Anna Azriati Che Azmi and Nurmazilah Mahzan. Faculty of Business and Accountancy University Malaya

Transcription

1 The adoption of FRS 112 and the treatment for unabsorbed tax losses, unabsorbed capital allowances, unutilised reinvestment allowances, pioneer losses and allowances for increase of export Anna Azriati Che Azmi and Nurmazilah Mahzan Faculty of Business and Accountancy University Malaya Abstract Adoption of FRS 112 Income Taxes in the year 2007 is one of the progresses towards full convergence. Since FRS 112 is a standard that outlines the recognition and disclosure and measurement rules for book tax differences, the impact of certain tax rules in Malaysia on accounting practices will have implications on book tax differences. One such rule concerns the treatment of tax incentives that allow for carry forward of allowances and tax losses such as unutilised reinvestment allowances (RA) and investment tax allowances (ITA). This study provides information on the recognition of allowances and tax losses due to the normal operations of businesses (category I) and those dues to businesses that are granted tax incentives (category II). In view of this, there are two research objectives. First is to observe the current practices of companies on the recognition of temporary differences that arises due to unabsorbed tax losses and allowances upon the application of FRS112 ( i.e. for category I and II). Second is to identify a pattern between companies and their auditors characteristics with their recognition of deferred tax assets. Two conclusions could be made from preliminary descriptive analysis. Firstly, the recognition rate of deferred tax assets for category I is more diversified among companies than category II. Secondly, for category II, among the auditors characteristics that are analysed in this study, differences between Big-4 auditors do play a bigger role in the rate of recognition for deferred tax assets. The different practices adopted by auditors could possibly be due to the different interpretations in the requirements of para of FRS112 or the revised IAS 12. These two conclusions could possibly be due to the lack of definition in revised IAS 12 on tax credit and investment tax credit. Hence, issue arises whether the tax allowances such as ITA and RA are eligible to be defined as tax credit. Therefore, there are different opinion hence different practices by companies. Keyword: Deferred tax, Investment incentives, Conservatism, Fair presentation 1

2 1.1 Introduction Most of the countries around the world are moving towards convergence with International Financial Reporting Standard (IFRS) promulgated by International Accounting Standard Board (IASB). The benefits of a global financial reporting framework are numerous and include greater comparability of financial information for investors, greater willingness on the part of investors to invest across borders, lower cost of capital, more efficient allocation of resources, and higher economic growth. Malaysia, being part of the competitive global economy also respond to the pressure of the global intense of economic competition by setting the deadline for full convergence to be on the 1st January It is believed that the branding of IFRS Compliant will help Malaysian Companies maintain its global recognition and competitiveness (MIA, 2008). The Malaysian Accounting Standard Board (MASB) a body responsible for the accounting standard setting process in Malaysia has also outlined a schematic roadmap towards achieving the goal of full IFRS Compliant by 2012 which effectively means that all IFRS have to be adopted and used by public companies by However, there is bound to be an implementation issue arising from different legal and regulatory framework. One of the prominent areas is taxation in which, Malaysian tax legislation contains salient features not available in other jurisdictions. For example, promotion of investments mechanism such as investment tax allowance and reinvestment allowance. From the financial reporting perspective, adoption of IASB based standard on Income Tax which was FRS 112 in the year 2007 is one of the progresses towards full convergence. FRS 112 which replaced FRS prescribes that companies recognise any book-tax differences using the full provision method. The objective of this research is to firstly observe the current practices of companies on the recognition of temporary differences that arises due to unabsorbed tax losses and capital allowances due to normal businesses and businesses that are granted tax incentives. For unabsorbed tax losses and allowances arising from normal businesses, we identify it as category I. For unabsorbed tax losses and allowances arising from businesses that were granted tax incentives from reinvestment allowances/investment allowances (RA/ITA), pioneer losses and allowa nce for increased exports (AIE), we identify it as category II. Secondly, we examine any patterns that emerge due to characteristics of companies and their auditors with the recognition practices for deferred tax assets in category I and II. 1.2 Recognition of deferred tax assets under FRS 112 Since FRS 112 is a standard issued by MASB that outlines the recognition and disclosure rules for book-tax differences, the impact of certain tax rules in Malaysia on accounting practices will have implications on book-tax differences. FRS 112 prohibits the initial recognition of an asset or liability in most cases. However, companies may recognise deferred tax asset for unused tax losses and tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised (para 34). This rule is controversial in Malaysia because of the existence of Malaysian tax incentives such as reinvestment allowances (RA) and investment tax allowances (ITA). These incentives along with the interpretation of para 34 of FRS 112 allow companies to additionally recognise tax allowances and losses as deferred tax assets. The recognition of deferred tax assets has significant effects on the balance sheet. Air Asia, for example, in its annual report 2006, reports that unutilised reinvestment allowances should be recognised as temporary differences. According to Air Asia s annual report, this treatment entails a fairer presentation of the financial position and performance of the company, as the company projects future profits in its opearations. Due to this treatment, Air Asia reported a book-tax difference that is nearly 6 times the amount declared under FRS , which increases the profit after tax figure to nearly three times the amount of those declared under FRS The reason for the difference in the treatment of unutilised reinvestment allowance between FRS 112 and FRS is because FRS 112 did not adopt para 36 of FRS Para 36 prohibited any unutilised reinvestment allowance to be recognised as temporary differences. As a result, Air Asia s treatment of unutilised RA/ITA 2

