DipIFR Syllabus B. Elements of financial statements - Deferred Tax Scenarios - Past Papers ^{2 / 4}

You are the financial controller of Omega, a listed entity which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). You have recently prepared the financial statements for the year ended 30 September 2017 and these are due to be published shortly. The managing director has reviewed these financial statements and has prepared a list of queries arising out of the review.

Query Two 
I noticed that OCI includes a gain of $64 million relating to the revaluation of our portfolio of properties. I looked in the notes to check that a corresponding amount of $64 million had been added to property, plant and equipment. However, the note explaining movements in property, plant and equipment showed a revaluation increase of $80 million. There was a reference to tax in one of the notes I looked at but I don’t see why this is relevant. I know our rate of tax is 20% and this would explain the difference but we won’t pay any tax on this gain unless we sell the properties. We have no intention of selling any of them in the foreseeable future, so what relevance does tax have? Please explain the difference between the $64 million gain in OCI and the $80 million gain added to property, plant and equipment. (6 marks)

Required:
Provide answers to the queries raised by the managing director. You should justify your answers with reference to relevant International Financial Reporting Standards.

Note: The mark allocation is shown against each of the four queries above

Note 1 – Alpha’s investment in Beta
On 1 October 2013, Alpha acquired 80 million shares in Beta by means of a share exchange of one share in Alpha for every two shares acquired in Beta. On 1 October 2013, the market value of an Alpha share was $7·00.

Alpha incurred directly attributable due diligence costs of $3 million on acquisition of Beta. The directors of Alpha included these acquisition costs in the carrying amount of the investment in Beta in the draft statement of financial position of Alpha. There has been no change to the carrying amount of this investment in Alpha’s own statement of financial position since 1 October 2013.

On 1 October 2013, the individual financial statements of Beta showed the following balances:
– Retained earnings $150 million.
– Other components of equity $5 million.

The directors of Alpha carried out a fair value exercise to measure the identifiable assets and liabilities of Beta at 1 October 2013. The following matters emerged:
– Property having a carrying amount of $160 million (land component $70 million, buildings component $90 million) had an estimated fair value of $200 million (land component $80 million, buildings component $120 million). The buildings component of the property had an estimated useful life of 30 years at 1 October 2013.

– Plant and equipment having a carrying amount of $120 million had an estimated fair value of $140 million. The estimated remaining useful life of this plant at 1 October 2013 was four years. None of this plant and equipment had been disposed of between 1 October 2013 and 30 September 2016.

– On 1 October 2013, the notes to the financial statements of Beta disclosed a contingent liability. On 1 October 2013, the fair value of this contingent liability was reliably measured at $6 million. The contingency was resolved in the year ended 30 September 2014 and no payments were required to be made by Beta in respect of this contingent liability.

– The fair value adjustments have not been reflected in the individual financial statements of Beta. In the consolidated financial statements the fair value adjustments will be regarded as temporary differences for the purposes of computing deferred tax. The rate of deferred tax to apply to temporary differences is 20%.

The directors of Alpha used the proportion of net assets method when measuring the non-controlling interest in Beta in the consolidated statement of financial position.

Note 2 – Impairment review of goodwill on acquisition of Beta
No impairment of the goodwill on acquisition of Beta was evident when the reviews were carried out on 30 September 2014 and 2015. On 30 September 2016, the directors of Alpha carried out a further review and concluded that the recoverable amount of the net assets of Beta at that date was $400 million. Beta is regarded as a single cash generating unit for the purpose of measuring goodwill impairment.

Note 3 – Alpha’s investment in Gamma
On 1 October 2015, Alpha acquired 60 million shares in Gamma by means of a cash payment of $140 million. The purchase agreement provided for an additional payment on 31 October 2017 to the former holders of the 60 million acquired shares. The amount of this additional payment is dependent on the financial performance of Gamma in the two-year period from 1 October 2015 to 30 September 2017. On 1 October 2015, the fair value of this additional payment was estimated to be $20 million. This estimate was revised to $24 million on 30 September 2016. Alpha has not made any entries in its draft financial statements to record this potential additional payment.

