Profit and Loss Impact (Financial Statement Imbalance)
Our starting point is when the Consolidation Unit’s reported financial data is submitted. The net result of profit and loss accounting agrees with the equivalent balance (of retained earnings item) in the balance sheet. It can be modified by dividend payments when they are not liquidating dividends. Both statement of financial position and net income statement are in balance. Because of manual and automated adjusting entries those statements can go out of balance. This happens for example when we are writing off the excess of FMV (Fair Market Value) over the historical cost from the viewpoint of the enterprise and post an expense and thus reduce the net income. By posting the write-off expense we immediately impact the profit and loss result but without consideration of the balance sheet. In a similar fashion, we can have an impact from impairing a fixed asset. The result is an unbalanced balance sheet. The system adjusts for deferred taxes (whenever they are configured in the document type) and the overall balance as a profit and loss impact.
Figure: Net Income Configuration
For the system to post a netting entry, a configuration of required Selected Items is needed. The actual FS Item values depend on the accounting approach:
1. When dividends are accounted for in the Income Statement (non-US GAAP), then clearing is through the Balance Sheet
2. When dividends are accounted for in the Equity of Balance Sheet (US GAAP) then clearing is through the Income Statement FS Item “Net Income”…
The following should serve as an illustration. In an acquisition, the excess purchase price over the cost of the identified intangible asset is paid in the amount of $10M. The amortization period of useful life is 10 years.
The acquisition takes place at the beginning of the period and the quarterly amortization expense is in the amount of $250K.
Dr Amortization Expense 250,000
Cr Intangible Asset 250,000
The amortization journal entry has an immediate impact on the Profit and Loss (FS Item 37000000). The net profit is decreased by $250K. The FS Item 37000000 is the net result of all revenues and expenses and the FS Item 25712000 is the Balance Sheet equivalent amount of the net result (retained earnings), calculated by the system. Please note that the FS Item 25712000 cannot be changed either manually or automatically. This FS Item only changes when the P&L impact is posted.
By entering the amortization expense a disagreement between both net result amounts is created. The agreement is restored during the posting of the P&L impacts through the utilization of an additional Net Income FS Item – 39000000 or any other item that is configured in the Selected Item master data. This item always reflects inversely the totals item 37000000. Item 39000000 accumulates all P&L impact amounts and carries them forward.
Figure: Net Income in Balance Sheet
The dividend payouts in the Balance Sheet are henceforth accounted for in two FS Items of the Net Income statement:
1. FS Item 37000000: This is a totals (text node) item which represents the net result of all revenues and expenses and as a totals item cannot be posted into. Whenever expenses or revenues change, so does this item by virtue of the default totaling operation.
2. FS Item 39000000: This is a value (leaf) item that is required for posting P&L impacts. The item’s balance must equal an inverted balance of item 37000000.
The P&L impact item can be configured either in the Document Type or in the Selected Items. The Selected Item configuration takes precedence over the global setting of the document type (characteristic). The item (alphanumeric) value is entered in either B/S or Net Income clearing input fields. Each selected item can have one or more breakdowns. When more than one are used a default setting is needed. During posting, the system first checks against subassignment settings of the Document Type. Secondly, it will use the default setting of the configured Selected Item. Document Type configuration is thus optional…
The system is validating each and every manual or automatic posting to the extent of any potential P&L impacts and produces additional line items in such cases. Within the manual postings, such line items are then automatic. The P&L impact is recorded based on the configurations as follows (without consideration of deferred income taxes).
Dr Current year result – 25712000 250,000
Cr Net Income – 39000000 250,000
In case of intercompany revenues and expenses, both reciprocal Consolidation Units have the P&L impact posted depending on configuration of Document Type’s clearing – Consolidation Unit items. When the input field for Clearing – Consolidation Unit is populated the impact is posted as per Consolidation Unit. Otherwise, whenever interunit revenues and expenses match, no impact is posted as per Consolidation Unit.
