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

Chapter 12

Pensions, Share Options, Leases, Taxation and Foreign Currency

Financial Information Analysis 2Copyright 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?


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


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


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


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


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


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


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’


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


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%

Accounts Tax

Cost 300 300Depreciation/Cap Allow 100 180Carrying Amount 200 120

Temporary difference = £80k: Deferred tax = £24k (80 x 30%)


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


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


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

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

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