CIMA. Paper F1. Financial Reporting and Taxation. Study Text

Transcription

1 CIMA Paper F1 Financial Reporting and Taxation Study Text

2 Published by: Kaplan Publishing UK Unit 2 The Business Centre, Molly Millars Lane, Wokingham, Berkshire RG41 2QZ Copyright 2015 Kaplan Financial Limited. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher. Acknowledgements We are grateful to the CIMA for permission to reproduce past examination questions. The answers to CIMA Exams have been prepared by Kaplan Publishing, except in the case of the CIMA November 2010 and subsequent CIMA Exam answers where the official CIMA answers have been reproduced. Notice The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. Kaplan is not responsible for the content of external websites. The inclusion of a link to a third party website in this text should not be taken as an endorsement. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library. ISBN: Printed and bound in Great Britain. ii

3 Contents Page Chapter 1 Fundamentals of Business Taxation 1 Chapter 2 Accounting for Investments in Subsidiaries and Associates 67 Chapter 3 Consolidated Statement of Financial Position 75 Chapter 4 Consolidated Statement of Profit or Loss and other comprehensive income 143 Chapter 5 Associates 173 Chapter 6 The Regulatory Environment 203 Chapter 7 The Conceptual Framework 221 Chapter 8 External Audit 247 Chapter 9 Code of Ethics 265 Chapter 10 Corporate governance 279 Chapter 11 Introduction to Single Entity Accounts 301 Chapter 12 IAS 7 Statement of Cash Flows 357 Chapter 13 Non current Assets 405 Chapter 14 IFRS 5 Non current Assets Held for Sale and Discontinued Operations 457 Chapter 15 IAS 20 Government Grants and IAS 40 Investment Properties 485 Chapter 16 IAS 2, 8, 10, 34 and IFRS Chapter 17 IAS 12 Income Taxes 543 Chapter 18 IAS 21 The Effects of Changes in Foreign Exchange Rates 563 Chapter 19 IAS 19 Employee benefits 579 Chapter 20 Short term finance and investments 597 Chapter 21 Working capital management 631 iii

4 Chapter 22 Working capital management accounts receivable and payable 679 Chapter 23 Working capital management inventory control 719 Chapter 24 Working capital management cash control 743 iv

5 chapter Intro Introduction v

6 How to use the materials These official CIMA learning materials have been carefully designed to make your learning experience as easy as possible and to give you the best chances of success in your Objective Test Examination. The product range contains a number of features to help you in the study process. They include: a detailed explanation of all syllabus areas; extensive practical materials; generous question practice, together with full solutions. This Study Text has been designed with the needs of home study and distance learning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to undertake extensive question practice. However, the Study Text is also ideal for fully taught courses. The main body of the text is divided into a number of chapters, each of which is organised on the following pattern: Detailed learning outcomes. These describe the knowledge expected after your studies of the chapter are complete. You should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading. Step by step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters. Activities. Some chapters are illustrated by more practical elements, such as comments and questions designed to stimulate discussion. vi

7 Question practice. The text contains three styles of question: Exam style objective test questions (OTQs) 'Integration' questions these test your ability to understand topics within a wider context. This is particularly important with calculations where OTQs may focus on just one element but an integration question tackles the full calculation, just as you would be expected to do in the workplace. Case style questions these test your ability to analyse and discuss issues in greater depth, particularly focusing on scenarios that are less clear cut than in the Objective Test Examination, and thus provide excellent practice for developing the skills needed for success in the Operational Level Case Study Examination. Solutions. Avoid the temptation merely to audit the solutions provided. It is an illusion to think that this provides the same benefits as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, where provided, and then make your own attempt before referring back to the full solution. If you work conscientiously through this Official CIMA Study Text according to the guidelines above you will be giving yourself an excellent chance of success in your Objective Test Examination. Good luck with your studies! Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an to mykaplanreporting@kaplan.com with full details, or follow the link to the feedback form in MyKaplan. Our Quality Co ordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. Icon Explanations Definition These sections explain important areas of knowledge which must be understood and reproduced in an assessment environment. Key point Identifies topics which are key to success and are often examined. Supplementary reading These sections will help to provide a deeper understanding of core areas. The supplementary reading is NOT optional reading. It is vital to provide you with the breadth of knowledge you will need to address the wide range of topics within your syllabus that could feature in an assessment question. Reference to this text is vital when self studying. Test your understanding Following key points and definitions are exercises which give the opportunity to assess the understanding of these core areas. vii

