Changing Values
About This Chapter
There are some standards that are important for certain circumstances, and we discuss four of these in this chapter. Companies pay tax, and we need to know how they account for it. They also deal in foreign currencies and make payments with their own shares. These are both activities that are addressed by accounting standards. Finally, the concept of “fair value” was raised in earlier chapters, and we discuss it in this chapter.
For some, taxation is not the most exciting of topics, but it is important to understand because companies sometimes have to pay significant amounts. The standard that applies to all entities is IAS 12 Income taxes. First issued in 1979, there have been numerous amendments, the latest being in 2017. Not surprisingly, the tax authorities prefer their own calculation of profit as opposed to that shown on a company’s Income Statement, and the standard explains the accounting treatment the entity should follow.
Standard IAS 21 The Effect of Changes in Foreign Exchange Rates was issued in 1983 with a revised version issued in 2003. The problem for companies is accounting for interests in activities they may have in other countries. Assuming we are dealing with different currencies, there are various issues. The first issue is recording in the company’s records foreign currency transactions and operations. Second, there is the issue of deciding how to translate financial statements into a presentation currency, and the standard gives appropriate guidance.
In earlier chapters, we referred to the concept of “fair value.” IFRS 13 addresses this concept. The standard was first issued in 2011, and two amendments were made in 2013. The standard applies only to those companies that need to use fair value measurement because of the requirements of another standard. IFRS 13 sets out the requirements for measuring fair value and the necessary disclosures.
IAS 12 Income Taxes
Entities prepare their financial statements so that they comply with accounting standards. The Income Statement or profit and loss account is the statement that shows the profit as required by the standards. However, the tax authorities, which have the legal powers, calculate their version of the profit on which the company must pay tax.
If an entity calculated its tax solely on accounting profit, there could be an inducement for entities to make their profit the smallest amount possible, although shareholders may not be happy. Tax authorities are not enthusiastic about entities using accounting standards to calculate profit. They apply their own rules to calculate taxable profit and thus the amount of payable tax.
Although a company may be using international accounting standards, the country in which it is based has its own tax laws. This may create difficulties in the interpretation of the legislation within that country and its impact on the requirements of IAS 12 (Yapa, Kraal, and Joshi 2015).
The international standard includes all domestic and foreign taxes calculated on taxable profits and includes transactions and other events of the current period that are recognized in the financial statements, for example the presentation of income tax charges in the financial statements.
In view of the differences in the requirements of the accounting standards and the tax regulations, we need a standard to reconcile and explain to users of financial statements the differences between the accounting and tax methods for calculating profits. There are several issues to be addressed, and we shall begin with temporary tax differences.
Temporary differences give rise to deferred tax, and in this section we concentrate on that issue. The main differences between the taxable “profit” and the entity’s reported profits are:
- •The depreciation calculated under IAS 16 for reporting purpose differs from the allowances accepted by the tax authorities. They have their own rules.
- •Employee expenditure recognized when incurred for accounting purposes and when paid for tax purposes.
- •Costs of research and development charged in the Income Statement in one period for accounting purposes but allowed for tax purposes in another period.
Such differences give rise to what is termed deferred tax, which may be either a liability or an asset.
In this section, we explain the treatment of depreciation as this is a good example of the issue. Depreciation charged on noncurrent assets required by IAS 16 is very different from the allowance the tax regulations in a particular country will allow. The company is attempting to spread the cost of the asset over the financial periods that will benefit from it. The regulations of the tax authorities follow the strategy of the government.
For example, a company may have purchased equipment for $100,000 and has decided to depreciate it over 4 years with the depreciation charge being $25,000 dollars per annum. It may be that at that time it is the policy of the government to encourage investment in noncurrent assets as a way of boosting the economy. Therefore, under the tax regulations, the full cost of the depreciation for 4 years is deducted from the accounting profit to give the taxable profit.
Assuming the company makes a profit in 2018 of $150,000 before charging depreciation, the amount of profit on the financial statements is $150,000 − $25,000 = $125,000. However, in calculating the tax profits, the tax authorities decide that in the first year the full cost of the equipment of $100,000 should be deducted on the Income Statement, leaving a taxable profit of $50,000.
