Cima P 7 Official Learning System Managerial Level Financial Accounting & Tax Principles[1]


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Cima P 7 Official Learning System Managerial Level Financial Accounting & Tax Principles[1]

  1. 1. CIMA’S Official Learning System Managerial Level Financial Accounting and Tax Principles Tom Rolfe
  2. 2. CIMA Publishing is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA First edition 2006 Copyright © 2006 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone ( 44) (0) 1865 843830; fax ( 44) (0) 1865 853333; e-mail: Alternatively you can submit your request online by visiting the Elsevier web site at, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13: 978 0 7506 8049 3 ISBN-10: 0 7506 8049 0 For information on all CIMA publications visit our web site at Typeset by Integra Software Services Pvt. Ltd, Pondicherry, India Printed and bound in Great Britain 06 07 08 09 10 10 9 8 7 6 5 4 3 2 1 Working together to grow libraries in developing countries | |
  3. 3. Contents The CIMA Learning System xvii Acknowledgements xvii How to use the CIMA Learning System xvii Study technique xix Financial Accounting and Tax Principles xxi 1 Principles of Business Taxation – Introduction 1 Learning Outcomes 1 1.1 Introduction 1 1.2 Taxation as a source of government revenue 2 1.3 Principles of taxation 2 1.3.1 Canons of taxation 2 1.3.2 The American Institute of Certified Public Accountants’ (AICPA) statement – Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals 3 1.4 Basic tax terminology 3 1.4.1 Direct taxes 3 1.4.2 Indirect taxes 4 1.4.3 Incidence 4 1.4.4 Taxable person 4 1.4.5 Competent jurisdiction 4 1.4.6 Hypothecation 5 1.4.7 Withholding responsibilities 5 1.4.8 Tax rate structure 5 1.4.9 The tax gap 6 1.5 Tax bases and classification of taxes 6 1.6 Sources of tax rules 6 1.7 Summary 8 Revision Questions 9 Solutions to Revision Questions 11 2 Direct Taxes on an Entity’s Profits and Gains 13 Learning Outcome 13 2.1 Introduction 13 2.2 The corporate tax base 14 2.2.1 Schedular systems of corporate taxation 14 2.2.2 Classification of income 15 2.2.3 Expenditure 16 2.2.4 Capital gains 19 2.3 Nominal corporate tax rates 21 iii 2006.1
  4. 4. iv FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 2.4 The interaction of the corporate tax system with the personal tax system 21 2.4.1 Classical system 21 2.4.2 Imputation system 21 2.4.3 Partial imputation system 22 2.4.4 Split rate systems 22 2.4.5 Examples to illustrate the difference between traditional and imputation systems 22 2.5 Rules recharacterising interest as dividends 23 2.6 Treatment of losses 23 2.6.1 Trading losses 23 2.6.2 Capital losses 23 2.6.3 Cessation of business 24 2.7 The concept of tax consolidation 24 2.7.1 Capital losses and tax groups 25 2.8 Summary 25 Revision Questions 27 Solutions to Revision Questions 31 3 Indirect Taxes and Employee Taxation 33 Learning Outcome 33 3.1 Introduction 33 3.2 Indirect taxes collected by the entity 34 3.2.1 Unit taxes and ad valorem taxes 34 3.3 Consumption taxes 34 3.3.1 Single-stage sales taxes 34 3.3.2 Multi-stage sales taxes 34 3.4 Value-added tax (VAT) 35 3.4.1 Transactions liable to VAT 36 3.5 Indirect taxes paid by the entity 38 3.5.1 Excise duties 38 3.5.2 Property taxes 38 3.5.3 Wealth taxes 38 3.6 Employee taxation 39 3.6.1 The employee as a separate taxable person subject to a personal income tax regime 39 3.6.2 Social security contributions 40 3.6.3 Other payroll taxes 41 3.7 Use of employer reporting and withholding to ensure compliance and assist tax collection 41 3.8 Summary 41 Revision Questions 43 Solutions to Revision Questions 45 4 Administration of Taxation 47 Learning Outcomes 47 4.1 Introduction 47 2006.1
