Chapter 12 Pensions, Share Options, Leases, Taxation and Foreign Currency

Chapter 12 © Philip O’Regan Pensions zPension payments are a large cost for many firms z2 principal types of pension scheme ydefined benefit: pension related to salary ydefined contribution: pension related to payments zDefined contribution becoming increasingly common zAccounting for pensions raises two issues: yHow much to charge to income statement? yHow should underlying assets and liabilities be valued?

Chapter 12 © Philip O’Regan Accounting for pension costs zIAS 19: Accounting treatment depends on type zDefined contribution: yExpenses recognized in period contribution is payable zDefined benefit: yB/S liability equal to net of: xpresent value of expected future payments xdeferred actuarial gains/losses and past service costs, and xfair value of any plan assets at B/S date yIS figure is generally the resulting change in B/S value zIAS 19 has yincreased volatility by prioritizing B/S issues over IS

Chapter 12 © Philip O’Regan Share options zIncreasingly common as means of reward yAttractive for recipients and companies yDid not lead to any expense recorded in IS zAccounting theory, frauds and abuse have caused change in accounting practice zConsiderable political issues zIFRS 2 requires annual charge in IS and credit in B/S over vesting period

Chapter 12 © Philip O’Regan Options: example p.418 zX plc grants option on 1/1/01 for 100k shares vesting on 31/12/03. Price 1/1/01 = £5 zIFRS 2: estimated cost to be charged to IS over vesting period (3 years) zThis will require various estimates etc. yprice will rise to 31/12/03 y75% probability employee will satisfy requirements z  1/1/01 value = 100k x £0.50 x.75 = £37,500 zIFRS 2 requires this to be charged to IS over three years = £12.5k per annum

Chapter 12 © Philip O’Regan Leases zArrangements whereby lessee obtains right of use, often without obtaining legal title zFinance Leases: most risks and rewards transferred to lessee zOperating Leases: most risks and rewards of ownership retained by lessor zIAS 17: emphasizes commercial reality: yassets and liabilities created regardless of legal fiction

Chapter 12 © Philip O’Regan Accounting for leases zIAS 17 accounting treatment follows type: yFinance: asset and corresponding liability shown in balance sheet of lessee yOperating: lessee merely shows leasing cost in IS zClassification may have significant impact on relevant ratios e.g. Gearing zIASB/FASB Convergence Project: yexposed fundamental differences

Worked example p.421 Year ending Amount owed at start of year (£) Finance charge 15% (£) Sub-total (£)Rental (£) Owed at end of year (£) 20X139,9705,99545,96514,00031,965 20X231,9654,79536,76014,00022,760 20X322,7603,41426,17414,00012,174 20X412,1741,82614,000 nil Chapter 12 © Philip O’Regan

Chapter 12 © Philip O’Regan Taxation zCompanies pay tax in their own right as separate legal entities yeg UK resident companies liable to Corporation Tax zFixed rate of tax applied to profits (income and capital gains) zIAS 12 requires entities to account for tax in a manner consistent with underlying transactions

Chapter 12 © Philip O’Regan Deferred tax zTax and accounting principles differ in UK zi.e., profit computed by accountants differs from that computed by HM Revenue and Customs ypermanent differences ytiming differences, e.g., depreciation v. capital allowances zThus, tax due will also differ zThis leads to “deferred tax”

Chapter 12 © Philip O’Regan Deferred tax ctd. zIAS 12 focuses on “temporary differences” y“Differences between tax base of an asset or liability and its B/S carrying amount” zAll temporary differences are also timing differences zIAS 12 provides that liability method be applied yThis requires a recalculation of any potential liability in light of changes in tax rates

Chapter 12 © Philip O’Regan Deferred tax example (p.426) zY plc bought plant for £300k; now has carrying amount in B/S of £200k after depreciation. Capital allowances to date equal £180k. CT is 30%. AccountsTax Cost Depreciation/Cap Allow Carrying Amount Temporary diff. = £80k: Deferred tax = £24k (£80k x 30%)

Chapter 12 © Philip O’Regan Foreign currency zGlobalization and dominance of MNEs mean foreign currency transactions more common zIAS 21 distinguishes between two currencies: yFunctional – primary economic currency yPresentation – currency used for financial statements zIAS 21 also distinguishes between: yMonetary items: items to be settled by cash – e.g. debtors, creditors, loans, etc. yNon-monetary items: other balances, e.g. fixed assets

Chapter 12 © Philip O’Regan Foreign currency – IAS 21 z1. Transaction date: use exchange rate applying between foreign and functional currencies z2. Balance Sheet date: yMonetary items: use closing rate on that date yNon-monetary items: xWhere historic cost was used originally, these are retained xWhere fair value used, translate at rate for that date z3. Exchange differences arising on settlement of monetary items recognized in income statement

Chapter 12 © Philip O’Regan Summary zIFRS results in considerable changes in accounting practice zPolitical issues have impinged on standard setting process, e.g. in relation to options zImportant to understand these technical areas for informed analysis zBut emphasis must remain on bigger picture