financial accounting and tax principles - gbv system managerial level financial accounting and tax...

CIMA'S OfficialLearning System

Managerial Level

Financial Accountingand Tax Principles

Tom Rolfe

ELSEVIERAMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD

PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO

Contents

The C IMA Learning System xixAcknowledgements , xixHow to use the CIMA Learning System xixGuide to the Icons used within this Text xxStudy technique xxiFinancial Accounting and Tax Principles xxiii

1 Principles of Business Taxation - Introduction 1Learning Outcomes ^ 3Learning aims 3

1.1 Introduction 31.2 Taxation as a source of government revenue 41.3 Principles of taxation 4

1.3.1 Canons of taxation 41.3.2 The American Institute of Certified Public Accountants'

(AICPA) statement - Guiding Principles of Good TaxPolicy: A Framework for Evaluating Tax Proposals 5

1.4 Basic tax terminology 51.4.1 Direct taxes 51.4.2 Indirect taxes 61.4.3 Incidence 61.4.4 Taxable person 61.4.5 Competent jurisdiction 61.4.6 Hypothecation 71.4.7 Withholding responsibilities 71.4.8 Tax rate structure 71.4.9 The tax gap 8

1.5 Tax bases and classification of taxes 81.6 Sources of tax rules 91.7 Summary 9

Revision Questions 11

Solutions to Revision Questions 13

2 Direct Taxes on an Entity's Profits and Gains 15Learning Outcome 17

2.1 Introduction 172.2 The corporate tax base 18

2.2.1 Schedular systems of corporate taxation 182.2.2 Classification of income 192.2.3 Expenditure 202.2.4 Capital gains 23

in

iv FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7

£ 2.3 Nominal corporate tax rates 24\H 2.4 The interaction of the corporate tax system with the personal tax system 24O 2.4.1 Classical system 25u ' 2.4.2 Imputation system 25

2.4.3 Partial imputation system 252.4.4 Split rate systems 252.4.5 Examples to illustrate the difference between traditional

and imputation systems 262.5 Rules recharacterising interest as dividends 262.6 Treatment of losses 27

2.6.1 Trading losses 272.6.2 Capital losses 272.6.3 Cessation of business 28

2.7 The concept of tax consolidation 282.7.1 Capital losses and tax groups 29

2.8 Summary 29



3 Indirect Taxes a n d Employee Taxat ion 37Learning Outcome 39

3.1 Introduction 393.2 Indirect taxes collected by the entity 40

3.2.1 Unit taxes-and ad valorem taxes 403.3 Consumption taxes 40

3.3.1 Single-stage sales taxes 403.3.2 Multi-stage sales taxes 40

3.4 Value-added tax 413.4.1 Transactions liable to VAT 42

3.5 Indirect taxes paid by the entity 433.5.1 Excise duties 433.5.2 Property taxes 443.5.3 Wealth taxes 44

3.6 Employee taxation 453.6.1 The employee as a separate taxable person subject

to a personal income tax regime 453.6.2 Social security contributions 463.6.3 Other payroll taxes 46

3.7 Use of employer reporting and withholding to ensurecompliance and assist tax collection 46

3.8 Summary 46



4 Administration of Taxation 55Learning Outcomes 57

4.1 Introduction 57

FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 v

4.2 The need for record-keeping and record retention 58 Q4.2.1 Corporate income tax 58 Z4.2.2 Sales tax or VAT 58 z4.2.3 Overseas subsidiaries 59 °°4.2.4 Employee taxes and social security 59

4.3 The need for deadlines for reporting (filing returns) and tax payments 594.4 Types of powers of tax authorities to ensure compliance with tax rules 60

4.4.1 Power to review and query filed returns 604.4.2 Power to request special reports or returns 604.4.3 Power to examine records (generally extending back some years) 614.4.4 Powers of entry and search 614.4.5 Exchange of information with tax authorities in other jurisdictions 61

4.5 Tax avoidance and tax evasion 614.5.1 Tax evasion 624.5.2 Tax avoidance 624.5.3 Statutory general anti-avoidance provisions and case law regimes 62

4.6 Forum on tax administration 634.7 International tax dialogue 634.8 Summary 64



International Taxation 69Learning Outcome 71

5.1 Introduction 715.2 The Organisation for Economic Co-operation and Development

(OECD) - Model tax convention 715.3 The concept of corporate residence 72

5-3.1 Place of control and central management of an entity 725.3.2 Place of incorporation 725.3.3 Place of control and place of incorporation 72

