Chapter 14: Taxation in company financial statements Flashcards
14.1 Accounting Issues in VAT
FRS 102 Section 29 deals with guidance on VAT for companies (the principles still apply to sole traders, partnerships and LLP’s). If a person is VAT registered, they must charge VAT on certain goods and services. The trader acts as a collector of the VAT on behalf of HMRC. As the VAT does not belong to the trader it should not be shown in the value of sales or turnover in the financial statements. The accounting entries for sales or turnover:
£ £
Dr Bank/debtor (with VAT inclusive X
amount)
Cr Sales/turnover (with VAT exclusive X
amount)
Cr VAT control account (output VAT) X
Overview of the mechanics of input VAT – the business may incur VAT as part of the cost of its purchases and expenses, known as input VAT and may be reclaimed by HMRC by a VAT registered person and should not normally be an expense. It should not be shown in the value of costs or expenses in the financial statements. The accounting entry for expenses and purchases are:
£ £
Dr Expenses/purchases (with VAT X
exclusive amount)
Dr VAT control account (input VAT) X
Cr Bank/ creditors (with VAT inclusive amount) X
14.1 Accounting Issues in VAT
VAT control account – the difference between the VAT charged on sales (output VAT) and the recoverable VAT incurred on the expenses and purchases (input VAT) must be paid over to or reclaimed from HMRC generally once a quarter. This amount will be equal to the closing balance on the VAT control account. Usually the closing balance will be a VAT creditor, where a business owes money to HMRC, but it can represent a VAT debtor balance. Where amounts are given inclusive of VAT the VAT element is calculated as:
VAT rate divided by (100+ VAT rate) multiplied by the VAT inclusive amount
Irrecoverable VAT – sometimes VAT on purchases and expenses cannot be recovered by HMRC, in accordance with VAT legislation. The main examples relate to client entertainment and blocked VAT on cars. In these situations, VAT is effectively a cost of the business and the full purchase price (including VAT) will be charged (debited) to the expense or asset account. Irrecoverable VAT can arise where a business makes supplies that are exempt from VAT. The business is said to be partially exempt and has to carry out a partial exemption calculation to determine how much input VAT it is entitled to recover.
VAT and the flat rate scheme – were introduced for small businesses from 25 April 2002, its aim is to simplify small businesses VAT accounts, so less time and money is spent keeping VAT records and calculating VAT payable. Businesses on the scheme still charge VAT on its invoices at appropriate rate of VAT, at the end of the VAT period the business calculates its VAT payment to HMRC as a percentage of this VAT-inclusive turnover. The percentages used is determined by HMRC and depends on the trade sector of the business. Input tax is not deductible under the flat rate scheme unless it relates to purchases of capital assets with a VAT inclusive value of £2,000 or more, or it relates to pre-registration input tax. Businesses under the scheme should prepare annual accounts using gross sales less the flat rate payment made to HMRC, expenses should be shown inclusive of VAT.
14.2 Accounting for Income Tax
FRS 102 Section 29 offers guidance on accounting for income tax. When companies make certain payments, such as annual interest on debentures and patent royalties to individuals they are required to deduct basic rate income tax at source and pay it to HMRC. Similarly of companies receive such payments from individuals they will receive them net of basic rate income tax, companies do not pay income tax so there is a mechanism to ensure it is recovered from HMRC.
Interest and patent royalties payable – these paid by a company to an individual are paid to the recipient net of basic rate income tax. The gross amount represents the expense of the company; therefore, the gross figures are shown on the profit and loss account. This is similar when the company acts as a collecting agent for VAT. It records income tax owed to HMRC on payments made to individuals net of tax, usually the closing balance will be an income tax creditor, where the business owes money to HMRC.
