ACT-B332_U03_171.pdf - ACT B332 Company Accounting II Unit...

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Unformatted text preview: ACT B332 Company Accounting II Unit 3 Income tax and statement of cash flows 171 OUHK Course Team Developer: W F Hui, Consultant Designer: Caroline Leung, OUHK Coordinator: Dr Lynne Chow, OUHK Member: Maggie Tsong Ming-chun, OUHK Production ETPU Publishing Team Copyright © The Open University of Hong Kong, 2011, 2012, 2014, 2015, 2016. Reprinted 2017. All rights reserved. No part of this material may be reproduced in any form by any means without permission in writing from the President, The Open University of Hong Kong. Sale of this material is prohibited. The Open University of Hong Kong Ho Man Tin, Kowloon Hong Kong This course material is printed on environmentally friendly paper. Contents Introduction 1 Income tax 3 Recognition of current tax liabilities and current tax assets Rationale for providing deferred tax General principles for providing deferred tax Tax base, temporary difference and deferred tax Recognition of deferred tax liabilities and deferred tax assets Unused tax losses Changes in tax rates Recognition of deferred tax in equity Disclosure Statement of cash flows The purpose and usefulness of a statement of cash flows Cash and cash equivalents The structure of a statement of cash flows Preparing a statement of cash flows Analysing a statement of cash flows 3 5 11 11 22 27 28 31 32 38 38 40 41 44 73 Summary 82 Case studies 83 Feedback to activities 85 Suggested answers to self-tests 103 Suggested answers to case studies 129 Unit 3 Introduction This unit covers two topics: deferred tax and statement of cash flows. The issue of deferred tax would not exist if the tax authorities determined how much tax a company needed to pay based on the accounting standards and financial reporting rules required for financial reporting. Although this was in fact true for many countries in the past and probably still is in some countries today, most countries have different sets of rules for measuring income for tax purposes and for financial reporting purposes. The reason is that the objectives of accounting standards and tax rules are very different. The accounting standards aim at providing useful information to decision makers, whereas the tax rules are used to operate the government and to regulate or stimulate an economy. When the profit determined by accounting standards differs from the profit determined by tax rules, the income tax expense reported on the financial statements will be either greater or smaller than the tax payable to the tax authority. This unit discusses various scenarios in which different methods used for financial reporting and tax reporting may result in differences in income tax expense and income tax liability. It also helps you learn to distinguish between temporary differences and permanent differences, and how to account for them. The second half of the unit covers statement of cash flows. You will learn the presentation format of a statement of cash flows and how to prepare it for publication. A statement of cash flows reveals the type and degree of financing required by a company. Brief analysis of this statement will enhance your understanding of the company’s current and prospective financial health. In short, this unit: • illustrates the difference between profit or loss for accounting purposes and for taxation purposes; • identifies types of transactions and factors leading to deferred tax liabilities and assets; • evaluates the approaches to account for deferred tax; • outlines the practical difficulties encountered in determining deferred tax; • explains the purpose of a statement of cash flows; • discusses the meaning of cash and cash equivalents; • illustrates how to classify cash flows into operating, investing and financing activities; • describes how to prepare a statement of cash flows by direct or indirect methods from operating activities; and 1 2 ACT B332 Company Accounting II • explains how to appraise the compliance and presentation of a statement of cash flows and how to interpret it. It is important that you thoroughly understand the specific accounting practices and the rationale behind the required or recommended accounting treatments. You should be able to apply them in practice and to discuss the key issues in your own words. For this unit, you need to refer to: • Chapters 19 and 8 of your Cotter textbook; and • HKAS 12 Income Taxes and HKAS 7 Statement of Cash Flows issued by the Hong Kong Institute of Certified Public Accountants. You should aim to complete the unit within four weeks. Of this period, you should allow time for reading and reviewing the study unit and the associated texts and articles, and for doing the activities and answering the self-tests. The feedback and answers provided at the back of the unit are only suggested answers. There are inevitably different approaches to answering theoretical questions. As long as you have discussed the