Deferred Income Taxes in the Context of Financial Statement Preparation
The extent to which the income tax amounts are calculated according to IAS 12 originates in the temporary differences accounting. The temporary differences are those differences that result from different amounts and valuation of assets and liabilities of the Accounting Base and the Tax Base that may lead in subsequent periods to additional tax burden or tax relief. The permanent differences are those differences that exist between the pretax income and taxable income in the current as well as all other periods.
The Balance Statement approach works off a hypothetical assumption that the temporary differences between the book and tax basis will eventually reverse and achieve realization or fulfillment. In case of assets the realization takes place through depreciation (amortization) or through the disposition. Liabilities are extinguished when they are forgiven, paid off or voided. Accordingly, the differences may be reduced in future periods by different valuations. The temporary differences can have an immediate P&L impact and thus influence income taxes or be income neutral in the originating period and create tax effects only in future periods.
The calculation of Deferred Income Taxes takes place according to the liability method. The goal of the method is to account for the future tax liability or asset resulting from temporary differences. The Deferred Tax Liability measures the tax burden arising from reduction of temporary differences and Deferred Tax Asset is the expected tax benefit resulting from reduction of those differences. Deferred taxes are thus not only calculated balances but also are included in asset or liabilities sections of the balance sheet depicting future benefits or future obligations of the enterprise.
Deferred Tax Liability from future tax burdens
Future taxable amounts from temporary differences are accounted for as Deferred Tax Liabilities. Higher tax burdens are created from the future taxable amounts in the periods when the differences are reduced. The future taxable amounts are created in the current period from the business point of view and respectively, those future obligations are accounted for in the Deferred Tax Liability. This account balance needs to be utilized for higher income taxation cost. This cost results in a correction to the business after-tax net income.
Deferred Tax Asset from future tax benefits
Deferred Tax Asset amounts are accrued for the future tax benefits or future deductible amounts resulting from temporary differences. The differences included in the temporary differences require in the period of reversal a lower tax burden or the actual tax benefit (credit). The lower taxation event occurs already in the period of accrual and is reflected in the amount of Deferred Tax Asset.
With reversal of temporary differences we need to differentiate whether they do or do not have a P&L impact.
- Differences with P&L impact are created when the elements of taxable income and financial income are of the equal amounts, but have different timing of their realization. In the accrual period the financial income differs from taxable income. Therefore, the B/S tax payable amounts do not agree with the taxable income when compared with financial income. Both the accrual and its reversal are effected through the Income Statement.
- Differences with no P&L impact are additional timing temporary differences originating in different valuations of assets and liabilities. According to IAS 12.58 there are two situations:
- Revaluations reflected in Other Comprehensive Income or in a valuation reserve balance as per IAS 16 or IAS 38.
- Tax assets and liabilities purchased in an acquisition
In the first case, the changes in the fair value of assets lead to a temporary difference that must not have a P&L impact according to IAS 12.61. The reversal of accrued tax asset or liability occurs when the underlying asset is disposed of via sale or any other means. The actual disposal has income consequences with exception of revaluation as per IAS 16 or IAS 38. In the second case, the tax asset or liability is created by revaluation in conjunction with application of purchase accounting and in the effect increases or decreases the value of the acquired net assets. The tax provision reversal takes place after the useful life of the asset ends or the liability is finally extinguished. In some cases, the depreciation itself has no P&L impact and so its tax effect has no P&L impact.
Deferred tax assets and liabilities show the features of an asset or a liability. The valuation of the balance is driven by the tax rate applicable to the future period of temporary differences reversal or when the taxable losses can be offset with taxable gains. As long as the future changes in tax rates cannot be ascertained the rates to be applied are those that are valid as of the Balance Sheet statement date. Applying future tax rates is allowed when the changes are already prescribed in legislation or have been announced and their effective period is expected with certainty.
IAS 12 does not describe in detail which tax rates should be applied. It can however be determined that all income taxes should be included in calculations. What is relevant is the rate and thus the actual tax payable or receivable amount whenever the parent company and its subsidiaries have different future tax rates. This is especially important for multinational enterprises. In calculating deferred taxes, both assets and liabilities, the tax rate of each subsidiary or in case of an asset deal the tax rate of the acquiring entity need to be configured. Materiality principle can be applied when there is a need for an enterprise wide mixed tax rate.
