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

Financial Information Analysis2 Copyright 2006 John Wiley & Sons Ltd Pensions Pension payments are a large cost for many firms 2 principal types of pension scheme defined benefit: pension related to salary defined contribution: pension related to payments Defined contribution becoming increasingly common Accounting for pensions raises two issues: How much to charge to Income Statement? How should underlying assets and liabilities be valued?

Financial Information Analysis3 Copyright 2006 John Wiley & Sons Ltd Accounting for pension costs IAS 19:Accounting treatment depends on type Defined contribution: expenses recognised in period contribution payable; Defined benefit: B/S liability equal to net of: Present value of expected future payments Deferred actuarial gains/losses and past service costs, and Fair value of any plan assets at B/S date IS figure is generally the resulting change in B/S value IAS 19 has prioritised B/S issues over IS increased volatility

Financial Information Analysis4 Copyright 2006 John Wiley & Sons Ltd Share Options Increasingly common as means of reward Attractive for recipients and companies Did not lead to any expense recorded in IS Accounting theory, frauds and abuse have caused change in accounting practice Considerable political issues IFRS 2 requires annual charge in IS and credit in B/S over vesting period

Financial Information Analysis5 Copyright 2006 John Wiley & Sons Ltd Options: IFRS 2 example X plc grants option on 1/1/01 for 100k shares vesting on 31/12/03. Price 1/1/01 = £5 IFRS 2: estimated cost to be charged to IS over vesting period (3 years) This will require various estimates etc. price will rise to 31/12/03 75% probability employee will satisfy requirements  1/1/01 value = 100k x.75 x £0.50 = £37,500 IFRS 2 requires this to be charged to IS over three years = £12.5k per annum

Financial Information Analysis6 Copyright 2006 John Wiley & Sons Ltd Leases Arrangements whereby lessee obtains right of use, often without obtaining legal title Finance Leases: most risks and rewards transferred to lessee Operating Leases: most risks and rewards of ownership retained by lessor IAS 17: assets and corresponding liabilities are created, regardless of legal fiction

Financial Information Analysis7 Copyright 2006 John Wiley & Sons Ltd Accounting for leases IAS 17, accounting treatment depends on type: Finance: asset and corresponding liability shown in balance sheet of lessee Operating: lessee merely shows leasing cost in P&L Classification may have significant impact on relevant ratios e.g. Gearing

Financial Information Analysis8 Copyright 2006 John Wiley & Sons Ltd Taxation Companies pay tax in their own right as separate legal entities UK resident companies liable to Corporation Tax Fixed rate of tax applied to profits (income and capital gains) Rate applies to financial year (April 1 - March 31) IAS 12 requires entities to account for Tax in a manner consistent with underlying transactions

Financial Information Analysis9 Copyright 2006 John Wiley & Sons Ltd Deferred Tax Tax and accounting principles differ in UK i.e., profit computed by accountants differs from that computed by HM Customs & Revenue permanent differences timing differences, e.g., Depreciation v. Capital Allowances Thus, tax due will also differ This leads to ‘Deferred Tax’

Financial Information Analysis10 Copyright 2006 John Wiley & Sons Ltd Deferred Tax IAS 12 introduces ‘Temporary differences’ “Differences between tax base of an asset or liability and its B/S carrying amount” All Temporary differences are also Timing differences IAS 12 provides that balance sheet liability method be applied This requires a recalculation of any potential liability in light of changes in tax rates

Financial Information Analysis11 Copyright 2006 John Wiley & Sons Ltd Deferred Tax example Y 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 difference = £80k: Deferred tax = £24k (80 x 30%)

Financial Information Analysis12 Copyright 2006 John Wiley & Sons Ltd Foreign Currency Globalisation and dominance of MNEs mean foreign currency transactions more common IAS 21 distinguishes between two currencies: Functional – primary economic currency Presentation – currency used for financial statements IAS 21 also distinguishes between: Monetary items: items to be settled by cash – e.g. debtors, creditors, loans, etc. Non-monetary items: other balances, e.g. fixed assets

Financial Information Analysis13 Copyright 2006 John Wiley & Sons Ltd Foreign Currency – IAS Transaction date: use exchange rate applying between foreign and functional currencies 2. Balance Sheet date: Monetary items: use closing rate on that date Non-monetary items: Where historic cost was used originally, these are retained Where fair value used, translate at rate for that date 3. Exchange differences arising on settlement of monetary items recognised in Income Statement

Financial Information Analysis14 Copyright 2006 John Wiley & Sons Ltd Summary IFRS results in considerable changes in accounting practice Political issues have impinged on standard setting process, e.g. in relation to Options Important to understand these technical areas for informed analysis But emphasis must remain on bigger picture