8 Illustration To help develop an understanding of particular topics. The illustrative examples are useful in preparing for the Test your understanding exercises. Exclamation mark This symbol signifies a topic which can be more difficult to understand. When reviewing these areas, care should be taken. Study technique Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section we briefly outline some tips for effective study during the earlier stages of your approach to the Objective Test Examination. We also mention some techniques that you will find useful at the revision stage. Planning To begin with, formal planning is essential to get the best return from the time you spend studying. Estimate how much time in total you are going to need for each subject you are studying. Remember that you need to allow time for revision as well as for initial study of the material. With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and final question practice. Prepare a written schedule summarising the above and stick to it! It is essential to know your syllabus. As your studies progress you will become more familiar with how long it takes to cover topics in sufficient depth. Your timetable may need to be adapted to allocate enough time for the whole syllabus. Students are advised to refer to the notice of examinable legislation published regularly in CIMA s magazine (Financial Management), the students e newsletter (Velocity) and on the CIMA website, to ensure they are up to date. The amount of space allocated to a topic in the Study Text is not a very good guide as to how long it will take you. The syllabus weighting is the better guide as to how long you should spend on a syllabus topic. viii

9 Tips for effective studying (1) Aim to find a quiet and undisturbed location for your study, and plan as far as possible to use the same period of time each day. Getting into a routine helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to minimise interruptions. (2) Store all your materials in one place, so that you do not waste time searching for items every time you want to begin studying. If you have to pack everything away after each study period, keep your study materials in a box, or even a suitcase, which will not be disturbed until the next time. (3) Limit distractions. To make the most effective use of your study periods you should be able to apply total concentration, so turn off all entertainment equipment, set your phones to message mode, and put up your do not disturb sign. (4) Your timetable will tell you which topic to study. However, before diving in and becoming engrossed in the finer points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your Study Text. With experience, you will learn to assess the pace you need to work at. Each study session should focus on component learning outcomes the basis for all questions. (5) Work carefully through a chapter, making notes as you go. When you have covered a suitable amount of material, vary the pattern by attempting a practice question. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered more briefly. Be aware that all component learning outcomes will be tested in each examination. (6) Make notes as you study, and discover the techniques that work best for you. Your notes may be in the form of lists, bullet points, diagrams, summaries, mind maps, or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. (7) Organise your notes. Make sure that all your notes, calculations etc. can be effectively filed and easily retrieved later. ix

10 Objective Test Objective Test questions require you to choose or provide a response to a question whose correct answer is predetermined. The most common types of Objective Test question you will see are: Multiple choice, where you have to choose the correct answer(s) from a list of possible answers. This could either be numbers or text. Multiple choice with more choices and answers, for example, choosing two correct answers from a list of eight possible answers. This could either be numbers or text. Single numeric entry, where you give your numeric answer, for example, profit is $10,000. Multiple entry, where you give several numeric answers. True/false questions, where you state whether a statement is true or false. Matching pairs of text, for example, matching a technical term with the correct definition. Other types could be matching text with graphs and labelling graphs/diagrams. In every chapter of this Study Text we have introduced these types of questions, but obviously we have had to label answers A, B, C etc rather than using click boxes. For convenience we have retained quite a few questions where an initial scenario leads to a number of sub questions. There will be questions of this type in the Objective Test Examination but they will rarely have more than three sub questions. Guidance re CIMA on screen calculator As part of the CIMA Objective Test software, candidates are now provided with a calculator. This calculator is on screen and is available for the duration of the assessment. The calculator is available in each of the Objective Test Examinations and is accessed by clicking the calculator button in the top left hand corner of the screen at any time during the assessment. All candidates must complete a 15 minute tutorial before the assessment begins and will have the opportunity to familiarise themselves with the calculator and practise using it. Candidates may practise using the calculator by downloading and installing the practice exam at The calculator can be accessed from the fourth sample question (of 12). x