  5. 5. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 v 4.2 The need for record-keeping and record retention 48 CONTENTS 4.2.1 Corporate income tax 48 4.2.2 Sales tax or VAT 48 4.2.3 Overseas subsidiaries 49 4.2.4 Employee taxes and social security 49 4.3 The need for deadlines for reporting (filing returns) and tax payments 49 4.4 Types of powers of tax authorities to ensure compliance with tax rules 50 4.4.1 Power to review and query filed returns 50 4.4.2 Power to request special reports or returns 50 4.4.3 Power to examine records (generally extending back some years) 51 4.4.4 Powers of entry and search 51 4.4.5 Exchange of information with tax authorities in other jurisdictions 51 4.5 Tax avoidance and tax evasion 51 4.5.1 Tax evasion 52 4.5.2 Tax avoidance 52 4.5.3 Statutory general anti-avoidance provisions and case law regimes 52 4.6 Forum on tax administration 53 4.7 Summary 53 Revision Questions 55 Solutions to Revision Questions 57 5 International Taxation 59 Learning Outcome 59 5.1 Introduction 59 5.2 The Organisation for Economic Co-operation and Development (OECD) – Model tax convention 59 5.3 The concept of corporate residence 60 5.3.1 Place of control and central management of an entity 60 5.3.2 Place of incorporation 60 5.3.3 Place of control and place of incorporation 60 5.4 The OECD Articles of the model convention with respect to taxes on income and on capital 61 5.5 Withholding tax 62 5.6 Underlying tax 62 5.7 Means of establishing a taxable presence in another country 63 5.7.1 Subsidiary 63 5.7.2 Branch 63 5.8 Double taxation treaties 64 5.8.1 The OECD model tax convention 64 5.8.2 Principles of relief for foreign taxes 65 5.9 Summary 65 Readings 67 Revision Questions 77 Solutions to Revision Questions 79 2006.1
  6. 6. vi FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 6 Taxation in Financial Statements 81 Learning Outcome 81 6.1 Introduction 81 6.2 Calculation of current tax 82 6.3 Accounting for current tax 82 6.4 Calculation of deferred tax 83 6.4.1 Introduction to deferred tax 83 6.4.2 Timing difference approach 84 6.4.3 Temporary difference approach 85 6.4.4 Deferred tax assets 87 6.4.5 Tax losses 87 6.5 Accounting for deferred tax 88 6.6 Income tax charge 89 6.7 Disclosure 90 6.8 Summary 90 Revision Questions 91 Solutions to Revision Questions 95 7 The IASC and the Standard-Setting Process 101 Learning Outcomes 101 Learning Aims 101 7.1 The need for regulation of financial statements 102 7.2 Variation from country to country 102 7.2.1 Sources of finance and capital markets 102 7.2.2 The political system 102 7.2.3 Entity ownership 103 7.2.4 Cultural differences 103 7.3 Harmonisation versus standardisation 103 7.3.1 The need for harmonisation of accounting standards 103 7.4 Elements that might be expected in a regulatory framework for published accounts 104 7.4.1 Local law that applies to entities 104 7.4.2 Locally adopted accounting standards 105 7.4.3 Local stock exchange requirements 105 7.4.4 International body requirements 105 7.4.5 International accounting standards 105 7.4.6 Locally developed or international conceptual framework for accounting 105 7.5 Generally accepted accounting practice (GAAP) 105 7.6 The International Accounting Standards Committee Foundation (IASC Foundation) 106 7.6.1 Structure of the IASC Foundation 107 7.6.2 IASC Foundation 107 7.6.3 The International Accounting Standards Board (IASB) 108 7.6.4 The International Financial Reporting Interpretations Committee (IFRIC) 108 7.6.5 The Standards Advisory Council (SAC) 109 2006.1
