x (LOOO x 1) 480
Tax expense 11,280
Net income 12,220
238
ADJUSTED HISTORIC COST
Bal. sheet per 31112 1979 on a LIFO-basis (publication purposes)
Cash 49,500 Owners' equity 60,000

Accounts receivable 42,000 Income for the year 12,220
Stock of goods Bank loan 40,000
(4,000 kg x 8) 32,000 Tax payable 13,200
'Anticipated' tax 1,920
125,420 125,420
The difference between taxable income (27,500) and book income before tax
(23,500) constitutes a negative timing difference, with a tax effect of 0.48 x
4,000 = 1,920, since taxable income and book income would have been the
same on the sale of the whole of product A. as is shown below:
1ncome statement 011 the sale FIFO-basis LIFO-basis

of the whole stock
Sales: 76,500 + 4,000 x 14 132,500 132,500

COGS: 49,000 + 9 x 4,000
(FIFO) or 53,000 +
8 x 4,000 (LIFO) 85,000 85,000
Income before tax 47,500 47,500
Tax payable: +0.48 x 20,000 22,800 22,800
Tax effect of or.neg.t.d. 0 (2,400)
Tax effect of rev .neg. t.d. 0 2,400
Tax expense 22,800 22,800
Net income 24,700 24,700
From this example it follows that merely a difference in inventory-valuation

systems gives rise to timing differences only.
In the following attention is paid to systems of inflation accounting giving rise

to permanent differences. The methods of deferred-tax accounting discussed
in chapter 12 (the non-inclusive method and the reduced and unreduced
versions of the inclusive method) will be applied to the three inflation-account-
ing systems mentioned at the start of this chapter. This may seem a bit su-
peregatory but, except for Sandilands, none of the propositions on inflation
accounting is very distinct about deferred-tax accounting.
Part A. Deferred-tax accounting and adjusted historic cost
If the annual accounts for publication purposes are on an adjusted-historic-

cost basis (using a FIFO-system), the P/L-account will be:
239
I
Income statement 1979; adjusted historic cost
Sales: 150/100 x 2,000 x 11.5 = 34,500

1501120 x 1,000 x 1l.5 = 14,375 90,875
150/150 x 3,000 x 14 = 42,000
COGS on FIFO-basis:
150/80 x 2,000 x 8 = 30,000
150/80 x 1,000 x 8 = 15,000 88,500
150/80 x 2,000 x 8 = 30,000
150/100 x 1,000 x Y = 13,500
Operating income 2,375
Gain in purchasing power of monetary liabilities: 35,000
(150-80)/80 x 40,000
Loss in purchasing power of monetary assets * : (44,375)
Book income before tax (7,000)
Tax payable 13,200
Tax expense 13,200
Net income (20,200)
* Loss in purchasing power of monetary asset,:

+ (150-80) ISO x 100,000 = S7,500
- (150-80) ISO x 40,000 = (35,000)
- (150-100)/100 x 45,000 = (22,500)
+ (150-100)/100 x 23,000 = 11,50()
+ (150-120)/120 x 11,500= vm
+ (150-150)1150 x 42,000 = 0
44,375
The balance sheet based on adjusted historic cost will be:
Balance sheet per 31112 1979; adjusted historic cost
Cash 49,500 II Owners' equity:

Accounts receivable 42,000 ISO/SO x 60,000 112,500
Stock of goods: Income for the year (20,200)
150/lO0 x 36,000 54,000 Bank loan 40,000
Tax payable 13,200
145,500 145,500
Now, our first aim has to be to show that the difference between taxable in-
come (27,500 on an unadjusted FIFO-basis) and book income before tax (on
an adjusted FIFO-basis: (7,000» is a permanent one. This can again be shown
by supposing that the stock of goods is completely sold uut on the last day of
December 1979. Unlike the comparison between the FIFO and the L1FO-sys-
240
terns (where total income after sale of the entire stock was the same and the
existence of timing differences was established), the comparison between FI-
FO and adjusted historic cost on a FIFO-basis leads to the conclusion that total
income after sale of the entire stock is different. So it can be concluded that
there is a permanent difference between taxable income and book income.
Income statement on FIFO Adjusted historic cost on

sale of entire stock FIFO-basis
Sales 132,500 + 1501150 X 4,000 x 14 = 146,875

COGS 85,000 + 1501100 X 4 2000 X 9= 142 2500
Operating income 47,500 4,375
Gain in purch. power
mono liabilities - 35,000
Loss in purch, power +(150 - 150)/150 X
mono assets - 56,000 = (44,375)
Taxable income/Book
income 47,500 (5,000)
Tax payable 22,800 22,800
Tax effect of t.d. --- - -- -
Tax expense 22,800 22,800
Net income 24,700 (27,800)
A.I. Adjusted historic cost and the inclusive method with unreduced correction
As the difference between taxable income and book income turns out to be a
permanent one, its tax effect should accord with the income statement in which
the corresponding gain and loss figures are taken as being realized. So the bal-
ance sheet and income statement, as given above, can be regarded as being
drawn up according to the 'unreduced version', as it has been called in chapter
12. In this method, the tax effect of differences in valuation between tax bal-
ance sheet and publication balance sheet are not accounted for, since these
differences will lead to permanent differences in future income statements.
However, this method does not disclose how much of the correction on ac-
count of the diminishing purchasing power of equity has already been taxed. In
order to give this information this method can be extended with Burgert's
amendment als follows:
241
Bal. sheet 31112 1979; adjusted historic cost; unreduced version amended
• Owners' equity (originally) 60,000

• Correction for dimin. purch. power of equity-
already taxed: taxable income - book
income = [27 ,500 - (- 7 ,000)] = 34,500
• Correction for dimin. purch. power of equity-
still to be taxed: difference in asset val-
uation = [(54,000 - 36,(00)] = 18,000
Total equity in current monetary units 112,500
Income for the year (20,200)
Bank loan 40,000
Tax payable 13,200
145,500
However, it should be borne in mind that adjusted historic cost statements are
almost by nature supplementary to strict historic cost information, because
many legal and contractual commitments are (mostly implicitly) based on the
use of these historic figures. That is why adjusted historic cost figures are dis-
closed only by way of supplementary statements. But if the main accounts are
based on unadjusted historic cost, the readers ofthe annual accounts can easily
judge what part of the correction for diminishing purchasing power of the
equity is still to be taxed in the future, since this part must equal the difference
between the valuation of assets on a historic-cost basis (in the main accounts)
and the valuation of assets on an adju'sted-historic-cost basis (in the supple-
mentary statements), being 54,000 - 36,000 = 18,000.
A.2. Adjusted historic cost and the inclusive method with reduced correction
Application of the 'reduced version' would lead to the following credit-side of

the balance sheet on an adjusted-historic cost basis:
Balance sheet 31112 1979; adjusted historic cost; reduced version
• Owners' equity (originally) 60,000

• Correction for diminishing purch. power of equity: 43,860
[(1 - 0.48)x(112,500 - 60,000) + 0.48 x 34,500]
Deferred taxation on account of dim. purch. power
of equity: [0.48 x (112,500 - 60,000)-0.48 x 34,500] 8,640
Total equity 112,500
Bank loan 40,000
Tax payable 13,200
145,500
242
However, if the item 'Deferred taxation on account of diminishing purchasing

power of equity' is reckoned to be part of owners' equity, a division of equity is
effected which anticipates a future uncertain event. This future uncertain
event is the sale of the stock of goods A (4,000 kg) for Oft. 54,000 (being 150/
150 x 36,000, their adjusted historic value). But actual tax payment on sale of
the stock of goods A in the future will be based on the difference between a
future sales price and the historic cost of A (Dft. 36,000). Moreover, the tax
effect of a permanent difference originating from the future sale of the stock of
goods A depends also on the level of the consumer-price index at that time.
If the item: 'Deferred taxation on account of diminishing purchasing power
of equity' is regarded as a provision, a serious underestimation of equity re-
sults, since the correction for the diminishing purchasing power of equity will
increase in the future on usage or sale of assets, whereas the increase in the
consumer-price index has already occurred.
Moreover, as in the unreduced version, the future negative permanent dif-
ferences and their tax effect can easily be calculated by the readers of the annu-
al accounts with the assistance of supplementary statements.
A.3. Adjusted historic cost and the non-inclusive method
Under the non-inclusive method, income on an adjusted-historic cost-basis

would have been:
Income statement 1979; adjusted historic cost, non-inclusive method
Sales 90,875
COGS 88,500
Operating income 2,375
Gain in purchasing power of monetary liabilities 35,000
Loss in purchasing power of monetary assets (44,375)
Book income before tax (7,000)
Tax payable 13,200
Tax effect of timing differences: 34,500 x 0.48 (16,500)
Tax expense (48%) (3,360)
Net income (3,640)
243
The non-inclusive method would result in the following balance sheet:
Balance sheet 31112 1979; adjusted historic cost, non-inclusive method
• Owners' equity (originally 60,000

• Correction for diminishing purchasing power
of equity: (1 - 0.48) x (112,500 - 60,0(0) 27,300
Total equity 87,300
Bank loan 40,000
Provision for deferred tax:
0.48 x (112,500 - 60,(00) - 0.48 x 34,500 8,648
Tax payable 13 ,200
145,500
The comments on this method will now be clear. Firstly. it is obvious that per-
manent differences are treated as if they were timing differences. Secondly,
the maintenance of general purchasing power of equity is insufficient, being
only 52% of the decrease in purchasing power of the equity; the result is a
maintenance concept that varies with changes in the tax rate, which can hardly
be regarded as a real maintenance concept. Thirdly. the provision for deferred
tax anticipates the sale of goods A for an amount of Of!. 54,000, by charging
tax cost to equity at a moment of time when the related holding-gain has not
yet been realized. Moreover, it is rather confusing that a 'non-asset-purchasing
expenditure', namely tax cost, differs between the historic-cost income state-
ment (Of!. 13,200) and the adjusted historic-cost income statement (- Of!.
3,360).
Conclusion on deferred-tax accounting and adjusted historic cost
The inclusive method with unreduced correction for the diminishing purchas-
ing power of equity is a proper method of deferred-tax accounting under ad-
justed historic cost. The (unreduced) correction for the diminishing purchas-
ing power of equity can be split into a part which has already been taxed and a
part which remains to be taxed. However, this amendment of the unreduced
version loses some of its importance where supplementary statements or the
main accounts are based on unadjusted historic cost.
The inclusive method with reduced correction for the diminishing purchas-
ing power of equity and the non-inclusive method must be turned down for
application under adjusted historic cost.
244
CURRENT-COST ACCOUNTING
Part B. Deferred-tax accounting and current cost

It has been stated in chapter 12 that current-cost accounting as proposed in the
Sandilands Report is identical with the traditional replacement-value theory,
at least with regard to the calculation of book income. It has also been stated
that the Sandilands Report favours the inclusive method with reduced revalua-
tion. However, the amount of deferred tax because of revaluation is regarded
by Sandilands as a provision and not as part of shareholders' funds. This provi-
sion is added to the Revaluation surplus on successive realization of the assets
at their current value.
The objections to the non-inclusive method and the inclusive method with
reduced revaluation are the same as for the traditional replacement-value the-
ory. To this it should be added that the 'Sandilands-interpretation' ofthe inclu-
sive method with reduced revaluation (deferred tax because of revaluation is a
provision) results in a serious underestimation of equity, as has also been stat-
ed in chapter 12. So, we shall spend only a moment on deferred-tax accounting
under current-cost accounting as proposed by the Sandi lands Committee, by
giving the solution to example 13.1 under the different methods of deferred-
tax accounting.
B.l. Current-cost accounting and the inclusive method with unreduced revalu-
ation
This method, with Burgert's amendment, gives the following results for the
figures of example 13.1.
Income statement 1979; current-cost accounting, unreduced version
Sales 76,500
COGS (2,000 x 9 + 1,000 x 9 + 3,000 xlI) 60,000
Tax payable 13,200
Tax expense 13,200*
Net income 3,300
* Tax on book income: 0.48 x 16,500 = 7,920

