A government grant, compressed bookkeeping, and a controller who wants to spread the subsidy
Hokuriku Precision Co. (year-end 31 March) purchased a computer-controlled machining line. The supplier's invoice was ¥60,000,000; inland freight of ¥500,000 and installation and commissioning costs of ¥2,000,000 were paid separately. The line was ready for use on 1 July 20X4. On 20 September 20X4 the company received a government subsidy of ¥12,000,000 for the project, approved and paid in that month. The company uses the direct-reduction (compressed bookkeeping) method, the declining-balance method at a 25% rate with no residual value, and pro-rates depreciation monthly from the month the asset is placed in service. The effective tax rate is 30%. The controller argues the subsidy should simply be recognised as revenue over the asset's life, since 'the plant was bought to earn income, not to shrink the balance sheet', and the auditor wants the accounting and tax consequences before signing off.
1. Determine the acquisition cost and journalise the purchase, the subsidy, the compression and the first year's depreciation.
Read the worked answer
Acquisition cost includes all costs necessary to bring the asset to its usable condition: 60,000,000 + 500,000 freight + 2,000,000 installation = ¥62,500,000.
Entries:
- 1 July: (Dr) Machinery 62,500,000 / (Cr) Cash and deposits 62,500,000
- 20 Sept: (Dr) Cash and deposits 12,000,000 / (Cr) Gain on government subsidy received 12,000,000
- 20 Sept: (Dr) Loss on fixed asset compression 12,000,000 / (Cr) Machinery 12,000,000
Compressed carrying amount = 62,500,000 - 12,000,000 = ¥50,500,000. The compression loss is normally reported as an extraordinary loss and is recognised in the year the grant is received; deferring it is not permitted for tax purposes.
Depreciation is computed on the compressed cost, from the month of service (July) to March, i.e. 9 months:
50,500,000 × 25% × 9/12 = ¥9,468,750
- (Dr) Depreciation expense 9,468,750 / (Cr) Accumulated depreciation 9,468,750
The controller's suggestion - treating the grant as deferred revenue spread over the useful life - is the accounting for asset-related grants under some frameworks, but it is not the compressed-bookkeeping method, and the method chosen must match the tax election. Consistency between the book entry and the tax return is the point of the exercise.
2. Compare the direct-reduction method with the reserve (retained-earnings-reserve) method, including the deferred tax consequence, and advise which produces the more faithful income statement.
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Direct reduction (what Hokuriku did). The asset is carried at ¥50,500,000, the grant passes through profit once as an extraordinary loss and an extraordinary gain that offset, and depreciation is ¥9,468,750. Because book and tax depreciation are identical, no deferred tax arises.
Reserve method. The asset stays at ¥62,500,000 and a compression reserve of ¥12,000,000 is recognised in capital surplus (other capital surplus). Book depreciation becomes 62,500,000 × 25% × 9/12 = ¥11,718,750, while the tax deduction is based on ¥50,500,000, giving ¥9,468,750. The excess ¥2,250,000 is a deductible temporary difference:
- (Dr) Deferred tax asset 675,000 / (Cr) Income taxes adjustment 675,000 (2,250,000 × 30%)
The reserve is released as the excess depreciation reverses.
Judgement. The direct method keeps the balance sheet honest about the net cash the company actually committed, needs no scheduling of future taxable profit, and is by far the more common practice. Its weakness is precisely the controller's point: the asset's gross cost disappears, so the depreciation charge is understated for the rest of the life and the operating margin looks better than the physical wear warrants. The reserve method preserves the gross cost and the 'true' depreciation burden but creates a deferred tax asset whose recoverability must be assessed every year. If the company expects several years of tax losses, the reserve method may require a valuation allowance, which is an extra judgement the direct method avoids. Recommend the direct method, disclosed in the notes.
3. State the tax treatment of the compression and explain why the choice of method changes the deferred tax calculation but not the total tax paid over the asset's life.
Read the worked answer
Tax treatment. The compression is a tax deferral device: the amount of the grant, up to the acquisition cost, may be deducted in the year the qualifying asset is acquired, effectively allowing the cost to be recovered twice for tax purposes, once immediately and once through depreciation. The election must be made in the year of receipt, which is why the entry cannot be postponed.
Why the deferred tax differs. Deferred tax measures the gap between book carrying amount and tax base. Under the direct method both figures are ¥50,500,000 after compression, so the gap is zero and no deferred tax is recognised. Under the reserve method the book carrying amount stays at ¥62,500,000 while the tax base is ¥50,500,000, so the ¥2,250,000 annual depreciation difference accumulates as a deductible temporary difference and a deferred tax asset until the asset is fully depreciated.
Why total tax is unchanged. Compression shifts the timing of the deduction, not its amount. Over the asset's life the aggregate tax depreciation equals the compressed cost; the early-year saving is clawed back by lower deductions later. The deferred tax asset under the reserve method is exactly that timing difference, reversed in step with the excess book depreciation.
Practical caution. Do not record a deferred tax liability on the grant itself - under the direct method the grant and the compression loss offset within the same period, so there is no temporary difference on the subsidy.