Users of the financial statements may be misled by the profit figure. They may also not be aware that in future years the company will have to pay additional tax as it has been allowed to deduct the full cost of the noncurrent asset in 2018. To clarify the position, the entity must inform the user of the deferred tax as a deferred tax liability.
The accounting requirements and the tax legislation in many countries result in the accounting profits being different from the profit used to calculate the tax payable. Also, the purchase of a noncurrent asset may lead to the company having a tax liability for several years. These differences are only temporary, and there will be a reversal adjustment at some future stage.
The entity must therefore make a provision for the deferred tax, using the liability method, also known as the statement of financial position liability method, or simply as the balance sheet liability method. The method is explained in IAS 12.
A deferred tax asset is the opposite of the deferred tax liability and arises from a temporary difference. The company may have been required to pay more tax in 1 year, but this will be adjusted in the following years when it pays less tax. An entity must assess the carrying amount of its deferred tax assets at the end of each reporting period. It is common practice for an expert in taxation to ensure the correct application of the tax regulations and the impact of IAS 12 on the financial statements.
Entities operating at the international level can face very complex tax regulations but also some strategic opportunities. There are two basic national philosophies of taxation: the territorial principle and the worldwide principle. These are very important if you bear in mind that different countries have different tax rates. It may be 30 percent in one country but only 10 percent in another. There are no worldwide standard rates.
The territorial principle does not recognize income earned outside the home country for calculating the tax a company should pay on the profits earned in that country. There is the assumption that the company will pay tax in the foreign country. However, the worldwide principle gives the home country the right to collect taxes on income earned in both the home country and all other countries in which the entity operates and makes profits. The worldwide principle results in double taxation because the income an entity earns outside a country is taxed by the foreign tax authorities and also by the home tax authorities.
Understandably, multinational organizations wish to minimize the taxes they pay worldwide and to avoid double taxation. Entities adopt various strategies, and there are two legally acceptable ones—transfer prices and tax inversion.
A company may adopt transfer pricing for various reasons, one of them being that it can reduce its global tax charge. A multinational may have its production facilities in one country, and the products manufactured are sold in many other countries. A multinational may also charge a foreign subsidiary for any services it provides. The price it decides for the transfer will determine where the greatest profit is shown, in the holding company or in a subsidiary.
The different tax rates may offer multinationals an incentive to shift taxable profit to low-tax-rate countries, using transfer prices to do this. A transfer price is the value of goods transferred from a company’s subsidiary in one country to its subsidiary in another country. By adjusting the cost of the goods transferred it is possible to declare any profits in a low-tax country.
Tax inversion is another method that some companies may use to lower their total tax liability. Some countries will tax foreign profits, but these will have already been subject to the tax of the foreign country in which it operates. The foreign profits returned to the home country, less any foreign taxes that the entity has already paid on them, are also subject to tax in the home country. Some argue that this is unfair and that companies, as a result, may buy a foreign competitor, relocate their headquarters to that jurisdiction, and evade the tax rate in the home country.
When considering the impact of the standard on a company’s financial results, it must always be remembered, as a Bulgarian study confirmed, that there may be significant differences between accounting and taxable income (Cuza 2016). However, this is not the same for all countries, and taxable income and accounting profit are very close for large Australian companies (Carlon, Tran, and Nam 2013). The International Accounting Standards Board (IASB) is aware of this issue and issued an interpretation to specify how organizations should reflect uncertainty in their accounting for income taxes. IFRIC 23, issued by the IFRS Interpretations Committee, Uncertainty Over Income Tax Treatments, adds to the requirements in IAS 12 by specifying how the effects of uncertainty in accounting for income taxes should be reflected. The interpretation took effect on January 1, 2019.
IAS 21 Foreign Exchange Rates
IAS 21 is a complex standard, involving specific definitions. Multinational groups can find the translations of foreign operations time-consuming and challenging. In the following section, we summarize the most important aspects, first by explaining functional and presentation currencies and then considering the translation of currencies.
