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7 Example: Deferred tax adjustments 2

7 Example: Deferred tax adjustments 2

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Solution: Deferred tax adjustments 2

Transaction 1

This intra-group sale will give rise to a provision for unrealised profit on the unsold inventory of

$10,000,000  20%  25% = $500,000. This provision must be made in the consolidated accounts.

However, this profit has already been taxed in the financial statements of Payit. In other words there is a

timing difference. In the following year when the stock is sold outside the group, the provision will be

released, but the profit will not be taxed. The timing difference therefore gives rise to a deferred tax asset.

The asset is 30%  $500,000 = $150,000.

Deferred tax assets are recognised to the extent that they are recoverable. This will be the case if it is

more likely than not that suitable tax profits will exist from which the reversal of the timing difference

giving rise to the asset can be deducted. The asset is carried forward on this assumption.

Transaction 2

An unrelieved tax loss gives rise to a timing difference because the loss is recognised in the financial

statements but not yet allowed for tax purposes. When the overseas subsidiary generates sufficient

taxable profits, the loss will be offset against these in arriving at taxable profits.

The amount of the deferred tax asset to be carried forward is 25%  $8m = $2m.

As with Transaction 1, deferred tax assets are recognised to the extent that they are recoverable. This will

be the case if it is more likely than not that suitable tax profits will exist from which the reversal of the

timing difference giving rise to the asset can be deducted.



6.8 ED Recognition of deferred tax assets for unrealised losses

6.8.1 The issue

This ED was issued in August 2014 in order to clarify when a deferred tax asset should be recognised for

unrealised losses. For example, an entity holds a debt instrument that is falling in value, without a

corresponding tax deduction, but the entity knows that it will receive the full nominal amount on the due

date, and there will be no tax consequences of that repayment. The question arises of whether to

recognise a deferred tax asset on this unrealised loss.



6.8.2 Proposed change

The IASB proposes that unrealised losses on debt instruments measured at fair value and measured at

cost for tax purposes give rise to a deductible temporary difference regardless of whether the debt

instrument's holder expects to recover the carrying amount of the debt instrument by sale or by use.

This may seem to contradict the key requirement that an entity recognises deferred tax assets only if it is

probable that it will have future taxable profits. However, the ED also addresses the issue of what

constitutes future taxable profits, and concludes that:

(a)



The carrying amount of an asset does not limit the estimation of probable future taxable profits.



(b)



Estimates for future taxable profits exclude tax deductions resulting from the reversal of deductible

temporary differences.



(c)



An entity assesses a deferred tax asset in combination with other deferred tax assets. Where tax

law restricts the utilisation of tax losses, an entity would assess a deferred tax asset in combination

with other deferred tax assets of the same type.



6.8.3 Example: deferred tax asset and unrealised loss

Humbert has a debt instrument with a nominal value of $2,000,000. The fair value of the financial

instrument at the company’s year end of 30 June 20X4 is $1,800. Humbert has determined that there is a

deductible temporary difference of $200,000. Humbert intends to hold the instrument until maturity on 30

June 20X5, and that the $2,000,000 will be paid in full. This means that the deductible temporary

difference will reverse in full.



178



6: Income taxes  Part B Accounting standards



Humbert has, in addition, $60,000 of taxable temporary differences that will also reverse in full in 20X5.

The company expects the bottom line of its tax return to show a tax loss of $40,000.

Assume a tax rate of 20%.

Required

Discuss, with calculations, whether Humbert can recognise a deferred tax asset under IAS 12 Income

taxes.



Solution

The first stage is to use the reversal of the taxable temporary difference to arrive at the amount to be

tested for recognition.

Under the current requirements of IAS 12 Humbert will consider whether it has a tax liability from a

taxable temporary difference that will support the recognition of the tax asset:

Deductible temporary difference

Reversing taxable temporary difference

Remaining amount (recognition to be determined)



$’000

200

(60)

140



At least $60,000 may be recognised as a deferred tax asset.

The next stage is to calculate the future taxable profit. Under the proposals in the ED, this is done using a

formula, the aim of which is to drive the amount of tax profit or loss before the reversal of any temporary

difference:

Expected tax loss (per bottom line of tax return)

Less reversing taxable temporary difference

Add reversing deductible temporary difference

Taxable profit for recognition test



$’000

(40)

(60)

200

100



Finally, the results of the above two steps should be added, and the tax calculated:

Humbert would recognise a deferred tax asset of ($60,000 + $100,000) × 20% = $32,000. This deferred

tax asset would be recognised even though the company has an expected loss on its tax return.



