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X.1 Chapter 10: Learning objectives 1. Know the accounting criteria for an operating lease vs. a capital lease and the financial statement effects of each type of lease. 2. Understanding deferred taxes and the underlying concepts Understand how to allocate tax in the financial statements. Understand the difference between timing differences (income statement concept) and temporary tax differences (balance sheet concept). Understand the difference between permanent differences and timing differences. Understand the expression ”pre-tax income” and be able to distinguish it from book income. Understand the difference between the taxes payable method and the (taxes) deferral method, including an understanding of why we allocate deferred taxes from temporary differences. Understand where in the financial statement tax issues are dealt with. Understand the rules and regulation of the DCAA concerning tax in the financial statements. 3. Knowledge of the basic accounting relations concerning derivatives and hedging. Copyright 2000 by Harcourt Inc. All rights reserved. X.2 1. Leasing Companies can lease assets in stead of buying them. A genuine leasing contract will give the lessor (the one who pays for use of the assets) a short-term (but expensive) right of use to the asset (and a very low economic risk). Certain leasing contracts are very similar to a purchase. They can be non-cancelable, long-term and place all risk related to use of the asset during its entire useful life on the lessor. Private car leasing (common in the US) is typically so restrictive that the economic reality is a purchase and not a standard/normal car leasing contract Copyright 2000 by Harcourt Inc. All rights reserved. X.3 1. Leasing - (continued) – capital lease If a leasing contract is drawn up in such a way that it basically resembles an installment contract then the contract must be treated as a purchase in the financial statements on the basis of a “substance over form” consideration. Otherwise it would be a kind of off-balance sheet financing. In such leasing agreements (capital lease) the leasing rights and obligations are capitalized in the financial statements of the lessor. Capitalization means to incorporate the leasing agreement as if it were a credit purchase, i.e. recognize both an asset and an obligation. As in the case of installment purchase: The asset is depreciated and the leasing obligations are shown as a liability that carry interests and are repaid (both by the lease payments) Copyright 2000 by Harcourt Inc. All rights reserved. X.4 1. Leasing (continued) - operating leasing. If the lease contract does not resemble a purchase then the agreement is treated as a “genuine” lease agreement (called operating leasing). In this case the lease payments is treated as periodic expenses for the leasing period, i.e “as they are paid” – adjusted, however, for pre-payments or post-payments relative to the lease period In that case neither an asset or a long-term obligation is booked (in contrast to a capital lease). Copyright 2000 by Harcourt Inc. All rights reserved. X.5 1. Leasing (continued) - Criteria (US!) US GAAP require capitalization if any one of the following criteria is met by the contract: 1. It transfers ownership to the lessee at the end of the leasing period. 2. It gives an advantageous right of purchase for the lessee. 3. The leasing agreement runs for over 75% of the asset’s life. 4. The present value of leasing payments equals or exceeds 90% of the fair market value of the asset. If management wants to treat the agreement as an operating lease then it can try to make an agreement where all four criteria are avoided (but especially the last criterion - 90% of fair market value - can be difficult to avoid if the substance of the agreement actually is “credit purchase”). Similar criteria are used in DK but they are more unclear (DCAA is viewed as requiring capitalization) Copyright 2000 by Harcourt Inc. All rights reserved. X.6 1. Leasing - Summary Operating lease/“genuine lease”: Neither a leasing asset nor a leasing obligation is incorporated in the financial statements Leasing costs are recognized as expenses when leasing payments are made (allocated, however, if payments occurs prematurely or delayed in relation to the actual leasing period) Capital lease: Both the leased asset and the the related obligation (to pay future lease payments) is incorporated in the balance sheet – as an asset bought and a loan debt The asset is written down - the debt is amortized The leasing debt entails interest an repayments Copyright 2000 by Harcourt Inc. All rights reserved. X.7 2. Taxes owed and deferred taxes Accounting standard 14 section/paragraph 17: Taxes are to be paid of the company’s taxable income, which is stated on the basis of the rules and regulations of the tax laws – not on the basis of the financial statements These facts mean that companies in some areas can choose to defer taxable earnings and – especially push forward the tax deductions of costs and thus defer its tax payments (and in certain instances the tax allocation of costs must be different from the financial statement allocations of costs ) Copyright 2000 by Harcourt Inc. All rights reserved. X.8 2. Deferred taxes must be included § 47. Liabilities that are uncertain with regard to size or time for termination, must be included in the balance sheet and the income statement as provisions for liabilities. Deferred taxes are to be included. The financial result (“book income”) before taxes is stated in the financial statements on the basis of the accounting principles chosen by the company. => Many (though not all large) differences between book income and taxable income => deferred taxes Copyright 2000 by Harcourt Inc. All rights reserved. X.9 2. Central concepts related to deferred taxes Concepts related to the differences between tax income and financial income(/book income): On the basis of the income statement (differences between income sizes) differences are either Permanent differences Timing differences On the basis of the balance sheet (differences concerning balance sheet values) differences are either Taxable/deductible temporary differences Non-taxable/non-deductible temporary differences Copyright 