3 allowances is acceptable as no rules in FRS 112 actually prohibit this treatment. Air Asia recognises unutilized reinvestment allowances as tax credits. This adopted definition of tax credits is acceptable because FRS 112 does not define tax credits. MASB through its staff paper acknowledges the different accounting practices adopted by companies to define tax credits. There are 3 approaches of recognising these unutilised RA and ITA: the tax credit approach, the government grant approach and the tax base approach. By recognising unutilised RA and ITA under the first and second approach, deferred tax assets could be recognised. The tax base approach, however, meant that deferred tax assets should not be recognised for any unutilised RA and ITA. Such an understanding however, is not fully supported by the local office of the Big 4 accounting firms on the appropriate treatment for these unutilised allowances. MASB indicated that the unutilised RA and ITA are not tax credits, thus rejecting the first approach while one of the Big 4 firms is of the opinion that these unutilised allowances are tax credits. Additionally, if the unutilised ITA/RA are treated as tax credits, this practise could raise another issue. There are other forms of investment incentives particularly pioneer status, increased allowance for exports which apply similar principles of reducing taxable profit of companies as that of RA/ITA. All of these investment incentives offer unused allowances or losses to be offset against future taxable profit. However, the main distinction between these incentives is the characteristics of companies that could qualify for these incentives. Generally, companies which have incurred huge capital expenditure would select RA or ITA; companies with minimal capital expenditure but incurs losses would opt for pioneer status; companies which are in the export industry would apply for allowances for increased exports (AIE). Thus, the book-tax differences between the accounting treatments of the mentioned investment incentives should be similar to RA/ITA. If unutilised RA/ITA could result in temporary differences, these unutilised allowances from other investment incentives should also be considered as temporary differences up to the amount that there are future taxable profit to offset these allowances. Inconsistencies among the treatment of these investments incentives among companies suggest that only capital intensive companies which have unutilised RA are able to report a higher amount of profit after tax than companies that have chosen other types of investment incentives. This reduces the comparability of financial statements among companies. 2.0 Literature review The issue of recognition of deferred tax assets could be discussed in various ways. To be consistent with our study s objective, we focus on observing patterns in auditors or companies characteristics that may influence accounting practices. IFRS are principle-based standards and this may result in different forms of interpretation of its rules. Some studies (e.g. Jamal and Tan, 2010) have observed that auditor type influence companies on their accounting choice in principles-based standards. Similarly, there is another strand of literature (e.g. Gaeremynck and Van De Gucht, 2004) that observed company characteristics that influence their accounting choice in principle-based standards. Adopting a principles-based standard would mean that auditors and companies need to understand the underlying meaning of a rule instead of adopting its literal definition. There are also various ways that principles-based rules could be interpreted and applied. Conservatism is one way of dealing with uncertainty in financial reporting (H m l inen, 2011). Conservatism as defined by Basu (1997:7) as denoting accountants' tendency to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses. Many studies (e.g. Basu, 1997; Qiang, 2007) has identified that taxation is one of the reasons for different degrees of accounting conservatism. Many studies (eg Basu, 1997; H m l inen, 2011) indicated conservatism could be divided into two types of conservatism: conditional and unconditional. Conditional conservatism is related to earnings conservatism while unconditional conservatism is related to balance sheet conservatism (Beaver and Ryan, 2005). H m l inen (2011) identified two sources of accounting conservatism: accounting standards and incentives of managers and auditors. The interaction between accounting standards incentives of managers and auditors are studied by Ball, 3