11 Please note that the practice exam and tutorial provided by Pearson VUE at is not specific to CIMA and includes the full range of question types the Pearson VUE software supports, some of which CIMA does not currently use. Fundamentals of Objective Tests The Objective Tests are 90 minute assessments comprising 60 compulsory questions, with one or more parts. There will be no choice and all questions should be attempted. Structure of subjects and learning outcomes Each subject within the syllabus is divided into a number of broad syllabus topics. The topics contain one or more lead learning outcomes, related component learning outcomes and indicative knowledge content. A learning outcome has two main purposes: (a) To define the skill or ability that a well prepared candidate should be able to exhibit in the examination. (b) To demonstrate the approach likely to be taken in examination questions. The learning outcomes are part of a hierarchy of learning objectives. The verbs used at the beginning of each learning outcome relate to a specific learning objective, e.g. Calculate the break even point, profit target, margin of safety and profit/volume ratio for a single product or service. The verb calculate indicates a level three learning objective. The following tables list the verbs that appear in the syllabus learning outcomes and examination questions. xi

12 CIMA VERB HIERARCHY CIMA place great importance on the definition of verbs in structuring Objective Test Examinations. It is therefore crucial that you understand the verbs in order to appreciate the depth and breadth of a topic and the level of skill required. The Objective Tests will focus on levels one, two and three of the CIMA hierarchy of verbs. However they will also test levels four and five, especially at the management and strategic levels. You can therefore expect to be tested on knowledge, comprehension, application, analysis and evaluation in these examinations. Level 1: KNOWLEDGE What you are expected to know. VERBS USED List State Define DEFINITION Make a list of. Express, fully or clearly, the details of/facts of. Give the exact meaning of. For example you could be asked to make a list of the advantages of a particular information system by selecting all options that apply from a given set of possibilities. Or you could be required to define relationship marketing by selecting the most appropriate option from a list. Level 2: COMPREHENSION What you are expected to understand. VERBS USED Describe Distinguish Explain Identify Illustrate DEFINITION Communicate the key features of. Highlight the differences between. Make clear or intelligible/state the meaning or purpose of. Recognise, establish or select after consideration. Use an example to describe or explain something. For example you may be asked to distinguish between different aspects of the global business environment by dragging external factors and dropping into a PEST analysis. xii

13 Level 3: APPLICATION How you are expected to apply your knowledge. VERBS USED DEFINITION Apply Calculate For example you may need to calculate the projected revenue or costs for a given set of circumstances. Level 4: ANALYSIS Put to practical use. Ascertain or reckon mathematically. Demonstrate Prove with certainty or exhibit by practical means. Prepare Reconcile Solve Tabulate Make or get ready for use. Make or prove consistent/compatible. Find an answer to. Arrange in a table. How you are expected to analyse the detail of what you have learned. VERBS USED Analyse Categorise Compare/ contrast Construct Discuss Interpret Prioritise Produce DEFINITION Examine in detail the structure of. Place into a defined class or division. Show the similarities and/or differences between. Build up or compile. Examine in detail by argument. Translate into intelligible or familiar terms. Place in order of priority or sequence for action. Create or bring into existence. For example you may be required to interpret an inventory ratio by selecting the most appropriate statement for a given set of circumstances and data. xiii

14 Level 5: EVALUATION How you are expected to use your learning to evaluate, make decisions or recommendations. VERBS USED DEFINITION Advise Evaluate Counsel, inform or notify. Appraise or assess the value of. Recommend Propose a course of action. For example you may be asked to recommend and select an appropriate course of action based on a short scenario. xiv

15 PRESENT VALUE TABLE Present value of 1.00 unit of currency, that is ( 1+ r ) n where r = interest rate; n = number of periods until payment or receipt. Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

16 Cumulative present value of 1.00 unit of currency per annum, Receivable or Payable at the end of each year for n years Periods (n) n 1 (1+ r ) r Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods (n) Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

