Summary
The discipline of accounting is still an evolving subject and thus often been debatable as to what ails the discipline eve if there is a number of accounting standards governing the publication of accounting reports. Despite progress made over a time frame, there are sill many grey areas which needs more refinement.
This report would strive to discuss issues related to lease accounting, Impairment losses reported by entities and Income taxes.
The first topic that’s covered in this discussion is that of differences in reporting of taxes for accounting and tax purposes. As both considers different tax bases , there are temporary differences in tax consequence which gives rise to either deferred tax asses and deferred tax liabilities. While DTA is seen as a tax benefit which would be taken advantage of in future years and which would reduce the tax liability in future years, the DTL is seen as a liability which would occur in the future periods and increase actual tax liabilities. However, unlike normal loans and other liabilities which are statutory liabilities, the DTL is not considered a strict liability as the exact effect of the DTA and DTL as not settled and hence it can’t be considered a strict legal obligation.
The 2nd topic that’s covered in this discussion is that of Impairment losses. Impairment would have to be carried out by a frim if there is a certain decline in the asset being carried in the balance sheet and which is being considered as no more beneficial for the entity. The resulting decline in value would then be reported as a debit tot the income statement, and which is certainly likely to reduce profitability. Hence the impairment losses are required to be carried out at intervals but the same can also be misused by management. At times management thinks that carrying out an impairment loss in the income statement would ruin their profitability and hence delay the decision to impair certain assets which makes it impossible for the balance sheet and income statement to show an objective view of the financial operations. It remains a topic of highly debatable as to how the impairment must be carried out, at what intervals to show the true value of the balance sheet.
The 3rd topic that’s covered in this discussion is that of leasing obligations. As operating leases are not shown in the books despite being of sizable nature, this might create problems for the management in the future. Lease rent paid is shown as debit to income statement, but future obligations are not reported in the balance sheet. However Operating leases can be significant in its size at times and can be as high as 30-40% of the future revenue streams. However, as these items would be due to be paid in the future years the same is considered to be pitted against future revenues. The problem might arise if there is a stagnation of growth of revenue in the future or a decline in the revenue as leasing obligations would impact the bottom line quite considerably. If such a situation is warranted, then the stockholders and other stakeholders would definitely see a deep decline in earnings and returns on investment. However, this issue being different from other is now being monitored on apriority basis and all the operating leases now would have to be reported as financial leases in the books starting from 2019. This change in regulations would make sure liabilities are more ascertained and leasing obligations are better known to the stakeholders. For this there have suitable changes in the IFRS 16. While the leases taken would be shown as assets, the present value of the future payment obligations related to the leased asset would be required to be shown as liabilities. As a result of which leased assets would be depreciated by the leasing entity. This would solve the issue of lease being an off -balance sheet item and would be reported much better.
6391 Company Accounting
Executive Summary
The report discussed three important and controversial accounting topics including income taxes, impairment and lease. Secondary data was used to collect the data. It is identified that DTA/L does not increase confusion. Secondly, impairment test should be performed and gains and losses arising from it should be recognized. Lease is another controversial area which is now improved through AASB 116/IFRS 16. It influences the balance sheets and relevant ratios such as debt and asset turnover. However, it improves discourse and leads to better capital allocation. The report relied on secondary data which is also the limitation of this report.
1. Introduction
The discipline of accounting has many topics that face debate. Although the accounting standards and the framework reduce the confusion but there are still many areas that require consideration.
The aim of this report is to address three issues including income taxes, impairment losses and lease. It will also discuss the application of positive accounting theory. This is done by collecting secondary data from two listed firms. Finally, some opinions will provide to three different cases. The report will not conduct any detailed financial statement analysis.
There are three sections of the report. A literature review will conduct related to the three issues. Methodology will discuss including background information and data collection. Findings and discussion will take place.
2. Literature Review
DTAs and DTLs (DTA/L) occur due to temporary differences in taxes. According to Graham, Raedy and Shackelford (2012) DTL is the income tax that is shown as a tax expense in the income statement of existing financial year but paid in the future. DTA is the amount that decrease the income tax of existing financial year but in reality reduces future tax payments. Consequently, DTA is a tax benefit that will accrue in the future year.