6.9 Section summary

In relation to deferred tax and business combinations you should be familiar with:













Circumstances that give rise to taxable temporary differences

Circumstances that give rise to deductible temporary differences

Their treatment once an acquisition takes place

Reasons why deferred tax arises when investments are held

Recognition of deferred tax on business combinations



Part B Accounting standards  6: Income taxes



179



Chapter Roundup





Taxation consists of two components.







Current tax

Deferred tax







Current tax is the amount payable to the tax authorities in relation to the trading activities during the

period. It is generally straightforward.







Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting

impact. It is quite complex.







Deferred tax assets and liabilities arise from taxable and deductible temporary differences.







IAS 12 Income taxes covers both current and deferred tax. It has substantial presentation and disclosure

requirements.







You must appreciate the deferred tax aspects of business combinations: this is the aspect of deferred tax

most likely to appear in the Paper P2 exam.



Quick Quiz

1



What is the difference between 'current tax' and 'deferred tax'?



2



How should current tax be measured?

A

B

C

D



180



The total liability, including deferred tax

The amount expected to be paid to (or recovered from) the tax authorities

The amount calculated on profit at current tax rates

The amount calculated on profit at future tax rates



3



A taxable temporary difference gives rise to a deferred tax liability. True or false?



4



What is the basis of provision for deferred tax required by IAS 12?



5



What two methods can be used for calculating deferred tax when the tax rate changes?



6



Current tax assets and liabilities cannot be offset. True or false?



7



How do temporary differences arise when investments are held in subsidiaries, associates and so on?



6: Income taxes  Part B Accounting standards



Answers to Quick Quiz

1



(a)

(b)



Current tax is the amount actually payable to the tax authorities.

Deferred tax is used to match the tax effects of transactions with their accounting impact.



2



B



The amount expected to be paid to (or recovered from) the tax authorities.



3



True.



4



Full provision



5









6



False. They can be offset only if the entity has a legally enforceable right to offset and it intends to actually

carry out the offset.



7



When the carrying amounts of the investment become different to the tax base of the investment.



Deferral method

Liability method



Now try the question below from the Practice Question Bank



Number



Level



Marks



Time



Q9



Examination



25



49 mins



Part B Accounting standards  6: Income taxes



181



182



6: Income taxes  Part B Accounting standards



Financial

instruments



Topic list



Syllabus reference



1 Financial instruments



C3



2 Presentation of financial instruments



C3



3 Recognition of financial instruments



C3



4 Measurement of financial instruments



C3



5 Embedded derivatives



C3



6 Hedging



C3



7 Disclosure of financial instruments



C3



8 Fair value measurement



F2



Introduction

Financial instruments sounds like a daunting subject, and indeed this is a

complex and controversial area. The numbers involved in financial instruments

are often huge, but don't let this put you off. In this chapter we aim to simplify

the topic as much as possible and to focus on the important issues.

IFRS 9 Financial instruments was issued in final form in July 2014, replacing

IAS 39.



183



Study guide

Intellectual level

C3



Financial instruments



(a)



Apply and discuss the recognition and derecognition of financial assets and

financial liabilities



2



(b)



Apply and discuss the classification of financial assets and financial

liabilities and their measurement



2



(c)



Apply and discuss the treatment of gains and losses arising on financial

assets or financial liabilities



2



(d)



Apply and discuss the treatment of the expected loss impairment model



2



(e)



Account for derivative financial instruments and simple embedded

derivatives



2



(f)



Outline the principle of hedge accounting and account for fair value hedges

and cash flow hedges, including hedge effectiveness



2



Exam guide

This is a highly controversial topic and therefore, likely to be examined, probably in Section B.



Exam focus

point



Although the very complexity of this topic makes it a highly likely subject for an exam question in Paper P2,

there are limits as to how complicated and detailed a question the examiner can set with any realistic

expectation of students being able to answer it. You should therefore concentrate on the essential points.

To date, financial instruments have mainly been examined within a larger scenario based question. However,

the expected loss impairment model in particular could be tested using a numerical example, as the ED

which preceded the revision of IFRS 9 was tested in June 2011.



1 Financial instruments

FAST FORWARD



6/12 – 12/15



Financial instruments can be very complex, particularly derivative instruments, although primary

instruments are more straightforward.



1.1 Background

If you read the financial press you will probably be aware of rapid international expansion in the use of

financial instruments. These vary from straightforward, traditional instruments, eg bonds, through to

various forms of so-called 'derivative instruments'.

We can perhaps summarise the reasons why a project on the accounting for financial instruments was

considered necessary as follows:

(a)



The significant growth of financial instruments over recent years has outstripped the development

of guidance for their accounting.



