H8049-Prelims.qxd 6/9/06 3:03 PM Page i CIMA’S Official Learning System Managerial Level Financial Accounting and Tax Principles Tom Rolfe H8049-Prelims.qxd 6/9/06 3:03 PM Page ii CIMA Publishing is an imprint of Elsevier Linacre House,Jordan Hill,Oxford OX2 8DP,UK 30 Corporate Drive,Suite 400,Burlington,MA 01803,USA First edition 2006 Copyright © 2006 Elsevier Ltd.All rights reserved No part of this publication may be reproduced,stored in a retrieval system or transmitted in any form or by any means electronic,mechanical,photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford,UK:phone ((cid:2)44) (0) 1865 843830;fax ((cid:2)44) (0) 1865 853333; e-mail:[email protected] you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions,and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability,negligence or otherwise,or from any use or operation of any methods,products,instructions or ideas contained in the material herein. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13:978 0 7506 8049 3 ISBN-10:0 7506 8049 0 For information on all CIMA publications visit our web site at books.elsevier.com Typeset by Integra Software Services Pvt.Ltd,Pondicherry,India www.integra-india.com Printed and bound in Great Britain 06 07 08 09 10 10 9 8 7 6 5 4 3 2 1 Working together to grow libraries in developing countries www.elsevier.com | www.bookaid.org | www.sabre.org H8049-Prelims.qxd 6/9/06 3:03 PM Page iii Contents The CIMA Learning System xvii Acknowledgements xvii How to use the CIMA Learning System xvii Study technique xix Financial Accounting and Tax Principles xxi 1 Principles of Business Taxation – Introduction 1 Learning Outcomes 1 1.1 Introduction 1 1.2 Taxation as a source of government revenue 2 1.3 Principles of taxation 2 1.3.1 Canons of taxation 2 1.3.2 The American Institute of Certified Public Accountants’ (AICPA) statement – Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals 3 1.4 Basic tax terminology 3 1.4.1 Direct taxes 3 1.4.2 Indirect taxes 4 1.4.3 Incidence 4 1.4.4 Taxable person 4 1.4.5 Competent jurisdiction 4 1.4.6 Hypothecation 5 1.4.7 Withholding responsibilities 5 1.4.8 Tax rate structure 5 1.4.9 The tax gap 6 1.5 Tax bases and classification of taxes 6 1.6 Sources of tax rules 6 1.7 Summary 8 Revision Questions 9 Solutions to Revision Questions 11 2 Direct Taxes on an Entity’s Profits and Gains 13 Learning Outcome 13 2.1 Introduction 13 2.2 The corporate tax base 14 2.2.1 Schedular systems of corporate taxation 14 2.2.2 Classification of income 15 2.2.3 Expenditure 16 2.2.4 Capital gains 19 2.3 Nominal corporate tax rates 21 iii 2006.1 H8049-Prelims.qxd 6/9/06 3:03 PM Page iv iv FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 S 2.4 The interaction of the corporate tax system with the personal tax system 21 T N 2.4.1 Classical system 21 E T N 2.4.2 Imputation system 21 O C 2.4.3 Partial imputation system 22 2.4.4 Split rate systems 22 2.4.5 Examples to illustrate the difference between traditional and imputation systems 22 2.5 Rules recharacterising interest as dividends 23 2.6 Treatment of losses 23 2.6.1 Trading losses 23 2.6.2 Capital losses 23 2.6.3 Cessation of business 24 2.7 The concept of tax consolidation 24 2.7.1 Capital losses and tax groups 25 2.8 Summary 25 Revision Questions 27 Solutions to Revision Questions 31 3 Indirect Taxes and Employee Taxation 33 Learning Outcome 33 3.1 Introduction 33 3.2 Indirect taxes collected by the entity 34 3.2.1 Unit taxes and ad valorem taxes 34 3.3 Consumption taxes 34 3.3.1 Single-stage sales taxes 34 3.3.2 Multi-stage sales taxes 34 3.4 Value-added tax (VAT) 35 3.4.1 Transactions liable to VAT 36 3.5 Indirect taxes paid by the entity 38 3.5.1 Excise duties 38 3.5.2 Property taxes 38 3.5.3 Wealth taxes 38 3.6 Employee taxation 39 3.6.1 The employee as a separate taxable person subject to a personal income tax regime 39 3.6.2 Social security contributions 40 3.6.3 Other payroll taxes 41 3.7 Use of employer reporting and withholding to ensure compliance and assist tax collection 41 3.8 Summary 41 Revision Questions 43 Solutions to Revision Questions 45 4 Administration of Taxation 47 Learning Outcomes 47 4.1 Introduction 47 2006.1 H8049-Prelims.qxd 6/9/06 3:03 PM Page v FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 v 4.2 The need for record-keeping and record retention 48 C O 4.2.1 Corporate income tax 48 N T 4.2.2 