There are arguments for or against DTA/L. Opponents argue that there are timing differences and there are also tax rate differences and that deferred accounts are similar to accounts payable because both of these accounts never settled (Bauman & Shaw, 2016; Peterson, Schmardebeck & Wilks, 2015)
Proponents on the other hand argue that it shows cash flow effects of deferring taxes. Secondly, these accounts cannot be compared with account payable because account payable includes legal obligations and DTA/L is not legal obligation. For example it can reduce or remove by recognizing losses. Finally, timing difference can increase the DTA/L overtime but complete provision of DTA/L also increase overtime (Laux, 2013; Guenther & Sansing, 2004; Chludek, 2011).
Based on the above discussion it is evident that there is a lack of understanding related to this topic.
Impairment is an important area in accounting. Impairment test is conducted to identify an item in the balance sheet really has the same worth that is mentioned in the balance sheet (Li, Shroff, Venkataraman & Zhang, 2011). This means that if the impaired test founds that the value of an item is more than the amount mentioned in the balance sheet than its value must increase in the balance sheet or vice-versa.
Studies found that impairment loss announcement by a firm have a negative relation with financial and accounting performance and market reaction (Strong & Meyer, 1987; Elliott & Shaw, 1988; Feuilloley & Sentis, 2006). It is also argued that management defers impairment losses to avoid volatility in earnings (Jahmani, Dowling & Torres, 2010). This can be explained with positive accounting theory which argues that firm chooses accounting practices and policies that increase profitability, efficiency and chances of survival (Deegan, 2013).
Financial statements that facilitate decision making must have fundamental qualitative characteristics. This includes relevance and faithfulness (Loftus, 2017). They must also possess enhancing qualities. This means that information must be comparable, verifiable, provided in timely manner and easy to understand (Loftus, 2017).
The IFRS 16 is related to lease. Most companies do not report off balance sheet liabilities for instance operating leases. These leases are in high amount for companies such as trucks, retail, airlines etc (Dožić & Krnić, 2016). This is because these companies create many operating leases contracts to purchase assets. The companies show the amount of lease in notes which usually investors do not look. In times of financial crisis companies with high amount of operating lease do not survive as evident in financial crisis of 2008-10 (Hoogervorst, 2016). This new standard will increase comparability but also affects ratios, covenants, credit rating and leverage. The problem here is that this standard improves disclosure but also affects management incentives. Agency theory explains this problem and provides suggestion to align interest of management shareholders (Jensen & Meckling, 1976)
3. Research Design
Fortescue
Fortescue is a public listed company of Australia. Fortescue operates in mining industry and it is basically a manufacturing firm because it has inventory in its balance sheet. Fortescue established in 2003. According to Forbes (2018) the number of employees is 5,455. The major operation of the company is to extract iron ore. However, it also owns railway lines which it allows small scale mining companies to use in Australia (Paul, 2017). It also has offers marine Towage services (Regan, 2016).
Woolworths
Woolworths is a public company of Australia. Woolworth operates in retail industry and it is basically a trading company retailing firm. It is a very old company established in 1924. It has 205,000 employees as of 2018 (Woolworths, 2018a). Besides retailing, Woolworths offers liquor and supply poker gaming machines to hotels. There are other companies in different countries operating with a name Woolworths but Australian Woolworths do not have any association with them.
The report collected data from secondary sources. These include Australian Securities and Investment Commission (ASIC), annual reports of the selected companies, journal articles (different databases such as Wiley etc.) and books. Thus, the data collected from variety of sources. Some calculations for questions 1 and 3 were used such as ratios and reconciliation of income tax figures. Two different companies from different industries are selected to see the impact of DTA/L on income tax.
4. Findings and Discussion
Income Tax Expense in Profit and Loss Statement
The income tax expense of Fortescue included in the profit and loss statement is $367 million in 2018 while in Woolworths is $718 million from continuing operations while $74 million from discontinued, making aggregate income tax expense of $792 million. No amount of income tax is shown in comprehensive income statement of either company.
The Current and Deferred Tax components in Income Tax Expense
The disclosure rule is that in income statement income tax includes current tax expense plus deferred tax expense. This is itemized appendix 1.
Similarly, in Woolworths the current income tax expense is $699 million and deferred tax component is $99 million, adjustment to prior year is $6 million itemized in appendix 2.
DTA and DTL in Financial Position
Fortescue’s balance sheet shows deferred tax liabilities of $1606 million. The breakdown is presented appendix 3.
The balance sheet of Woolworths shows deferred assets of $271 million. The notes show that net deferred tax asset is $372 million $99 million charged to income and $2 million is related to acquisition (refer appendix 4).