Functional and Presentation Currencies
Every individual entity must issue financial statements in its functional currency, which is the currency of the primary economic environment wherever it operates in the world. The functional currency can be assumed to be the one in which transactions are normally conducted.
It may be difficult to identify the functional currency. An entity may have many activities, with cash flows, financing, and transactions occurring in more than one currency. Management may have to determine the relative importance of each of the indicators in the particular circumstances in identifying the functional currency.
An entity does not have a choice of functional currency. All currencies, other than the functional one, are foreign currencies. Usually, the functional currency will be the currency of the country whose economy drives the business and reflects the economic effects of the underlying transactions, events, and conditions.
An entity does have a choice in its presentation currency, which is the currency in which the financial statements are drawn up. An entity’s management may choose a different presentation currency than the functional currency in which to present financial statements.
At the group level, various entities within a multinational group will often have different functional currencies, identified at the entity level for each group entity. Each group entity translates its results and financial position into the presentation currency of the reporting entity. For example, an Australian subsidiary would prepare its accounts in Australian dollars (the functional currency), but the Canadian holding company would present its group results in Canadian dollars (the presentation currency).
Translation of Currencies
An entity may be involved in transactions in a different currency than the local (domestic) currency of the country in which it is located. Purchases, sales, and other services may be held with entities in other countries with their currency being used. Those currencies must be translated into the functional currency.
During a financial period, an entity initially records a foreign currency transaction in the functional currency. It does this by using the spot exchange rate between the functional currency and the foreign currency at the date of the transaction. For revenues, expenses, gains, and losses, the entity applies the spot exchange rate, which is the exchange rate for immediate delivery, at the dates on which those elements are recognized.
For large entities, there may be numerous transactions, and it may be impossible to apply the spot rate on the dates that all the transactions are taking place. In these cases, it is usual to use a rate that approximates the actual rate, such as an average rate for the period in which the transactions are conducted.
At the end of an accounting period, a company may still hold assets or liabilities in its statement of financial position that were obtained or incurred in a foreign currency. This involves the regulations concerning such currency translation. There are three types of translation:
- •Monetary items, for example, accounts receivable/payment, should be translated using the closing rate and should be reported as part of the profit or loss for the year. The closing rate is the spot exchange rate at the balance sheet date.
- •Nonmonetary items measured at historic cost. The translations are made on the basis of the date of the transaction.
- •Nonmonetary items measured at fair value and any gain or loss should be shown in comprehensive income such as a property revaluation.
The exception to the above rules is exchange differences arising on monetary items that form part of the reporting entity’s net investment in a foreign operation. The reporting entity recognizes these differences in the consolidated financial statements that include the foreign operation in other comprehensive income. When the reporting entity disposes the net investment, the results of the transaction will be recognized in profit or loss and not other comprehensive income.
Translating Foreign Operations
A foreign operation is an entity that is a subsidiary, associate, joint venture, or branch of a reporting entity. Their financial statements are usually drawn up in a currency other than that of the reporting entity. Each individual entity in a group of companies, wherever it is in the world, must prepare its own financial statements in its functional currency.
The consolidated financial statements of the group will be drawn up in the presentation currency of the holding entity. If the presentation currency differs from the functional currency, the financial statements must be retranslated into the presentation currency. Any goodwill and fair value adjustments are treated as assets and liabilities of the foreign entity and therefore retranslated at each balance sheet date at the closing spot rate.
IFRS 2 Share-Based Payments
Share-based payments, also known as stock options, are those where an entity pays for goods or services by employees or third parties with shares. These types of transactions are frequently carried out as a way of rewarding employees.
There are three types of share-based payments:
Share-based payment transactions. A payment may be made in shares.
Equity-settled share-based payment transactions. This is where the entity issues shares in exchange for goods or services.
Cash-settled share-based payment transactions. The entity pays cash with the amount being calculated on the entity’s share price.
The practice of rewarding employees with share or share options is well established but not widespread. It is used mostly for senior managers and directors. The argument is that the employee will be motivated to increase the financial performance of the entity that will lead to an increase in the share price.