key concepts in a logical and coherent manner, your answers may be equally as valid as the suggested answers. If your answers are very different from the suggested answers, make sure that you attend the tutorials and discuss your answers with your tutor and other students. You should also spend some time working on Assignment 2 (TMA 2). The actual time you require for covering the unit may vary, depending on your previous experience in accounting and your working experience. As you move through the study units, you should jot down the queries you wish to discuss with your tutor so that you can share these with other students at the tutorial sessions. Unit 3 Income tax You may be puzzled by the inclusion of the topic of taxation in this accounting course. This course does not teach you how to compute personal or corporate tax. Instead this topic explains the relationship between accounting profit and taxable profit, tax payable based on accounting profit and on taxable profit, and how to account for their differences. The book value of an asset and liabilities for tax purposes are often different from the value as reported in the statement of financial position. In turn, the impact on the profit or loss will also be different. When you start to study deferred tax, imagine that you are constructing a statement of financial position based on tax laws. The difference between the taxbased statement of financial position and the one prepared for financial purposes implies that accounting profit (or loss) is different from the taxable profit in the same period. Before we go into the detailed discussion on deferred tax, let’s refresh our memories on the accounting treatment for current tax liabilities and tax assets incurred by an entity. Recognition of current tax liabilities and current tax assets Income tax for current and prior periods should, to the extent unpaid, be recognized as a liability. This means that current tax should be charged to the profit or loss as an expense and the unpaid portion would remain in the statement of financial position, recognized as a liability. If the amount already paid in respect of current and prior periods exceeds the amount due for those periods, the excess should be recognized as an asset. In Hong Kong, payments in advance for next year’s estimated taxable profit may be required and we need to record this advance payment. Example 3.1 ABC Ltd starts operation on 1 January Year 1 in Hong Kong. The profits tax for Year 1 is estimated as $360,000. ABC Ltd’s financial year ends on 31 December annually. The following journal entry is made on 31 December Year 1 to recognize the tax payable for Year 1: 3 4 ACT B332 Company Accounting II Profit or loss — Income tax expense Current tax payable (To record current tax payable) Debit $000 360 Credit $000 360 This is shown in the statement of financial position as a current liability as at 31 December Year 1. In October Year 2, ABC Ltd received an assessment notice from the Inland Revenue Department, demanding a payment of $560,000, being the assessed profits tax for Year 1 of $300,000, and the advance profits tax payable for Year 2 of $260,000 (estimated based on Year 1 profits). This was paid on 1 December Year 2. The following journal entry is made to record the payment: Current tax payable Bank (To record payment of profits tax for Year 1 and Year 2) Debit $000 560 Credit $000 560 On 31 December Year 2, ABC Ltd estimated its profits tax for Year 2 as $310,000. As ABC Ltd has ‘over-provided’ its tax liability for Year 1 (i.e. provision of $360,000, and assessed liability of $300,000), the overprovision is adjusted in Year 2. Therefore, the tax expense for Year 2 would be $250,000 (i.e. Estimated tax payable $310,000 − Overprovision for Year 1 $60,000). On 31 December Year 2, the following journal entry is made to recognize the tax expense for Year 2: Profit or loss — Income tax expense Current tax payable (To record current tax payable) Debit $000 250 Credit $000 250 The credit balance of $50,000 would be recognized as a liability in ABC Ltd’s statement of financial position as at 31 December Year 2, being the excess of estimated tax liability for Year 2 ($310,000) over the advance tax payment ($260,000). Unit 3 The tax payable account is shown as below: Current tax payable 31 Dec Year 1 Balance c/f 1 Dec Year 2 Payment 31 Dec Year 2 Balance c/f $000 360 560 50 610 $000 31 Dec Year 1 Profit and Loss 360 1 Jan Year 2 Balance b/f 360 31 Dec Year 2 Profit and loss 1 Jan Year 3 Balance b/f Please note that if the tax payable shows a debit balance, it indicates overpayment of tax, and this is to be shown as a current asset in the statement of financial position. 