Netting of deferred tax assets and liabilities can be effected according to IAS 12.71 when (a) the enterprise has unequivocal right to offset tax burdens with tax benefits and (b) the deferred tax assets and liabilities are from revenue taxes that are taxed by the same tax authority. Deferred tax assets and liabilities resulting from allocation of purchase price can be netted when they are for the same type of tax, duration, and tax authority.
Outside Basis Differences
According to IAS 12.38 the temporary differences between taxable basis of investment and share ownership of the subsidiary, i.e. net assets behind the investment inclusive of goodwill, need also be accrued. The outside basis differences accrual by the enterprise’s investment is understood to constitute an independent taxpayer as is the case of a subsidiary that has been incorporated. In addition to taxation at the corporate level the investing enterprise can have additional tax obligations from holding the investment in addition to outside basis differences. Whereas at the time of first consolidation basically there are no temporary differences since the acquisition book value is a fictional amount, but it conforms with the equity, bringing forward purchase price excess and goodwill can create temporary differences.
Deferred tax assets within the outside basis differences have to be reported along IAS 12.44 whenever there is a probability that the temporary difference reverses in the foreseeable future and its value can be preserved. Deferred tax liability has to be always reported unless the following two conditions are fulfilled
• The parent entity or the shareholder or the partnership is in position to control the timing of the reversal and
• It is probable that the temporary difference will not reverse in the foreseeable future.
Deferred tax provision during the close
Deferred taxes of the enterprise
During the data submission, the reported deferred tax asset balances are transferred to the consolidated reporting entity level. When during the fiscal year there is a new entity acquired so are its deferred tax balances transferred at par during the close.
Uniform enterprise reporting and valuation
Whenever the adjustments of subsidiary balances are made for reporting and valuation of the parent enterprise there can be P&L timing differences with P&L impact or no P&L impact. In addition to the P&L impacting temporary differences there can also be differences with no P&L impact that have to be accrued. For deferred tax assets created by an adjusting entry there is a requirement for releasing it when the releasing conditions are met, especially the requirement of value preservation.
Foreign Currency Translation
In subsidiary books that have balances in a currency different than that of the parent the comparison between tax and accounting basis takes place in the functional currency. In the task of currency translation both bases are converted in a linear fashion, so out of the currency translation deferred taxes are only created due to an outside basis difference.
Intercompany balances eliminations
The accrual of deferred taxes can only result from the reported float reconciliation. When the intercompany reconciling items are eliminated in the current year with a P&L impact, accrual results from both a timing and temporary difference. The deferred tax provisions in the subsequent years until the reversal need to be carried forward without the P&L impact with only the incremental differences versus prior year having the P&L impact. The intercompany float reconciling items with no P&L impact result in no timing differences but in temporary differences requiring an accrual. In that case, the tax basis to be applied is that of the entity which is the subject of valuation. When the intercompany float is the result of currency differences according to the treatment above there is no accrual for deferred taxes.
Intraperiod profit eliminations
During the intraperiod (interim) profit elimination the profits need to be adjusted to conform with enterprise reporting requirements. The realized profits of the current year are reported during the close of each subsidiary and are fully taxable even if they are not taxable as they have not yet been realized from the point of view of the whole enterprise. When the interim profits that have been eliminated in prior periods become realizable for the enterprise in the future periods then they have no bearing on the taxation of profits of the subsidiary, just like eliminations did not. Thus, there is no taxation of the interim profits of the enterprise, but they become taxable when realized. Considering deferred taxes, realization of subsidiary profits included in consolidated profits of the enterprise takes precedence over the enterprise-wide realization. Profit reporting in financial statements is deferred until the shipments or service delivery are executed for external Consolidation Unit’s customers or sold outside of the enterprise.
IAS 27.25 explicitly requires that timing differences due to eliminations of profits and losses during internal business transactions need to be accrued for taxes. However, there is no indication of the tax rate that should be used (neither in IAS 27 nor in IAS 12. It is genarally assumed that the tax rate of the entity taking delivery, can be applied. For US GAAP, it is the delivery provider.