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Top five investigation hotspots

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22nd Mar 2010
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Steve Collings outlines the areas typically targeted by HMRC accountants in financial statements.

During the course of a tax investigation inspectors may query the accounting treatment of certain points in the financial statement. In certain cases, the inspector will refer the matter(s) to the revenue accountants who will then interpret the relevant accounting standards. Where HMRC accountants disagree with an accounting treatment, they will then provide details of the relevant standards or legislation. Revenue accountants also inform tax inspectors whether, in their opinion, financial statements comply with UK GAAP.

Accounting policies
Under FRS 18 and FRSSE, entities are required to adopt accounting policies that are most appropriate to its particular circumstances. Under FRS 18 provisions, where management deem a policy no longer applicable to their circumstances, they are required to change the policy and apply this change retrospectively to the previous year's financial statements.

Problems can arise when a transaction is not covered by an accounting standard or FRSSE. Where FRSSE is concerned, then the mainstream accounting standards should be consulted. Where no specific UK standard covers an accounting issue, then IFRS or US GAAP should be referred to in order to determine best practice.

Problem areas
HMRC accountants have a list of 'hot spots' which they consider to be the most problematic areas in financial statements which are discussed below.

Bad debt provisions
Specific bad debt provisions are generally allowable for tax purposes, whereas general bad debt provisions are not. Significant bad debts which are written off are often challenged by HMRC and they often require an explanation of how management deemed the debt to be bad. It is recommended to have some documentary evidence of large bad debts which are written off, such as correspondence from a liquidator.

Provisions
Under FRS 12, FRSSE and IFRS, a provision can only be recognised in the financial statements if it meets three specific criteria:

  • There is a legal or constructive obligation
  • An outflow of economic benefits will be required to discharge the obligation
  • The amount of the obligation can be measured reliably

Where those three criteria are not met, then no provision is made and a contingent liability is recognised. If the three criteria are met then HMRC have a problem with excessive provisions being made, for example a provision for £10,000 in respect of a legal case being brought against the company, whereas realistically the amount required to settle is actually £5,000.

Related parties
Related-party transactions are a ‘hot spot’ for tax inspectors and revenue accountants. Under current tax legislation, where companies are ‘associated’ for tax purposes, then the lower and upper profit limits are scaled down proportionately depending on the number of associated companies during the accounting period. The related party note can often reveal details of any associated companies which have not been taken into consideration when dealing with the tax computation and is a simple mistake to make, but could be quite costly.

Revenue recognition
When UITF 40 was issued in 2005 it caused outcry within the profession. The introduction of this task force abstract resulted in accelerated revenue having to be recognised, despite the fact that the work had not been invoiced which in turn resulted in higher tax liabilities. Under the concept of UITF 40, an entity is required to recognise revenue when a critical event (a milestone) passes. The critical event is where the entity receives a right to consideration. Large work-in-progress balances held at the year-end may trigger an enquiry to see if the provisions in UITF 40 have been correctly applied.

Deferred revenue is often queried by HMRC. This usually occurs where an entity invoices for services (for example support services) and these services span two accounting periods. An entity can only recognise revenue in the accounting period which it relates so it is worth ensuring that the accounting policy for deferred revenue is sufficiently disclosed within the notes to the financial statements.

Directors’ bonuses
It is common for companies to pay the directors a bonus depending on the profits yielded at the end of the year using a predetermined formula. In almost every case, the financial statements of an entity will not be finalised until sometime after the year end and this is where problems can sometimes occur.

Under FRS 12 (and as discussed above), a provision can only be made in the financial statements if an obligation exists at the balance sheet date. If the bonus has been declared after the balance sheet date, then a provision should not be recognised. This also applies to dividends declared after the balance sheet date. FRS 12 provisions are often cited by revenue accountants when challenging bonus provisions.

However, where an entity has always paid profit-related bonuses to the directors, then FRS 12 provisions are satisfied because the directors will ‘expect’ a bonus and it is this expectation which creates a constructive obligation at the balance sheet date and thus it is reasonable to recognise a provision.

Steve Collings FMAAT ACCA DipIFRS is the audit and technical manager at LWA Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’ and lectures on financial reporting and auditing issues.