Tax effect of neg. perm. differences:
[0.48 x (2,000 x 1 + 1,000 x 1 + 2,000 x 3 + 1,000 x 2)] = 5,280
Tax expense 13.200
245
Bal.sheet 31112 1979; current-cost accounting, unreduced version amended
Cash 49,SOO Owners' equity 60,000

Accounts receivable 42,000 Revaluation surplus
Stock of goods already taxed* 11,000
(4,000 kg. x 11) 44,000 Revaluation surplus
still to be taxed R,OOO
Income for the year 3,JOO
Bank loan 40,000
Tax pavable 13,200
13S,SOO 13S,SOO
* Taxable income (27,SOO) ~ hook income (lh,'i()O) = 11,000

Difference in valuation on tax balance sheet (36,O()O) and puhlication halance sheet
(44,000) = k.OOO
Note again that if these current-cost statements arc supplementary statements

to historic-cost accounts it is easy to judge what part of the Revaluation surplus
will still be taxed on the future use or sale of the assets, This part equals the
difference in the valuation of assets between the main accounts and the supple-
mentary statements,
B.2. Current-cost accounting and the inclusive method with reduced revalua-
tion
The right-hand side of the balance sheet under this method becomes:
Balance sheet 31112 1979; current-cost accounting, reduced version
Owners' equity 60,000

Revaluation surplus" IS,160
Total equity 75,160
Income for the year 3,300
Bank loan 40,000
Provision for deferred tax'" 3,R40
Tax payable 13,200
13S,SOO
* [(l~OAk) x 19,000 + OAX x Il.OOOi

** (OAk x 19.000 ~ OAX x 11.0(0).
Note that the tax effect of the future negative permanent differences Oil account of revaluation
does not form part of the owners' equity. according to the Sandilands Report (sec chapter 12
and the opening lines of part B of this chapter for objections to this opinion).
246
CURRENT-COST ACCOUNTING
The comments on this method are the same as for adjusted historic cost (part
A.2 of this chapter) and for the traditional replacement-value theory (chapter
12). That part of the deferred-taxation provision, which represents the tax ef-
fect of future negative permanent differences that will arise on sale or usage of
the revalued assets at the valuation shown in the balance sheet, can again easily
be calculated by means of supplementary statements. That part of the
deferred-tax account will be added in full to owners' equity on the sale of the
entire stock of goods A: the provision for deferred taxation anticipates a future
uncertain event, namely the sale of the revalued assets at their present current
value.
B.3. Current-cost accounting and the non-inclusive method
The income statement and the balance sheet under the non-inclusive method
become:
Income statement 1979; current-cost accounting, non-inclusive method
Sales 76,500
COGS 60,000
Tax payable 13,200
Tax effect of timing diff.: 0.48 x 11,000 = (5,280)
Tax expense (48%) 7,920
Net income 8,580
Balance sheet 31112 1979; current-cost accounting, non-inclusive method

Accounts receivable 42,000 Revaluation surpl. * 9,880
Stock of goods 44,000 Total equity 69,880
Bank loan 40,000
Deferred tax** 3,840
Tax payable 13,200
135,500 135,500
* [(1-0.48) x 19,OOOj
(0.48 x 19,000 - 0.48 x 11,0(0)
247
The objections to this non-inclusive method should by now be clear. Although

full physical capital-maintenance cannot be said to be the main object of cur-
rent-cost accounting as proposed by the Sandi lands Committee, it will be clear
that the resulting form of capital maintenance, namely 52% of the specific
price-increases of the assets, is absolutely unfounded.
Conclusion on deferred-tax accounting and current cost
The objections to the non-inclusive method and the inclusive method with re-
duced revaluation are m.m. the same as for the traditional replacement-value
theory. The inclusive method with unreduced revaluation is the only appropri-
ate method under current-cost accounting as well.
Part C. Deferred-tax accounting and simplified current-cost ac-

counting
A simplified form of current-cost accounting was introduced in the U.K. in

1977 by the so-called Hyde-Guidelines. The s.implification was mainly that,
starting from historic-cost accounts, supplementary statements should be pub-
lished including a depreciation adjustment and a cost-of-sales adjustment
(COSA). Moreover, the Hyde-Guidelines took into account the view that a
'gearing adjustment' was necessary to show how the method of financing the
business had affected the impact of price-level changes. The subsequent expo-
sure draft (ED 24) introduced, separately from the 'gearing adjustment', the
'depreciation adjustment', and the COSA, an adjustment called the 'mone-
tary-working-capital adjustment' (MWCA), which in effect extends the cost-
of-sales adjustment to the monetary working-capital items. The last Statement
of Standard Accounting Practice no. 16 is completely in line with ED 24, apart
from the fact that it offers individual companies the choice of deciding which
accounts are the main accounts and which are the supplementary ones, the
current-cost accounts or the historic-cost accounts.
Application of this simplified form of current-cost accounting to the figures
of example 13.1 gives results different from those of Sandilands, partly be-
cause Sandilands does not know a gearing adjustment and partly because CO-
SA (and MWCA) are based on an average increase in the current value instead
of current values at the end of the year or current values at the moment of sale
or usage of assets.
248
SIMPLIFIED CURRENT-COST ACCOUNTING
C.l. Simplified current-cost accounting (SSAP 16) and the inclusive method
with unreduced current cost reserve
Under the unreduced version without the amendment of Burgert, the income
statement and the balance sheet for this simplified form of current-cost ac-
counting (which, for short, will be called SSAP 16) become:
Income statement 1979; SSAP 16, unreduced current cost reserve
Sales 76,500
COGS (FIFO, unadjusted historic cost) 49,000
COSA* 8,000
MWCA** 7,875
64,875
Current-cost operating profit 11,625
Gearing adjustment 40,000/100,000 x 15,875 6,350
17,975
Tax payable 13,200
Tax expense 13,200
Current-cost operating profit attributable to shareholders 4,775
* Average current value: (11+8)12 = 9.5
COSA = number of units sold x average current value - COGS (FIFO) = (6,000 x 9.5) -
49,000 = 8,000
** The only working-capital items involved in the operation of this company are the sales
madt; on credit (accounts receivable of 42,000 at the end of the year). The MWCA is based on
the average increase of the current value, being (11-8)/2: 8/100 = 18314 %. The MWCA then
becomes: 42.000 x 0.1875 = 7,875.
Balance sheet 311/2 1979; SSAP 16, unreduced version unamended

Accounts receivable 42,000 Current cost reserve* 17,525
Stock of goods 44,000 Total equity 77,525
Bank loan 40,000
Tax payable 13,200
135,500 I 135,500
• The current cost reserve (the term used in SSAP 16), will include, where appropriate:
• the per-balance revaluation, using average current values, of fixed assets, stock and invest-
ments 16,000
+ MWCA 7,875
- Gearing adjustment (6,350)
17,525
249
As for the application of the amendment of Burgert to this unreduced version

it should be borne in mind that the reader of the annual accounts can judge
what part of the current cost reserve has been taxed this year, even in the ab-
sence of supplementary statements based on historic cost. For, that part of the
current cost reserve which is taxed this year will equal the sum of COSA, de-
preciation adjustment and MWCA minus the Gearing adjustment. But that
part of the current cost reserve which will be taxed in the future can be calculat-
ed only if adequate historic-cost information is provided (by way either of main
accounts or of supplementary statements). Application of Burgert's amend-
ment to the unreduced version gives the following balance sheet:
Balance sheet 31/121979; SSAP 16, unreduced version amended

Current cost reserve/still to be taxed:
difference in asset valuation (44,000- 36,000) = 8,000
Current cost reserve/already taxed:
COSA (8,000) + MWCA (7,875) - Gearing (6,350)= 9,525
Total equity 77,525
Bank loan 40,000
Tax payable 13,200
135,500
C.2. SSAP 16 and the inclusive method with reduced current cost reserve
As concerns the application of the reduced version to simplified current-cost

accounting, it should be noted that ED 24 stated explicitly in paragraph 17:
'The provisions of SSAP 15 'accounting for deferred taxation' apply equally to
the current cost accounts as well as to the historical cost accounts'. S.S.A.P. 15
states: ' ... Full provision (!) for deferred taxation should be made in respect of
stock appreciation relief except to the extent that it can be demonstrated with
reasonable probability that stock values will not be reduced in the future by
reason of lower volumes or prices or that the relief is unlikely to be reclaimed
by the Government (12) Provision for taxation payable on the disposal of a
fixed asset which has been revalued should be made out of the revaluation sur-
plus as soon as a liability is foreseen based on the value at which the fixed asset
is carried in the balance sheet ... ' .5 This seems to imply that when the peculiar
features of the probability method (discussed in part A of chapter 5) are taken
into account, the reduced version has to be applied. However, SSAP 16 does
5. The Accountant, October 26th 1978. pages 549-551. Emphasis mine.
250
not mention deferred taxation at all. On the contrary, it seems to advocate the
unreduced version by proposing a division between a realized and an unrealiz-
ed part of the current cost reserve, by stating in paragraph 24: 'The current cost
balance sheet includes a reserve in addition to those included in historical cost
accounts. The additional reserve may be referred to as the current cost re-
serve. The total reserves will include, where appropriate:
a. unrealised revaluation surpluses on fixed assets, stocks and investments;

and
b. realised amounts equal to the cumulative net total of the current cost
adjustments, that is:
the depreciation adjustment (and any adjustments on the disposal
of fixed assets);
ii the two working capital adjustments; and
iii the gearing adjustment'.
Moreover, paragraph 56 of SSAP 16 states: 'A reconciliation should be pro-
vided between the current cost operating profit and the profit or lass before
charging interest and taxation calculated on the historical cost basis ... '.6
But since paragraph 12 of SSAP 15 (quoted above) still holds, it cannot be
concluded that SSAP 16 forswears the reduced version of the inclusive meth-
od. This method applied to simplified current-cost accounting as proposed by
SSAP 16 gives as a result:
Balance sheet 31112 1979; SSAP 16, reduced version