(b)



The topic is of international concern, other national standard-setters are involved as well as the

IASB.



(c)



There have been recent high-profile disasters involving derivatives (eg Barings) which, while not

caused by accounting failures, have raised questions about accounting and disclosure practices.



There are three accounting standards on financial instruments:

(a)



IAS 32 Financial instruments: Presentation, which deals with:

(i)



184



The classification of financial instruments between liabilities and equity



7: Financial instruments  Part B Accounting standards



(ii)



Presentation of certain compound instruments



(b)



IFRS 7 Financial instruments: Disclosures, which revised, simplified and incorporated disclosure

requirements previously in IAS 32.



(c)



IFRS 9 Financial instruments, issued in final form in July 2014, replaces IAS 39 Financial

instruments: Recognition and measurement. The standard covers:

(i)

(ii)

(iii)

(iv)



Recognition and derecognition

The measurement of financial instruments

Impairment

General hedge accounting (not macro hedge accounting, which is a separate IASB project,

currently at the discussion paper stage)



1.2 Definitions

The most important definitions are common to all three standards.

FAST FORWARD



The important definitions to learn are:









Key terms



Financial asset

Financial liability

Equity instrument



Financial instrument. Any contract that gives rise to both a financial asset of one entity and a financial

liability or equity instrument of another entity.

Financial asset. Any asset that is:

(a)



Cash



(b)



An equity instrument of another entity



(c)



A contractual right to receive cash or another financial asset from another entity; or to exchange

financial instruments with another entity under conditions that are potentially favourable to the

entity, or

A contract that will or may be settled in the entity's own equity instruments and is:



(d)



(i)



A non-derivative for which the entity is or may be obliged to receive a variable number of

the entity's own equity instruments; or



(ii)



A derivative that will or may be settled other than by the exchange of a fixed amount of cash

or another financial asset for a fixed number of the entity's own equity instruments.



Financial liability. Any liability that is:

(a)



(b)



A contractual obligation:

(i)



To deliver cash or another financial asset to another entity, or



(ii)



To exchange financial instruments with another entity under conditions that are potentially

unfavourable; or



A contract that will or may be settled in the entity's own equity instruments and is:

(i)



A non-derivative for which the entity is or may be obliged to deliver a variable number of the

entity's own equity instruments; or



(ii)



A derivative that will or may be settled other than by the exchange of a fixed amount of cash

or another financial asset for a fixed number of the entity's own equity instruments.



Equity instrument. Any contract that evidences a residual interest in the assets of an entity after deducting

all of its liabilities.



Part B Accounting standards  7: Financial instruments



185



Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly

transaction between market participants at the measurement date.

Derivative. A financial instrument or other contract with all three of the following characteristics:

(a)



Its value changes in response to the change in a specified interest rate, financial instrument price,

commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or

other variable (sometimes called the 'underlying');



(b)



It requires no initial net investment or an initial net investment that is smaller than would be

required for other types of contracts that would be expected to have a similar response to changes

in market factors; and

It is settled at a future date.

(IAS 32, IFRS 9 and IFRS 13)



(c)



Exam focus

point



These definitions are very important so learn them.

We should clarify some points arising from these definitions. First, one or two terms above should be

themselves defined.

(a)



A 'contract' need not be in writing, but it must comprise an agreement that has 'clear economic

consequences' and which the parties to it cannot avoid, usually because the agreement is

enforceable in law.



(b)



An 'entity' here could be an individual, partnership, incorporated body or government agency.



The definitions of financial assets and financial liabilities may seem rather circular, referring as they do

to the terms financial asset and financial instrument. The point is that there may be a chain of contractual

rights and obligations, but it will lead ultimately to the receipt or payment of cash or the acquisition or

issue of an equity instrument.

Examples of financial assets include:

(a)

(b)

(c)



Trade receivables

Options

Shares (when used as an investment)



Examples of financial liabilities include:

(a)

(b)

(c)

(d)



Trade payables

Debenture loans payable

Redeemable preference (non-equity) shares

Forward contracts standing at a loss



As we have already noted, financial instruments include both of the following.

(a)



Primary instruments: eg receivables, payables and equity securities



(b)



Derivative instruments: eg financial options, futures and forwards, interest rate swaps and

currency swaps, whether recognised or unrecognised



IAS 32 makes it clear that the following items are not financial instruments.



186



(a)



Physical assets, eg inventories, property, plant and equipment, leased assets and intangible assets

(patents, trademarks etc)



(b)



Prepaid expenses, deferred revenue and most warranty obligations



(c)



Liabilities or assets that are not contractual in nature



(d)



Contractual rights/obligations that do not involve transfer of a financial asset, eg commodity

futures contracts, operating leases



7: Financial instruments  Part B Accounting standards



Question



Why not?