17 F1 FINANCIAL REPORTING AND TAXATION Syllabus overview F1 covers the regulation and preparation of financial statements and how the information contained in them can be used. It provides the competencies required to produce financial statements for both individual entities and groups using appropriate international financial reporting standards. It also gives insight into how to effectively source and manage cash and working capital, which are essential for both the survival and success of organisations. The final part focuses on the basic principles and application of business taxation. The competencies gained from F1 form the basis for developing further insights into producing and analysing complex group accounts (covered in F2) and formulating and implementing financial strategy (covered in F3). Summary of syllabus Weight Syllabus topic 10% A. Regulatory environment for financial reporting and corporate governance 45% B. Financial accounting and reporting 20% C. Management of working capital, cash and sources of short-term finance 25% D. Fundamentals of business taxation

18 F1 A. REGULATORY ENVIRONMENT FOR FINANCIAL REPORTING AND CORPORATE GOVERNANCE (10%) Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component 1 explain the need for and the process of regulating the financial reporting information of incorporated entities. (a) explain the need for the regulation of the financial reporting information of incorporated entities and the key elements of an ethical regulatory environment for such information (b) explain the roles and structures of the key bodies involved in the regulation of financial reporting information (c) explain the scope of IFRS and how they are developed The need for the regulation of financial reporting information. Key elements of the regulatory environment for financial reporting including local corporate law, local and international conceptual frameworks, local and international financial reporting standards and other regulatory bodies. Sources of professional codes of ethics. Provisions of the CIMA Code of Ethics for Professional Accountants of particular relevance to the preparation of financial reporting information. Rules-based versus principles-based approaches to accounting regulation. Role and structure of: The IFRS Foundation. The International Accounting Standards Board (IASB). IFRS Advisory Council. IFRS Interpretations Committee. International Organisation of Securities Commissions (IOSCO). Interaction of local GAAP bodies with the IASB. Scope of specific standards in specialised circumstances IAS 26 Accounting and Reporting by Retirement Benefit Plans, IAS 41 Agriculture, IFRS 4 Insurance Contracts, IFRS 6 Exploration for and Evaluation of Mineral Resources and IFRS for SMEs (specific knowledge of these standards will not be tested). The standard setting process for IFRS.

19 Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component (d) describe the role of the external auditor in the Powers and duties of external auditors. context of the financial reporting information of Content of the audit report. incorporated entities and the content and Types of audit report. significance of the audit report. Significance of the audit report. 2 discuss the need for and key principles of corporate governance regulation. (a) discuss the need for and scope of corporate governance regulation (b) compare and contrast the approach to corporate governance in different markets. The need for corporate governance regulation. Scope of corporate governance regulation. Approach to corporate governance regulations in primary markets around the world, in particular the US and UK. Key differences in approach across these markets.

20 F1 B. FINANCIAL ACCOUNTING AND REPORTING (45%) Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component 1 explain the main elements of and key principles underpinning financial statements prepared in accordance with international financial reporting standards. 2 produce the primary financial statements of an individual entity incorporating accounting transactions and adjustments, in accordance with relevant international financial reporting standards, in an ethical manner. (a) describe the main elements of financial statements prepared in accordance with IFRS (b) explain the key principles contained within the IASB s Conceptual Framework for Financial Reporting. (a) produce the primary financial statements from trial balance for an individual entity in accordance with IFRS (b) apply the rules contained in IFRS to generate appropriate accounting entries in respect of reporting performance, accounting for taxation, employee benefits, non-current assets, accounting for government grants, impairment, inventories and events after the reporting period Content of financial statements as specified in: preface to IFRS IAS 1 Presentation of Financial Reporting IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors IAS 34 Interim Financial Reporting IFRS 8 Operating Segments. Key principles of the Conceptual Framework for Financial Reporting. Broad principles of accounting for fair values (contained in IFRS 13 Fair Value Measurement). Production of the: statement of financial position statement of comprehensive income statement of changes in equity statement of cash flows for a single incorporated entity in accordance with IAS 1 Presentation of Financial Reporting and IAS 7 Statement of Cash Flows. Reporting performance IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and IAS 21 The Effects of Changes in Foreign Exchange Rates (individual transactions only). Accounting for taxation IAS 12 Income Taxes (not deferred tax). Employee benefits IAS 19 Employee Benefits. Non-current assets IAS 16 Property, Plant and Equipment, IAS 23 Borrowing Costs, IAS 38 Intangible Assets, IAS 40 Investment Property, and IFRS 5 Non-current Assets Held for Sales and Discontinued Operations.