Current cost reserve:
[(1-0.48) x 17,525 + 0.48 x 9,525] 13,685
Total equity 73,685
Bank loan 40,000
Deferred tax: (0.48 x 17,525 - 0.48 x 9,525) 3,840
Tax payable 13,200
135,500
at least if deferred tax on account of future negative permanent differences is

not regarded as a part of shareholders' funds. The objections to the reduced
version when applied to this type of simplified current-cost accounting are the
same as for its application to other types of inflation accounting, in brief: the
part of the deferred-tax account, that represents future negative permanent
6. Emphasis mine.
251
differences, which will arise on future sale or use of revalued assets, involves
an anticipation of a future uncertain event, namely the sale or usage of the
revalued assets at their present current value. Moreover, if deferred tax on the
unrealized part of the current cost reserve is not regarded as a part of share-
holders' funds, as suggested by SSAP 157 , there results a serious underestima-
tion of equity.
C.3. SSAP 16 and the non-inclusive method
The objections to the non-inclusive method also hold good under simplified
current-cost accounting:
• future permanent differences are treated as if they were timing differ-

ences originating in the year of revaluation;
• the provision for the tax effect of future negative permanent differences
anticipates the future sale or usage of revalued assets at their present current
value;
• the result is that tax costs are charged to equity at a moment of time
when the related holding-gain has not yet been realized; .
• and although full physical capital-maintenance cannot be said to be the
aim of SSAP 16, the actual result is a physical capital-maintenance of 52%
(100% - tax rate) of the specific (average) price increase of assets financed
by equity, a maintenance concept that changes with changes in the rate of
tax.
The results of the application of the non-inclusive method to SSAP 16 are:
Income statement 1979; SSAP 16. non-inclusive method

Sales 76,500
COGS (FIFO. unadjusted hist. cost) 49,000
COSA 8,000
MWCA 7,875
15.875
Adjusted COGS 64,875
Current-cost operating profit 11,625
Gearing adjustment 6,350
17,975
(Income statement continued on next page.)
7. Paragraph 12 of SSAP 15 uses the words: .... Provision for taxation payable ... made out
ofthe revaluation surplus .. .'. These words seem to imply that deferred tax on acount ofthe
future negative permanent differences cannot be regarded as part of shareholders' funds.
252
Tax payable 13,200

Tax effect of timing diff.: 0.48 x (COSA +
MWCA - Gearing adjustment) = 0.48 x 9,525 = (4,572)
Tax expense (0.48 x 17,975) 8,628
Current-cost operating profit attributable to
shareholders 9,374
Balance sheet 31112 1979; SSAP 16, non-inclusive method

Current cost reserve [(1- 0.48) x 17,525] 9,113
Total equity 69,113
Bank loan 40,000
Deferred tax (0.48 x 17,525 - 0.48 x 9,525) 3,840
Tax payable 13,200
135,500
Again, it may be noted that the part of the deferred-tax account that represents
the tax effect of future negative permanent differences can easily be calculated
from the difference in asset-valuation on a historic-cost basis and a current-
value basis: [0.48 x (44,000 - 36,000)] = 3,840.
Conclusion on deferred-tax accounting and simplified current-cost accounting
The objections to the non-inclusive method and the inclusive method with re-
duced revaluation are m.m. the same as for the other systems of inflation ac-
counting. The inclusive method with unreduced revaluation is the only appro-
priate method under simplified current-cost accounting.
The three types of deferred-tax accounting already discussed in chapter 12

were applied to three types of inflation accounting (adjusted historic cost, cur-
rent-cost accounting and simplified current-cost accounting with a gearing ad-
justment).
All objections to the inclusive method in its reduced version and to the non-
inclusive method given in chapter 12 held, mutatis mutandis, good. To this it
should be added that the 'Sandilands-interpretation' of the inclusive method
253
with reduced revaluation as well as the 'SSAP 15 - interpretation' result in a

serious underestimation of equity.
Contrary to the Sandi lands Report and contrary to SSAP 15, the inclusive
method with unreduced correction for diminishing purchasing power of
equity, or unreduced revaluation surplus, or unreduced current cost reserve
was found to be the only appropriate method of deferred-tax accounting for
the three types of inflation accounting discussed in this chapter.
Burgert's amendment for the unreduced version of the inclusive method los-
es some of its importance where there are supplementary statements.
254
14. Loss carry-over when there are other
timing differences
In the literature only one author made a profound analysis of the combination
of loss carry-back and/or carry-forward and the origination or reversal of other
timing differences. This author, H.A. Black, made a pilot-study which result-
ed in the U.S.A. APB Opinion No. 11 issued in December 1967. In this Opin-
ion the analysis of Black can be recognized in only one paragraph (paragraph
48) on the recognition of carry-forwards as offsets to deferred-tax credits.
Black analysed three situations, which can exist under his preferred method (a
combination of method 2 - assurance beyond any reasonable doubt - and
method 3 - loss carry-forward as an offset to deferred-tax credits - mentioned
in chapter 6). These three situations may also arise under the preferred meth-
od 4 of chapter 6 (prudent estimation of the value of loss carry-forward).
'An operating loss may result in anyone of three situations:
1. the entire loss is carried back and the refund is recognized currently,
2. part of the loss remains to be carried forward and both the refund and
the probable future benefit are recognized currently, or
3. part of the loss remains to be carried forward and only the refund is
recognized currently.
If a timing difference originating or reversing in a loss year affects the amount

of a tax refund or a recorded carryforward asset, it has a tax effect in the loss
year and may be considered in the same way as if it had increased or decreased
the amount of a tax payment. The possible combinations of circumstances and
of amounts are nearly limitless. The discussion of some common situations ...
provides some general guides, but the facts of individual cases need to be con-
sidered in applying the general principles'. 1
Black's general conclusions on this subject can be summarized as in table
14.1.
Although Black's conclusions about the use of method 4 are acceptable, a
1. H.A. Black: 'Interperiod allocation of corporate income taxes', Accounting Research

Study no. 9, New York, 1966, page 97.
255
LOSS CARRY-OVER AND TIMING DIFFERENCES
more general analysis can nevertheless be made leading to conclusions going

further than in Black's analysis. In this analysis the following situations are
distinguished:
A. Carry-back of a loss (carry-back period of three years).

B. Carry-forward of a loss (carry-forward period of two years):
a. full tax benefit recognized in the loss year; carry-forward turns out to
be possible;
b. full tax benefit recognized in the loss year; carry-forward becomes im-
possible;
c. no tax benefit on account of loss carry-forward is recognized in the loss
year; carry-forward turns out to be possible;
d. no tax benefit on account of loss carry-forward is recognized in the loss
year; carry-forward becomes impossible.
Table 14.1: Black's conclusions on operating losses and interperiod allocation. 2
~Typeof Originating , Originating Reversing Reversing

positive negative positive negative
P"-~
iod of timing timing timing timing
origination difference difference difference difference
or reversal
CARRY-BACK
PERIOD:
Carry-forw. no accounting no accounting no accounting no accounting
recognized adjustment adjustment adjustment adjustment
in loss year necessary necessary necessary necessary
Carry-forw. if no payment claim for no accounting no accounting
recognized is expected refund is adjustment adjustment
when real- write-off partly a necessary necessary
ized in the loss reduction
year is a of prepaid
correction tax, the
of the year remainder
of accrual is a cred-
it for the
loss year
2. The summary of Black's conclusions in this table is my own.
256
FOURTY POSSIBLE CASES
~ Originating Originating Reversing Reversing

per- t. d. positive negative posit~ve negative
iod of timing timing timing timing
origination difference difference difference difference
or reversal
LOSS YEAR:
Carry-forw. no accounting no accounting refund is inclusion in
recognized adjustment adjustment reduced by inc. statement
in loss year necessary necessary tax effect of or loss year
reversing reduces eff.
timing of the claim
differences for refund
Carry-forw. too conser- no recog- refund is inclusion in
recognized vative to nition of reduced by inc. statement
when real- recognize an asset tax effect of of loss year
ized a liability for carry- reversing reduces eff.
forward timing of the claim
differences for refund
CARRY-FORW.
PERIOD:
Carry-forw. normal tax- normal tax- a liability prepaid tax
recognized effect effect remains to remains to be
in loss year accounting accounting be paid amortized.
Carry-forw. normal tax- normal tax- depending on depelJding on-·
recognized effect effect the adjust- the treatment
when real- accounting accounting mentof tax in the loss
ized effoin the loss year
year
As concerns existing, originating and reversing timing differences during the

carry-over period the following situations are distinguished:
I. a negative timing difference originated during tht; carry-back period;

full reversal in the loss year;
II. a negative timing difference originated during the carry-back period;
full reversal during the carry-forward period;
III. a positive timing difference originated during the carry-back period;
full reversal in the loss year;
257
IV. a positive timing difference originated during the carry-back period;

full reversal during the carry-forward period;
V. a negative timing difference originates in the loss year; full reversal
in the carry-forward years;
VI. a positive timing difference originates in the loss year; full reversal in
the carry-forward years.
The combination of these situations gives us thirty different cases. Actually,

the number of cases to be analysed is increased for two reasons:
1. carry-back: some people think that adjustmem of an existing net-

deferred-tax credit is necessary.l This affects situation III and IV.
2. carry-forward: recognition of an asset on account of loss carry-forward
as an offset against existing net-deferred-tax credits (method 3, chapter 6)
increases the number of cases in situation IV.
If positive timing differences originated during or before the carry-back period

or in the loss year and are expected to reverse during the carry-forward period
(or after the carry-forward period) it is possible in the combinations Bc-IV,
Bd-IV, Bc-VI and Bd-VI that:
• no tax benefit is recognized in the loss year;

• a tax benefit is recognized in so far as it can be set off against existing
or originating positive timing differences and the balance of the deferred-tax
account is reinstated during the carry-forward years;
• a tax benefit is recognized in so far as it can be set off against existing
or originating positive timing differences and the balance of the deferred-tax
account is not reinstated.
This leads to 40 basic possible cases for the relation of loss carry-over and other
timing differences, namely:
A. Carry-back 8 cases
B. Carry-forward
a. full tax benefit in the loss year; carry-forward possible 6 cases
b. full tax benefit in the loss year; carry-forward impossible 6 cases
c. in principle no tax benefit; carry-forward possible 10 cases
d. in principle no tax benefit; carry-forward impossible 10 cases
40 cases
3. In the U.S.A. inter alia: paragraph 44 of APB Opinion no. n, states that this is neces-
sary. Also paragraph 49 of International Accounting Standard no. 12.
258
CARRY-BACK: THE A-SITUATIONS
It is impossible to discuss the full details of any of these cases. The situations
will be analysed in general, only going into details when necessary. The
common assumptions for the following examples are:
1. 50% tax rate for all years.