  7. 7. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 vii 7.7 Objectives of the IASC Foundation 109 CONTENTS 7.8 The International Organisation of Securities Commissions (IOSCO) 109 7.9 Local regulatory bodies 110 7.9.1 Convergence activities 110 7.9.2 International reaction 110 7.10 The standard-setting process 111 7.10.1 Development of a standard 112 7.10.2 Other aspects of due process 112 7.10.3 Co-ordination with national standard-setting 112 7.10.4 Benchmark treatments and allowed alternatives 113 7.11 Ways in which IFRS’s are used by countries 113 7.11.1 Adoption as local GAAP 113 7.11.2 Model for local GAAP 113 7.11.3 Persuasive influence in formulating local GAAP 113 7.11.4 Local GAAP developed with little or no reference to IFRS’s 114 7.12 Summary 114 Revision Questions 115 Solutions to Revision Questions 117 8 Regulatory Framework 121 Learning Outcome 121 8.1 Introduction 121 8.2 The development of the Framework 122 8.2.1 Purpose of the Framework 8.2.2 Status of the Framework 122 8.2.3 Scope of the Framework 122 8.3 The Framework 123 8.3.1 The objective of financial statements 123 8.3.2 Underlying assumptions 123 8.3.3 The qualitative characteristics of financial information 124 8.3.4 The elements of financial statements 125 8.3.5 Recognition of the elements of financial statements 126 8.3.6 Measurement of the elements of financial statements 126 8.3.7 Concepts of capital and capital maintenance 127 8.4 Usefulness of a conceptual Framework 127 8.5 The IASB’s Framework and the standard-setting process 128 8.6 Summary 128 Revision Questions 129 Solutions to Revision Questions 131 9 The Role of the External Auditor 135 Learning Outcome 135 9.1 External audit 135 9.1.1 The purpose of an audit 135 9.1.2 The auditor’s duties 136 9.1.3 The powers of auditors 137 9.1.4 The audit process 137 2006.1
  8. 8. viii FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 9.2 The audit report 138 Independent auditor’s report 138 9.2.1 A closer look at the report 140 9.3 Qualified reports 142 9.3.1 Materiality 143 9.3.2 The wording of a qualified report 144 9.3.3 Independent auditor’s report showing qualified opinion 145 9.3.4 Independant auditor’s report, adverse opinion 146 9.4 Summary 147 Readings 149 Revision Questions 159 Solutions to Revision Questions 161 10 Published Financial Statements 163 Learning Outcome 163 Learning aims 163 10.1 Introduction 163 10.2 General requirements 164 10.2.1 Purpose of financial statements 164 10.2.2 Responsibility for financial statements 164 10.2.3 Components of financial statements 164 10.2.4 Fair presentation and compliance with IFRSs 165 10.2.5 Other requirements affecting the preparation of financial statements 166 10.3 The balance sheet 167 10.3.1 Specimen balance sheet 167 10.3.2 Information to be presented on the face of the balance sheet 168 10.3.3 Information to be presented either on the face of the balance sheet or in the notes 171 10.3.4 Share capital and reserves disclosures 172 10.3.5 The current/non-current distinction 173 10.3.6 Current assets 174 10.3.7 Current liabilities 174 10.4 The income statement 174 10.4.1 Specimen income statement 174 10.4.2 Information to be presented on the face of the income statement 175 10.4.3 Information to be presented either on the face of the income statement or in the notes 176 10.5 Changes in equity 178 10.5.1 First format for the Statement of changes in equity 179 10.5.2 Second format – a statement of income and expense and a reconciliation note 181 10.6 Notes to financial statements 181 10.6.1 Structure 181 10.6.2 Accounting policies 182 2006.1
  9. 9. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 ix 10.7 An illustrative question 182 CONTENTS 10.8 Summary 187 Revision Questions 189 Solutions to Revision Questions 197 11 Reporting Financial Performance 209 Learning Outcome 209 11.1 Introduction 209 11.2 IAS 18 Revenue recognition 209 11.2.1 Introduction 209 11.2.2 Sale of goods 210 11.2.3 Rendering of services 210 11.2.4 Interest, royalties and dividends 210 11.2.5 Disclosure requirements 210 11.3 Profit or loss for the period 211 11.3.1 Extraordinary items 211 11.3.2 Profit or loss from ordinary activities 212 11.4 Definitions – Accounting policies, accounting estimates and errors 213 11.5 Changes in accounting policies 213 11.5.1 Treatment and disclosure 214 11.6 Changes in accounting estimates 215 11.7 Errors 215 11.7.1 Treatment and disclosure 216 