Question 3
(a) The acquisition of the subsidiaries during the year has an impact on the deferred taxation charge. The deferred tax position is reviewed as that of the enlarged group as a whole. Individual companies may not be able to recognise, for example, a deferred tax asset but it may now be able to because there are tax profits of the acquiree available to utilise any unused tax losses. Thus provision is made for all differences between the fair values recognised for the net assets (Tea $4 million) and their tax bases (Tea $3·5 million). No provision is required in respect of the temporary difference arising on the recognition of non tax deductible goodwill (Tea $1 million).
Coffee is planning to list its shares on a recognised stock exchange with no new shares being issued. The company will become a publicly traded company and given the directors’ belief in the growth of the company, it would appear that the company will in the future be subject to the standard rate of taxation for public companies. Deferred taxation should be measured at the average tax rates expected to apply when the asset is realised or the liability is settled, based on current enacted tax rates and laws. Some of the temporary differences may reverse at the higher tax rate and thus deferred tax should be provided at this rate.
Acquisition of Tea
(i) There is some doubt as to the acceptability of the directors’ opinion that the intangible asset of $0·5 million will be allowed for tax purposes. The directors will compute taxable profit based upon the premise that the intangible asset will be deductible for tax purposes. There is the possibility that the company will have to return the excess benefit to the tax authority and thus if the directors insist on deducting the intangible asset for tax purposes then a liability for that excess tax benefit should be recognised.
(ii) The intra group profit in inventory is eliminated on consolidation ($0·6 million) but no equivalent adjustment is made for tax purposes. Taxes paid by the seller on these profits have been included in the consolidated income statement for the period. The temporary difference between the carrying amount of inventory ($1·2 million) and its higher tax base ($1·8 million) is provided for at the receiving company’s rate of tax (Coffee) since the temporary difference arises in its statements.
(iii) Provision is required on the unremitted profits of subsidiaries if the parent company is unable to control the timing of the remittance or it is probable that remittance will take place in the foreseeable future. Coffee seems to be recovering the carrying value of its investment in Tea. The payment of the dividends is under the control of Coffee and it would not normally
recognize the deferred tax liability in respect of the undistributed profits of Tea. However, as the profits are to be distributed, and tax would be payable on the amount remitted, then a provision for deferred tax should be made.
(b) Gold Software
(i) Computer hardware and revenue recognition
The capitalisation of interest on tangible non-current assets, is permitted under IAS23 ‘Borrowing Costs’. This represents a change in the recognition and presentation of the tangible non-current asset and is, therefore, a change in accounting policy which requires disclosure. The change in the depreciation method does not affect the recognition and measurement of the asset, and represents a change in an accounting estimate technique which is used to measure the unexpensed element of the asset’s economic benefits. However, as depreciation is now being shown as part of costs of sales rather than administrative expenses, then this represents a change in the presentation of the item and is a change in accounting policy.
A change in an accounting estimate is not normally a change in accounting policy. Disclosure of the change in policy will have to be made (see above). IAS8 states that a company should judge the appropriateness of its accounting policy against the objectives of relevance and reliability. A company should implement a new accounting policy if it is judged more appropriate to the entity’s circumstances than the present accounting policy. Thus, for the reasons of relevance, the company should adopt the normal industry approach which would constitute a change in the measurement basis and thus a change in accounting policy with the necessary disclosure taking place (see above). Also given the potential charge against profits under IAS37 below, then the new accounting policy might alleviate the impact of the provision.
(ii) Provisions
Under IAS37 ‘Provisions, Contingent Liabilities and Contingent Assets’, a provision should be made if
(a) there is a present obligation as a result of a past event;
(b) it is probable that a transfer of economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
The assessment of a legal claim is one of the most difficult tasks in the area of provisioning because of the inherent uncertainty in the judicial process. A provision or disclosure could in fact prejudice the outcome of any case. A provision will be required if on the basis of the evidence, it can be concluded that a present obligation is more likely than not to exist (subject to meeting the other conditions). In determining whether a transfer of economic benefits is likely to occur, account should be taken of expert advice and the probability of the outcome determined. Only in rare cases will a reasonable estimate of the obligation not be possible.
In the case of the invoice from the accountants, it seems as though the solicitors feel confident that the amount will not be payable and, therefore, it constitutes a contingent liability which, under IAS37, means that the estimated financial effects, any uncertainties relating to the amount or timing of any outflow, and the possibility of any reimbursement should be disclosed.
As regards the plagiarism case the following table illustrates the potential outcomes:
Present values at 5%
$000 Year –P–V– Probability Total
$000 $
Best case 500 1 476 30% 142,857
Most likely 1,000 2 907 60% 544,218
Worse case 2,000 3 1,728 10% 172,768
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859,843
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The most likely outcome seems to indicate that a provision for $907,000 is required whereas when probability is introduced then this is reduced to $859,843. The difference, considering that an accounting estimate has been used, is not material and, therefore, a provision of $860,000 should be made as this is based on a more ‘scientific’ approach.
