A European example of faulty reasoning in applying IAS 12
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 19th edition:
- The issuer specialized in planting cacao trees, operating a cacao plantation and harvesting cacao in Africa. After planting the young cacao trees, the first harvests were expected after 18 months and the lifetime of the trees was expected to be 30-35 years. The issuer started planting trees in 2013 and expected the first harvest in October 2015. At the end of 2014, the trees still had to grow about four more years before they would reach their maturity. Afterwards their fair value would decrease after each harvest.
- In accordance with paragraph 12 of IAS 41 the cacao trees were measured on initial recognition and at the end of each reporting period at fair value less costs to sell. As the tax base of the trees was nil, a taxable temporary difference existed. Between 2014 and 2026, the issuer is exempt from all income taxes in the country where the cacao plantation is located. In 2027 the normal tax rate would be reduced by 50% and in 2028 by 25%. Afterwards the normal tax rate of 25% would apply.
- The issuer did not recognize a deferred tax liability as it believed that the temporary difference existing at 31 December 2014 would reverse entirely during the tax holiday period. The issuer believed that the temporary difference would be recovered by the harvests in the first four to six years and that the temporary differences that reverse after the end of the tax holiday period would only arise in the future due to the future growth of the trees until they reach maturity.
The enforcer (as ESMA likes to term it) disagreed with this treatment, in the following terms:
- According to paragraph 16 of IAS 12, the amount by which the carrying amount of an asset exceeds its tax base is a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability. As the entity recovers the carrying amount of the asset, the taxable temporary difference will reverse and the entity will have taxable profit. According to paragraph 47 of IAS 12, a deferred tax liability shall be measured at the tax rates that are expected to apply to the periods when the asset is realised. The issuer should have determined which part of the asset is realised during the tax holiday period and which part is realised afterwards.
- It is not appropriate to estimate that the temporary difference as of 31 December 2014 relating to young cacao trees with a lifetime of 30-35 years will be recovered in full during the next four to six years and that the temporary differences that will reverse after the tax holiday period will entirely be generated after 2014. The growth of the young cacao trees that occurred until 31 December 2014 is the basis for all benefits that will flow to the issuer during the entire lifetime of the trees. Therefore, the period over which the asset is realised is the entire lifetime of the trees.
This sounds like a difference in the “unit of account” at which the issuer applied the concepts of the standard – that is, a failure to consider a temporary difference as something that arises in concept on an asset by asset basis, and that reverses over time on that same basis. It’s an odd omission, because it’s clear from the very first paragraphs of IAS 12 that the concept of temporary differences arises from basic concepts of assets and liabilities:
- It is inherent in the recognition of an asset or liability that the reporting entity expects to recover or settle the carrying amount of that asset or liability. If it is probable that recovery or settlement of that carrying amount will make future tax payments larger (smaller) than they would be if such recovery or settlement were to have no tax consequences, this Standard requires an entity to recognize a deferred tax liability (deferred tax asset), with certain limited exceptions.
It’s no more reasonable to apply some kind of aggregated approach to assessing the reversal of temporary differences than it would be (say) to fail to consider impairment of receivables, on the basis that other receivables will arise in the future to replace any current items that can’t ultimately be collected. And yet, one can perhaps sense why it seems more reasonable – why assets and liabilities arising from temporary differences seem more malleable than others do. In large part, it might reflect the widespread sense that those tax balances don’t really provide any useful information content (as we recently discussed here), and so lend themselves to rationalizations that wouldn’t be considered elsewhere. The implied challenge is one we’ve also touched on before – to try to develop the most coherent accompanying disclosure both in the notes and the MD&A, so that users understand the tax balances in the context of an entity’s overall tax strategy and exposure…
The opinions expressed are solely those of the author