21 Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component Accounting for government grants IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. Impairment IAS 36 Impairment of Assets. Inventories IAS 2 Inventories. Events after the reporting period IAS 10 Events after the Reporting Period. 3 produce the consolidated statement of financial position and consolidated statement of comprehensive income in accordance with relevant international financial reporting standards, in an ethical manner. (c) discuss the ethical selection and adoption of relevant accounting policies and accounting estimates. (a) explain whether an investment in another entity constitutes a subsidiary or an associate relationship in accordance with relevant international financial reporting standards (b) explain situations where a parent entity is exempt from preparing consolidated financial statements (c) produce the consolidated statement of financial position and statement of comprehensive income in accordance with relevant IFRS for a group comprising of one or more subsidiaries (being either wholly or partially directly owned) or associates, including interests acquired part way through an accounting period. Ethics in financial reporting in respect of selection and adoption of accounting policies and estimates. Provisions of IFRS 10 Consolidated Financial Statements and IAS 28 Investments in Associates in respect of power to control and significant influence. Exemptions from preparing consolidated financial statements, in accordance with IFRS 10 Consolidated Financial Statements and the requirements of IAS 27 Separate Financial Statements. Principles of full consolidation and equity accounting in accordance with IFRS 3 Business Combinations and IAS 28 Investments in Associates. Production of: consolidated statement of financial position consolidated statement of comprehensive income.

22 Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component Including the adoption of both full consolidation and the principles of equity accounting, in accordance with the provisions of IAS 1 Presentation of Financial Statements, IAS 28 Investments in Associates, IFRS 3 Business Combinations and IFRS 10 Consolidated Financial Statements. Note: Fair value adjustments in respect of assets and liabilities at acquisition will not be tested, however noncontrolling interests at either fair value or share of net assets will be tested.

23 F1 C. MANAGEMENT OF WORKING CAPITAL, CASH AND SOURCES OF SHORT-TERM FINANCE (20%) Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component 1 describe the sources of short-term finance (a) describe the sources of short-term finance and Types of short-term finance including trade and cash investment. methods of short-term cash investment available payables, overdrafts, short-term loans and debt to an entity. factoring. Types of cash investment including interestbearing deposits, short-term treasury bills and other securities. 2 evaluate the working capital position of an entity. (a) analyse trade receivables, trade payables and inventory ratios (b) discuss policies for the management of the total level of investment in working capital and for the individual elements of working capital Calculation of trade receivable, trade payable and inventory days. Interpretation of the ratios either in comparison to prior periods, competitors or to the industry as a whole, taking into account the nature of the industry. Working capital cycle. Policies for the management of the total level of investment in working capital aggressive, moderate and conservative. Methods of trade receivables management, including credit control procedures. Methods of trade payables management and significance of trade payables as a source of finance and how this affects the relationship with suppliers. Methods of inventory management, including calculations of the economic order quantity (EOQ). (c) evaluate working capital policies Financial impact of changing working capital policies. Impact and risks of overtrading. Identification of areas for improvement. (d) discuss approaches to the financing of working Approaches to the financing of the investment in capital investment levels. working capital aggressive, moderate and conservative.

24 Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component 3 analyse the short-term cash position of an (a) discuss measures to manage the short-term Preparation of short-term cash flow forecasts. entity. cash position of an entity. Identification of surpluses or deficits from cash flow forecasts. Selection of appropriate short-term solutions. Principles of investing short term including maturity, return, security and liquidity.