11.8 Discontinuing operations 217 11.8.1 Objective 217 11.8.2 Definition of a discontinued operation 218 11.8.3 Measurement of a non-current asset (or disposal group) 219 11.8.4 Presentation and disclosure 220 11.9 Segment reporting 223 11.9.1 Business and geographical segments 223 11.9.2 Segment results 224 11.9.3 Reporting formats 224 11.9.4 Reportable segments 224 11.9.5 Segment accounting policies 225 11.9.6 Disclosure 225 11.10 Summary 227 Revision Questions 229 Solutions to Revision Questions 233 12 Cash Flow Statements 237 Learning Outcome 237 12.1 Introduction 237 12.2 Objective of IAS 7 Cash flow statements 238 12.3 Cash flow statement format 238 12.3.1 Cash flows from operating activities 239 12.3.2 Cash flows from investing activities 241 2006.1
  10. 10. x FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 12.3.3 Cash flows from financing activities 241 12.3.4 Increase (or decrease) in cash and cash equivalents during period 241 12.4 A worked example 242 12.4.1 Worked example 242 12.4.2 Cash flow from operations 244 12.4.3 Cash flows from investing activities 247 12.4.4 Cash flows from financing activities 248 12.4.5 The cash flow statement 248 12.5 Interpreting a cash flow statement 249 12.6 Summary 249 Revision Questions 251 Solutions to Revision Questions 257 13 Non-current Tangible Asset Standards 263 Learning Outcome 263 13.1 IAS 16 property, plant and equipment 263 13.1.1 Objective 263 13.2 Revision of some definitions in IAS 16 263 13.2.1 Property, plant and equipment 264 13.2.2 Carrying amount 264 13.2.3 Cost 264 13.2.4 Depreciable amount 264 13.2.5 Depreciation 264 13.2.6 Fair value 264 13.2.7 Impairment loss 264 13.2.8 Recoverable amount 264 13.2.9 Residual value 264 13.2.10 Useful life 264 13.3 Recognition 265 13.3.1 Elements of cost 265 13.3.2 Self-constructed assets 265 13.4 Measurement 265 13.4.1 Cost model 265 13.4.2 Revaluation model 266 13.5 Subsequent expenditure 266 13.6 Accounting for depreciation 266 13.6.1 Review of useful life 267 13.6.2 Depreciation method 267 13.7 Retirements and disposals 268 13.8 Revaluation of assets 269 13.8.1 Revaluation surplus 269 13.8.2 Revaluation deficits 270 13.8.3 Disposal of a revalued asset 270 13.9 Disclosure requirements 271 13.10 IAS 23 borrowing costs 272 13.10.1 Introduction 272 13.10.2 The benchmark treatment 272 13.10.3 The allowed alternative treatment 272 2006.1
  11. 11. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xi 13.10.4 Interest rate 272 CONTENTS 13.10.5 Period of capitalisation 272 13.10.6 SIC2-Consistency-Capitalisation of borrowing costs 273 13.10.7 Disclosure 273 13.11 Available for sale financial assets 273 13.12 Summary 273 Revision Questions 275 Solutions to Revision Questions 279 14 Accounting for Leases 283 Learning Outcome 283 14.1 Introduction 283 14.2 Key definitions 284 14.3 Characteristics of leases 284 14.3.1 Finance leases 284 14.3.2 Operating leases 285 14.3.3 Leases of land and buildings 285 14.4 Accounting for operating leases 286 14.4.1 Rent-free period 286 14.4.2 Cashback incentives 287 14.5 Disclosures for operating leases 287 14.6 Accounting for finance leases 288 14.7 Calculating the implied interest on finance leases 289 14.7.1 In advance/in arrears 294 14.8 Disclosures for finance leases 295 14.9 Summary 296 Revision Questions 297 Solutions to Revision Questions 301 15 Inventories and Construction Contracts 307 Learning Outcome 307 15.1 Introduction 307 15.2 IAS 2 Inventories 307 15.2.1 Definition of Inventories 307 15.2.2 Measurement 308 15.2.3 Determining cost 308 15.2.4 Costs not included in cost of inventory 308 15.2.5 Allocation of overheads 308 15.2.6 Calculation of costs 309 15.2.7 Allowed alternative method 310 15.2.8 Disclosures for inventories 310 15.3 IAS 11 construction contracts 310 15.3.1 General principle 310 15.3.2 Accounting treatment 311 15.3.3 Sales revenue 312 15.3.4 Recognisable contract profits 313 15.3.5 Expected contract losses 314 15.3.6 Uncertain outcome 315 2006.1