On 1 October 2015, the individual financial statements of Gamma showed a balance on retained earnings of $75 million.

On 1 October 2015, the fair values of the net assets of Gamma were the same as their carrying amounts with the exception of some land which had a carrying amount of $50 million and a fair value of $70 million. This land continued to be an asset of Gamma at 30 September 2016. The fair value adjustment has not been reflected in the individual financial statements of Gamma. In the consolidated financial statements the fair value adjustment will be regarded as a temporary difference for the purposes of computing deferred tax. The rate of deferred tax to apply to temporary differences is 20%.

No impairment issues arose concerning the measurement of Gamma in the consolidated statement of financial position of Alpha at 30 September 2016.

The directors of Alpha used the full goodwill (fair value) method when measuring the non-controlling interest in Gamma in the consolidated statement of financial position. On 1 October 2015, the fair value of a share in Gammawas $2·30.

Note 4 – Trade receivables and payables
Group policy is to clear intra-group balances on a given date prior to each year end. Beta complied with this policy at 30 September 2016 but Gamma was late in making the required payment of $10 million to Alpha. The payment was made by Gamma on 29 September 2016 and received and recorded by Alpha on 2 October 2016.

Note 5 – Provision
On 1 October 2015, Alpha completed the construction of a non-current asset with an estimated useful life of 20 years. The costs of construction were recognised in property, plant and equipment and depreciated appropriately. Alpha has a legal obligation to restore the site on which the non-current asset is located on 30 September 2035. The estimated cost of this restoration work, at 30 September 2035 prices, is $25 million. The directors of Alpha have made a provision of $1·25 million (1/20 x $25 million) in the draft statement of financial position at 30 September 2016. An appropriate annual discount rate to use in any relevant calculations is 6% and at this rate the present value of $1 payable in 20 years is 31·2 cents.

Required:
Prepare the consolidated statement of financial position of Alpha at 30 September 2016. You need only consider the deferred tax implications of any adjustments you make where the question specifically refers to deferred tax.

(a) Deferred tax is the tax on temporary differences. Temporary differences are identified on individual assets and liabilities in the statement of financial position. Temporary differences arise when the carrying value of an asset or liability differs from its tax base.

Required:
Explain:
(i) How IAS 12 – Income Taxes – defines the tax base of assets and liabilities. (3 marks)
(ii) How temporary differences are identified as taxable or deductible temporary differences. (2 marks)
(iii) The general criteria prescribed by IAS 12 for the recognition of deferred tax assets and liabilities. You do NOT need to identify any specific exceptions to these general criteria. (2 marks)

Epsilon prepares consolidated financial statements to 31 March each year. During the year ended 31 March 2014, the following events affected the tax position of the group:

(i) Lambda, a wholly owned subsidiary of Epsilon, made a loss adjusted for tax purposes of $3 million. Lambda is unable to utilise this loss against previous tax liabilities and local tax legislation does not allow Lambda to transfer the tax loss to other group companies. Local legislation does allow Lambda to carry the loss forward and utilise it against its own future taxable profits. The directors of Epsilon do not consider that Lambda will make taxable profits in the foreseeable future. (2 marks)

(ii) Just before 31 March 2014, Epsilon committed itself to closing a division after the year end, making a number of employees redundant. Therefore Epsilon recognised a provision for closure costs of $2 million in its statement of financial position as at 31 March 2014. Local tax legislation allows tax deductions for closure costs only when the closure actually takes place. In the year ended 31 March 2015, Epsilon expects to make taxable profits which are well in excess of $2 million. On 31 March 2014, Epsilon had taxable temporary differences from other sources which were greater than $2 million. (3 marks)

(iii) During the year ended 31 March 2014, Epsilon capitalised development costs which satisfied the criteria in paragraph 57 of IAS 38 – Intangible Assets. The total amount capitalised was $1·6 million. The development project began to generate economic benefits for Epsilon from 1 January 2014. The directors of Epsilon estimated that the project would generate economic benefits for five years from that date. The development expenditure was fully deductible against taxable profits for the year ended 31 March 2014. (3 marks)