4 Robin and Wu (2003). Malaysia was one of the countries that were included in their analysis. They found that (ibid: 236): accounting standards and preparer incentives in these countries interact to produce generally low quality financial reporting, consistent with the hypothesis that reporting quality ultimately is determined by the underlying economic and political factors influencing managers and auditors incentives, and not by accounting standards per se. Faithfulness or true and fair view representation, similar to the argument presented by the Air Asia example, is another concept that is important in accounting. To illustrate this concept, we draw on two literatures that highlight how certain lease rules may result in managers of companies and auditors structuring transactions off balance sheet, thus abdicating the concept of faithful presentation. Hales, Ventaraman and Wilks (2011) draws from the psychology literature and indicate that standard setters need to be aware of introducing a lease renewal option rule that may result in managers adopting transactions off balance sheet. Another study, Jamal and Tan (2010 ) found that auditors are able to influence managers of companies on the classification of lease accounting as operating or finance lease. Classification of leases on its substance and not form is an example of fair presentation Research Methodology Our study observes the patterns of companies characteristics and auditors characteristics in the recognition of deferred tax assets within the application of FRS 112. Data was collected from the annual report of all listed companies of the Bursa Malaysia. The annual reports of 2008 are used for the analysis since FRS 112 was adopted in 2007 replacing FRS The following data is collected from the annual report in relation to details of the companies that may influence the recognition of deferred tax assets by company characteristics: Type of industry, as identified by Bursa Malaysia; Size of companies by total assets; and Size of companies by total revenue. For auditor types, we focus on big 4 and non big 4 and among the big 4. The variables for company and auditors characteristics are chosen from the literature (e.g. Iatridis, 2011) For category I, unabsorbed capital allowances and tax losses were collected from the annual report. Companies commonly recognise category I items as deferred tax assets, thus these practices are compared against the recognition of category II. In regard to the treatment of tax incentives (category II), particularly reinvestment allowances/investment allowances ( RA/ITA), pioneer losses and allowance for increased exports (AIE), the following items were collected: Deferred tax assets recognized due to unabsorbed tax losses and capital allowances Unrecognised unabsorbed tax losses and capital allowances Deferred tax assets recognized due to any unutilized reinvestment allowances, pioneer and allowances for increased export Unrecognised unutilized reinvestment allowances, pioneer and allowances for increased export By observing these items, we are paying particular attention to how para of FRS 112 is being interpreted and disclosed by companies in relation to the observed tax incentives. Only 880 companies provided disclosure on the above items, thus, only these companies are used for the analysis. 4.0 Research Results The following sections present the general recognition of deferred tax assets by year. This is followed by characteristics of companies: Industry, total revenue and total assets. Next, the characteristics of auditor are presented: Big 4 against Non Big 4 audit firms and individual Big 4 audit firms. 4.1 Profile of companies 4