5.4 The OECD Articles of the model convention with respect totaxes on income and on capital 73

5.5 Withholding tax 735.6 Underlying tax 745.7 Means of establishing a taxable presence in another country 74

5.7.1 Subsidiary 745.7.2 Branch 75

5.8 Double taxation treaties 755.8.1 The OECD model tax convention 765.8.2 Principles of relief for foreign taxes 76

5.9 Summary 77

Revision Questions 79Solutions to Revision Questions 83

v i FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7

| 6 Taxation in Financial Statements 85b; Learning Outcome 87O 6.1 Introduction 87

6.2 Calculation of current tax 886.3 Accounting for current tax 886.4 Calculation of deferred tax 89

6.4.1 Introduction to deferred tax 896.4.2 Timing difference approach 906.4.3 Temporary difference approach 916.4.4 Deferred tax assets 936.4.5 Tax losses 93

6.5 Accounting for deferred tax 946.6 Income tax charge 956.7 Disclosure 966.8 Summary 96


7 The IASC and the Standard-Setting Process 113Learning Outcomes 115Learning aims 115

7.1 The need for regulation of financial statements 1167.2 Variation from country to country 116

7.2.1 Sources offinance and capital markets 1167.2.2 The political system 1167.2.3 Entity ownership 1177.2.4 Cultural differences 117

7.3 Harmonisation versus standardisation 1177.3.1 The need for harmonisation of accounting standards 117

7.4 Elements that might be expected in a regulatory frameworkfor published accounts 1187.4.1 Local law that applies to entities 1187.4.2 Locally adopted accounting standards 1197.4.3 Local stock exchange requirements 1197.4.4 International body requirements 1197.4.5 International accounting standards 1197.4.6 Locally developed or international conceptual framework

for accounting 1197.5 Generally accepted accounting practice (GAAP) • 1197.6 The International Accounting Standards Committee Fo.undation

(IASC Foundation) 1207.6.1 Structure of the IASC Foundation 1217.6.2 IASC Foundation 1217.6.3 The International Accounting Standards Board (IASB) 1227.6.4 The International Financial Reporting Interpretations

Committee (IFRIC) 1227.6.5 The Standards Advisory Council (SAC) 123

FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 v i i

7.7 Objectives of the IASC Foundation 123 Q7.8 The International Organisation of Securities Commissions (IOSCO) 123 Z,7.9 Local regulatory bodies 124 z

7.9.1 Convergence activities 124 °°7.9.2 International reaction 124

7.10 The standard-setting process 1257.10.1 Development of a standard 1257.10.2 Other aspects of due process 1267.10.3 Co-ordination with national standard-setting 1267.10.4 Benchmark treatments and allowed alternatives 126

7.11 Ways in which IFRS's are used by countries 1267.11.1 Adoption as local GAAP 1277.11.2 Model for local GAAP 1277.11.3 Persuasive influence in formulating local GAAP 1277.11.4 Local GAAP developed with little or no reference to IFRS's 127

7.12 Summary 127



8 Regulatory Framework 137Learning Outcome 139

8.1 Introduction 1398.2 The development of the Framework 140

8.2.1 Purpose of the Framework 1408.2.2 Status of the Framework 1408.2.3 Scope of the Framework 140

8.3 The Framework 1418.3.1 The obj ective of financial statements 1418.3.2 Underlying assumptions 1418.3.3 The qualitative characteristics of financial information 1428.3.4 The elements of financial statements 1438.3.5 Recognition of the elements of financial statements 1448.3.6 Measurement of the elements of financial statements 1448.3.7 Concepts of capital and capital maintenance 145

8.4 Usefulness of a conceptual Framework 1458.5 The IASB's Framework and the standard-setting process 1468.6 Summary 146



9 The Role of the External Auditor 155Learning Outcome 157

9.1 External audit 1579.1.1 The purpose of an audit 1579.1.2 The auditor's duties 1589.1.3 The powers of auditors 1599.1.4 The audit process 159

vi i i FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7

| 9.2 The audit report 160|±! 9.2.1 A closer look at the report 162O 9.3 Modified audit reports 164u 9.3.1 Materiality 165

9.3.2 The wording of a modified audit report 1669.3.3 Independent auditor's report showing qualified opinion 1679.3.4 Independant auditor's report-adverse opinion 168

