Tax reconciliation and the distributable amount at Minami Industries
Minami Industries Ltd. reports pre-tax profit of ¥84,000,000 for the year ended 31 March 20X5. Three items explain the gap from taxable profit: depreciation charged in the accounts exceeded the tax depreciation limit by ¥12,000,000; a general allowance for doubtful debts of ¥3,000,000 was charged, deductible for tax only when the debt is actually written off; and ¥1,800,000 of entertainment expenses were paid, none of which is deductible. The effective tax rate is 30% and no deferred tax balances relating to these items existed at the start of the year. Separately, the board proposes a cash dividend of ¥60,000,000 from retained earnings. The balance sheet shows share capital ¥200,000,000, legal capital surplus ¥50,000,000, legal retained earnings reserve ¥25,000,000, retained earnings ¥150,000,000 before the dividend, and treasury shares of ¥40,000,000 at book value, which the company intends to hold. There are no other equity items, no goodwill and no deferred charges.
1. Compute taxable profit, current and deferred tax, and profit for the year, and journalise the tax entries.
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Taxable profit. Start from pre-tax profit and add back the non-deductible items:
84,000,000 + 12,000,000 (excess depreciation) + 3,000,000 (general allowance) + 1,800,000 (entertainment) = ¥100,800,000.
Current tax = 100,800,000 × 30% = ¥30,240,000.
Deferred tax. Two of the three items are temporary differences that will reverse:
- Excess depreciation 12,000,000 × 30% = 3,600,000
- General allowance 3,000,000 × 30% = 900,000
- Entertainment expenses are a permanent difference - never deductible, so never a deferred tax asset.
Deferred tax asset = ¥4,500,000.
Entries:
- (Dr) Income taxes, inhabitant taxes and enterprise tax 30,240,000 / (Cr) Income taxes payable 30,240,000
- (Dr) Deferred tax asset 4,500,000 / (Cr) Income taxes adjustment 4,500,000
Profit for the year = 84,000,000 - 30,240,000 + 4,500,000 = ¥58,260,000.
Presentation point: the income taxes adjustment is shown with the tax line, after pre-tax profit, not inside operating expenses. Recognising the asset and then burying it in selling, general and administrative expenses would misstate operating profit.
2. Determine the distributable amount available for the dividend, state whether a legal earnings reserve must be provided, and journalise the dividend.
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Distributable amount. Only surplus - not share capital and not the legal reserves - counts, less treasury shares and the goodwill/deferred-charge adjustment:
- Other capital surplus: ¥0 (the ¥50,000,000 is legal capital surplus, a reserve, not surplus)
- Other retained earnings = retained earnings ¥150,000,000
- Less treasury shares at book value ¥40,000,000
- Less goodwill/deferred charge adjustment ¥0
Distributable amount = ¥110,000,000. The proposed ¥60,000,000 dividend is within it.
Legal earnings reserve. The default rule requires 10% of the dividend, i.e. ¥6,000,000, to be set aside until the combined legal reserves reach one quarter of share capital. Combined legal reserves = 50,000,000 + 25,000,000 = ¥75,000,000, against a threshold of 200,000,000 × 1/4 = ¥50,000,000. The threshold was passed long ago, so no reserve is required - the ¥6,000,000 that a mechanical 10% calculation would produce is wrong.
Entry:
- (Dr) Retained earnings 60,000,000 / (Cr) Dividends payable 60,000,000
Two further points of judgement. The distributable amount is fixed at the resolution date, not the year-end, so any post-year-end treasury share purchase reduces it. And a dividend from retained earnings is a profit distribution, so it is not deductible for tax - no tax entry arises on the payment itself.
3. The company forecasts tax losses for the next three years. Discuss whether the deferred tax asset should still be recognised, and what evidence would change your answer.
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The asset is not automatic. A deferred tax asset is only recognised to the extent that taxable profit will be available against which the deductible temporary differences can be used. Three consecutive loss years are strong contrary evidence.
Assess by category. The excess depreciation and the general allowance are both deductible temporary differences, but they reverse differently. The depreciation difference reverses as tax depreciation catches up - mechanically, over the remaining useful life, regardless of profit. The allowance reverses only when the receivable is written off, which the company controls to some extent. Neither produces taxable profit on its own, so both depend on the entity generating taxable profit from other sources.
Evidence that would support recognition:
- A credible budget showing a return to taxable profit within the carry-forward period, with the assumptions stress-tested.
- Substantial existing taxable temporary differences (for example an unrealised gain on land) that will reverse in the same window - these are the strongest support, since they do not depend on new profit.
- Tax planning opportunities that create taxable profit in the relevant period, such as electing to forgo a group relief claim.
- A history of short, self-correcting losses rather than a structural decline.
Evidence against: an entrenched decline in the core market, no credible plan, or losses exceeding the five-year carry-forward window. If the support is thin, recognise the asset only up to the amount that can be supported - a partial recognition - rather than reversing the whole ¥4,500,000. Reversing it in full in a year when recoverability is merely uncertain is as much an error as recognising it on hope.