25 F1 D. FUNDAMENTALS OF BUSINESS TAXATION (25%) Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component 1 discuss the types of taxation that typically apply to an incorporated entity and the regulatory environment for taxation. (a) discuss the features of the types of indirect and direct taxation that typically apply to an incorporated entity (b) discuss the regulatory environment for taxation, including the distinction between tax evasion and tax avoidance. Definitions of direct taxation, indirect taxation, taxable person, incidence and competent jurisdiction. Types of taxation progressive, proportional and regressive. Features of the following types of indirect taxation: unit taxes ad valorem taxes excise duties property and wealth taxes consumption taxes mechanism of value added tax in the context of an incorporated entity. Features of the following types of direct taxation: tax on trading income capital taxes. Impact of employee taxation. Sources of taxation rules such as domestic legislation, court rulings, domestic interpretations and guidelines, EU guidelines and taxation agreements between different countries. Administration of taxation including the principles of record keeping, deadlines and penalties. Powers of taxation authorities. Distinction between tax evasion and tax avoidance and the ethical considerations faced by an entity in respect of tax avoidance.

26 Learning outcomes On completion of their studies, students should be able to: Indicative syllabus content Lead Component 2 explain the taxation issues that may apply to an incorporated entity that operates internationally. 3 produce computations for corporate income tax and capital tax. (a) explain the taxation issues that may apply to an incorporated entity that operates internationally. (a) produce corporate income tax computations from a given set of rules (b) produce capital tax computations from a given set of rules. International taxation issues: the concept of corporate residence and the key bases of determining residence types of overseas operations: subsidiary or branch and the implications of each on taxation issue of double taxation and the methods of gaining relief types of foreign taxation and the distinction between withholding tax and underlying tax (calculations will not be tested) transfer pricing and related, ethical and taxation issues. Distinction between accounting profit and taxable profit and the reconciliation between them. This will include (based upon a set of rules given in the examination): identification and treatment of exempt income or income taxed under different rules identification and treatment of disallowable expenditure replacement of accounting depreciation with tax depreciation calculation of tax depreciation allowances calculation of corporate income tax liability relief for trading losses. Principle of a capital tax computation on the sale of an asset. Allowable costs. Methods of relieving capital losses. Concept of rollover relief.

27 chapter 1 Fundamentals of Business Taxation Chapter learning objectives On completion of their studies students should be able to: Discuss the features of the types of indirect and direct taxation that typically apply to an incorporated entity. Discuss the regulatory environment for taxation, including the sources of taxation rules, record keeping, powers of tax authorities and the distinction between taxation evasion and avoidance. Explain the taxation issues that may apply to an incorporated entity that operates internationally such as the concept of corporate residence, the types of overseas operations, the principles of double taxation relief and the types of foreign taxation. Prepare corporate income tax calculations based on a given set of rules. Prepare capital tax computations from a given set of rules. 1

28 Fundamentals of Business Taxation 1 Session content 2 Introduction The Government needs tax revenues to finance expenditure such as the Health Service, Retirement Pensions, Social Benefits and to finance Government borrowing. The Government will use tax to stimulate one sector of the economy and control another. For example, allowances on capital expenditure may develop the manufacturing sector, while high taxes on tobacco and alcohol may discourage sales. In Wealth of Nations, Adam Smith proposed that a good tax should have the following characteristics: fair (reflect person s ability to pay) absolute (certain not arbitrary) convenient (easy to pay) efficient (low collection costs) The 3 major principles of good tax policy are as follows: equity A good tax should be fairly levied between one taxpayer and another. efficiency A good tax should be cheap and easy to collect, i.e. UK tax system uses the PAYE (pay as you earn) to collect tax at source on salaries and wages. economic effects A good tax should consider the way in which a tax should be collected. 2

29 chapter 1 What is a good tax? The American Institution of Certified Public Accountants lists the following principles that a good tax policy should have: equity and fairness transparency and visibility certainty economy in collection convenience of payment simplicity appropriate government revenues (determining the amount of tax revenues and date of collection) minimum tax gap (the difference between actual collection and amount due) neutrality economic growth and efficiency It is not always possible to incorporate all ten into a tax system. Definition of terms A tax is either a direct or indirect tax. Direct taxes These are imposed directly on the person or enterprise required to pay the tax, i.e. tax on personal income such as salaries, tax on business profits or tax on disposals of chargeable assets. The person or enterprise must pay the tax directly to the tax authorities on their income. Examples in the UK of direct taxes would be income tax, capital gains tax or corporation tax. Indirect taxes This tax is imposed on one part of the economy with the intention that the tax burden is passed on to another. The tax is imposed on the final consumer of the goods or services. The more the consumer consumes the greater the tax paid. An example would be sales tax such as VAT in the UK. 3