9.4 Summary 169



10 Published Financial Statements 179Learning Outcome 181Learning aims 181

10.1 Introduction 18110.2 General requirements 182

10.2.1 Purpose of financial statements 18210.2.2 Responsibility for financial statements 18310.2.3 Components of financial statements 18310.2.4 Fair presentation and compliance with IFRSs 18310.2.5 Other requirements affecting the preparation

of financial statements 18410.3 The statement of financial position 185

10.3.1 Specimen statement of financial position 18510.3.2 Information to be presented in the statement r

of financial position 18610.3.3 Information to be presented either in the

statement of financial position or in the notes 18710.3.4 Share capital and reserves disclosures 18810.3.5 The current/non-current distinction 18810.3.6 Current assets 18910.3.7 Current liabilities 189

10.4 The statement of comprehensive income 18910.4.1 Information to be presented in the statement

of comprehensive income 19010.4.2 Specimen statements of comprehensive income 19010.4.3 Information to be presented either in the statement

of comprehensive income or in the notes 19210.5 Changes in equity 194

10.5.1 Format for the statement of changes in equity 19410.6 Notes to financial statements 195

10.6.1 Structure 19510.6.2 Accounting policies 196

FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 i x

10.7 An illustrative question 196 Q10.8 Summary 201 Z

m

Revision Questions 203 5CO


11 Reporting Financial Performance 215Learning Outcome . 217

11.1 Introduction 217, 11.2 IAS 18 Revenue Recognition 218

11.2.1 Introduction 21811.2.2 Sale of goods 21811.2.3 Rendering of services 21811.2.4 Interest, royalties and dividends 21811.2.5 Disclosure requirements 218

11.3 Profit or loss for the period 21911.3.1 Extraordinary items 21911.3.2 Profit or loss from ordinary activities 219

11.4 Definitions - Accounting policies, accounting estimates and errors 22011.5 Changes in accounting policies 220

11.5.1 Treatment and disclosure 22011.6 Changes in accounting estimates 22211.7 Errors 222

11.7.1 Treatment and disclosure 22311.8 Discontinuing operations 224

11.8.1 Objective 22411.8.2 Definition of a discontinued operation 22511.8.3 Measurement of a non-current asset (or disposal group)

held for sale i 22611.8.4 Presentation and disclosure 226

11.9 International financial reporting standard 8 OperatingSegments (IFRS 8) 23011.9.1 IFRS 8 Operating Segments - core principle 23011.9.2 Definition of operating segment 23111.9.3 Reportable segments 23111.9.4 Segment accounting policies 23111.9.5 Disclosure 23211.9.6 Reconciliations 23311.9.7 Information about geographical areas 23411.9.8 Information about major customers 234

11.10 Main differences between IAS 14 segment reportingand IFRS 8 operating segments 235

11.11 Summary 236



x FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7

| 12 Statement of Cash Flows 249!= Learning Outcome 251O 12.1 Introduction 251

12.2 Objective of IAS 7 Statements of Cash Flows 25212.3 Statements of cash flows format " 252

12.3.1 Cash flows from operating activities 25312.3.2 Cash flows from investing activities 25512.3.3 Cash flows from financing activities 25512.3.4 Increase (or decrease) in cash and cash

equivalents during period 25512.4 A worked example 256

12.4.1 Worked example 25612.4.2 Cash flow from operations 25812.4.3 Cash flows from investing activities 26112.4.4 Cash flows from financing activities 26212.4.5 The statements of cash flows 262

12.5 Interpreting a statements of cash flows 26312.6 Summary 263



13 Non-current Tangible Asset S tandards 281Learning Outcome 283

13.1 IAS 16 Property, Plant and Equipment 28313.1.1 Objective , 283

13.2 Revision of some definitions in IAS 16 28313.2.1 Property, plant and equipment 28413.2.2 Carrying amount 28413.2.3 Cost 28413.2.4 Depreciable amount 28413.2.5 Depreciation 28413.2.6 Fair value 28413.2.7 Impairment loss 28413.2.8 Recoverable amount 28413.2.9 Residual value 28413.2.10 Useful life 284

13.3 Recognition 28513.3.1 Elements of cost 28513.3.2 Self-constructed assets 285

13.4 Measurement '~ 28513.4.1 Cost model 28613.4.2 Revaluation model 286

13.5 Subsequent expenditure 28613.6 Accounting for depreciation 286

13.6.1 Review of useful life 28713.6.2 Depreciation method 288

FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 x i

Q13.7 Retirements and disposals 288 Q13.8 Revaluation of assets 289

13.8.1 Revaluation surplus 28913.8.2 Revaluation deficits 29013.8.3 Disposal of a revalued asset 290

13.9 Disclosure requirements 29213.10 IAS 23 Borrowing Costs (revised 2007) 292

13.10.1 Introduction 29213.10.2 Borrowing costs — accounting treatment 29213.10.3 Interest rate 29213.10.4 Period of capitalisation 29313.10.5 Disclosure 293