Replies (10)

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By atkinson-accountancy
22nd Mar 2010 09:43

Good article

I will incorporate this into my completion checklists

 ----------------------------

Winchester Accountant

 

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Teignmouth
By Paul Scholes
22nd Mar 2010 13:51

Very useful thanks Steve

The "provision" aspect is one that always gets the client going and trying to find their paperwork.  We had our first ever "compliance check" over related parties two months ago, it was satisfied by a simple list to back up the return but was still a wake up call.

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By User deleted
22nd Mar 2010 13:53

accounts

excellent article, can now show my clients I'm not dreaming these things up!

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By Peter Cane
22nd Mar 2010 14:14

Bad debt provisions

Steve

Thanks for the article.

I have heard it mentioned on several courses in the last year or so that there is now no distinction between specific and general bad debt provisions for companies. (Unincorporated business are still on the old rules)

The speakers have stated that, since FA 2005, any impairment for trade debts is now within the loan relationship rules and therefore any provision (whether specific or general) is allowable unless it is to a connected party.

My notes from a Finance Act 2009 course by Mercia state the following "Where a company writes off a money debt that has arisen in the course of a trade, or a UK or overseas property business, the debit in the company's accounts is now brought into the ambit of the loan relationship rules. The result is that where the creditor company is unconnected with the debtor, the creditor will get relief for the impairment either as a trading expense or as part of a non-trading loan relationships deficit. HMRC would also regard relief as being available if the debit arises from the creditor having formally released the debt"

Do you have any thoughts on that?

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By Ayesha Bham
22nd Mar 2010 14:38

Fab article
Steve another fantastic article. Thanks for that we will be updating our procedures accordingly.

Thank you.

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By User deleted
24th Mar 2010 09:17

Good article to show some stroppy clients

I have one question about the very last paragraph...

If the director/shareholders "expect" a dividend every year is the treatment the same as the "expectation" of a salary bonus?

In other words can my clients prepare their March year end accounts in June and back-date quarterly dividends which they have drawn but not done the paperwork for when the accounts are done as they have always done it that way and have an "exspectation" that this will happen each year?

 

 

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collings
By Steven Collings
25th Mar 2010 21:50

Re Dividends

Re the dividend expectation.  I can definitely see your point in relation to my article, however FRS 21 prohibits the backdating of dividends (SSAP 17 used to allow this, but FRS 21 explicitly prohibits such).  Dividends should be declared before the balance sheet date, and the necessary paperwork drawn up to corroborate the dividend in order for the dividend to be included in that year's financial statements. 

Apologies for my delay in replying to your thread as well.

Best wishes

Steve

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collings
By Steven Collings
25th Mar 2010 22:03

Ref Loan Relationship Rules

Hi Peter,

My understanding of Section 42 FA 2009 is that if a creditor company is connected with a debtor company (as in, say, a group structure) and the creditor writes off the debt then no tax charge arises on the debtor - conversely no tax relief is given to the creditor. 

Your Mercia notes refer to situations where the two companies are not connected and where creditor writes off a debtor balance, creditor will get tax relief.

As my article mentions (and as has been asked of me quite recently), bad debt write offs are generally queried by HMRC where they are significant.  If they form an aspect enquiry you can lay odds the Inspector will want evidence that the debt is bad, such as correspondence from the Liquidator or other forms of documentary evidence to prove the debit in the profit and loss account.

Again, I apologise for the delay in replying to your query (long week!!)

Best wishes

Steve

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collings
By Steven Collings
25th Mar 2010 22:04

Thanks

Just wanted to thank you for your positive feedback on this article.   It is much appreciated.

Best wishes

Steve

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By todwadley
08th Aug 2013 17:26

Loan Interest

What would be the position regarding Loan Interest and FRS12 ?

A loan would most probably meet all three criteria, namely :

 - A legal obligation

 - An outflow of economic benefit required to discharge the obligation, and

 - The amount of the obligation can be measured reliably (in may cases to the penny)

Does FRS12 permit the total interest charge for the loan term to be relieved against profits in the first year of the loan?

What impact, if any, does UK GAAP have?

How would HMRC react ?

Thanks for any help

Regards

 

 

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