If an employee receives stock options, they usually do not have control over the stock or options immediately. There is what is known as a vesting period, which is normally 3 to 5 years. During this period, the employee cannot sell or transfer the stock or options. The employee must continue working for the entity to get the benefit of the stock options and hope the performance of the company improves and thus the value of the stock option.
In the UK, IFRS 2 did not have the same impact as in the United States, where fraud was taking place. The standard has been in force for over 10 years, with no criticisms of its application.
IFRS 13 Fair Value Measurement
In previous chapters, we have identified where a standard either requires or permits fair value measurements. The method for determining fair value is provided in IFRS 13. The standard does not apply only to financial instruments but to all assets and liabilities where the relevant standards either require or allow fair value measurements. The purpose of the standard is to ensure the consistency and comparability in fair value measurements contained in other standards.
IFRS 13 has a three-level fair value hierarchy based on the inputs that entitles use to estimate the fair value. The hierarchy distinguishes between observable and unobservable inputs. Observable inputs are publicly available information about actual events or transactions. For example, share prices on stock exchanges. Unobservable inputs consist of management’s assumptions that cannot be corroborated with observable market data.
Level 1 inputs are quoted prices in active markets for identical assets or liabilities. These should be available at the date the measurement is made.
Level 2 inputs are those that are observable for the asset or liability, either directly or indirectly. If the price for an identical asset or liability is not available, an entity can use a quoted price for an asset or liability that is similar to the asset or liability being measured.
Level 3 deals with unobservable inputs where there is no market data. In such cases, the entity must use the best information available about the assumptions that market participants would use when pricing the asset or liability. The measurements therefore depend on the reporting entity’s own view of the assumptions that market participants would use.
An entity, attempting to make a fair value measurement, must estimate the price for an orderly transaction to sell the asset or transfer the liability. It is assumed that the transaction would take place between market participants at the measurement date under current market conditions. The entity must also decide the hierarchical level at which the measurement falls.
IFRS 13 requires extensive disclosures related to fair value measurements. The question has arisen as to whether such disclosures are an improvement for certain uses. In a study of banks as users, it was concluded that financial statements complying with IAS 13 provide less relevant information for bank valuation than under current Generally Accepted Accounting Principles (GAAP) (McInnis, Yu, and Yust 2018).
A review of the literature (Marra 2016) concluded that the opinions of the supporters and opponents of fair value were equally spilt and was uncertain of the informational utility to investors. However, the author concluded that there is likely to be an increase in the use of fair value accounting.
IAS 33 Earnings per Share
IAS 33 requires companies to calculate and to disclose the basic earnings per share (EPS). Although the financial statements show the total profits for the entire organization, the individual shareholder is more interested in knowing how their own shares have performed. The standard requires a company to show the EPS on the Income Statement. The information it must disclose is:
- •details of basic and diluted EPS. Diluted EPS demonstrates the quality of a company’s EPS if all the convertible securities in issue were exercised. Convertible securities are all outstanding convertible preferred shares, convertible debentures, stock options, and warrants.
- •the amount used as profit or loss for ordinary shareholders in calculating the EPS
- •the weighted average number of ordinary shares used in calculating the EPS
- •the description of ordinary share transactions or potential transactions that occur after the balance sheet date and that would have a significant effect on the EPS
Conclusions
In this chapter we have concentrated on “stand-alone” standards that are designed to address a particular situation or event. You can appreciate that with income tax and foreign exchange, the absence of standards would tempt companies to use a method that best enhances their financial statements.
One could argue that IAS 12 still allows companies considerable scope, but remember that the IASB is working completely separately from the tax authorities. The latter has its own aims and objectives, and improvements in corporate financial reporting is not high on the list. Their aim is to ensure that the companies pay the appropriate amount of tax.
IFRS 2 is a well-established standard that was developed to make publicly evident the benefits some employees were receiving. Before the standard was passed, there were opportunities for companies to hide the total benefits they were paying some senior employees.
If there are likely to be any changes to any of these standards, IFRS 13 Fair Value Measurement is the most likely candidate. There is the problem of what is the best measure of fair value. There is also the issue of its relationship with standards related to financial instruments. We discuss these standards in the next chapter.