30 Fundamentals of Business Taxation Incidence The incidence of a tax is the distribution of the tax burden, i.e. who is paying the tax. What is incidence? Incidence This can be split into two elements: (1) Formal incidence: this is the person who has direct contact with the tax authorities, i.e. who is legally obliged to pay the tax. (2) Actual Incidence: this is the person who actually ends up bearing the cost of the tax, i.e. who actually bears the burden of the tax. If we consider VAT the formal incidence would be the entity making the sale because they will be responsible for making the payment to the relevant tax authorities. The actual incidence would be the consumer who bears the cost of the tax when they make a purchase from the entity. Taxable person The person accountable for the tax payment, e.g. individual or entity. Competent jurisdiction A taxable person normally pays tax in the country of origin. Competent jurisdiction is the tax authority that has the legal power to assess and collect the taxes. This is usually the combined responsibility of the central government and local authorities within a country. The tax law is enforceable by sanction (fines or imprisonment). Hypothecation This means that certain taxes are devoted entirely to certain types of expenditure, e.g. road tax is used entirely on maintaining roads, London congestion charge is used to pay for transport for the area. Tax gap This is the gap between the tax theoretically collectable and the amount actually collected. The tax authorities will aim to minimise this gap. 4

31 chapter 1 Tax rate structure There are three types of taxes: (1) Progressive taxes: These take an increasing proportion of income as income rises. (E.g. UK Income tax 20%, 40%, 50%). (2) Proportional taxes: These take the same proportion of income as income rises. (3) Regressive taxes: These take a decreasing proportion of income as income rises. (E.g. UK National Insurance contributions 11% then 1%). Tax rate structure Progressive tax means the proportion of tax increases as income increases, i.e. salary $10,000 pays tax of $1,000 = 10% but a salary of $20,000 pays tax of $3,000 = 15%. Proportionate tax means the proportion of tax remains the same, regardless of the level of income, i.e. salary $10,000 pays tax of $1,000 = 10% and a salary of $20,000 pays tax of $2,000 = 10%. Regressive tax means the proportion of tax reduces as income increases, i.e. salary $10,000 pays tax of $1,000 = 10% but a salary of $20,000 pays tax of $1,800 = 9%. Source of tax rules The sources of tax rules are as follows: Legislation produced by a national government of the country, e.g. Finance Acts in the UK. Precedents based on previous legislation. Tax authorities also issue interpretations, e.g. Tax bulletins in the UK. Directives from international bodies such as European Union guidelines on VAT. Agreements between different countries such as double tax treaties, e.g. UK/US Double tax treaties. 5

32 Fundamentals of Business Taxation Income can be taxed twice Foreign income is often taxed twice, once in the country of origin and once in the country of residency. In order to avoid this "double taxation", countries enter into tax treaties, see later in the chapter for types of double taxation relief. Tax base Taxes are classified according to their tax base (what is being taxed). Income or profits e.g. Income and Corporation tax in the UK Assets e.g. Capital gains tax in the UK Consumption e.g. Sales tax in the UK Most countries separate different types of income into categories and have a set of rules to determine how that income will be taxed. 3 Direct taxes There are two types of direct tax you need to consider: Tax on trading income Trading income relates to income from the main business activity. The tax base should be profits. The accounting profit needs to be adjusted for tax purposes as in many countries there are differences between what the accounting standards allow you to show as an income/expense and what the tax system deems to be the income/expense. These adjusted profits will enable you to calculate the taxable profit. The standard proforma is as follows: Accounting profit Less: income exempt from tax or taxed under other rules Add: disallowable expenses Add: accounting depreciation Less: tax depreciation Taxable profit $ X (X) X X (X) X 6