DTA and DTL Confusion or Clarity
The presence of DTA/L in financial statements requires reviewing the conceptual framework meaning that whether DTA/L satisfy the definition of assets and liabilities respectively. Asset is a resource owned by the company due to past events while liability is an obligation arises due to past event (AASB, 2016). Some situations meet these definitions such as the case of depreciation and capital allowance and fair value adjustment of a subsidiary (Deller, 2018) while others do not such as in revaluation when gain occurs both gain and its tax effect requires to be recognized through double entry leading to DTL. Framework defines liability as a present obligation, the DTL represent current tax liability that must be paid when the asset is sold. However, when the firm is not intent to sale asset, there should be no present obligation (ACCA, 2018).
The findings are consistent with the literature. DTA/L must not be compared with accounts payable because DTA/L increase/decrease due to tax treatment and accounting profit/loss (Laux, 2013) as evident in the case of Fortescue and Woolworths. DTL decrease in Fortescue while DTA decrease in Woolworths. Moreover, proper allocation DTA/L will likely overcome the timing difference issue (Chludek, 2011).
The DTA/L offer clarity in understanding the tax expense of the corporation. The presence of DTA/L represents tax benefit and obligation respectively that will occur in the future. In reality it is a very difficult topic to understand and requires strong accounting knowledge for comprehension. Those individuals who do not have adequate knowledge related to DTA/L will mislead while others can understand the impact these accounts have on the income tax expense. Therefore, it reduces the confusion of individuals capable of understanding DTA/L while for others it poses problem.
A corporation has several contracts. Accounting practices are adopted to reduce the contractual costs. The positive accounting theory offer three hypothesis why firm choose one accounting policy over the other (Deegan, 2013). Management adopts policies that increase profit so that they receive incentives. They also adopt policies that show better liquidity and solvency. Lastly, they sometimes adopt policies that lower profitability to avoid attracting attention of politicians and public. These arguments in line with the research that management defers impairment losses because it decreases profit so to attain incentives and better liquidity (Jahmani, Dowling & Torres, 2010). The negative relation with of impairment loss announcement also explains the negative relation of impairment loss with financial and accounting and market reaction (Feuilloley & Sentis, 2006).
Part 1 – Evaluation of the Statement
Impairment testing ensures that assets are not recorded in the balance sheet at an amount that is more than recoverable amount. Revaluation model change the reported amount of an asset with respect to changes in fair value. Comparatively, the cost model reports an asset on historical cost subtract depreciation and impairment loss. In this no changes made to value due to change in conditions.
The fair value and recoverable amount are not the same but they have a relation. If an asset’s recoverable amount is disregarded, it might leads to the situation where fair value is more than recoverable amount. This is the situation where an asset value is basically recoverable amount equals fair value less discarding cost. However, if an asset is reported at its fair value, the carrying amount will be higher than discarding cost.
Moreover, timing of impairment testing and revaluation also leads to overstatement. Impairment test performed each year while revaluation performed 3-5 years. If impairment loss is not considered in revaluation then this will lead to overstatement.
Therefore, impairment is important in revaluation model and assets fall under these categories should be impaired (Li, Shroff, Venkataraman & Zhang, 2011). However, companies avoid recognizing impairment loss due to management incentives and liquidity.
Part 2 – Evaluation of the Statement
The article of John Price reflects that Australian companies do not provide quality financial statements and complete disclosure. Companies have done impairment write-down after ASIC inquires (ASIC, 2014). The inquiry identified that cash flow assumptions are not accurate such as cash flow include inflows and outflows arise from restructuring etc., reliability of assumptions of external sources are not checked and forecast of more than five years is used despite the company is not competent in making forecasts (ASIC, 2014).
According to the conceptual framework these deficiencies affect the fundamental and enhancing qualitative characteristics of the financial statements. The users of the financial statements will not use present information to predict future and there are inaccuracies such as inaccurate forecasts. Moreover, it will also affect the comparability and verifiability of the information (Loftus, 2017).
Impact of AASB 16/IFRS 16 on Company’s Obligation
The lender and borrower have different interest. The lender requires timely interest payment, principal payment at maturity and security of the loan. In case of corporation the borrower is the management that may have differing interest or goal such as compensation etc. Agency theory states that borrower and lender can overcome this problem through a debt covenant (Townsend, 1979). This covenant requires borrower not to increase leverage up to certain amounts, maintain certain rations such as total liabilities to total assets by a certain percentage and many other such as not to mortgage general purpose assets. In this way, the borrower and lender can have safe sides.