  12. 12. xii FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 15.3.7 Inventories 316 15.3.8 Receivables 316 15.3.9 Payables 317 15.3.10 Provisions for foreseeable losses 318 15.3.11 Disclosure requirements 318 15.3.12 Illustrations from IAS 11 318 15.3.13 A comprehensive example 322 15.4 Summary 324 Revision Questions 325 Solutions to Revision Questions 331 16 Non-current Intangible Assets 335 Learning Outcome 335 16.1 Introduction 335 16.1.1 Objective of IAS 38 intangible assets 335 16.1.2 Recognition and initial measurement 336 16.1.3 Internally generated goodwill 336 16.1.4 Internally generated intangible asset 337 16.1.5 Subsequent expenditure 338 16.1.6 Subsequent measurement 339 16.1.7 Amortisation 339 16.1.8 Impairment losses 340 16.1.9 Retirements and disposals 340 16.1.10 Disclosure 340 16.2 Purchased goodwill 341 16.2.1 Purchased goodwill – recognition and measurement 341 16.2.2 Negative purchased goodwill 341 16.3 IAS 36 impairment of assets 341 16.3.1 Introduction 341 16.3.2 Procedures to check for impairment 342 16.3.3 Recognition and measurement of an impairment loss 342 16.4 Disclosure of impairments 345 16.5 Summary 345 Revision Questions 347 Solutions to Revision Questions 351 17 Share Capital Transactions 357 Learning Outcome 357 17.1 Introduction 357 17.2 IAS 1 Requirements 358 17.2.1 Interests of shareholders 358 17.2.2 Disclosures 358 17.3 Different classes of shares 359 17.4 IAS 32 Financial Instruments Disclosure and Presentation 360 17.5 Issue of shares 361 17.5.1 Process 361 17.5.2 Accounting for the issue of shares 362 2006.1
  13. 13. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xiii 17.5.3 Share issue costs, redemption costs and dividends 366 CONTENTS 17.5.4 Redeemable Shares 366 17.5.5 Convertible Debt 367 17.6 Bonus issues 367 17.6.1 Process 367 17.6.2 Accounting for a bonus issue 368 17.7 Accounting for a rights issue 369 17.8 Accounting for treasury shares 369 17.9 The purchase and redemption of shares 370 17.9.1 Purchases out of distributable profits 371 17.10 Summary 373 Revision Questions 375 Solutions to Revision Questions 379 18 Recognition and Disclosure of Other Significant Accounting Transactions 383 Learning Outcome 383 18.1 Introduction 383 18.2 IAS 10 Events after the balance sheet date 383 18.2.1 Introduction 383 18.2.2 Definitions 384 18.2.3 Adjusting events 384 18.2.4 Non-adjusting events 385 18.3 Proposed dividends 385 18.4 Going concern 385 18.5 Disclosure requirements of IAS 10 385 18.6 IAS 37 Provisions, Contingent Liabilities and Contingent Assets 386 18.6.1 Introduction 386 18.6.2 Provisions 386 18.6.3 Provision for warranties 387 18.7 Contingent liabilities and contingent assets 387 18.8 Problems with IAS 37 as regards contingencies 388 18.9 Related party disclosures 389 18.10 Definitions 389 18.10.1 Exclusions 390 18.11 Disclosure 390 18.11.1 Disclosure of control 390 18.11.2 Disclosure of transactions and balances 390 18.11.3 Examples of related party transactions 391 18.12 Summary 391 Revision Questions 393 Solutions to Revision Questions 397 19 Working Capital Ratios 399 Learning Outcome 399 Learning aims 399 19.1 Introduction 399 2006.1
  14. 14. xiv FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 19.2 Working capital management 399 19.2.1 The investment decision 400 19.2.2 The financing decision 401 19.3 Working capital ratios 402 19.3.1 Illustration 402 19.3.2 Liquidity ratios 403 19.3.3 The current ratio 403 19.3.4 The quick ratio 403 19.4 Efficiency ratios 404 19.4.1 Inventory turnover 404 19.4.2 Receivables turnover 405 19.4.3 Payables turnover 405 19.5 The working capital cycle 406 19.6 Shortening the working capital cycle 408 19.7 Summary 408 Revision Questions 409 Solutions to Revision Questions 413 20 Sources of Short-term Finance and Types of Investment 415 Learning Outcomes 415 20.1 