13.11 Available for sale financial assets 29313.12 Summary 293



14 Accounting for Leases 303Learning Outcome 305

14.1 Introduction 30514.2 Key definitions 30614.3 Characteristics of leases 306

14.3.1 Finance leases 30614.3.2 Operating leases 30714.3.3 Leases of land and buildings 307

14.4 Accounting for operating leases 30814.4.1 Rent-free period 30814.4.2 Cashback incentives 309

14.5 Disclosures for operating leases' 30914.6 Accounting for finance leases 31014.7 Calculating the implied interest on finance leases 311

14.7.1 In advance/in arrears 31614.8 Disclosures for finance leases 31714.9 Summary 318



15 Inventories a n d Construction Contracts 329Learning Outcome 331

15.1 Introduction 33115.2 IAS 2 Inventories 331

15.2.1 Definition of inventories 33115.2.2 Measurement 33215.2.3 Determining cost 33215.2.4 Costs not included in cost of inventory 332

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£ 15.2.5 Allocation of overheads 332(y 15.2.6 Calculation of costs / 333O 15.2.7 Allowed alternative method 334u 15.2.8 Disclosures for inventories 334

15.3 IAS 11 Construction Contracts 33415-3.1 General principle 33415.3.2 Accounting treatment 33515.3.3 Sales revenue 33615.3.4 Recognisable contract profits 33715.3.5 Expected contract losses 33815.3.6 Uncertain outcome 33915.3.7 Inventories 34015.3.8 Receivables 34015.3.9 Payables 34115.3.10 Provisions for foreseeable losses 34215.3.11 Disclosure requirements 34215.3.12 Illustrations from IAS 11 34215.3.13 A comprehensive example 346

15.4 Summary 348



16 Non-current Intangible Assets 359Learning Outcome 361

16.1 Introduction 36116.1.1 Objective of IAS 38 Intangible Assets 36116.1.2 Recognition and initial measurement 36216.1.3 Internally generated goodwill 36216.1.4 Internally generated intangible asset 36316.1.5 Subsequent expenditure 36416.1.6 Subsequent measurement 36416.1.7 Amortisation 36516.1.8 Impairment losses 36616.1.9 Retirements and disposals 36616.1.10 Disclosure 366

16.2 Purchased goodwill 36716.2.1 Purchased goodwill — recognition and measurement 36716.2.2 Negative purchased goodwill 367

16.3 IAS 36 Impairment of Assets 36716.3.1 Introduction 36716.3.2 Procedures to check for impairment 36816.3.3 Recognition and measurement of an impairment loss 368

16.4 Disclosure of impairments 37016.5 Summary 371



FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 x i i i

17 Share Capital Transactions 387 gLearning Outcome 387 pn

17.1 Introduction 387 517.2 IAS 1 requirements 388

17.2.1 Interests of shareholders 38817.2.2 Disclosures 388

17.3 Different classes of shares 38917.4 IAS 32 Financial Instruments — Presentation 39017.5 Issue of shares 391

17.5.1 Process 39117.5.2 Accounting for the issue of shares 39217.5.3 Share issue costs, redemption costs and dividends 39617.5.4 Redeemable shares 39617.5.5 Convertible debt 397

17.6 Bonus issues 39717.6.1 Process 39717.6.2 Accounting for a bonus issue 398

17.7 Accounting for a rights issue 39917.8 Accounting for treasury shares 39917.9 The purchase and redemption of shares 400

17.9.1 Purchases out of distributable profits 40117.10 Summary 403



18 Recognition and Disclosure of OtherSignificant Accounting Transactions 413

Learning Outcome , 41518.1 Introduction ' 41518.2 IAS 10 Events After the Reporting Period 415

18.2.1 Introduction 41518.2.2 Definitions 41618.2.3 Adjusting events 41618.2.4 Non-adjusting events 417

18.3 Proposed dividends 41718.4 Going concern 41718.5 Disclosure requirements of IAS 10 41718.6 IAS 37 Provisions, Contingent Liabilities and Contingent Assets 418

18.6.1 Introduction 41818.6.2 Provisions 41818.6.3 Measurement of provisions 41918.6.4 Provision for decommissioning costs 41918.6.5 Provision for warranties 419

18.7 Contingent liabilities and contingent assets 42018.8 Problems with IAS 37 as regards contingencies 42118.9 Related party disclosures 421

x i v FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7

£ 18.10 Definitions 422j | 18.10.1 Exclusions 422§ 18.11 Disclosure 423u 18.11.1 Disclosure of control 423