5 A total of 880 companies listed in the Bursa Malaysia were chosen for this analysis. These companies were chosen because they are the companies, which provide disclosure on deferred tax assets regarding the following items: (1) unabsorbed tax losses and capital a llowances, and (2) unutilized reinvestment allowances, pioneer losses and/or allowances for increased export. Table 1 Profile of companies Industry N % revenue Year 2008 N % Closed End Funds less than RM Construction RM200 -RM Consumer RM Finance Hotels Industrial IPC Mining Other Assets Year 2008 N % Plantation less than RM Properties RM200 -RM Reit RM Technology Trading & Service Big 4 audit firms N % PWC Big 4 versus non big 4 N % KPMG Non Big EY Big Deloitte The majority of these companies come from 3 of the following industries: Industrial products (30%), Trading and Service (19.2%) and Consumer (16.9%). Based on the value of assets disclosed, nearly half of these companies, 41.3%, have less than RM200 of assets. Similarly, nearly 56% earn less than RM200 of revenue for the year % of these companies are audited by the Big 4 audit firms while the rest (i.e. 43.8%) are audited by non Big 4 audit firms. Most of the companies that were audited by the Big 4 audit firms are audited by Ernst and Young (47.1%). Figure 1 presents table 1 in pie charts. 4.2 Recognition of deferred tax assets by year The objective of this study is to observe the current practices of recognising deferred tax assets. In this section, the observation is divided into 2 categories. Category I is dealing with the recognition of deferred tax assets for unabsorbed tax losses and capital allowances. Category II is dealing with recognition of deferred tax assets for unutilised reinvestment allowances, pioneer losses and allowances for increased exports. Table 2 presents the recognition rate for category I deferred tax assets in 2007 and Most companies chose not to recognise deferred tax assets (n= 189) or to recognise the deferred tax asset at minimal level, which is 1%-20% (n= 197 for 2007 and n=192 for 2008). Overall, there is an increase in the percentage of recognition of deferred tax assets from 2007 and Table 2 Category I: Percentage of recognition of deferred tax assets for 2007 and 2008 % recognised Year Year Difference 5

6 % % - 20% % - 40% % - 60% % - 80% % - 99% % Table 3 presents the recognition rate for category II deferred tax assets in 2007 and For category II, most companies (n= 79 in 2007 and n=65 in 2008) chose not to recognize deferred tax assets. Overall, there is a decrease in the number of companies that recognise deferred tax assets in this category from 2007 to Table 3 Category II: Percentage of recognition of deferred tax assets for 2007 and 2008 % recognised Year Year Differen ce 0% More than 0% less than 100% % Recognition of deferred tax assets based on companies characteristics Table 4 and 5 present the recognition rate of deferred tax assets based on industries for category I and II, respectively. The industries that have the highest percentage of recognition of deferred tax assets for category I and II are industrial products, consumer products and trading and services. Table 4 Category I: Percentage of recognition of deferred tax assets (DTA) based on industries Panel I: Recognition of DTA by companies in 2007 Construction Consumer Finance Hotels Industrial IPC Other Plantation Properties REIT Technology Trading & Service Industries 0% % - 20% % - 40% % - 60% % - 80% % - 99% % Panel II: Recognition of DTA by companies in

7 Construction Consumer Finance Hotels Industrial IPC Other Plantation Properties REIT Technology Trading & Service Industries 0% % - 20% % - 40% % - 60% % - 80% % - 99% % Table 5 Category II: Percentage of recognition of deferred tax assets based on industries Panel I: Recognition of DTA by companies in 2007 Industries Construction Consumer Industrial IPC Other Plantation Properties REIT Technology Trading & Service 0% More than 0% less than 100% % Panel II: Recognition of DTA by companies in 2008 Industries Construction Consumer Industrial Other Properties Technology Trading & Service 0% More than 0% less than 100% % Table 6 and 7 present the recognition rate of deferred tax assets based on total revenue for category I and II, respectively. Companies with total revenue of less than RM200 have the highest percentage of recognition of deferred tax assets for category I and II. Table 6 Category I: Percentage of recognition of deferred tax assets based on total revenue Panel I: Recognition of DTA by companies in 2007 % of recognition/ revenue less than RM200 RM200 - RM400 RM

