Corporate Finance

Five-Minute MBA - Corporate Finance

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Auditing Fundamentals

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Table of Contents

• Preface
• Chapter 1: Introduction
• Chapter 2: Pre-Audit Research
• Chapter 3: Audit Planning and Documentation
• Chapter 4: Entrance Conference
• Chapter 5: Audit Procedures
• Chapter 6: Managed Audit Policy and Procedures
• Chapter 7: Sampling
• Chapter 8: Exit Conference and Administrative Remedies
• Chapter 9: Audit Finalization
• Chapter 10: Disclosure Policies
• Appendix
• Glossary

Deferred tax

This article is about deferred tax as an accounting concept. For deferral of tax liabilities in cash-flow terms, see tax deferral (below).

 Deferred tax is an accounting concept (also known as future income taxes), meaning a future tax liability or asset, resulting from temporary differences or timing differences between the accounting value of assets and liabilities and their value for tax purposes.

 Temporary Differences

 Temporary differences may be either:

• taxable temporary differences,
• deductible temporary differences,

Tax base

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes:

• the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.
• the tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.

Illustrated example

The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common example in which a company has fixed assets which qualify for tax depreciation.

The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years. The company claims tax depreciation of 25% per year. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value.

	Purchase	Year 1	Year 2	Year 3	Year 4
Accounting value	$1,000	$800	$600	$400	$200
Tax value	$1,000	$750	$563	$422	$316
Taxable/(deductible) temporary difference	$0	$50	$37	$(22)	$(116)
Deferred tax liability/(asset) at 35%	$0	$18	$13	$(8)	$(41)

As the tax value, or tax base, is lower than the accounting value, or book value, in years 1 and 2, the company should recognise a deferred tax liability. This also reflects the fact that the company has claimed tax depreciation in excess of the expense for accounting depreciation recorded in its accounts, whereas in the future the company should claim less tax depreciation in total than accounting depreciation in its accounts.
In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.

Timing differences

Whereas International Financial Reporting Standards and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAPs such as UK GAAP require deferred tax to be instead recognised in respect of timing differences.
A timing difference arises when an item of income or expense is recognised for tax purposes but not accounting purposes, or vice versa, and is therefore consistent with a profit and loss approach to deferred tax.
In many cases the deferred tax outcome will be similar for a temporary difference or timing difference approach. However, differences can arise such as in relation to revaluation of fixed assets qualifying for tax depreciation, which gives rise to a deferred tax asset under a balance sheet approach, but in general should have no impact under a timing difference approach.lll

[edit] Justification for deferred tax accounting

Deferred tax is irrelevant to matching principle.

[edit] Examples

[edit] Deferred tax liabilities

Deferred tax liabilities generally arise where tax relief is provided in advance of an accounting expense, or income is accrued but not taxed until received. Examples of such situations include:

• a company claims tax depreciation at an accelerated rate relative to accounting depreciation
• a company makes pension contributions for which tax relief is provided on a paid basis, whereas accounting entries are determined in accordance with actuarial valuations

[edit] Deferred tax Assets

Deferred tax assets generally arise where tax relief is provided after an expense is deducted for accounting purposes.Examples of such situations include:

• a company may accrue an accounting expense in relation to a provision such as bad debts, but tax relief may not be obtained until the provision is utilised
• a company may incur tax losses and be able to "carry forward" losses to reduce taxable income in future years

[edit] Deferred tax in modern accounting standards

Modern accounting standards typically require that a company provides for deferred tax in accordance with either the temporary difference or timing difference approach. Where a deferred tax liability or asset is recognised, the liability or asset should reduce over time (subject to new differences arising) as the temporary or timing difference reverses.
Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes, which is similar (but not identical) to SFAS 109 under US GAAP. Both these accounting standards require a temporary difference approach.
Other accounting standards which deal with deferred tax include:

• UK GAAP - Financial Reporting Standard 19: Deferred Tax (timing difference approach)
• Mexican GAAP or PCGA - Boletín D-4, el impuesto sobre la renta diferido
• Canadian GAAP - CICA Section 3465
• Russian PBU 18 (2002) Accounting for profit tax (timing difference approach)

[edit] Derecognition of deferred tax assets and liabilities

Management has an obligation to accurately report the true state of the company, and to make judgements and estimations where necessary. In the context of tax assets and liabilities, there must be a reasonable likelihood that the tax difference may be realised in future years.
For example, a tax asset may appear on the company's accounts due to losses in previous years (if carry-forward of tax losses is allowed). In this case a deferred tax asset should be recognised if and only if the management considered that there will be sufficient future taxable profit to utilise the tax loss.^[2] If it becomes clear that the company does not expect to make profits in future years, the value of the tax asset has been impaired: in the estimation of management, the likelihood that this tax loss can be utilised in the future has significantly fallen.
In cases where the carrying value of tax assets or liabilities has changed, the company may need to do a write down, and in certain cases involving in particular a fundamental error, a restatement of its financial results from previous years. Such write-downs may involve either significant income or expenditure being recorded in the company's profit and loss for the financial year in which the write-down takes place.

 

 

 

 

 

 

Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes. It is a general fact of taxation that when taxpayers can choose when to pay taxes, the total amount paid in tax will likely be lower.^{[citation needed]}

[edit] Corporate tax deferral

Corporations (or other enterprises) may often be allowed to defer taxes, for example, by using accelerated depreciation. Profit taxes (or other taxes) are reduced in the current period by either lowering declared revenue now, or by increasing expenses. In principle, taxes in future periods should be higher.