Can you give the reasons why the first two items listed above do not qualify as financial instruments?



Answer

Refer to the definitions of financial assets and liabilities given above.

(a)



Physical assets: control of these creates an opportunity to generate an inflow of cash or other

assets, but it does not give rise to a present right to receive cash or other financial assets.



(b)



Prepaid expenses, etc: the future economic benefit is the receipt of goods/services rather than the

right to receive cash or other financial assets.



(c)



Deferred revenue, warranty obligations: the probable outflow of economic benefits is the delivery

of goods/services rather than cash or another financial asset.



Contingent rights and obligations meet the definition of financial assets and financial liabilities

respectively, even though many do not qualify for recognition in financial statements. This is because the

contractual rights or obligations exist because of a past transaction or event (eg assumption of a

guarantee).



1.3 Derivatives

A derivative is a financial instrument that derives its value from the price or rate of an underlying item.

Common examples of derivatives include:

(a)



Forward contracts: agreements to buy or sell an asset at a fixed price at a fixed future date



(b)



Futures contracts: similar to forward contracts except that contracts are standardised and traded

on an exchange



(c)



Options: rights (but not obligations) for the option holder to exercise at a pre-determined price; the

option writer loses out if the option is exercised



(d)



Swaps: agreements to swap one set of cash flows for another (normally interest rate or currency

swaps)



The nature of derivatives often gives rise to particular problems. The value of a derivative (and the

amount at which it is eventually settled) depends on movements in an underlying item (such as an

exchange rate). This means that settlement of a derivative can lead to a very different result from the one

originally envisaged. A company which has derivatives is exposed to uncertainty and risk (potential for

gain or loss) and this can have a very material effect on its financial performance, financial position and

cash flows.

Yet because a derivative contract normally has little or no initial cost, under traditional accounting it may

not be recognised in the financial statements at all. Alternatively, it may be recognised at an amount which

bears no relation to its current value. This is clearly misleading and leaves users of the financial

statements unaware of the level of risk that the company faces. IASs 32 and 39 were developed in order

to correct this situation.



1.4 Section summary





Three accounting standards are relevant:





IFRS 9 Financial instruments , now complete with the final version published in July 2014







IAS 32: Financial instruments: Presentation







IFRS 7: Financial instruments: Disclosures

Part B Accounting standards  7: Financial instruments



187







The definitions of financial asset, financial liability and equity instrument are fundamental to the

standards.







Financial instruments include:



Primary instruments



Derivative instruments



2 Presentation of financial instruments

2.1 Objective

The objective of IAS 32 is:

'to establish principles for presenting financial instruments as liabilities or equity and for offsetting

financial assets and financial liabilities.'



2.2 Scope

IAS 32 should be applied in the presentation of all types of financial instruments, whether recognised or

unrecognised.

Certain items are excluded.



















Interests in subsidiaries (IAS 27: Chapter 12)

Interests in associates (IAS 28: Chapter 12)

Interests in joint ventures (IFRS 11: Chapter 13)

Pensions and other post-retirement benefits (IAS 19: Chapter 4)

Insurance contracts

Contracts for contingent consideration in a business combination

Contracts that require a payment based on climatic, geological or other physical variables

Financial instruments, contracts and obligations under share-based payment transactions

(IFRS 2: Chapter 9)



2.3 Liabilities and equity

FAST FORWARD



Financial instruments must be classified as liabilities or equity according to their substance.

The critical feature of a financial liability is the contractual obligation to deliver cash or another financial

asset.

The main thrust of IAS 32 here is that financial instruments should be presented according to their

substance, not merely their legal form. In particular, entities which issue financial instruments should

classify them (or their component parts) as either financial liabilities, or equity.

The classification of a financial instrument as a liability or as equity depends on the following.







The substance of the contractual arrangement on initial recognition

The definitions of a financial liability and an equity instrument



How should a financial liability be distinguished from an equity instrument? The critical feature of a

liability is an obligation to transfer economic benefit. Therefore, a financial instrument is a financial

liability if there is a contractual obligation on the issuer either to deliver cash or another financial asset to

the holder or to exchange another financial instrument with the holder under potentially unfavourable

conditions to the issuer.

The financial liability exists regardless of the way in which the contractual obligation will be settled. The

issuer's ability to satisfy an obligation may be restricted, eg by lack of access to foreign currency, but this

is irrelevant as it does not remove the issuer's obligation or the holder's right under the instrument.



188



7: Financial instruments  Part B Accounting standards



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