2000 by Harcourt Inc. All rights reserved. X.10 2. Income statement Inflow :Permanent differences Permanent differences: A difference between the book income before tax and the taxable income which is caused by special revenues/expenses only being included in one of the two types of statements (book income before taxes or taxable income) - they are included in one of these incomes, but will never be included in the other income. If no permanent differences existed then the sum of a company’s book incomes over its total lifetime would be equal to the sum of that company’s taxable incomes over its total lifetime. Copyright 2000 by Harcourt Inc. All rights reserved. X.11 2. Income statement inflow: Timing differences Timing differences Are differences between the book income before taxes and the taxable income, which stems from revenues/costs, which are “in the end” included in both types of statements with equally large amounts ( i.e. over the company´s lifetime), but they are included in different years in the two incomes. The timing differences will over the life of the company sum up to 0. Copyright 2000 by Harcourt Inc. All rights reserved. X.12 2. Taxes without allocation (taxes payable method) •Taxes in the financial income statement are stated as the taxes that are calculated from taxable income. •Taxes payable in the balance sheet are the amount of taxes not yet paid. They are shown as short-term liabilities until payment is made. •Deferred taxes are not included in the balance sheet, but only in the notes to the financial statements. The method is no longer allowed. Copyright 2000 by Harcourt Inc. All rights reserved. X.13 2. Allocation of taxes (deferred taxes method) •Accounting standard 14 section/paragraph 20: •It is in accordance with basic accounting principles to make an allocation of the company’s tax expenses and tax reduction in such a way that the both the effect of a transaction/an event and the derived tax effect of that transaction influence the financial income and shareholders´equity at the same time (i.e. in the same year). • I.e. if the company has a high operating pre-tax result one year then the high taxes resulting from that result shall be included as an expense in that year too. Copyright 2000 by Harcourt Inc. All rights reserved. X.14 2. Income statement: Calculated tax expense from financial income Calculation of tax effect of financial income: Annual financial income before taxes - Revenues/gains in the financial income statement which are never to be included in taxable income (non-taxable revenues). + Expenses in the financial income statements which are never to be included in tax income (non-tax-deductible expenses) - Deductions in the annual taxable income which are never to be included in the financial income statements (taxable income adjustments/deductions) ” The taxable financial income” = That part of the financial income which will - sooner or later - result in tax payments. Copyright 2000 by Harcourt Inc. All rights reserved. X.15 2. Deferred taxes method in the income statement ”Taxable financial income” * Tax rate = Calculated taxes Taxes payable Changes in deferred taxes That part of calculated taxes to be paid on the basis of the taxable income of the period The difference between ”actual taxes” for the year- calculated on the taxable income for the year - and calculated taxes for the year Copyright 2000 by Harcourt Inc. All rights reserved. X.16 2. Deferred taxes method in the income statement The relation between ”taxable annual financial result” and book income: Taxable financial income +/- Timing differences __________________________ = Financial income/Book income before taxes Copyright 2000 by Harcourt Inc. All rights reserved. X.17 2.Deferred taxes derived from the balance sheets By the balance sheet approach to deferred taxes, focus is on the temporary differences, i.e. the differences between (1) the valuations in the balance sheet in the financial statement and (2) valuations in the tax balance sheet The (taxable/deductible) temporary differences is found as: The difference between the financial accounting valuations and the tax account valuations at the same point of time (year end) A temporary difference will give rise too either a deferred tax liability (most often) or a deferred tax asset Tax rate x the total of temporary tax differences = deferred taxes in the financial balance sheet Copyright 2000 by Harcourt Inc. All rights reserved. X.18 2. Balance sheet approach: Deferred taxes - temporary differences Net temporary differences result in deferred tax (an obligation) and arise typically when the financial account value of an asset is higher than the tax account value of the asset. Example: if a machine will recover its book value sale or use, this “recovery” will result in taxes when its book value>its taxable value – due to positive effect on taxable income. Example: if the taxable value of a liability is higher than the accounted value (but it is rare) Copyright 2000 by Harcourt Inc. All rights reserved. X.19 2. Balance sheet: deferred taxes in the balance sheet - positive temporary differences Reasons for positive temporary differences: Fixed assets are depreciated more slowly in the financial accounts than in the tax accounts1). Some costs are expensed when incurred in the tax accounts but capitalized in the financial accounts 1). Revenues/gains are recognized in the financial income statement before they are included in the tax accounts 1). An asset is written up/revaluated in the financial statement but its value in the tax accounts is not altered2). 