Sales tax or VAT 48 E N 4.2.3 Overseas subsidiaries 49 TS 4.2.4 Employee taxes and social security 49 4.3 The need for deadlines for reporting (filing returns) and tax payments 49 4.4 Types of powers of tax authorities to ensure compliance with tax rules 50 4.4.1 Power to review and query filed returns 50 4.4.2 Power to request special reports or returns 50 4.4.3 Power to examine records (generally extending back some years) 51 4.4.4 Powers of entry and search 51 4.4.5 Exchange of information with tax authorities in other jurisdictions 51 4.5 Tax avoidance and tax evasion 51 4.5.1 Tax evasion 52 4.5.2 Tax avoidance 52 4.5.3 Statutory general anti-avoidance provisions and case law regimes 52 4.6 Forum on tax administration 53 4.7 Summary 53 Revision Questions 55 Solutions to Revision Questions 57 5 International Taxation 59 Learning Outcome 59 5.1 Introduction 59 5.2 The Organisation for Economic Co-operation and Development (OECD) – Model tax convention 59 5.3 The concept of corporate residence 60 5.3.1 Place of control and central management of an entity 60 5.3.2 Place of incorporation 60 5.3.3 Place of control and place of incorporation 60 5.4 The OECD Articles of the model convention with respect to taxes on income and on capital 61 5.5 Withholding tax 62 5.6 Underlying tax 62 5.7 Means of establishing a taxable presence in another country 63 5.7.1 Subsidiary 63 5.7.2 Branch 63 5.8 Double taxation treaties 64 5.8.1 The OECD model tax convention 64 5.8.2 Principles of relief for foreign taxes 65 5.9 Summary 65 Readings 67 Revision Questions 77 Solutions to Revision Questions 79 2006.1 H8049-Prelims.qxd 6/9/06 3:03 PM Page vi vi FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 TS 6 Taxation in Financial Statements 81 N TE Learning Outcome 81 N O 6.1 Introduction 81 C 6.2 Calculation of current tax 82 6.3 Accounting for current tax 82 6.4 Calculation of deferred tax 83 6.4.1 Introduction to deferred tax 83 6.4.2 Timing difference approach 84 6.4.3 Temporary difference approach 85 6.4.4 Deferred tax assets 87 6.4.5 Tax losses 87 6.5 Accounting for deferred tax 88 6.6 Income tax charge 89 6.7 Disclosure 90 6.8 Summary 90 Revision Questions 91 Solutions to Revision Questions 95 7 The IASC and the Standard-Setting Process 101 Learning Outcomes 101 Learning Aims 101 7.1 The need for regulation of financial statements 102 7.2 Variation from country to country 102 7.2.1 Sources of finance and capital markets 102 7.2.2 The political system 102 7.2.3 Entity ownership 103 7.2.4 Cultural differences 103 7.3 Harmonisation versus standardisation 103 7.3.1 The need for harmonisation of accounting standards 103 7.4 Elements that might be expected in a regulatory framework for published accounts 104 7.4.1 Local law that applies to entities 104 7.4.2 Locally adopted accounting standards 105 7.4.3 Local stock exchange requirements 105 7.4.4 International body requirements 105 7.4.5 International accounting standards 105 7.4.6 Locally developed or international conceptual framework for accounting 105 7.5 Generally accepted accounting practice (GAAP) 105 7.6 The International Accounting Standards Committee Foundation (IASC Foundation) 106 7.6.1 Structure of the IASC Foundation 107 7.6.2 IASC Foundation 107 7.6.3 The International Accounting Standards Board (IASB) 108 7.6.4 The International Financial Reporting Interpretations Committee (IFRIC) 108 7.6.5 The Standards Advisory Council (SAC) 109 2006.1 H8049-Prelims.qxd 6/9/06 3:03 PM Page vii FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 vii 7.7 Objectives of the IASC Foundation 109 C O 7.8 The International Organisation of Securities Commissions (IOSCO) 109 N T 7.9 Local regulatory bodies 110 E N 7.9.1 Convergence activities 110 TS 7.9.2 International reaction 110 7.10 The standard-setting process 111 7.10.1 Development of a standard 112 7.10.2 Other aspects of due process 112 7.10.3 Co-ordination with national standard-setting 112 7.10.4 Benchmark treatments and allowed alternatives 113 7.11 Ways in which IFRS’s are used by countries 113 7.11.1 Adoption as local GAAP 113 7.11.2 Model for local GAAP 113 7.11.3 Persuasive influence in formulating local GAAP 113 7.11.4 Local GAAP developed with little or no reference to IFRS’s 114 7.12 Summary 114 Revision Questions 115 Solutions to Revision Questions 117 8 Regulatory Framework 121 Learning Outcome 121 8.1 Introduction 