33 chapter 1 The taxable profit will then be charged at the appropriate tax rate for that accounting period. The rules for allowed and disallowed items will vary according to the tax regime of the country in question. This will always be given in the assessment question. Calculation of the trading profit The accounting profit is the profit shown in financial statements before taxation. Income exempt from tax or taxed under other rules is any income included in the accounting profit which does not relate to the main trading activity, i.e. rental income, dividend income, interest receivable, etc, that maybe taxed under other rules or income exempt from taxation under that particular countries rules. Disallowable expenses are expenses that have been deducted from the accounting profit, i.e. they are allowable under the accounting standards, but for tax purposes can't be claimed. These expenses will differ from country to country and the examiner will always tell you the rules for that particular country in the question. Examples of disallowable expenses in the UK are entertaining customers, gift aid payments, political donations. Depreciation is added back because it is an accounting entry that is not allowed for tax purposes because it is too subjective (i.e. you can choose the way to depreciate your assets). It is replaced with tax depreciation. Tax depreciation may be called capital allowances in the exam. The rules will be given in the exam to tell you what can be claimed. It is a replacement for depreciation. They are often given on a reducing balance basis. Allowances are given if the asset is owned at the accounting date, i.e. no time apportionment for mid year acquisitions. 7

34 Fundamentals of Business Taxation Test your understanding 1 Trading income In year ending 31/03/20X2, an entity George made an accounting profit of $80,000. Profit included $5,500 of entertaining costs which are disallowable for tax purposes and $8,000 of income exempt from taxation. George has no capital items. Tax is charged at 25%. Calculate the tax payable for the year ended 31/03/X2. Illustration 1 Trading income In year ending 31/12/20X1 an entity Zippy made an accounting profit of $50,000. Profit included $3,500 of entertaining expenses which are disallowable for tax purposes and $5,000 of income exempt from taxation. Zippy has $70,000 of non current assets which were acquired on 01/01/20X0 and are depreciated at 10% on cost. Tax depreciation rates are 20% reducing balance. Calculate the accounting depreciation for the year ended 31/12/X1. Solution The accounting depreciation is $70,000 10% = $7,000 Illustration 2 Trading income Using the information from illustration 1 calculate the tax depreciation for the year ended 31/12/X1. 8

35 chapter 1 Solution Tax depreciation WDV at start of year $56,000 ($70,000 80%) Tax depreciation at 20% $11,200 The asset had been purchased in the previous accounting period, therefore tax depreciation has already been claimed for Ye. 31/12/X0. This year's tax depreciation must be calculated on the tax WDV at the beginning of the year, i.e. $56,000. WDV means written down value. This represents the cost of the asset less accumulated tax depreciation. Illustration 3 Trading income Using the information from illustrations 1 and 2 calculate the taxable profit for the year ended 31/12/X1. Solution $ Accounting profit 50,000 Less: exempt income (5,000) Add back: disallowable expenses 3,500 Add back: depreciation (illustration 1) 7,000 Less: tax depreciation (illustration 2) (11,200) Taxable profit 44,300 Illustration 4 Trading income Using the information from illustrations 1 to 3 calculate the tax payable for the year ended 31/12/X1. You should assume a tax rate of 30%. 9

36 Fundamentals of Business Taxation Solution $ Accounting profit 50,000 Less: exempt income (5,000) Add back: disallowable expenses 3,500 Add back: depreciation (illustration 1) 7,000 Less: tax depreciation (illustration 2) (11,200) Taxable profit 44,300 Tax at 30% 13,290 Test your understanding 2 Trading income In year ending 31/03/20X2, an entity Bungle made an accounting profit of $60,000. Profit included $4,500 of political donations which are disallowable for tax purposes and $4,000 of income exempt from taxation. Bungle has $10,000 of plant and machinery which was acquired on 01/04/20X0 and purchased a new machine costing $5,000 on 01/04/20X1. This new machine is entitled to FYAs (first year allowances) of 100% instead of the usual tax depreciation. All plant and machinery is depreciated in the accounts at 10% on cost. Tax depreciation rates on plant and machinery are 20% reducing balance. Bungle also has a building that cost $100,000 on 01/04/20X0 and is depreciated in the accounts at 4% on a straight line basis. Tax depreciation is calculated at 3% on a straight line basis. Calculate the total accounting depreciation for the year ended 31/03/X2. Test your understanding 3 Trading income Using the information from TYU 2 calculate the total tax depreciation for the year ended 31/03/X2. 10