2. Carry-back period of three years.
3. Carry-forward period of two years.
Part A: Carry-back and tax-effect accounting for other timing dif-

ferences: the A-situations
Situations III, IV and V may present some difficulties, situations III and IV
because of the opinion that carry-back of losses may require an adjustment of
existing net-deferred-tax credits. Bevis and Perry give the following example
of this situation:
Example 14.1: 'Application of loss carryback against existing deferred tax cred-
its
Yr. Inc. (loss) before Income Tax Expense Cumulative

Income taxes (credit) Net De-
ferred Tax
Account- Tax- Current Deferred Total Credits
ing able
1 $ 15,000 $ 5,000 $ 2,500 $ 5,000 $ 7,500 $ 5,000

2 15,000 5,000 2,500 5,000 7,500 10,000
3 15,000 5,000 2,500 5,000 7,500 15,000
4 15,000 5,000 2,500 2,500 7,500 20,000
5 (35,000) (45,000) (7,500)A (1O,OOO)B (17,500) 1O,OOOC
6 5,000 15,000 0 A 2,500 D 2,500 12,500
Assumptions:
1. 50% tax rate for all years.
2. Surtax exemptions and investment credits ignored.
Notes:
A. Taxes paid in years 2, 3 and 4 aggregating $ 7,500 become refundable as a result of the
carryback of the loss from year 5. No tax is payable in year 6 because of the loss carryforward
from year 5.
B. For years 2 through 5 cumulative accounting income is $ 10,000 which at a 50% tax rate
requires a deferred tax credit of $ 5,000.
C. The cumulative deferred tax credit at the end of year 5 consists of $ 5,000 from year 1
plus $ 5,000 for years 2 through 5 ...
259
D. Represents the tax benefit ($ 2,500) of the loss carryforward to year 6 previously recog-
nized in year 5 ... '.'
The tax effect of loss carry-forward in year 6 is not $ 2,500 but $ 7,500, being
the actual carry-forward times the tax rate. The adjustment of the existing
deferred-tax credits because of loss carry-back turns out to be nothing other
than an offset of the tax effect of loss carry-forward against existing deferred-
tax credits, as becomes clear from the following 'rearrangement' of this exam-
ple:
Yr. Pre-tax Tax. Tax Tax eff. of tim.. Tax expo Cum. net
acc.inc. mc. payabl. differences def.tax
credits
1 15,000 5,000 2,500 or.pos. 5,000 7,500 5,000

2 15,000 5,000 2,500 or.pos. 5,000 7,500 10,000
3 15,000 5,000 2,500 or.pos. 5,000 7,500 15,000
4 15,000 5,000 2,500 or.pos. 5,000 7,500 20,000
5 (35,000) (45,000) (7,500) 1 (17,500) 10,000
I
ocpos. 5.000
orJleg.on
ace. of
loss c.f. (15,000)
6 5,000 15,000 0 rev.pos. (5,000) 2,500 12,500
rev.neg.on
ace.of
loss e.f. 7,500
T. 30,000 10,000
Situation V (originating negative timing difference in the loss year, reversal in

subsequent years) poses a quite different problem in the case of carry-back. In
the other carry-back cases the negative tax expense of the loss yem can be cal-
culated on the basis of the reported accounting loss. The essence of situation V
is that part of the loss has to be carried forward for accounting purposes,
whereas it is carried back for tax purposes. See the following example.
4. D.J. Bevis and R.E. Perry: 'Accounting for income taxes. An interpretation of APB
Opinion No. 11', New York, 1969, page 22.
260
CARRY-BACK: THE A-SITUATIONS
Example 14.2: Case A-V: Carry-back; or neg.t.d. in the loss year; reversal in
subsequent years
Year Pre-tax Taxable Tax Tax effect of

accounting income payable timing differences
income
1 120,000 120,000 60,000 0

2 120,000 120,000 60,000 0
3 120,000 120,000 60,000 0
4 (420,000) (360,000) (180,000) or.neg. (30,000)
5 130,000 100,000 50,000 rev.neg. 15,000
6 130,000 100,000 50,000 rev.neg. 15,000
Year Deferred-tax Tax expense Net income

account at
year-end
1 0 60,000 60,000
2 0 60,000 60,000
3 0 60,000 60,000
4 db. 30,000 (210,000) (210,000)
5 db. 15,000 65,000 65,000
6 0 65,000 65,000
The possibility of offsetting the originating negative timing difference of

60,000 (tax effect 30,000) because of the loss depends as much on future in-
come as the recognition of a tax benefit on account of loss carry-forward does.
If taxable income in the reversal period is not positive, the reversal of this neg-
ative timing difference will be impossible as well. Yet this situation has not
been analysed in the literature studied. There is, however, no special problem
in this situation; the originating negative timing difference would have been
recorded in the case of positive income, and the occurrence of a loss cannot
prevent the recognition of a negative timing difference as long as the going-
concern assumption remains valid. It is surprising, however, that the advo-
cates of (over-) prudence in method 1 (tax effect of loss carry-forward to carry-
forward years) and method 2 (tax effect of loss carry-forward recognized cur-
rently as far as assured beyond any reasonable doubt) clearly do not hesitate to
261
record a negative timing difference originating in the loss year', as long as it is

not a negative timing difference because of the tax effect of loss carry-forward.
Part B: Carry-forward and tax-effect accounting for other timing

differences: the B-situations
B.a. Full tax benefit is recognized in the loss year; carry-forward turns out to be
possible
No accounting problems arise in this situation. The reported tax refund on ac-
count of carry-back consists of two elements: one the actual tax refund, based
on carry-back of the taxable loss, the other an originating negative timing dif-
ference on account of loss carry-forward, as is shown in the following example
for situation III:
Example 14.3: Case Ba-III

Carry-forward; tax benefit of carry-forward recognized in the loss year;
originating positive timing difference durinog carry-back period; full reversal in
the loss year; carry-forward turns out to be successful.

accounting income payable timing differences
income
1 140,000 120,000 60,000 or.pos. 10,000

2 140,000 120,000 60,000 or.pos. 10,000
3 140,000 120,000 60,000 or.pos. 10,000
4 (620,000) (560,000) (180,000) rev.pos. 30,000
or.neg.c.f. 100,000 A
5 100,000 100,000 0 rev.neg.c.f. jO,OOO B
6 100,000 100,000 0 rev.neg.c.f. 50,000 B
5. A few authors have analysed the situation in which an originating positive timing differ-
ence increases both the refund on account of carry-back and the carry-forward opportunities,
when no tax benefit is recognized for carry-forward. These are the cases Bc-VI and Bd-VI in
my analysis. See inter alia: E.L. Hicks: 'Income Tax Allocation', Financial Executive, Oct.
1963. See also: Black, page 100/101.
262
CARRY-FORWARD: THE B-SITUATIONS
Year Deferred-tax Tax expense Net income

accollnt at
year-end
1 cr. 10,000 70,000 70,000

2 cr. 20,000 70,000 70,000
3 cr. 30,000 70,000 70,000
4 db, 100,000 C (310,000) (310,000)
5 db. 50,000 50,000 50,000
6 0 50,000 50,000
Notes:
A.:Or.neg.c.f. means: originating negative timing difference on account of loss carry-for-
\'/ard.
B.: Rev.neg.c.r. means: reversing negative timing difference on account of loss carry-forward.
c.: Although the offsetting of timing differences, certainly not in the case of 'normal' timing
differences and timing differences on account of loss carry-forward, is not advocated, offset-
ling is applied in these examples for the sake of simplicity.
B.b. Full tax benefit is recognized in the loss year; carry-forward turns out to
be impossible
Loss-evaporation, as this situation was called earlier, poses no special prob-

lems. Theoretically speaking, the matching concept suggests a prior-period ad-
justment in this case; if generally accepted accounting principles prevent such
a prior-period adjustment, a second-best alternative is to take the tax effect of
loss-evaporation as an extraordinary loss in the last carry-forward year. Treat-
ment as a prior-period adjustment in situation II would give the following re-
sults:
Example 14.4: Case Bb-II

Carry-forward; tax benefit of carry-forward recognized in the loss year;
originating negative timing differences during the carry-back period; reversal
during carry-forward years; carry-forward turns out to be partially impossible.
263
Yr. Pre-tax Taxahle Tax Tax effect of

(lCe. IIlC. income p{[vahle timing differences
I 100,000 120,000 60,000 or.neg. lO,OOO

2 100,000 120,000 60,000 or.neg. 1.0,000
:; 100,000 120,000 60,000 or.neg. 10,000
4 (560,000) (560,000) ( I~O,OOO) or.neg.e.L 100,000
5 130,000 100,000 0 {rev .neg.c. f. 50,000
rev.neg. IS ,(l00
6 80,000 50.000 () \ rev.neg. 15,000
rev.neg.c.f. 25,000
7 100,O(lO 100,000 50,000 (l
Total 50,000 50,000 50, ()()O ()
Yr. Deferred- Tax Prior- Net ill- Tax Tax hur-

tax ace. expense period come hurden den after
at year- adjllsl- originally ong. pnor-
end menl rep0rled report- period
I'd adjustm.
1 db. IO,OO() 50,0()O 50.000 50% 50%
2 db. 20,000 50,000 50,000 50o/!: 50%
:I db. :lO,()OO 5(),00O 50,()OO 50% 50%
4 db. 130,000 (2~0,OOO) (25J)OO) (2~(), 0(0) (5WYt: )(45 1/2%)
5 db. 65,(JOO 65,000 t 65,(lOO 50% 50%
6 OA 65,000 25,000 IS ,000 ~I lWYc 50%
7 0 50,000 50,000 50o/!: 50%
Total () 50,000 ()
Noles:
A.: The debit balance of the deferred-tax account is the debit balance at the end of year 5: 65,000
Normal reversing negative t.d.: 30,000 x 50% cr. 15,000
Reversing negative t.d. because of loss carry· forward: 50,000 x 50% cr. 25,000
Loss on account of loss-evaporation: 50,000 x 50% cr. 25,000
Balance at the end of year 6: 0
B.c. In principle no tax benefit on account ofloss carry-forward is recognized in

the loss year; carry-forward turns out to be possible
In contrast to the Bb-situations there is now a prior-period adjustment in the

carry-forward years, because the loss was initially overstated. Normally this
constitutes no problem when there are other timing differences as is shown in
the following example for sifllation f.
264
Case Bc-!
Example 14.5: Case Bc-I:

Carry-forward; no tax benefit on account ofloss carry-forward recognized in
the loss year; originating negative timing differences during the carry-back pe-
riod; full reversal in the loss year; carry-forward turns out to be possible.
Year Pre-tax Taxable Tax Tax eff. of Deferred-

accounting income payable timing tax acc.
income differences at year-
end
1 100,000 120,000 60,000 or.neg. 10,000 db. 10,000

2 100,000 120,000 60,000 or.neg. 10,000 db. 20,000
3 100,000 120,000 60,000 or.neg. 10,000 db. 30,000
4 (500,000) (560,000) (180,000) rev.neg. 30,000 0
5 100,000 100,000 0 0 0
6 100,000 100,000 0 0 0
Year Tax Prior- Net op. Tax Tax burden

expense period income burden after prior-
adjustm. originally orig. period ad-
reported reported justments
1 50,000 50,000 50% 50%

2 50,000 50,000 50% 50%
3 50,000 50,000 50% 50%
4 (150,000) [100,000 (350,000) (30%) 50%
5 0 (50,000) 100,000 0% 50%
6 0 (50,000) 100,000 0% 50%
Now the claim for refund of 180,000 in year 4 is partly a reduction of prepaid
taxes (30,000) and the remainder (150,000) is a credit for the loss year. No
accounting adjustment is necessary in the loss year. The realization of loss car-
ry-forward in years 5 and 6 is essentially a prior-period adjustment6 on ac-
count of the original overstatement of the net loss. Disclosure of the tax effect
of loss carry-forward can be given by way of a note to the prior-period adjust-
ment or can be given in the P/L-account if the calculation of the tax expense
starts from pre-tax accounting income instead offrom tax payable, as follows:
6. In the Bc-cases also it can be argued that a prior-period adjustment would not be justifi-
able, because the realization of the tax benefit from the operating loss result from a subse-
quent event, namely the profitable operation during the carry-forward years.
265
PI L-account year 5; based on tax payable
Pre-tax accounting income 100,000

Tax payable o
Tax effect of t.d. 0*
Tax expense o
Net operating income 100,000
Prior-period adjustment of year 4

on account of overstatement of loss* 50,OO()
* The tax effect of loss carry-forward realized this year equals 50,000. As no originating neg-
ative timing difference was recognized in year 4, the loss carry-forward is treated as a prior·
period adjustment. The remaining loss of 100,000 may be carried forward to year 6.
PIL-account year 5; based on pre-tax accounting income