8 0% % - 20% % - 40% % - 60% % - 80% % - 99% % % of recognition/ revenue less than RM200 Panel II: Recognition of DTA by companies in 2008 RM200 RM RM400-0% % - 20% % - 40% % - 60% % - 80% % - 99% % Table 7 Category II: Percentage of recognition of deferred tax assets based on total revenue revenue Panel I: Recognition of DTA by companies in 2007 less RM200 RM than - RM200 RM % More than 0% less than 100% % revenue Panel II: Recognition of DTA by companies in 2008 less RM200 RM than - RM200 RM % More than 0% less than 100% %

9 Table 8 and 9 present the recognition rate of deferred tax assets based on total revenue for category I and II, respectively. Companies with total revenue of less than RM200 have the highest percentage of recognition of deferred tax assets for category I and II. % of recognition/ asset Table 8 Category I: Percentage of recognition of deferred tax assets based on total assets Panel I: Recognition of DTA by companies in 2007 less than RM200 RM200 - RM400 RM % % - 20% % - 40% % - 60% % - 80% % - 99% % % of recognition/ asset less than RM200 Panel II: Recognition of DTA by companies in 2008 RM200 RM RM % % - 20% % - 40% % - 60% % - 80% % - 99% % Tota l Table 9 Category II: Percentage of recognition of deferred tax assets based on total assets asset Panel I: Recognition of DTA by companies in 2007 less RM200 RM than - RM200 RM % More than 0% less than 100% %

10 asset Panel II: Recognition of DTA by companies in 2008 less RM200 RM than - RM200 RM % More than 0% less than 100% % Recognition of deferred tax assets based on auditors characteristics Table 10 presents the recognition rate for category I deferred tax assets by audit firms which are classified as Big 4 and non Big 4. Overall, the companies that are audited by these two types of audit firms do show some similar pattern of recognition. For both groups, there are 3 practices that are most common for recognition of deferred tax assets in category I. They are (1) no recognition of deferred tax asset, (2) minimal recognition (i.e. 1% -20%) of deferred tax assets and (3) 100% recognition of deferred tax assets. There is a slight difference between the practices of companies audited by the Big 4 firms and non Big 4 firms; companies audited by the Big 4 firms prefer to recognise minimal disclosure (1%-20%) than no disclosure at all. Table 10 Category I: Percentage of recognition of deferred tax assets based on Big 4 versus non Big 4 audit firms % recognised Non Big 4 Big 4 Non Big 4 Big 4 0% % - 20% % - 40% % - 60% % - 80% % - 99% % Table 11 presents the recognition rate for category II deferred tax assets by audit firms which are classified as Big 4 and non Big 4. Overall, the companies that are audited by these two types of audit firms do show some similar pattern of recognition. For both groups, there are 2 practices that are most common for recognition of deferred tax assets in category II. They are (1) no recognition of deferred tax asset is the most preferred choice, (2)there is a drastic decrease in the recognition of deferred tax assets from 2007 to Table 11 Category II: Percentage of recognition of deferred tax assets based on Big 4 versus non Big 4 audit firms % recognised Non Big 4 Big 4 Non Big 4 Big 4 10