(iv) On 1 April 2013, the total goodwill arising on consolidation in Epsilon’s consolidated statement of financial position was $4 million. On 31 March 2014, the directors reviewed the goodwill for impairment and concluded that the goodwill was impaired by $600,000. There was no tax deduction available for any group company as a consequence of this impairment charge as at 31 March 2014. (2 marks)

(v) On 1 April 2013, Epsilon borrowed $10 million. The cost to Epsilon of arranging the borrowing was $200,000 and this cost qualified for a tax deduction on 1 April 2013. The loan was for a three-year period. No interest was payable on the loan but the amount repayable on 31 March 2016 will be $13,043,800. This equates to an effective annual interest rate of 10%. Under the tax jurisdiction in which Epsilon operates, a further tax deduction of $3,043,800 will be claimable when the loan is repaid on 31 March 2016. (3 marks)

Required: 
Explain and show how each of these events would affect the deferred tax assets/liabilities in the consolidated statement of financial position of the Epsilon group at 31 March 2014. Where relevant, you should assume the rate of corporate income tax is 25%

Note: The mark allocation is shown against each of the five transactions above.

(a) When preparing financial statements it is important to ensure that the tax consequences of all transactions are appropriately recognised. IAS 12 – Income Taxes – prescribes the treatment of both current and deferred tax assets and liabilities.

Current tax is the amount of income tax payable or recoverable in respect of the taxable profit or tax loss for a period. Deferred tax is tax on temporary differences. A temporary difference is the difference between the carrying amount of an asset or liability and its tax base. A taxable temporary difference leads to a potential deferred tax liability and a deductible temporary difference leads to a potential deferred tax asset.

Required: 
Explain how the tax base of both an asset and a liability is computed and state the general requirements of IAS 12 regarding the recognition of both deferred tax liabilities and deferred tax assets. You do not need to identify any of the exceptions to these general requirements which are set out in IAS 12. (5 marks)

(b) Kappa prepares consolidated financial statements to 30 September each year. During the year ended 30 September 2013 Kappa entered into the following transactions:

(i) On 1 October 2012, Kappa purchased an equity investment for $200,000. The investment was designated as fair value through other comprehensive income. On 30 September 2013, the fair value of the investment was $240,000. In the tax jurisdiction in which Kappa operates, unrealised gains and losses arising on the revaluation of investments of this nature are not taxable unless the investment is sold. Kappa has no intention of selling the investment in the foreseeable future. (5 marks)

(ii) On 1 August 2013, Kappa sold products to Omega, a wholly owned subsidiary operating in the same tax jurisdiction as Kappa, for $80,000. The goods had cost Kappa $64,000. By 30 September 2013, Omega had sold 40% of these goods, selling the remaining 60% in October and November 2013. (6 marks)

(iii) On 31 March 2013, Kappa received $200,000 from a customer. This payment was in respect of services to be provided by Kappa from 1 April 2013 to 31 January 2014. Kappa recognised revenue of $120,000 in respect of this transaction in the year ended 30 September 2013 and will recognise the remainder in the year ended 30 September 2014. Under the tax jurisdiction in which Kappa operates, the $200,000 received on 31 March 2013 was included in the taxable profits of Kappa for the year ended 30 September 2013. (4 marks)

Required: 
Explain and show how the tax consequences (current and deferred) of the three transactions would be reported in the statement of financial position of Kappa at 30 September 2013 and its statement of profit or loss and other comprehensive income for the year ended 30 September 2013.

Note: The mark allocation is shown against each of the three transactions above.

You should assume that:
– The rate of income tax in the jurisdiction in which Kappa operates is 25%.
– Both Kappa and Omega are profitable companies which consistently generate annual taxable profits of at least $1,000,000.

In answering this part, you do NOT need to consider the possible offset of deferred tax assets against deferred tax liabilities.