Tax rate x acc. inc. = 50,000
Tax effect of perm. diff. o
Tax expense 50,000
Extraordinary items:
• Gain from loss carry-forward 50,000
• Prior-period adjustment year 4
on account of overstatement of loss* (50,000)
* The remaining loss of a 100.000 may be carried forward to year 6.
Case Bc-II
The same application would be possible in case Bc-II (reversal of the nega-
tive timing difference in the carry-forward years). In that case the claim for
refund would be partly a credit for the loss year and the remainder would be
renewal or flow-through of originating negative timing differences. But there
would be a rather serious inconsistency in the treatment of the existing nega-
tive timing differences and the timing differences on account of loss carry-
forward. If no originating negative timing difference on account of loss carry-
forward is recognized, the existing 'normal' negative timing differences could
be abandoned in the loss year, because the reversal of the latter may be just as
uncertain as the realization of loss carry-forward. In that case there are
essentially two types of prior-period adjustment necessary, a first type in the
266
loss year because the originally built up negative timing differences are regard-
ed as having been unjustifiable by reason of the subsequent loss and a second
type in every carry-forward year on account of an original overstatement of a
loss which can be carried over. This is illustrated in the following example:
Example 14.6: Case Be-lIb

Carry-forward; no tax benefit on account ofloss carry-forward recognized in
the loss year; originating negative timing differences during the carry-back pe-
riod; reversal after the loss year, carry-forward turns out to be possible; the
existing negative timing differences are abandoned because their reversal is as
uncertain as the realization of loss carry-forward (for which equally a negative
timing difference is not recognized).
Yr. Pre-tax Taxable Tax Tax effect Deferred-

acc.inc. income payable of timing tax acc. at
differences year-end
1 100,000 120,000 60,000 or.neg. 10,000 db. 10,000

2 100,000 120,000 60,000 or.neg. 10,000 db. 20,000
3 100,000 120,000 60,000 or.neg. 10,000 db. 30,000
4 (560,000) (560,000) (180,000) extraord.
5 130,000 100,000
°
loss 30,000
° °
°
6 130,000 100,000
° ° °
Yr. Tax Prior- Net op. Tax burden Tax burden
expense period inc.orig. originally after prior-
adjustm. reported reported period adjustm.
1 50,000 (10,000) 50,000 50% 60%

2 50,000 (lO'OOO)~ 50,()()O 50% 60%
3 50,000 (10,000) 50,000 50% 60%
j
4 (150,000) {30,000 (410,000) (27%) (32% )/(50%)
100,000
5 0 (50,000) 130,000 0% 38%
6 0 (50,000) 130,000 0% 38%
The income statements and the final results after prior-period adjustments are
as follows:
267
Income statement of year: I 2 3
Pre-tax accounting income 100,000 100,000 100,000

Tax payable 60,000 60,000 60,000
Tax effect of timing diff. (10,000) (10,000) (10,000)
Tax expense 50,000 50,000 50,000
Net operating income 50,000 50,000 50,000
Prior-period adjustment of yr.:
Income for the year 50,000 50,000 50,000
Ex-post effect of prior- from yr. 4 from yr. 4 from yr. 4

period adjustments (10,000) (10,000) (10,000)
Income for the year after
prior-period adjustments 40,000 40,000 40,000
Income statement of year: 4 5 6 Total
°
Pre-tax accounting income (560,000) 130,000 130,000 ----
Tax payable
Tax eff. of tim.diff.
(180,000)
30,000 °
° °
° °
°
° ° °
Tax expense (150,000)
°
Net operating income (410,000) 130,000 130,000
Prior-period adj. of year: yr. 1-3 yr. 4 yr. 4
Amount 30,000 (50,000) (50,000) (70,000)
Income for the year (380,000) 80,000 80,000 (70,000)
Ex-post effect of prior-

I
from yr. 5+6
period adjustments 100,000 70,000
Income for the year
after prior-period
°
adjustments (280,000) 80,000 80,000
Case Bc-III
Case Bc-III (Carry-forward; no tax benefit of loss carry-forward recognized
in the loss year; originating positive timing difference in or before the carry-
back period; full reversal in the loss year; carry-forward turns out to be
possible) poses no special problems. The reported refund of tax is now partly a
real credit for the loss year (equal to the tax effect of actual carry-back) and
partly the reversal of a liability. No accounting adjustment is necessary in the
loss year. The realization of loss carry-forward could be treated as a prior-peri-
od adjustment of the loss year because of the original overstatement of the
loss.
268
The Bc-IV cases

The Bc-IV cases are still more complicated. The three possible situations
that can be distinguished are:
• Bc-IVa: No negative timing difference is recognized because of loss car-

ry-forward;
• Bc-IVb: A negative timing difference because of loss carry-forward is
recognized in so far as it can be set off against existing positive timing differ-
ences, which are expected to reverse during the carry-forward period; no
reinstatement of positive timing differences is attempted;
• Bc-IVc: A negative timing difference because of loss carry-forward is rec-
ognized in so far as it can be set off against existing positive timing differ-
ences, which are expected to reverse during the carry-forward period; as the
benefit of the loss carry-forward is realized, the net positive timing differ-
ences eliminated to give recognition to the carry-forward (as well as those
related to originating positive timing differences of the loss year) are
reinstated.
Case Bc-IVa (Loss carry-forward; no tax benefit on account of loss carry-for-

ward recognized in the loss year; originating positive timing difference during
or before the carry-back period; reversal during the carry-forward period; car-
ry-forward turns out to be possible) poses no special problem. The benefit of
loss carry-forward can be treated as a prior-period adjustment ofthe loss year.
The only problem in this situation is that net operating income will exceed pre-
tax accounting income on account of the reversal of positive timing differences
as is shown in the following example:
Example 14.7: Case Be-IVa
Year Pre-tax Taxable Tax Tax eft. of Deferred-

acc. income payable timing tax acc.
income differences at year-end
1 140,000 120,000 60,000 or.pos. 10,000 cr. 10,000

2 140,000 120,000 60,000 or.pos. 10,000 cr. 20,000
3 140,000 120,000 60,000 or. pos. 10,000 cr. 30,000
4 (560,000) (560,000) (180,000) cr. 30,000
5 70,000 100,000 0 rev.pos. 15,000 cr. 15,000
6 70,000 100,000 0 rev.pos. 15,000 0
(Continued on the next page.)
269
Year Tax Net Tax bur- Prior- Net inc.

expense operating den orig. period for the
income reported adjustm. year
1 70,000 70,000 50% 70,000

2 70,000 70,000 50% 70,000
3 70,000 70,000 50% 70,000
4 (180,000) (380,000) (32%) (380,000)
{ subsidy EOO'~)
5 (15,000) 85,000 (21%) 50,000 35,000
{ subsidy
6 (15,000) 85,000 (21 %) 50,000 35,000
This effect could be prevented by starting the calculation of the tax expense
from pre-tax accounting income as was shown in example 14.5 for case Bc-1.
The income statement for year 5 in case Bc-IVa would be:
Income statement year 5 (case Bc-IVa):

Tax rate times pre-tax acc. income 35,000
Tax effect of permanent differences o
Tax expense 35,000
• Gain from loss carry-forward realized this year 50,000
• Prior-period adjustment of year 4 because of over-
statement of loss (50,000)
Another way of preventing this effect would be to include the tax effect of loss
carry-forward in the income-tax expense; the tax effect of loss carry-forward is
not treated as a prior-period adjustment in that case. This method, as laid
down in paragraph 61 of APB opinion no. 11, gives a different income figure
for the year, as matter of fact:
Income statement year 5 (case Bc-IVa, no prior-period adjustment):

°
Tax payable
Tax effect of timing differences (15,000)
Tax effect of loss carry-forward 50,000
Tax expense 35,000
270
• Reduction of income taxes arising from loss
carry-forward 50,000
Case Bc-IVb: requires two types of prior-period adjustments, one for the loss
carry-forward in every carry-forward year and a second type for the non-rever-
sal of a positive timing difference in the expected years of reversal, as is shown
in the following example.
Example 14.8: Case Bc-IVb
Year Pre-tax Taxable Tax Tax effect Deferred-tax

acc. income payable of timing account at
income differences year-end
1 140,000 120,000 60,000 or.pos. 10,000 cr. 10,000

2 140,000 120,000 60,000 or.pos. 10,000 cr. 20,000
3 140,000 120,000 60,000 or.pos. 10,000 cr. 30,000
4 (560,000) (560,000) (180,000) { carry-
5 70,000 100,000
°
forw. 30,000A
°°
6 70,000 100,000
° °
Year Tax Net op. Tax bur- Prior-period Net income
expense income den orig- adjustments for the
orig. inally year
reported reported
1 70,000 70,000 50% 70,000
t t
2 70,000 70,000 50% 70,000
3 70,000 70,000 50% 70,000
4 (210,000) (350,000) (371/ 2 %) 100,OOOB (30,000)C (350,000)D
5
6 °
°
70,000
70,000
0%
0%
(50,000)
(50,000)
15,000
15,000
35,000
35,000
Notes:
A. The negative timing difference on account of loss carry-forward is restricted to the expect-
ed reversal of positive timing differences during the carry-forward years.
271
B. Prior-period adjustment of year 4 on account of overstatement of the loss.

C. Prior-period adjustment of year 4 on account of non-reversal of positive timing differ-
ences.
D. Net income as reported in the year.
The income statements and the final results after prior-period adjustments are
as follows.
Income statement of year 1 2 3 4
Pre-tax accounting income 14°2°00 14°2°°0 140 2000 140,000

Tax payable 60,000 60,000 60,000 (560,000)
Tax eff. of tim. diff. 10,000 10,000 10,000 (30,000)
Tax expense 70,000 70,000 70,000 (210,000)
Net operating income 70,000 70,000 70,000 (350,000)
Prior-period adjustment of yr.:
•.on acount of loss carry-f.w .
• on acount of non-reversal
----
Income for the year 70,000 70,000 70,000 (350,000)
Ex-post effect of pr. per. adj. 70,000
Ex-post income for the year 70,000 70,000 70,000 (280,000)
Income statement of year 5 6 Total
Pre-tax accounting income 70,000 70,000 °

Tax payable U ° °
Tax eff. of tim. diff. ° 0 0
Tax expense 0 0 0
Net operating income 70,000 70,000 0
Prior-period adjustment of yr. year 4 year 4
.on account of loss carry-f.w. (50,000) (50,000) (100,000)
• on account of non-reversal 15,000 15,000 30,000
Income for the year 35,000 35,000 (70,000)
Ex-post effect of pr. per. adj. 70,000

Ex-post income for the year 35,000 35,000 -0-
272
Note that the same results would have been reached in this example, ifthe loss
carry-forward had been based on accounting income during the carry-forward
years. If the negative timing difference on account of loss carry-forward is not
strictly restricted to the positive timing differences that are expected to reverse
during the carry-forward period, the income statements can be influenced for a
considerable time.
If the loss carry-forward had not been treated as a prior-period adjustment,
net operating income in years 5 and 6 would have been 20,000 each year and
income for the year would have been 70,000 each year. (Note the difference
from case Bc-IVa).
Case Bc-IVc (with reinstatement of positive timing differences) has already

been discussed in chapter 6. Application of this method to the figures of case
Bc-IV gives as a result:

acc. income payable timing
income differences
1 140,000 120,000 60,000 or.pos. 10,000

