With two days to go before Christmas, a lot of people are rushing to complete their holiday shopping and prepare for Noche Buena and family gatherings. Traditionally, the celebration and merrymaking continue until we welcome the New Year. The excitement and engagement that everyone feels during this festive season can be likened to the mood of those involved in financial reporting at this point in the run-up to the end of the calendar year.
Several companies following a calendar year ending on December 31 are now busy preparing to close their books and determining their operating results for the year. The final results could be the basis for confirming the performance incentives of deserving officers and employees.
As a follow-up to last week’s edition of PwC’s Needles in a Haystack—in which we discussed some important financial closing activities companies should focus on—I am discussing below key considerations related to matters applicable to both public and non-public entities which are sometimes overlooked by management.
Philippine Accounting Standard (PAS) 16 requires that the depreciable amount of an asset should be allocated over its useful life. The same standard requires reviewing the residual value and usefulness of fixed assets at least at each year-end and, if expectations are different from previous estimates, with the changes accounted for.
There could be instances where management would re-assess and revise the estimated useful life of an asset. Similarly, an entity’s repair and maintenance policy may also affect an asset’s useful life. There may be subsequent costs being capitalized if they passed the recognition criteria, which may extend the fixed asset’s useful life or increase its residual value.
For a change in an asset’s depreciation after revising its useful life or residual value, no restatement should be done on prior year balances. The change should be accounted for by adjusting the depreciation rate for the current and future periods.
Fair value measurement of financial assets is an area relevant to all companies, not just financial services institutions. Cash, accounts receivable, investments in equity securities and debt instruments are the more common examples of financial assets.
While the accounting standards governing financial instruments are considered as the more difficult to understand, there is no excuse for companies in complying with the measurement and disclosure requirements for financial instruments.
For valuation of financial assets, the use of inputs or information that can be readily observed in the market (e.g. interest and foreign exchange rates) shall be maximized while the use of unobservable inputs should be minimized. For example, the fair value of listed securities actively traded on the Philippine Stock Exchange (PSE) can be readily obtained from the PSE website. This is a classic example of a quoted price in an active market without need for any adjustment; hence, assets falling under this type are commonly classified as ‘Level 1’ in the fair value hierarchy.
If current prices of financial instruments are unavailable come reporting date (which may be the case for some equity and debt instruments), the price of the latest transaction, adjusted for any change in conditions between transaction and balance sheet date, should be used. This is the ‘valuation technique’ used by an entity to come up with a reliable fair value.
Relative to the disclosure requirements covering financial instruments, a description of the valuation technique adopted by an entity is required in the financial statement. Furthermore, when regulators review financial statements, they look at some of the more common disclosures such as the inputs used for valuation, change in valuation techniques, levels of fair value hierarchy and sensitivity to changes in unobservable inputs.
Tax compliance has always been a key area for regulators and investors alike. Only when the final balances have been determined can the income tax calculation be finalized.
Most transactions and events recorded in financial statements have a tax consequence, which may be recognized currently or deferred to some future date. Recognizing the effects of all income and expenses, assets and liabilities on taxes in the same period these have been recorded, and not in the period in which they form part of taxable profit, is consistent with the matching principle that we follow in accounting.
The tax expense for the period comprises current and deferred taxes. However, there may be instances when companies are not able to account for deferred tax implications applicable for the reporting period. The concept of temporary difference is fundamental to computing deferred taxes according to accounting standards. The term “temporary” connotes that all differences between the amount of assets and liabilities and the corresponding tax bases will eventually be reversed.
Common transactions that may create a temporary difference include the accrual of retirement benefit obligation and other bonuses, provisions for receivables, unrealized foreign exchange gains or losses and fair value changes for financial assets.
A deferred tax liability should be recognized for all taxable temporary differences except for limited circumstance mentioned in PAS 12. On the other hand, a deferred tax asset is recognized to the extent that an entity has sufficient taxable profits against which the temporary differences can be utilized. Thus, a deferred tax asset arising from a carryover net operating loss is not automatically recognized unless an entity is able to show that a taxable profit can probably be generated.
Deferred tax assets and liabilities should always be presented as part of non-current accounts in classified financial statements. It is in the disclosure notes that deferred tax assets and liabilities are further segregated into their expected recoverability within 12 months from the date of the balance sheet and beyond.
The areas mentioned above are only a few of the items that management would need to think through as they close their books and craft their financial statements. As there are several stakeholders in any organization, it is imperative for management to produce reliable business information that at the same time assures compliance with accounting standards, tax rules and other local regulations.
A well-planned closing process, which includes assessing current recognition, measurement and disclosure practices of an entity, among others, can indeed contribute to a smoother financial reporting and allow management to finally say, “It’s a wrap!”
Ruth F. Blasco is a Partner from Assurance and the Methodology Co-Leader of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.