In terms of payments made by the company the interest expense account or patent payments account (expense ledger) is debited with the gross sum, the bank is credited with the net amount paid and an income tax creditor is credited with the income tax that has been deducted, as follows:
£ £
Dr Interest/ patent royalty expense X
(gross amount)
Cr Bank (net amount) X
Cr Income tax control account (income tax) X
FRS 102 states the full amount should be charged in the P+L. The company will also be showing the income tax payable to HMRC as a creditor in the balance sheet. When it is paid, the entry will be:
£ £
Dr Income tax control account (creditor) X
Cr Bank X
14.3 Accounting for corporation Tax
When preparing year end accounts, an estimate of the corporation tax based on profits is made. The amount is then accrued for at then end of the accounting period. It is normally paid over to HMRC 9 months and one day after the end of the accounting period for small companies and are paid in instalments for large companies. The accounting entries for corporation tax are:
£ £
Dr Corporation tax charge (P+L account) X
Cr Corporation tax creditor with the X
estimate of the amount
of corporation tax due on the year’s profits
Adjustment for under/over provisions – if the estimate is wrong, you make an under or over provision is used to correct the corporation tax charge. An under provision is accounted for as follows:
£ £ Dr Corporation tax charge X (P+L account) Cr Corporation tax creditor X
An under provision in the previous year effectively increases the following year’s corporation tax charge in the profit and loss account. An over provision in the previous year effectively decreases the following year’s corporation tax charge in the profit and loss account. An over provision is accounted for as follows:
£ £
Dr Corporation tax creditor X
Cr Corporation tax charge (P+L X
account)
14.4 Accounting for deferred tax - permanent and timing differences
It is reasonable to assume the tax charge in the accounts is the current rate of CT multiplied by the PBT, this is called the expected tax charge. However, the tax system can distort this as the accounting profit and the taxable profit are calculated in different ways. Deferred tax is used to correct some aspects of this distortion.
Deferred tax is the name given to an accounting adjustment, it is not a type of tax and does not affect the cash position of the entity. It requires a reconciliation between the tax charge you expect, and the actual corporation tax charge calculated using the taxable profit figure. The differences between the expected tax charge and actual tax charge can be broken down into permanent differences and timing differences.
Permanent differences – arise when certain types of income and expenditure are recognised in the accounts but never appear in the tax computation as an item of taxable income or an allowable expense. An example is client entertaining which is a legitimate expense in accounting but not allowable for tax purposes. Another example is dividends received which is an item of income in the accounts but not in the tax computation.
Accounting for permanent differences - Permanent differences do not give rise to deferred tax adjustments, but the difference will lead to a distortion of the tax charge so will be included in the reconciliation required under FRS 102.
Timing differences – arise when certain types of income and expenditure are recognised in different periods for the purpose of the financial statements and taxation. An example is that depreciation charges appear in the financial statements but are not allowed as an expense for tax purposes. Instead capital allowances reduce taxable profits. Over the lifetime of a fixed asset the depreciation will equal capital allowances, however in any particular accounting period the amount will be different and create a timing difference.
14.4 Accounting for deferred tax
Accounting for timing differences – deferred tax is a system of dealing with the distortions caused by timing differences. Without deferred tax, the tax charge in the P+L account would only be based on the actual liability payable to HMRC. When looking at timing differences caused by depreciation and capital allowances consider:
• A year when capital allowances are high compared to the depreciation charge. The tax liability will be lower than the reported profits would suggest, or
• A year when capital allowances fall short of the depreciation charge. This would result in the tax liability being higher than our reported profits would suggest.
To overcome this problem, the tax charge shown in the P+L account is not simply the tax liability agreed with HMRC. Instead it is the liability adjusted (up or down) by an amount reflecting the value of timing differences.
When we buy an asset and claim the capital allowances, we know that we will have to pay more tax in the future and therefore have a deferred tax liability. We account for this by providing for deferred tax on all timing differences. We can calculate the timing differences by comparing the capital allowances and depreciation each year. For a deferred tax liability, the entry would be:
£ £
Dr Deferred taxation charge (profit X
and loss account)
Cr Deferred taxation provision (BS Creditor) X
This realises that we will have to pay more tax in the future. For a deferred tax asset, the entry would be:
£ £
Dr Deferred taxation provision (BS) X
Cr Deferred taxation charge (P+L account) X
The deferred tax is merely an accounting adjustment and does not reflect the amount of tax paid to HMRC. FRS 102 requires all timing differences giving rise to deferred tax liabilities to be accounted for. This includes adjustments for fixed asset disposals where a profit is shown in the accounts but for tax purposes a claim is made to defer tax on the gain by a rollover relief election. Also includes adjustments where holiday pay or bonuses are accrued in the accounts but not paid within 9 months of the year end so tax relief on the expense is delayed.
You can have a deferred tax asset; an example is where there are unrelieved brought forward losses that for tax purposes are able to be offset against future profits. FRS 102 requires all unrelieved tax losses and other deferred tax assets to be only recognised to the extent it is probable that they will be recovered against the reversal of deferred tax liabilities or other future taxable profits.
14.4 Accounting for deferred tax
Profit Reconciliations – FRS 102 considers it important to explain to the users of the accounts why the tax charge differs from what it expected and therefore requires companies to produce a reconciliation between the expected tax charge and the actual corporation tax charge. Timing differences and permanent differences cause the accounting profit and taxable profit to be different, FRS 102 states these are the only two things that can give rise to the differences. We need to identify the differences between the accounting profit and taxable profit, split them into permanent and timing differences and list them out.