2 140,000 120,000 60,000 or.pos. 10,000
3 140,000 120,000 60,000 or.pos. 10,000
4 (560,000) (560,000) (180,000) carry-f.w. (30,000)A
5 70,000 100,000 0 reinstatem. 15,000 B
6 70,000 100,000 0 rev.pos. 15,000 C
Year Deferred- Tax Net Reported

tax acc. at expense operating tax
year-end income burden
1 cr. 10,000 70,000 70,000 50%

2 cr. 20,000 70,000 70,000 50%
3 cr. 30,000 70,000 70,000 50%
4 0 (210,000) (350,000) (371/2%)
5 cr. 15,000 15,000 55,000 21%
6 0 (15,000) 85,000 subsidy.of 21 %
Notes:
A. The expected reversal during the carry-forward years is 60,000. So the tax effect of the
negative timing difference on account of loss carry-forward is restricted to 50% of 60,000 =
30,000.
273
B. Possible reinstatement is tax effect of actual carry-forward: 50,000

Necessary reinstatement is tax effect of eliminated positive timing difference: 30,000
Actual reinstatement 30,000
Tax effect of reversing positive timing difference in year 5: 15,000
Resulting reinstatement 15,000
C. No reinstatement necessary.
The peculiar results for the reported tax burden have been noted in chapter 6.
These odd results for net income for the year can be prevented by treating the
tax effect of loss carry-forward as a prior-period adjustment, as is done in the
following income statements:
Income statement of year 1 2 3 4
Pre-tax accounting income 140,000 140,000 140,000 (560,000)
Tax payable 60,000 60,000 60,000 (180,000)

Tax effect of timing diff. 10,000 10,000 10,000 (30,000)
Tax expense 70,000 70,000 70,000 (210,000)
Net operating income 70,000 70,000 70,000 (350,000)
Prior period adjustments of

year:
• on account of loss carry-
forward
• on account of unnecessary
usage of deferred-tax credit
Net income for the year 70,000 70,000 70,000 (350,000)

period adjustment 70,000
Ex-post income for the year 70,000 70,000 70,000 (280,000)
274
Income statement of year 5 6 Total
Pre-tax accounting income 70,000 70,000

°
Tax payable
Tax eff. of tim. diff.
Tax expense
°
15,000
15,000
°
(15,000)
(15,000) -0-
°
°
Net operating income 55,000 85,000 -0-
Prior-period adjustments
of year: year 4 year 4
- on account of loss carry-
forward (50,000) (50,000) (100,000)
- on account of unnecessary
usage of deferred-tax credo 30,000 30,000
Net income for the year 35,000 35,000 (70,000)

period adjustment 70,000
Ex-post income for the year 35,000 35,000 -0-
Cases Be-V and Be-VI

Case Bc-V gives rise to the same problem as in case Bc-II. The originating
negative timing difference in the loss year may not be recognized because its
reversal may be just as uncertain as the realization of loss carry-forward.
Case Bc-VI gives rise to the same problems as in case Bc-IV, and the same
methods can be applied giving cases Bc-VIa, band C.
B.d. In principle no tax benefit on account ofloss carry-forward is recognized in

the loss year; carry-forward turns out to be impossible
If no negative timing difference on account of loss carry-forward was recog-

nized and loss carry-forward is completely impossible, no accounting adjust-
ments are necessary, and prior-period adjustments are not necessary either. If
no negative timing difference on account of loss carry-forward was recognized
275
and loss carry-forward turns out to be partly possible, the situation corres-
ponds to the cases described under Bc, except that the prior-period adjust-
ments should be restricted to the actual loss carry-forward.
If a negative timing difference on account of loss carry-forward was recog-
nized to the extent that it could be set off against existing positive timing differ-
ences that are expected to reverse during the carry-forward period, two possi-
bilities arise:
1. the negative timing difference on account of loss carry-forward is less

than the actual opportunities for carry-forward;
2. the negative timing difference on account of loss carry-forward is more
than the actual opportunities for carry-forward.
The first situation is the same as the cases described under Bb. A prior-period
adjustment can be made in every carry-forward year on account of the original
overstatement of the loss, as is illustrated in the following example:
Example 14.9: case Bd-VIb

Carry-forward; a negative timing difference on account of loss carry-for-
ward is recognized in so far as it can be set off against positive timing differen-
ces existing or originating in the loss year that are expected to reverse during the
carry-forward period; no reinstatement of positive timing differences is
attempted; originating positive timing differences in the loss year; reversal
during the carry-forward period; carry-forward turns out to be (partially) im-
possible. The negative timing difference on account of loss carry-forward is
less than the actual opportunities for carry-forward.
Year Pre-tax Taxable Tax Tax effect Deferred-

acc. income payable of timing tax acc.
end
1 120,000 120,000 60,000 0

2 120,000 120,000 60,000 0
3 120,000 120,000 60,000 0
4 (500,000) (560,000) (180,000) {or.pos. 30,000 A 0
or.neg. 30,000
5 20,000 60,000 0 rev. impossible 0
6 0 20,000 0 rev. impossible B 0
7 300,000 300,000 150,000 0
276
Year Tax Net op. Prior-period adjustments Ex-post inc.

expense income for the year
1 60,000 60,000 60,000

2 60,000 60,000 C D 60,000
3 60,000 60,000 loss carry-f.w. non-rev. 60,000
4 (180,000) (320,000) t;40,000 E(30,000) (310,000)
5 0 20,000 (30,000) 20,000 10,000
6 0 0 (10,000) 10,000 0
7 150,000 150,000 150,000
Notes:
A. Loss to be carried forward 200,000. Expected reversal of originating positive timing dif-
ferences during the carry-forward period 60,000; the negative timing difference on account of
loss carry-forward is restricted to the tax effect of this reversal.
B. No reinstatement is attempted.
C. Prior-period adjustment in every carry-forward year is based on the tax effect of the
actual carry-forward.
D. Tax effect of the non-reversal of positive timing differences:
in year 5: 50% of (60,000 - 20,0(0)
in year 6: 50% of (20,000 - 0)
In the second situation in which the recognized negative timing difference on

account of loss carry-forward exceeds the actual (ex-post) opportunities for
carry-forward, the same prior-period adjustment can be applied; but now it is
necessary on account of the original understatement of the loss. When the pri-
or-period adjustment is based on the actual loss carry-forward the full effect of
loss-evaporation is charged ex-post to the loss year. This situation is illustrated
in the following example:
Example 14.10: Case Bd·Vlb

Situation the same as in example 14.9 except that the negative timing differ-
ence on account of loss carry-forward exceeds the actual opportunities for
carry-forward.
277
Year Pre-tax Taxable Tax Tax effect Deferred-

acc. income payable of timing tax acc.
end
1
2
120,000
120,000
120,000
120,000
60,000
60,000 °
°
3
4
120,000
(460,000)
120,000
(560,000)
60,000
(180,000) or.pos. 50,000A
or.neg. 50,000
°
°
5
6 °
(20,000)
60,000
20,000 °
°
rev. impossible
rev. impossible °
°
7 300,000 300,000 150,000
°
Year Tax Net Prior-period adjustments Ex-post
expense operating inc. for
income the year
1 60,000 60,000 60,000

2 60,000 60,000 60,000
3 60,000 60,000 carry-f.w. non-reversal 60,000
t
4 (180,000) (280,000) [ 40,000 (50,000) (290,000)
5
6
7
°
°
150,000
°
°
150,000
(30,000)
(10,000)
30,000
20,000 °
(10,000)
150,000
Notes:
A. Loss to be carried forward 200,000. Expected reversal of originating positive timing dif-
ferences during the carry-forward period 100,000; the negative timing difference on account of
loss carry-forward is restricted to the tax effect of this expected reversal.
Summary of the analysis of loss carry-over when there are other timing differ-
ences
Carry-back and other timing differences: The A-situations
Accounting for carry-back of losses is straightforward and simple. An adjust-

ment of existing or originating positive timing differences as laid down in APB
Opinion No. 11 turned out to be nothing other than the recognition of a nega-
tive timing difference on account of loss carry-forward as far as that timing
difference could be set off against existing or originating positive timing differ-
ences. A negative timing difference originating in the loss year may increase
the reported tax refund; but non-recognition of this timing difference would
278
SUMMARY OF THE ANALYSIS
imply the expectation of no taxable income at all in future years. Such an ex-
pectation would force the company to drop the going-concern assumption.
The occurrence of a loss that can be carried back does not oblige the company
to make an accounting adjustment of already existing or originating timing dif-
ferences; its influence on the validity of the going-concern assumption, howev-
er, must be considered.
Carry-forward and other timing differences: The B-situations
Case B.a: Full tax benefit of possible carry-forward recognized in the loss year;
the expected carry-forward turns out to be successful. No accounting adjust-
ments of existing or originating timing differences are necessary in the loss
year, nor in the carry-forward years.
Case B. b: Full tax benefit of possible carry-forward recognized in the loss year;
the expected carry-forward turns out to be unsuccessful. No accounting adjust-
ments of existing or originating timing differences are necessary in the loss
year. The loss evaporation forces the company to abandon the negative timing
difference that was recognized in the loss year on account of the opportunities
for loss carry-forward. When the tax effect of this non-reversal is treated as a
prior-period adjustment of the loss year on account of the original understate-
ment of the loss, the amount of net income (after prior-period adjustments)
during the carry-forward years is not influenced by the loss-evaporation.
Case B. c: No full tax benefit of possible carry-forward recognized in the loss

year; but carry-forward turns out to be possible. If no tax benefit on account of
loss carry-forward was recognized at all in the loss year, a prior-period adjust-
ment in the carry-forward years may be applied on account of the reversal of a
negative timing difference because of loss carry-forward that was not recog-
nized. No accounting adjustment of existing or originating timing differences
is necessary in the loss year. The future reversal of negative timing differences
may, however, be just as uncertain as the realization of the benefit of a loss
carry-forward; this can be a reason for abandoning the existing negative timing
differences. But, as for the A-situations, the expectation of uncertain future
taxable income is not the same as the expectation of no future taxable income
at all. The occurrence of a loss that cannot be carried back does not oblige the
company to make accounting adjustments of existing or originating timing dif-
ferences; it can do so only through its influence on the going-concern assump-
tion.
If a tax benefit on account of loss carry-forward was only partly recognized
(either in so far as it could be set off against already existing or originating
positive timing differences that were expected to reverse during the carry-for-
279
ward years or in so far as actual carry-forward was estimated to be possible) but