The management of Balti Transport will not adopt the new standard because it will increase the leverage. This means that liabilities will be 66.67% of the total assets (refer appendix 5).
This will also go against the unsecured notes trust deed which states that liabilities must be 60% of the total assets. Thus, lender will review terms of the loan or may take other actions which makes the situation difficult for Balti Transport.
Impact of AASB 16/IFRS 16 on Company’s Executive Remuneration Contracts
Management and shareholders have differing interest. Management is interested in compensation while shareholders interested in high share prices and dividends. Management can manipulate financial statements to get compensation and bonuses as evident in Enron and other cases (Arnold & De Lange, 2004). Agency theory states that in order to align these differing interest or goals management should be offered competitive compensation and their bonuses must align with goals such as increase in operating income by certain percentage (Jensen & Meckling, 1976).
Balti Transport offers senior managers bonuses when pre-tax return on assets is more than 15%. If the new proposal is accepted it will not have material impact on the profit due to low interest rate. However, it will impact the asset side of the balance sheet. This is because when off balance sheet liabilities are recognized in the balance sheet it will also increase the asset side to equalize the balance sheet. This will increase the total asset amount as evident in the early adoption of the standard in the given information of Balti Transport (Asset increased by $400,000). Therefore, if profit before tax is remained at $1,600,000 the return on profit ratio will decrease (refer appendix 6).
This will eliminate the bonuses of senior management as return on asset will decrease from 20%-13.33% and bonus is awarded at 15%. This is happening because the numerator (profit before tax) remains constant while denominator (total assets) increases. In this case, Balti must increase profit.
5. Conclusion
The aim of the report is to conduct research related to income tax, impairment loss and lease. DTA/L is a very difficult topic in accounting and requires good understanding. DTA/L does not increase confusion but communicates difference that arises between financial statement and tax calculation. Both DTA/L may or may not satisfy the definition of asset and liability of financial framework. Secondly, impairment is test is required to perform and gains and losses arising from it should be recognized. Lastly, AASB 116/IFRS 16 has a considerable impact on the financial statements of firms that have high operating lease. It will impact firm’s loan covenant and management incentives but increase transparency. This will improve capital allocation.
6. Appendices
Appendix 1
Below is the itemization of tax:
| Particulars | Amount in million $ |
| Current tax expense | 320 |
| Add: Deferred tax | 47 |
| Total | 367 |
Source: Fortescue (2018)
Appendix 2
The disclosure rule is that in income statement income tax includes current tax expense plus deferred tax expense. This is itemized below:
| Particulars | Amount in million $ |
| Current tax expense | 699 |
| Add: Deferred tax | 99 |
| Less: Other adjustments of prior year | 6 |
| Total | 792 |
Source: Woolworths (2018b)
Appendix 3
Fortescue’s balance sheet shows deferred tax liabilities of $1606 million. The breakdown is presented below:
| Particulars | Amount in million $ |
| Deferred tax liability | 2037 |
| Less: Deferred tax assets | (431) |
| Total | 1606 |
Source: Fortescue (2018)
Appendix 4
The balance sheet of Woolworths shows deferred assets of $271 million. The notes show that net deferred tax asset is $372 million $99 million charged to income and $2 million is related to acquisition (372-99-2 = 271).
| Particulars | Amount in million $ |
| Net deferred tax assets | 372 |
| Less: Deferred tax assets charged to income | (99) |
| Less: Acquisition | (2) |
| Total | 271 |
Source: Woolworths (2018b)
Appendix 5
The management of Balti Transport will not adopt the new standard because it will increase the leverage. This means that liabilities will be 66.67% of the total assets, itemized as below:
| Particulars | Amount in $ |
| Liabilities (a) | 800,000 |
| Assets (b) | 1,200,000 |
| Total debt to assets ratio (a/b) | 66.67% |
Appendix 6
| Before AASB 116/IFRS 16 adoption | After AASB 116/IFRS 16 adoption | ||
| Particulars | Amount in $ | Particulars | Amount in $ |
| Profit before tax (a) | 1,600,000 | Profit before tax (a) | 1,600,000 |
| Total assets (b) | 8,000,000 | Total assets (b) | 12,000,000 |
| Return on asset ratio (a/b) | 20% | Return on asset ratio (a/b) | 13.33% |
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