Chapter 12

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

2. 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 Analysis

3. 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 Analysis

4. 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 Analysis

5. 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 £5.50 @ 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 Analysis

6. 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 Analysis

7. 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 Analysis

8. 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 Analysis

9. 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 Analysis

10. 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 Analysis

11. 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 300 300 Depreciation/Cap Allow 100180 Carrying Amount 200 120 Temporary difference = £80k: Deferred tax = £24k (80 x 30%) Financial Information Analysis

12. 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 Analysis

13. Foreign Currency – IAS 21 • 1. 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 Analysis

14. 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 Financial Information Analysis