turns out to be more successful, an accounting adjustment of timing differ-
ences is necessary in the actual carry-forward years. If this adjustment of ti-
ming differences is treated as a prior-period adjustment of the loss year on
account of the original overstatement of the loss, net income for the year dur-
ing the carry-forward years is not influenced by the estimation of the opportu-
nities for carry-forward in the loss year(s).
The adjustment of existing or originating positive timing differences, that
are expected to reverse during the carry-forward years in the case of an origi-
nating negative timing difference on account of loss carry-forward that is rec-
ognized in so far as it can be set off against those positive timing differences, is
obvious. When no reinstatement of the positive timing differences is attempt-
ed, a second type of prior-period adjustment on account of non-reversal is
necessary in the carry-forward years. If reinstatement of these positive timing
differences is attempted, it is preferable to treat this reinstatement as a prior-
period adjustment of the loss year, because of the original overstatement of
the loss for that year.
Case B.d: No full tax benefit of possible carry-forward recognized in the loss
year; carry-forward turns out to be unsuccessful. The conclusions on the
accounting adjustments of timing differences are either those mentioned in
case B.b or those mentioned in case B.c, depending on the amount ofthe nega-
tive timing difference on account of loss carry-forward recognized in the loss
year and the amount of actual carry-forward.
It is worth mentioning a special effect in cases Bd-IVc and Bd-Vlc, that was
illustrated in chapter 6, even though it is not related to the adjustment of other
timing differences. If a negative timing difference on account of loss carry-for-
ward was recognized in the loss year in so far as it could be set off against exist-
ing or originating positive timing differences that were expected to reverse
during the carry-forward years and reinstatement is attempted during the car-
ry-forward years, the income figures over the whole reversal period of the pos-
itive timing difference are influenced if the recognized negative timing differ-
ence on account of loss carry-forward exceeds the actual realization of the ben-
efit of the actual carry-forward, as was also shown in chapter 6.
There are only a few situations in which accounting adjustments of deferred-

tax credits or debits deserve serious consideration.
Accounting adjustments because of loss carry-back are never nel.:cssary as
long as the going-concern assumption can be considered justified. If the going-
concern assumption must be abandoned accounting adjustments of existing
280
CONCLUSIONS
deferred-tax credits and debits are part of the revaluation of all other assets
and liabilities.
Accounting adjustments because of loss carry-forward are not necessary if
the tax benefit of loss carry-forward is allocated to the loss year and the loss
carry-forward turns out to be successful. A difference between the estimated
tax effect of loss carry-forward (allocated to the loss year) and the tax effect of
actual loss carry-forward urges to accounting adjustments of the tax effect of
timing differences during the actual carry-forward years. These adjustments
can at best be treated either as prior-period adjustments or as extraordinary
items.
Accounting adjustments similar to those mentioned above are necessary if
no tax benefit because of loss carry-forward is recognized in the loss year and
actual carry-forward turns out to be possible. The influence of the loss on the
validity of the going-concern assumption, however, may be a reason for aban-
doning existing negative timing differences.
If the tax effect of loss carry-forward is allocated to the loss year in so far as it
can be set off against existing or originating positive timing differences, several
accounting adjustments are necessary. These adjustments can extend their ef-
fect far beyond the loss carry-over period, depending on the attempted rein-
statement and the successfulness of actual loss carry-forward.
281
15. Summary and conclusions part II
Some of the assumptions made in part I of this study have been dropped in part
II. First, the assumption of a constant tax rate. Second, the assumption of the
absence of parent/subsidiary relationships. Third, the assumption of the ab-
sence of inflation. Finally, the assumption of the absence of other timing dif-
ferences in case of loss carry-over.
Changes in tax rates
Problems arising in deferred-tax accounting as a result of rate changes were

treated in chapter 10. In most of the literature three basic methods for the
treatment of rate changes are mentioned: the liability method, the deferral
method and the net-of-tax method. But only the liability method and the de-
ferral method have something to do with rate changes.
The proponents of the liability method look on tax-allocation as an accruing
income-tax expense as a function of pre-tax book income, excluding perma-
nent differences between book income and taxable income. The estimated
amounts of future tax liabilities are computed at the tax rate expected to be in
effect in the future periods in which present timing differences are expected to
reverse. In the deferral method the emphasis is on the correctness of income
for the period of origination of timing differences. Rate changes after the origi-
nation of timing differences do not give rise to accounting adjustments in the
opinion of the proponents of the deferral method. They take pride in the sim-
plicity of the deferral method. But this simplicity is contradicted by the neces-
sary assumptions about the flow-through of timing differences, which may give
rise to rather complicated calculations on the reversal of timing differences.
The proponents of the liability method reproach the proponents of the deferral
method a 'mismatching' of tax expenses in the year of reversal of timing differ-
ences if the tax rate has changed between the date of origination and the date
of reversal of timing differences. But the same kind of 'mismatching' can be
objected against the liability method as concerns the years of origination of
timing differences.
282
GROUP ACCOUNTS
Three combined methods (i.e. combinations of deferral and liability meth-

ods) have been analysed. All these combined methods (proposed by Grady,
Perry and Black respectively) implicitly appeal to the prudence principle; but
it has not been shown for any method, why prudence is necessary only for rate
changes. Moreover, all these combined methods were found to be contradicto-
ry in themselves. The principal question concerning rate changes is to which
period the gains and losses due to rate changes should be allocated.
The essence of deferred-tax accounting is the matching of tax expenses with
related revenues. But gains and losses on account of rate changes cannot be
allocated to the revenues of the period of origination of timing differences (de-
ferral method), since the cause of these gains and losses cannot be found in
these revenues but in the rate change itself, independently of whether it is an
expected or an unexpected rate change. So, the gains and losses should be allo-
cated to the period of rate change itself, according to the matching principle.
This method is essentially a third basic method, which has been called the
'windfall-solution'. The windfall-solution is mostly treated as an interpretation
of the liability method, based on the presumption that the only reasonable as-
sumption about future tax rates is that the current rate will continue except
when a rate change is known or reasonably certain. The windfall-solution is
regarded as a separate method, since it recognizes all gains and losses from rate
changes in the year of the rate change itself, independently of whether the rate
change can reasonably be foreseen or not. As such, it is the only method that
meets all the requirements of the matching principle.
Deferred-tax accounting in group accounts
The problem of deferred-tax accounting in group accounts was treated in chap-

ter 11 for both national and international groups of companies.
i. intercompany transactions in national and international groups
Intercompany transactions between companies of a national group pose hard-

ly any special problems in the field of deferred-tax accounting. If tax is levied
on the different members of the group as separate taxpayers, the consolidated
group accounts will show a timing difference. This timing difference (usually a
negative one) will be found in the group accounts only, since the sales proceeds
for the group accounts will be taken into account only on sale to outside par-
ties, whereas the aggregate sales proceeds of the individual companies will in-
clude the intercompany transactions.
Intercompany transactions between members of an international group are
283
SUMMARY AND CONCLUSIONS PART II
much more complicated. In addition to the currency-translation problem and

the negative timing difference in the group accounts already referred to for
national groups, there are two causes of difference between the consolidated
tax-cost figure and the aggregate tax-cost figures of the individual member-
companies of an international group.
First, there is a possible difference in tax rate between the different coun-
tries of residence of the members of the group. The effective tax burden shown
in the group accounts differs from the tax rate in the country of residence of the
parent company or the company controlling the group. This problem still ex-
ists even if there are no intercompany transactions; but if there are intercom-
pany transactions it becomes much more complicated. This problem is similar
to that of the disclosure of the tax effect of permanent differences (chapter 8).
The conclusion was that there is a special type of permanent difference, to be
found in the group accounts only. This permanent difference is of a special
type, because it is not caused by an income difference but by a difference in tax
rates.
Second, a permanent difference will arise if the transfer prices set for inter-
national intercompany transactions by the tax authorities of one country are
not accepted by the tax authorities of another country. This permanent differ-
ence is a real one (in the sense of a permanent income difference) and will be
found in the group accounts as well as in the annual accounts of the group-
member company resident in the transfer-price-correcting country.
2. Relief from national double taxation in a parent/subsidiary relation
In the absence of any relief for the parent company of a group, double taxation
will arise on account of the earnings of its subsidiaries, or for both companies
where there are mutual shareholdings. For national groups, two of the most
common types of relief from (national) double taxation have been analysed,
viz. the affiliation privilege and grouping for tax purposes. The affiliation priv-
ilege prevents special problems in deferred-tax accounting, if all gains and loss-
es from the subsidiary are exempted from tax in the hands of the parent compa-
ny. The parent company will have a permanent difference in its own annual
accounts. Permanent differences can arise in the group accounts depending on
the method of consolidation. The existence of a permanent difference in the
group accounts, if not all gains and losses are exempted under the affiliation
privilege, has been shown by the example of the Dutch relief for the termina-
tion loss of a subsidiary.
A problem arising from grouping for tax purposes is the one known as 'allo-
cating tax advantages among affiliates' and is well-known in the U.S.A., where
grouping for tax purposes is permitted even when the shareholding is less than
284
100%. This problem turned out to be one not of deferred-tax accounting but of
valuation of minority interests.
3. Relief from international double taxation in a parent/subsidiary relation
Four basic methods of relief from international double taxation for interna-
tional groups were analysed. The exemption method, the deduction method,
the ordinary-credit method and the proportional method were discussed in
terms of loss-situations. The results of this analysis are summarized in tables
11.1 and 11.2 at the end of chapter 11; for brevity they are not repeated here.
Deferred-tax accounting under the replacement-value theory
The starting point for this analysis in chapter 12 was the traditional replace-
ment-value theory as formulated principally by Th. Limperg. Attention has
been paid as well to current-cost accounting as proposed by the British Sandi-
lands committee.
1. Rising replacement costs
Three methods of tax-effect accounting were analysed under this traditional

replacement-value theory for the case of a price increase; it was first assumed
that backlog depreciation was not applied. These three methods were referred
to as the inclusive method with reduced revaluation, the non-inclusive method
and the inclusive method with unreduced revaluation, respectively. If there is
an upward revaluation in the annual accounts, a future negative permanent
difference will arise between book income and taxable income if taxation is
based on historic-cost figures. This difference will originate only in the future,
either on sale of the revalued assets or on depreciation of fixed assets, since the
cost figures for tax purposes (historic cost) and for book purposes (current
cost) will differ in the future.
It is the traditional view that if there is an upward revaluation, a contingency
(or provision) for deferred taxation should be created at the charge of the Re-
valuation surplus on account of the difference between taxable income and
book income that will arise on the sale of the asset at its present current value.
The amount of deferred tax thus created is, in the inclusive method with re-
duced revaluation at least, added back to the Revaluation surplus, either in-
stantaneously (on the sale of assets) or gradually on the depreciation of fixed
assets. The objections to this inclusive method with reduced revaluation were:
285
• that it usually shows a fictitious amount of tax by acting as if the revalu-

ation caused the difference between book income and taxable income,
whereas it is really the usage or the sale of these assets that does so;
• that it anticipates a future uncertain event, namely the sale of an asset
before the end of its economic life and/or at its present current value;
• that it violates the going-concern assumption, at least where fixed assets
are concerned, since valuation of assets at their replacement value implies
that the company does not intend at present to sell the assets before the end
of their economic life.
As for the non-inclusive method, the same amount of deferred tax is created
upon an upward revaluation as in the inclusive method with reduced revalua-
tion. However, this amount of deferred tax is not added back to the Revalua-
tion surplus. Thus the tax effect of an upward revaluation is treated as if it were
the tax effect of a positive timing difference originating in the year of revalua-
tion and reversing on sale or depreciation of the revalued asset. Like the re-
duced version, this method also anticipates the future uncertain event of the
sale of an asset before the end of its economic life and/or at its present current
value. The result in this case, however, is that tax cost is actually charged to
equity at a moment of time when the related holding-gain has not yet been
realized. Moreover, the non-inclusive method was found to be incompatible
with the maintenance-concept lying at the root of the traditional replacement-
value theory.
The inclusive method with unreduced revaluation ultimately charges the tax
effect of future negative permanent differences to future income, as does the
reduced version; but it is not caught in the trap of a presentation of net assets
that anticipates future uncertain events. Neither the matching principle nor
the going-concern assumption is violated in the unreduced version. However,
there is a problem in this method in that it is unclear what part of the Rev-
aluation surplus has already been realized (and taxed). In order to disclose this
amount, the Revaluation surplus itself can be split into a part that has already
been taxed and a part that remains to be taxed in the future (Burgert's amend-
ment).
2. Backlog depreciation
Backlog depreciation has been considered inherent in the traditional replace-