Introduction 415 20.2 Sources of short-term finance 416 20.2.1 Trade credit 416 20.2.2 Overdrafts 416 20.2.3 Term loans 417 20.2.4 Factoring 417 20.3 Export finance 417 20.3.1 Export factoring 418 20.3.2 Bill of exchange 418 20.3.3 Documentary credits 419 20.3.4 Forfeiting 419 20.4 Managing cash surpluses 420 20.5 Debt yields 420 20.5.1 Interest yield 420 20.5.2 Yield to maturity (redemption yield) 420 20.5.3 Coupon rate 421 20.6 Short-term investments 422 20.6.1 Treasury bills 422 20.6.2 Bank deposits 422 20.6.3 Certificates of deposit 422 20.6.4 Money-market accounts 422 20.6.5 Local authority deposits 422 20.6.6 Commercial paper 423 20.6.7 Local authority bonds 423 20.6.8 Corporate bonds 423 2006.1
  15. 15. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xv 20.6.9 Government bonds 423 CONTENTS 20.6.10 Risk and return 423 20.7 Summary 424 Revision Questions 425 Solutions to Revision Questions 427 21 Working Capital: Receivables and Payables 429 Learning Outcomes 429 21.1 Introduction 429 21.2 Managing receivables 429 21.3 The credit cycle 430 21.3.1 Credit control 430 21.3.2 Payment terms 431 21.3.3 Cash discounts 431 21.3.4 Methods of payment 432 21.3.5 The stages in debt collection 433 21.4 Age analysis of trade receivables 433 21.5 Credit insurance 434 21.6 Factoring 434 21.7 Assessing the effectiveness of credit control 437 21.8 Evaluating a change in credit policy 438 21.9 Trade payables 439 21.10 The payment cycle 439 21.10.1 Cash discounts 440 21.10.2 Methods of payment 440 21.11 Age analysis of trade payables 441 21.12 Summary 441 Readings 445 Revision Questions 447 Solutions to Revision Questions 451 22 Working Capital: Inventory 457 Learning Outcome 457 22.1 Introduction 457 22.2 Inventory management 457 22.3 The nature of inventory 458 22.3.1 Raw materials 458 22.3.2 Work-in-progress 458 22.3.3 Finished goods 458 22.4 The costs of inventory 458 22.4.1 Holding costs 458 22.4.2 Order costs 458 22.4.3 The cost of running out of inventory 458 22.4.4 Unit cost 459 22.5 Inventory control policy 459 22.5.1 Dependent or independent demand 459 2006.1
  16. 16. xvi FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 CONTENTS 22.6 Inventory control systems 459 22.6.1 Reorder level system 459 22.6.2 Periodic review system 460 22.6.3 Mixed systems 461 22.7 Economic order quantity (EOQ) 461 22.7.1 Comments on Figure 22.3 461 22.8 Quantity discounts 463 22.9 Lead times 464 22.9.1 Lead times with constant demand 465 22.10 Just-in-time (JIT) purchasing 465 22.11 Summary 466 Readings 467 Revision Questions 473 Solutions to Revision Questions 477 23 Working Capital: Cash 483 Learning Outcomes 483 23.1 Introduction 483 23.2 Cash management 483 23.2.1 The time value of money 484 23.3 Cash budgets 484 23.3.1 Preparation of cash budgets 485 23.3.2 Managing cash deficits 487 23.3.3 Float 488 23.4 Cash-management models 488 23.4.1 The Baumol model 488 23.4.2 The Miller–Orr model 489 23.5 Efficient-cash management 491 23.6 The link between cash, profit and the balance sheet 491 23.7 Summary 494 Revision Questions 495 Solutions to Revision Questions 501 Preparing for the Examination 509 Revision technique 509 Getting down to work 510 Tips for the final revision phase 510 Format of the examination 510 Revision Questions I 513 Solutions to Revision Questions I 537 Revision Questions II 553 Solutions to Revision Questions II 585 November 2005 Examinations 633 Index 663 May 2006 Exam 2006.1