[edit] Income tax deferral

In many jurisdictions, income taxes may be deferred to future periods by a number of means. For example, income may be recognized in future years by using income tax deductions, or certain expenses may be provided as deductions in current rather than future periods. A 2010 study documents the large extent to which U.S. taxpayers accelerate their deductible state tax income taxes by prepaying them in December, instead of their normally due January of the following year. (Shon & Veliotis "December Effect: Strategic Prepayments of Deductible State Tax Payments,” Journal of the American Taxation Association, Fall 2010, Vol. 32, No. 2, 53-71). In jurisdictions where tax rates are progressive - meaning that income taxes as a percentage of income are higher for higher incomes or tax brackets, resulting in a higher marginal tax rate - this often results in lower taxes paid, regardless of the time value of money.
Tax deferred retirement accounts exist in many jurisdictions, and allow individuals to declare income later in life; if the individuals also have lower income in retirement, taxes paid may be considerably lower. In Canada, contributions to registered retirement savings plans or RRSPs are deducted from income, and earnings (interest, dividends and capital gains) in these accounts are not taxed; only withdrawals from the retirement account are taxed as income.
Other types of retirement accounts will defer taxes only on income earned in the account. In the United States, a number of different forms of retirement savings accounts exist with different characteristics and limits, including 401ks, IRAs, and more.
As long as the individual makes withdrawals when he or she is in a lower tax bracket (that is, has a lower marginal tax rate), total taxes payable will be lower.

 

Vertical Analysis

Vertical Analysis

 A method of financial statement analysis in which each entry for each of the three major categories of accounts (assets, liabilities and equities) in a balance sheet is represented as a proportion of the total account. The main advantages of vertical analysis is that the balance sheets of businesses of all sizes can easily be compared. It also makes it easy to see relative annual changes within one business.

For example, suppose XYZ Corp. has three assets: cash and cash equivalents (worth $3 million), inventory (worth $8 million), and property (worth $9 million). If vertical analysis is used, the asset column will look like:

Cash and cash equivalents: 15%
Inventory: 40%
Property: 45%

This method of analysis contrasts with horizontal analysis, which uses one year's worth of entries as a baseline while every other year represents differences in terms of changes to that baseline.

Vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets.

The restated amounts from the vertical analysis of the balance sheet will be presented as a common-size balance sheet. A common-size balance sheet allows you to compare your company’s balance sheet to another company’s balance sheet or to the average for its industry.

Vertical analysis of an income statement results in every income statement amount being presented as a percentage of sales.

The restated amounts are known as a common-size income statement. A common-size income statement allows you to compare your company’s income statement to another company’s or to the industry average.

Common Size Balance Sheet

A company balance sheet that displays all items as percentages of a common base figure.

The image above illustrates the difference between a regular balance sheet and a common size balance sheet. In the normal balance sheet, account values are expressed in dollar terms, while in the common size one, each value is listed as a percentage of total assets. This is also done for liabilities, where each liability account is a percentage of total liabilities.

Construction Accounting

 

Progress Billings

A series of invoices prepared at different stages in the process of a major project, in order to seek payment for the percentage of work that has been completed so far. 

Progress billing will show the original contract amount, any changes to that amount, how much has been paid to date, what percentage of the job has been completed to date, what payment is currently due and the total amount remaining to be paid by the project’s completion. Progress billing is common in the construction industry.

For example, in the construction business, the client or recipient of the finished project does not want to pay for the entire job up front because it is an expensive, long-term task with the potential for many financial miscalculations along the way.

The construction company does not want to wait to be paid until the project is completed because it needs to pay its employees and purchase materials as the project is carried out.

Progress billings meets the needs of both the construction company and its client by providing for payment at several stages during the process.

Construction Accounting

Construction accounting is a form of project accounting applied to construction projects. See also production accounting.

Construction accounting is a vitally necessary form of accounting, especially when multiple contracts come into play.

The construction field uses many terms not used in other forms of accounting, such as draw and progress billing.

Construction accounting may also need to account for vehicles and equipment, which may or may not be owned by the company as a fixed asset.

Construction accounting requires invoicing and vendor payment, more or less as to the amount of business done.

Revenue Recognition

Construction accounting requires unique revenue recognition rules for contracts in progress.
In most cases, revenue is recognized using the Percentage of Completion Method. Under this method, revenue is recognized using an estimate for the overall anticipated profit for a particular contract multiplied by the estimated percent complete of that contract. This involves the inherent risk of relying upon estimates.

Under SOP 81-1, revenue is also allowed to be computed using the Completed Contract Method. Under this method, contract revenues and costs are not recognized until the contract is substantially complete. However, this method is not allowable if the results are significantly different than results using the Percentage of Completion Method The Completed Contract Method is allowed in circumstances in which reasonable estimates cannot be determined. However, these types of circumstances can be construed as a lack of internal control.

Advance Financial Accounting and Analysis

Exam Past Paper (Stage - 4 ) - May 2011

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Financial Reporting

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The Cash Flow Statement

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Prior to 1987, companies were allowed to provide financial on a working capital or cash basis. 


For a while, many accepted that the adding back of depreciation to net income was an appropriate substitute for a cash flow statement, while others, especially creditors chose to use EBITDA (earnings before interest, taxes, depreciation and amortization). 


EBITDA is of course a measurement that maintained wide usage up to the late 1990s, before a string of corporate scandals (led by Enron and Worldcom) removed it from business pages.

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