121 8.2 The development of the Framework 122 8.2.1 Purpose of the Framework 8.2.2 Status of the Framework 122 8.2.3 Scope of the Framework 122 8.3 The Framework 123 8.3.1 The objective of financial statements 123 8.3.2 Underlying assumptions 123 8.3.3 The qualitative characteristics of financial information 124 8.3.4 The elements of financial statements 125 8.3.5 Recognition of the elements of financial statements 126 8.3.6 Measurement of the elements of financial statements 126 8.3.7 Concepts of capital and capital maintenance 127 8.4 Usefulness of a conceptual Framework 127 8.5 The IASB’s Framework and the standard-setting process 128 8.6 Summary 128 Revision Questions 129 Solutions to Revision Questions 131 9 The Role of the External Auditor 135 Learning Outcome 135 9.1 External audit 135 9.1.1 The purpose of an audit 135 9.1.2 The auditor’s duties 136 9.1.3 The powers of auditors 137 9.1.4 The audit process 137 2006.1 H8049-Prelims.qxd 6/9/06 3:03 PM Page viii viii FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 S 9.2 The audit report 138 T N Independent auditor’s report 138 E T N 9.2.1 A closer look at the report 140 O C 9.3 Qualified reports 142 9.3.1 Materiality 143 9.3.2 The wording of a qualified report 144 9.3.3 Independent auditor’s report showing qualified opinion 145 9.3.4 Independant auditor’s report, adverse opinion 146 9.4 Summary 147 Readings 149 Revision Questions 159 Solutions to Revision Questions 161 10 Published Financial Statements 163 Learning Outcome 163 Learning aims 163 10.1 Introduction 163 10.2 General requirements 164 10.2.1 Purpose of financial statements 164 10.2.2 Responsibility for financial statements 164 10.2.3 Components of financial statements 164 10.2.4 Fair presentation and compliance with IFRSs 165 10.2.5 Other requirements affecting the preparation of financial statements 166 10.3 The balance sheet 167 10.3.1 Specimen balance sheet 167 10.3.2 Information to be presented on the face of the balance sheet 168 10.3.3 Information to be presented either on the face of the balance sheet or in the notes 171 10.3.4 Share capital and reserves disclosures 172 10.3.5 The current/non-current distinction 173 10.3.6 Current assets 174 10.3.7 Current liabilities 174 10.4 The income statement 174 10.4.1 Specimen income statement 174 10.4.2 Information to be presented on the face of the income statement 175 10.4.3 Information to be presented either on the face of the income statement or in the notes 176 10.5 Changes in equity 178 10.5.1 First format for the Statement of changes in equity 179 10.5.2 Second format – a statement of income and expense and a reconciliation note 181 10.6 Notes to financial statements 181 10.6.1 Structure 181 10.6.2 Accounting policies 182 2006.1 H8049-Prelims.qxd 6/9/06 3:03 PM Page ix FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 ix 10.7 An illustrative question 182 C O 10.8 Summary 187 N T E Revision Questions 189 N T S Solutions to Revision Questions 197 11 Reporting Financial Performance 209 Learning Outcome 209 11.1 Introduction 209 11.2 IAS 18 Revenue recognition 209 11.2.1 Introduction 209 11.2.2 Sale of goods 210 11.2.3 Rendering of services 210 11.2.4 Interest, royalties and dividends 210 11.2.5 Disclosure requirements 210 11.3 Profit or loss for the period 211 11.3.1 Extraordinary items 211 11.3.2 Profit or loss from ordinary activities 212 11.4 Definitions – Accounting policies, accounting estimates and errors 213 11.5 Changes in accounting policies 213 11.5.1 Treatment and disclosure 214 11.6 Changes in accounting estimates 215 11.7 Errors 215 11.7.1 Treatment and disclosure 216 11.8 Discontinuing operations 217 11.8.1 Objective 217 11.8.2 Definition of a discontinued operation 218 11.8.3 Measurement of a non-current asset (or disposal group) 219 11.8.4 Presentation and disclosure 220 11.9 Segment reporting 223 11.9.1 Business and geographical segments 223 11.9.2 Segment results 224 11.9.3 Reporting formats 224 11.9.4 Reportable segments 224 11.9.5 Segment accounting policies 225 11.9.6 Disclosure 225 11.10 Summary 227 Revision Questions 229 Solutions to Revision Questions 233 12 Cash Flow Statements 237 Learning Outcome 237 12.1 Introduction 237 12.2 Objective of IAS 7 Cash flow statements 238 12.3 Cash flow statement format 238 12.3.1 Cash flows from operating activities 239 12.3.2 Cash flows from investing activities 241 2006.1