11 0% More than 0% less than 100% % Table 12 presents the recognition rate of deferred tax assets among the Big 4 for category I. Overall, most of the companies that are audited by PWC, KPMG, EY and Deloitte show some common practices. The three most common practices are (1) not recognising deferred tax asset, (2) minimal recognition (i.e. 1% -20%) of deferred tax assets and (3) 100% recognition of deferred tax assets. However, there is a slight difference between the recognition practices of companies audited by EY and other Big 4 audit firms. Companies audited by EY prefer to recognise minimal recognition of deferred tax asset than no recognition at all. Table 12 Category I: Percentage of recognition of deferred tax assets based among the Big 4 audit firms % recognised PWC KPMG EY Deloitte PWC KPMG EY Deloitte 0% % - 20% % - 40% % - 60% % - 80% % - 99% % Table 13 presents the recognition rate of deferred tax assets among the Big 4 for category II. Companies audited by Deloitte consistently showed no recognition of deferred tax assets for this category in 2007 and For companies audited by PWC, there are two practices that are common among these companies: No recognition and full recognition of deferred tax assets. For the year 2007, there is more or less an equal number of companies audited by PWC that did not recognise at all deferred tax asset and recognise fully deferred tax assets for category II. However, for 2008, there is a shift in the balance. Companies audited by PWC prefer to not recognise at all deferred tax assets than to fully recognise deferred tax assets. For companies audited by KPMG and EY, they depict two similar practices. Firstly, there are three types of recognition of deferred tax assets for No recognition at all presents the most preferred method for these companies and the next preferred method is full recognition of deferred tax assets. The least preferred method of recognition is the percentage of recognition between 0% and 100%. Secondly, the types of recognition of deferred tax assets were reduced from three to two in No companies audited by EY and KPMG recognized deferred tax assets fully under category II. The most preferred practice for these companies is to not recognise at all deferred tax assets under category II. Table 13 Category II: Percentage of recognition of deferred tax assets based among the Big 4 audit firms PWC KPMG KPM EY Deloitte PWC EY G Deloitte % recognised 0% More than

12 0% less than 100% 100% Discussions and Conclusion Based on the findings of this study, there are several conclusions that could be made. Firstly, the rate of recognition of deferred tax assets for category I is more diversified than category II. Secondly, for category II, auditors characteristics do play a bigger role in the rate of recognition for deferred tax assets. The different practices adopted by auditors are due to the different interpretations in the requirements of para of FRS112 or the revised IAS 12. The revised IAS 12 does not define tax credit and investment tax credit despite an agenda paper being issued and discussions made on the definition. Hence, issue arises whether the tax allowances such as ITA and RA are eligible to be defined as tax credit. Therefore there are different opinion hence different practices by companies which are may or may not be guided by the opinions of their auditors. In July 2007, the agenda paper 8B recommends that tax credits are defined as a benefit granted by the tax authorities that takes the form of a deduction against tax payable and investment tax credits are defined as tax credits that are directly related to the acquisition of depreciable assets. However, this definition is not adopted by the IASB board in the final version of the revised IAS 12 in The absence of definition and the impact of differences of treatment can be of significance to financial reporting practices in Malaysia in this area. 6.0 References Ball, R., Robin, A. and Wu, J. (2003) Incentives Versus Standards: Properties of Accounting Income in four East Asian Countries, and Implications for Acceptance of IAS. Journal of Accounting and Economics, 36(1-3), Basu, S. (1997) The conservatism principle and the asymmetric timeliness of earnings, Journal of Accounting and Economics, 24(1), Beaver, W.H. and Ryan, S.G. (2005) Conditional and unconditi onal conservatism: concepts and modeling, Review of Accounting Studies, 10(2-3), Gaeremynck, A. and Van De Gucht, L. (2004) The Recognition and Timing of Deferred Tax Liabilities, Journal of Business and Finance and Accounting, 31(7) & (8), Hales, J., Ventaraman, S. and Wilks, T.J. (2011) Accounting for Lease Renewal Options: The Informational Effects of Unit of Account Choices, Hämäläinen, S (2011) The effect of institutional settings on accounting conservatism Empirical evidence from the Nordic countries and the transitional economies of Europe, PhD dissertation. Iatridis, G.E. (2011) Accounting Disclosures, Accounting Quality and Conditional and Unconditional Conservatism, International Review of Financial Analysis, 20 (2011), Jamal, K. and Tan, H.T. (2010) Joint Effects of Principles-Based versus Rules-based Standards and Auditor Type in Constraining financial Managers Aggressive Reporting, The Accounting Review, 85(4), Qiang, X. (2007) The effects of contra cting, litigation, regulation, and tax costs on conditional and unconditional conservatism, Journal of accounting Research, 37 (supplement),