ment-value theory. When the holding-loss presented as backlog depreciation
is charged to Earned surplus, no tax problem arises, since retained earnings
are presented after tax. But, if the holding-loss presented as backlog deprecia-
tion is charged to the P/L-account, a normal negative permanent difference
286
arises, because the backlog depreciation will not be accepted by the tax author-
ities as long as the calculation of taxable income is based on historic cost.
3. Decline of replacement costs
Tax-effect acounting for a price decrease under the traditional replacement-

value theory is a much more doubtful business, since the case of a price de-
crease is only very briefly discussed in the literature and its tax effect has never
been discussed in the Dutch literature. As for the inclusive method with re-
duced revaluation, it has been concluded that if the corresponding holding-loss
on account of a price decrease is charged to the Revaluation surplus, its tax
effect must be charged proportionately to the Revaluation surplus and the 'Re-
serve for future taxation on account of revaluation'. However, if this holding-
loss is charged to the P/L-account, a negative permanent difference arises. In
the use of the inclusive method with unreduced revaluation, by contrast, no
problems arise: there will be a series of positive permanent differences on de-
preciation or one positive permanent difference on sale of the asset that has
been revalued downwards, at least if the current value falls below the original
historic cost and if this holding-loss is not accepted for the calculation of
taxable income. However, the non-inclusive method may give rise to a pecu-
liar accounting treatment if the price falls. The aim of the non-inclusive meth-
od is to charge the income statement with a tax expense that equals book
income times the current tax rate (at least in the absence of permanent differ-
ences other than those due to revaluation). But if the replacement value of an
asset falls below its original historic cost, this aim can be realized only if the tax
effect of the price decrease is capitalized. The tax effect of a negative timing
difference thus capitalized is the tax effect of future positive permanent differ-
ences that will arise on the sale of depreciation of the asset that has been re-
valued downwards.
Yet another incongruity of the non-inclusive method may arise from the fact
that future permanent differences on account of revaluation are treated as if
they were timing differences originating in the present. That happens when the
non-inclusive method is combined with the method in which the tax effect of
loss carry-forward is allocated to the loss year in so far as this tax effect is equal
to that part of the credit -balance of the deferred-tax account that is expected to
reverse during the carry-forward years. This combination of methods, which
has been called the 'Van Gelder method', evokes all the objections to these
separate methods. These objections may best be summed up in the words of
the Dutch Enterprise Chamber (translated) in its judgement on the 'Van Gel-
der method' : it 'involves recognition of a gain in the present at the charge of an
increasing tax burden in the future on the future reinstatement of these differ-
ences'. Moreover, the offset of the tax effect of loss carry-forward against the
287
tax effect of the anticipated future negative permanent differences under the
non-inclusive method is in direct conflict with the realization principle.
Deferred-tax accounting and inflation accounting
Although the traditional replacement-value theory cannot be regarded as a

method of inflation accounting, at least not in its original form, the analysis of
deferred-tax accounting under the replacement-value theory gave a good basis
for the examination of deferred-tax accounting under different methods of in-
flation accounting in chapter 13.
Three types of inflation accounting were discussed, namely Adjusted histor-
ic cost, Current-cost accounting and Simplified current-cost accounting with a
gearing adjustment. The three types of deferred-tax accounting already dis-
cussed in chapter 12 (the non-inclusive method and the reduced and unre-
duced versions of the inclusive method) were applied to these three types of
inflation accounting. The conclusions on the application of these methods of
deferred-tax accounting to the three types of inflation accounting were similar
to the conclusions on their application to the traditional replacement-value
theory.
The inclusive method with reduced revaluation anticipates a future uncer-
tain event, namely the sale of an asset at its present current value or its adjust-
ed historic cost, and gives a presentation of net assets that violates the going-
concern assumption. All objections to the non-inclusive method given in chap-
ter 12 held good, even mutatis mutandis the objection of an improper mainte-
nance-concept, since the actual maintenance results of this method [(I-tax
rate) x general or specific purchasing power of capital or equity] are absolutely
unfounded.
The inclusive method with unreduced revaluation was found to be the only
sensible method of deferred-tax accounting under inflation accounting as well.
However, where there are supplementary statements for inflation accounting
it can easily be judged what part of the Correction for diminishing purchasing
power of equity or what part of the Current cost reserve will be taxed in the
future on the usage or sale of assets. Burgert's amendment loses some of its
importance where there are supplementary statements.
Combination of loss carry-over with other timing differences
Deferred-tax accounting in the case of loss carry-back and loss carry-forward

was discussed in chapter 6 of part I. In addition, carry-back and carry-forward
of losses and their combination with timing differences were separately ana-
lysed in chapter 14, mainly because of apparent misunderstandings in practice
288
LOSS CARRY-OVER
(vide the 'Van Gelder method'). The analysis in chapter 14 is independent of

the method chosen for realization of the benefit of loss carry-forward.
1. Combination of loss carry-back with other timing differences
As for carry-back of tax losses, it turned out that no accounting adjustments of

deferred-tax credits or debits are necessary on account of the loss carry-back
itself. The adjustment of existing deferred-tax credits (the tax effect of existing
positive timing differences) in the loss year, as discussed in the meagre litera-
ture on this subject, turned out to be merely the recognition of the tax effect of
loss carry-forward in so far as it could be balanced against existing deferred-tax
credits.
Another aspect of loss carry-back and timing differences is that the few writ-
ers on this subject (Black and Bevis/Perry) seem to agree that a negative timing
difference originating in the loss year increases the reported tax refund on ac-
count of loss carry-back, since they say that the reported tax refund must be
consistently based on reported book income. This is somewhat at variance
with their reluctance to recognize the tax effect of loss carry-forward in the loss
year, since the actual future reversal of a negative timing difference originating
in a loss year may depend as much on future positive taxable income as does
the carry-forward of a loss.
2. Combination of loss carry-forward with other timing differences
As for carry-forward, it was found that there are only a few situations in which
accounting adjustments of existing deferred-tax credits and debits deserve se-
rious consideration. Existing deferred-tax credits can be adjusted in the loss
year, as has just been suggested because it is expected that there will be little or
no taxable income in the years of reversal/carry-forward. However, it should
be borne in mind that this adjustment is not caused by the occurrence of the
loss, but only by its influence on the expectation of future taxable income; the
valuation of other assets and liabilities is subject to this influence on the validi-
ty of the going-concern assumption as well.
If the actual loss carry-forward differs from the tax benefit of the loss carry-
forward expected and recognized in the loss year, an accounting adjustment in
the carry-forward years will be necessary, since either a negative timing differ-
ence reverses that was (partly) not accounted for on its origination (actual loss
carry-forward exceeds the expected tax benefit on account of loss carry-for-
ward) or a negative timing difference does not reverse even though it was ac-
counted for on its origination (actual loss carry-forward is smaller than the ex-
pected tax benefit on account of loss carry-forward).
289
These adjustments can either be treated as a prior-period adjustment on ac-

count of the original over- or understatement of the loss in the loss year, or
they can be treated as an extraordinary item. At least these adjustments should
preferably not be included in the tax expense during the carry-forward years,
in order to prevent net operating income differing considerably (i.e. by more
than the current tax rate) from book income, because either (part of) a nega-
tive timing difference has been treated as a permanent difference, or a perma-
nent difference (in the case of loss-evaporation) has been treated as a timing
difference.
There is little difficulty with the necessary adjustments of positive timing
differences that are expected to reverse during the carry-forward years if the
tax benefit of loss carry-forward is recognized in the loss year in so far as it can
be set off against these positive timing differences. However, when no
reinstatement during the carry-forward years is attempted, a prior-period ad-
justment or an extraordinary gain on account of the non-reversal of positive
timing differences will have to be reported during the carry-forward years. In
the case of reinstatement, the outcome may be rather strange results for the
reported tax burden, as has already been shown in chapter 6. This effect can be
prevented by introducing a prior-period adjustment on account of unnecessary
usage of the deferred-tax credit.
290
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Anticipated and Deferred

Corporate Income Tax in

Dr. M. A. van Hoepen

Cover design: Pieter J. van der Sm an

© 1981 Springer Science+Business Media Donlrecht

PART I. GENERAL ASPECfS OF DEFERRED-TAX ACCOUNTING

1. Background to the problem 3

The aim of this study 3

2. The nature of timing differences and permanent differences 17

Permanent differences, positive and negative 17

3. The calculation of timing differences 25

A jungle of methods in deferred-tax accounting 25

4. The nomenclature and classification of timing differences 37

Nomenclature and classification of timing differences in the P/L-

5. The valuation of timing differences 54

Part A. Discounted or nominal value 54

Part B. Lower valuation of originating negative timing differences 71

6. Deferred-tax accounting in the case of loss carry-back and carry-

Some different views on the accounting treatment of loss carry-

Conclusions chapter 6 100

7. The offsetting of timing differences 101

The offsetting of timing differences in practice 101

8. Accounting for permanent differences 108

Part A. Conditional and unconditional differences 110

Part B. When is the tax effect of permanent differences realized? 113

Part C. The disclosure of permanent differences in the PIL-account 119

Conclusion on the investment credit 130

Conclusions chapter 8 130

9. Summary and conclusions part I 131

Scope of the study 131

PART II. SOME SPECIAL ASPECTS OF DEFERRED-TAX

10. Timing differences and changes in tax rates 143

Three methods of accounting for rate changes 143

Conclusions chapter 10 166

11. Deferred-tax accounting in group accounts 168

Part A. Deferred-tax accounting in national group accounts 169

Part B. Deferred-tax accounting in international group accounts 180

• Conclusions on tax-effect accounting for different methods of re-

Conclusions chapter 11 199

12. Deferred-tax accounting under the replacement-value theory 201

Part A. l. Tax-effect accounting in the case of a price increase; no backlog

Part A. II. Tax-effect accounting and backlog depreciation in the

Part B. Tax-effect accounting in the traditional replacement-value theory

Part C. The non-inclusive method in the case of loss carry-forward 225

Conclusions chapter 12 233

13. Deferred-tax accounting and inflation accounting 234

Part A. Deferred-tax accounting and adjusted historic cost 239

Part B. Deferred-tax accounting and current cost 245

Part C. Deferred-tax accounting and simplified current-cost accounting 248

Conclusions chapter 13 253

Part A. Carry-back and tax-effect accounting for other timing differ-

Part B. Carry-forward and tax-effect accounting for other timing differ-

• Case Bc-III 268

Conclusions chapter 14 280

15. Summary and conclusions part II 282

Changes in tax rates 282

General aspects of deferred-tax accounting

The aim of this study

It might seem superfluous to write a study on the incorporation of deferred and

A delimitation of the problem is necessary in order to get a clear picture of

a. The problem is considered only for a company as a going concern, a

Causes of differences between taxable income and book income

Deferred-tax accounting is a direct outcome of differences between book in-