1) Temporary difference = sum of past timing differences 2) Temporary difference, but no timing difference in the past Copyright 2000 by Harcourt Inc. All rights reserved. X.20 2. Deferred taxes in the balance sheetnegative temporary differences Examples of deductible temporary differences (=>negative deferred taxes): Fixed assets are written down/off faster in the financial accounts than in the tax accounts (e.g. because a machine has become worthless and has thus been written down to 0 in the financial accounts). Expense recognition is carried out earlier in financial accounts than in tax accounts (e.g. in terms of inventories that have been written down to their net realizable value in the financial accounts). Charges in the financial accounts for estimated loss on receivables or for provisions for warranty costs are recognized earlier in the financial statements than in the tax accounts (loss/costs are typically not accepted as deductions from taxable income until they have been proved/incurred). Copyright 2000 by Harcourt Inc. All rights reserved. X.21 Deferred taxes and calculated tax expense DCAA and – especially – AS14 (somewhat simplified): Deferred taxes in the balance sheet= Temporary taxable differences * tax rate (balance sheet oriented) Tax expense for the year = taxable financial income for the year times the tax rate (calculated taxes, cf. above)* (income statement oriented) *However, possibly with addition/deduction of effect of a change of tax rate X.22 Deferred taxes in the balance sheet and the income statement AS 14 and the DCAA. : Deferred taxes are to be stated of all temporary differences. Calculated tax expense must include taxes derived from taxable income plus changes in deferred taxes that are caused by income items that are recognized in different years in the financial accounts and in the tax accounts, (i.e., plus that part of the change in deferred taxes resulting from timing differences). X.23 The relation: Deferred taxes - Calculated tax expense Changes in deferred taxes Deferred taxes opening balance + resulting from all changes in = temporary (balance) differences Those changes in deferred taxes resulting from timing differences (in the income statements) Deferred taxes ending balance Those changes that resulted from valuation adjustments that do not influence income + Taxes on taxable income = Calculated tax expenses in the income statement Direct adjustment of deferred taxes in the balance sheet X.24 Several possible calculation approaches (1) Examples Calculated tax expense, taxes on taxable income, direct valuation changes of balance items, and the deferred taxes at the beginning of the financial year are all known => the change in deferred taxes in the year and deferred taxes at the end of that year can be found Deferred taxes, “directly made changes” in deferred taxes, and tax from taxable income are all known => calculated taxes/the tax expense in the financial income statement (the unknown factor) X.25 Several possible calculation approaches (2) Knowledge of/possibility to determine: A. Deferred taxes in opening balance B. Taxable income resulting from the financial statement income (i.e. calculated taxes) and tax income/taxes resulting from taxable income => change in deferred taxes via the income statement C. Changes in deferred taxes by direct value adjustment of balance items outside, adjustments not included in the financial income statement (c. is often zero) => Deferred taxes in ending balance (the unknown factor) X.26 Several possible calculation approaches (3) Knowledge of/possibility of deciding: A. deferred taxes opening balance B. deferred taxes ending balance. (A and B) => Change in deferred taxes C. The change in deferred taxes that does not result from the financial income statement. D. Change in deferred taxes via the income statement. E. Taxes on taxable income => Calculated taxes/tax expense in the financial income statement (the unknown factor) X.27 2. Deferred taxes - tax rate/tax rate change Deferred taxes shall be determined by the use of that tax rate that is expected to apply for those years when the temporary differences are expected to be reduced/ to disappear, i.e. when the temporary differences are turned into additions to taxable income - the future tax rates are, however, presumed to be identical to the current tax rate unless a tax rate tax change has been enacted. A change in deferred taxes due to a tax rate change is charged to the financial income statement (included in calculated tax expense). Copyright 2000 by Harcourt Inc. All rights reserved. X.28 3. Derivatives (derived financial instruments) Companies encounter many risks when running a business: 1. The risk of customers stopping buying the company’s products and services. 2. The risk of prices for raw materials used for production increasing after the company has irrevocably committed itself to sell at a fixed price. 3. The risk of exchange rates changing after the company has entered into a contract/transaction denominated in a foreign currency. 4. The risk of interest rates changing. 5. The risk of employees quitting or retiring. Copyright 2000 by Harcourt Inc. All rights reserved. X.29 3. Derivatives (continued) The company can acquire derivatives which may be used for speculation in and hedging against certain risks (interest and currency risks as well as certain other ”market value”risks) A distinction is made between hedging of an item that is exposed for a risk of changes in market value (“fair-valuehedge) and hedging of an item that is exposed for a risk of cash flow will change (“cash-flow-hedge”) Example: Fair-value hedge: hedging of a receivable in DEM falling due in three months, for example by selling the amount via a futures contract (“a short sale”) Example: Cash-flow-hedge: hedging of the amount value for payment for orders received for goods, which have not yet been delivered (=> still not a receivable). Can also be hedged a futures contract . Copyright 2000 by Harcourt Inc. All rights reserved. X.30 3. Derivatives (continued) The accounted treatment is “international” (and now also used in DK -despite the wording of the law!): Derivatives are valued at the (estimated) market value in the balance sheet In relation to speculation (called “trade”) value changes are recognized in the income statement when market value changes occur For fair-value hedges value changes are recognized in the income statement for both the hedged item and its hedging derivative when change in market values occur=> only net gain or loss if the hedging is not totally efficient For cash-flow hedges the value changes in the derivative (hedging) instrument are recognizes directly in owners´ equity (i.e. not included in income). Only temporarily though, for is de-recognized in owner´s equity when the hedged transaction is included in the financial statements - at that point it is seen as an adjustment to the price of that transaction=> coupling. Copyright 2000 by Harcourt Inc. All rights reserved.