250 ___ 610 50 Accounting for current income tax is straightforward. In the following sections, we’ll move on to a more complicated accounting issue, deferred tax. Rationale for providing deferred tax This section looks at the reasons for providing deferred tax and how to handle it in accounting. Accounting academics and practitioners have plenty of reasons for providing deferred tax. They think that tax liabilities not paid in this year will generally be paid in later years, and thus the deferred tax is warranted to be provided according to accrual or the matching concept of accounting. It may not be much different from the accounting treatment for accrued electricity expenses. They argue that the ‘profit after tax’ is an important performance indicator that is used for computing earnings per share (EPS) and other accounting analysis. Therefore, failure to provide for deferred tax may distort the reported earnings per share and P/E ratio; dividends may consequently be over-distributed to shareholders. The following illustrative example can help explain the rationale behind and mechanics for computing and providing for deferred tax. Example 3.2 Company A starts a business and purchases a machine that costs $100,000 in Year 1. The depreciation rate is 25% of cost per annum with no residual value. Assume the Inland Revenue Department allows a 100% depreciation allowance in the year of purchase. 5 6 ACT B332 Company Accounting II Assume that there is no other fixed asset in the company and the profit tax rate involved in the calculation is 20%. Also, assume that the profit before depreciation and tax is $100,000 each for Years 1–4. The accounting profits for the company for these four years are as in Table 3.1. Table 3.1 Year 1 Year 2 Year 3 Year 4 $000 $000 $000 $000 Profit before depreciation and tax 100 100 100 100 Depreciation (25) (25) (25) (25) Profit before tax (accounting profit) 75 75 75 75 If tax expense is calculated based on the profit before tax shown above, the income statement would be as in Table 3.2. Table 3.2 Profit before tax Tax expense (20%) Profit after tax Year 1 Year 2 Year 3 Year 4 Total $000 $000 $000 $000 $000 75 75 75 75 (15) (15) (15) (15) 60 60 60 60 60 This is consistent with the matching concept that expenses are matched with related revenue/profits. However, the depreciation allowance (also known as ‘tax depreciation’) allowed by the Inland Revenue Department is different from the depreciation provided by the company. In this example, for simplicity, we assume that the depreciation allowance of the machine is 100% in the year of purchase. Then, the taxable profits for these four years are as in Table 3.3. Table 3.3 Profit before depreciation and tax Depreciation allowance Taxable profit Tax payable (20%) Year 1 Year 2 Year 3 Year 4 Total $000 $000 $000 $000 $000 100 100 100 100 (100) – – – 0 100 100 100 – 20 20 20 60 You must note that tax payable is based on taxable profit, not on accounting profit. Companies pay income tax on their taxable profits. Thus, the tax payable calculated above is different from those shown in Table 3.2. This is because accounting profit is different from taxable profit. This difference arises because the depreciation expense is Unit 3 different from depreciation allowance for tax purposes. This difference is called ‘temporary difference,’ and is calculated as below: Year 1 Year 2 Year 3 Year 4 Total $000 $000 $000 $000 $000 Accounting profit 75 75 75 75 300 Taxable profit 0 100 100 100 300 Temporary difference/(Reversing) 75 (25) (25) (25) Or, alternatively, the differences can be derived by comparing the depreciation expense and depreciation allowance: Year 1 Year 2 Year 3 Year 4 Total $000 $000 $000 $000 $000 Depreciation allowance (tax purpose) 100 – 100 – – Depreciation expense (accounting purpose) 25 25 25 25 100 Temporary difference/(Reversing) 75 (25) (25) (25) Please note that the temporary difference of $75,000 arising in Year 1 is caused by the different timing of recognition of depreciation by accountants and by tax assessors. However, total accounting depreciation is the same as the total tax depreciation allowance over the four years, i.e. $100,000 − Cost of the asset. Therefore, the timing difference is ‘temporary’ as it will reverse in the future. In the above calculations, the timing difference of $75,000 arising in Year 1 reverses in Years 2–4. In other words, more depreciation allowance given by tax assessors in Year 1 would mean the company pays less tax in Year 1. However, with the reversal of timing difference, tax payable in future years increases. If you compare Table 3.3 with Table 3.2, you may notice that no tax is payable in Year 1, but tax payable in Years 2–4 is greater than that shown in Table 3.2. Therefore, tax saved in Year 1 is not a permanent saving, but will be paid in later years. Company A pays less tax in Year 1, and defers part of its tax liability to future years. Such accrued or deferred tax liability may subsequently be paid in the years Year 2 to Year 4 (i.e. reversing) when there is no depreciation allowance (or the depreciation allowance is less than the accounting depreciation) in those years. We can look at the statement of profit or loss and other comprehensive income for these four years: Profit before tax Tax payable Profit after tax Year 1 Year 2 Year 3 Year 4 $000 $000 $000 $000 75 75 75 75 – (20) (20) (20) 75 55 55 55 7 8 ACT B332 Company Accounting II If you were a shareholder of the company, you might be misled by the above profit figures and think that the company’s performance is deteriorating. In fact, the company has earned the same profit throughout these four years. One may argue that tax on profit earned in Year 1 should be recognized in Year 1 according to the matching concept of accounting (as shown in Table 3.2). In fact, taxes not paid in Year 1 will be paid in other years because of the difference between depreciation and depreciation allowance (i.e. the temporary difference or difference in tax payment time). Accountants think that tax not paid in Year 1 is just the same as accrued expenses that should be provided in Year 1, and provision for the accrued tax should be made. This is the deferred tax concept. Based on the matching concept, as accounting profit is $75,000, it is logical to expect that the tax expense should be $15,000 (i.e. $75,000 × 20%) for each year. The figure of total tax liabilities over the four years, as shown in Tables 3.2 and 3.3 respectively, are the same (i.e. $60,000) but the timing of recognizing it is different. Therefore, accountants think that tax charged should be recognized in Year 1 even though no tax is payable. It is just deferred to future years. Provision for deferred tax is calculated based on temporary difference, calculated below: Year 1 Year 2 Year 3 Year 4 $000 $000 $000 $000 Temporary difference/(Reversing) 75 (25) (25) (25) Tax rate: 20% Deferred tax (reversal) 15 (5) (5) (5) The journal entries for making provision for deferred tax are as follows: $000 Year 1 Dr. Profit or loss — tax expense Cr. Deferred tax (liability) (To provide deferred tax arising from temporary difference) Year 2 Dr. Deferred tax (liability) Cr. Profit or loss — tax expense (To record reversal of deferred tax) Year 3 Dr. Deferred tax (liability) Cr. Profit or loss — tax expense (To record reversal of deferred tax) $000 15 15 5 5 5 5 Unit 3 Year 4 Dr. Deferred tax (liability) Cr. Profit or loss — tax expense (To record reversal of deferred tax) 5 5 The statement of profit or loss and other comprehensive income for Year 1 to Year 4 would then become: Profit before tax Tax payable Deferred tax Profit after tax Year 1 $000 75 – (15) (15) 60 Year 2 $000 75 (20) 5 (15) 60 Year 3 $000 75 (20) 5 (15) 60 Year 4 $000 75 (20) 5 (15) 60 The deferred tax account is as follows: Deferred tax 31 Dec Year 1 Balance c/f 31 Dec Year 2 Profit and loss 31 Dec Year 2 Balance c/f 31 Dec Year 3 Profit and Loss 31 Dec Year 3 Balance c/f 31 Dec Year 4 Profit and Loss $000 15 5 10 15 5 5 10 5 $000 31 Dec Year 1 Profit and loss 15 1 Jan Year 2 Balance b/f 15 __ 15 10 __ 10 5 1 Jan Year 3 Balance b/f 1 Jan Year 4 Balance b/f The credit balances of the deferred tax account are shown in the statement of financial position as at 31 December as a non-current liability: Year 1 Year 2 Year 3 Year 4 $000 $000 $000 $000 Non-current liabilities Deferred tax 15 10 5 – The above profit after tax figures reflects a more realistic picture of the company’s performance. Through the provision of deferred tax, the tax expense for each year is $15,000; that is, the same as tax payable based on accounting profit. The provision of deferred tax made in Year 1 represents a tax liability to be paid in future years, and it offsets $5,000 of tax payable each year from Year 2 to Year 4. The provision of deferred tax is to make a more realistic relationship between accounting profit and tax liability. Therefore, accounting for deferred tax is to ensure that the matching principle is applied. 9 10 ACT B332 Company Accounting II Try Activity 3.1 and make sure you understand how to calculate deferred tax by comparing the difference between accounting profit and tax profit. Activity 3.1 On 1 January Year 1, an enterprise buys equipment for $10,000 and depreciates it on a straight-line basis over its useful life of five years. For tax purposes, the equipment is depreciated at 25% per annum on a straight-line basis. The enterprise’s accounting profit before depreciation and tax expenses is $4,000 per annum for Year 1 to Year 5. The tax rate is 20%. For Year 1 to Year 5, do the following: 1 Calculate the accounting profit. 2 Calculate the tax profit and tax payable. 3 Calculate the temporary difference. 4 Calculate the deferred tax liabilities. 5 Prepare journal entries for making provision for deferred tax. 6 Prepare the statement of profit or loss and other comprehensive income with deferred tax. You have gone through the numerical exercise on calculating current and deferred tax and their temporary difference effect on the profit or loss. Try to consider the theoretical concept of providing deferred tax. Attempt Self-test 3.1. Self-test 3.1 1 Does deferred tax affect actual tax liability? 2 Explain why it is considered necessary to provide for deferred tax and briefly outline the principles of ...
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