18.11.2 Disclosure of transactions and balances 42318.11.3 Examples of related party transactions 423

18.12 Summary ' 424


435"437437437437438439439439440440440441441442442443445445445446

447Solutions to Revision Questions 451

2 0 Sources of Short-term Finance a n d Typesof Investment 453

Learning Outcomes 45520.1 Introduction 45520.2 Sources of short-term finance 456

20.2.1 Trade credit 45620.2.2 Overdrafts 45620.2.3 Term loans 45720.2.4 Factoring 457

19 Working Capital Ratios

19.119.2

19.3

19.4

19.519.6

19.719.8

Learning OutcomeLearning aimsIntroductionWorking capital management19.2.1 The investment decision19.2.2 The financing decisionWorking capital ratios19.3.1 Illustration19.3.2 Liquidity ratios19.3.3 The current ratio19.3.4 The quick ratioEfficiency ratios19.4.1 Inventory turnover19.4.2 Receivables turnover19.4.3 Payables turnoverThe working capital cycleOvertrading19.6.1 Symptoms of overtradingShortening the working capital cycleSummary

Revision Questions

FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 x v

20.3 Export finance 457 Q20.3.1 Export factoring 458 Z20.3.2 Bill of exchange 458 z20.3.3 Documentary credits 459 °°20.3.4 Forfaiting 460

20.4 Managing cash surpluses 46020.5 Debt yields 461

20.5.1 Interest yield 46120.5.2 Yield to maturity (redemption yield) 46120.5.3 Coupon rate 462

20.6 Short-term investments 46320.6.1 Treasury bills 46320.6.2 Bank deposits 46320.6.3 Certificates of deposit 46320.6.4 Money-market accounts 46320.6.5 Local authority deposits 46320.6.6 Commercial paper 46320.6.7 Local authority bonds 46420.6.8 Corporate bonds 46420.6.9 Government bonds 46420.6.10 Risk and return 464

20.7 Summary 465



21 Working Capital: Receivables and Payables 473Learning Outcomes 475

21.1 Introduction , 47521.2 Managing receivables 47521.3 The credit cycle 476

21.3.1 Credit control 47621.3.2 Payment terms 47721.3.3 Cash discounts 47721.3.4 Methods of payment 47921.3.5 The stages in debt collection 479

21.4 Age analysis of trade receivables 48021.5 Credit insurance 48121.6 Factoring 48121.7 Assessing the effectiveness of credit control 48321.8 Evaluating a change in credit policy 48421.9 Trade payables 48521.10 The payment cycle 486

21.10.1 Cash discounts 48621.10.2 Methods of payment 487

x v i FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7

£ 21.11 Age analysis of trade payables 487

L? 21.12 Summary 488

O Revision Questions 491


22 Working Capital: Inventory 501Learning Outcome " 503

22.1 Introduction 50322.2 Inventory management 50322.3 The nature of inventory 504

22.3.1 Raw materials 50422.3.2 Work-in-progress 50422.3.3 Finished goods 504

22.4 The costs of inventory 50422.4.1 Holding costs 50422.4.2 Order costs 50422.4.3 The cost of running out of inventory 50422.4.4 Unit cost 505

22.5 Inventory control policy 50522.5.1 Dependent or independent demand 505

22.6 Inventory control systems 50522.6.1 Reorder level system 50522.6.2 Periodic review system 50622.6.3 Mixed systems 507

22.7 Economic order quantity (EOQ) 50722.7.1 Comments on Figure 22.3 507

22.8 Quantity discounts 50922.9 Lead times - 510

22.9.1 Lead times with constant demand 51122.10 Just-in-time (JIT) purchasing 51122.11 Summary 512


23 Working Capital: Cash 523Learning Outcomes 525

23.1 Introduction 52523.2 Cash management , 525

23.2.1 The time value of money 52623.3 Cash budgets 526

23.3.1 Preparation of cash budgets 52723.3.2 Managing cash deficits 52923.3.3 Float . 530

23.4 Cash-management models 53023.4.1 The Baumol model 53023.4.2 The Miller-Orr model 531

FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xv i i

23.5 Efficient-cash management23.6 The link between cash, profit and the balance sheet23.7 Summary

Revision Questions

Solutions to Revision Questions

Preparing for the Examination „Revision technique

PlanningGetting down to workTips for the final revision phase

Format of the examinationStructure of the paper

Revision Questions ISolutions to Revision Questions IRevision Questions IISolutions to Revision Questions II

November 2007 Examinations 673

Index 701

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financial accounting and tax principles - gbv system managerial level financial accounting and tax...

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