  17. 17. The CIMA Learning System Acknowledgements Every effort has been made to contact the holders of copyright material, but if any here have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the first opportunity. We would also like to thank Luisa Robertson for her invaluable contribution as reviewer and author of previous editions of this text. How to use the CIMA Learning System This Financial Accounting and Tax Principles Learning System has been devised as a resource for students attempting to pass their CIMA exams, and provides: ● a detailed explanation of all syllabus areas; ● extensive ‘practical’ materials, including readings from relevant journals; ● generous question practice, together with full solutions; ● an exam preparation section, complete with exam standard questions and solutions. This Learning System has been designed with the needs of home-study and distance- learning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to undertake extensive question practice. However, the Learning System is also ideal for fully taught courses. The main body of the text is divided into a number of chapters, each of which is organ- ised on the following pattern: ● Detailed learning outcomes expected after your studies of the chapter are complete. You should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading. ● Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may strug- gle to understand later chapters. xvii 2006.1
  18. 18. xviii FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 THE CIMA LEARNING SYSTEM ● Readings and activities. Most chapters are illustrated by more practical elements, such as rel- evant journal articles or other readings, together with comments and questions designed to stimulate discussion. ● Question practice. The test of how well you have learned the material is your ability to tackle exam-standard questions. Make a serious attempt at producing your own answers, but at this stage don’t be too concerned about attempting the questions in exam conditions. In particular, it is more important to absorb the material thoroughly by completing a full solution than to observe the time limits that would apply in the actual exam. ● Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to think that this provides the same benefits as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, and then make your own attempt before referring back to the full solution. Having worked through the chapters you are ready to begin your final preparations for the examination. The final section of the CIMA Learning System provides you with the guidance you need. It includes the following features: ● A brief guide to revision technique. ● A note on the format of the examination. You should know what to expect when you tackle the real exam, and in particular the number of questions to attempt, which ques- tions are compulsory and which optional, and so on. ● Guidance on how to tackle the examination itself. ● A table mapping revision questions to the syllabus learning outcomes allowing you to quickly identify questions by subject area. ● Revision questions. These are of exam standard and should be tackled in exam condi- tions, especially as regards the time allocation. ● Solutions to the revision questions. As before, these indicate the length and the quality of solution that would be expected of a well-prepared candidate. If you work conscientiously through this CIMA Learning System according to the guidelines above you will be giving yourself an excellent chance of exam success. Good luck with your studies! Guide to the Icons used within this Text Key term or definition Equation to learn Exam tip to topic likely to appear in the exam Exercise Question Solution Comment or Note 2006.1
  19. 19. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xix Study technique THE CIMA LEARNING SYSTEM Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section we briefly outline some tips for effective study during the earlier stages of your approach to the exam. Later in the text we mention some tech- niques that you will find useful at the revision stage. Planning To begin with, formal planning is essential to get the best return from the time you spend studying. Estimate how much time in total you are going to need for each subject that you face. Remember that you need to allow time for revision as well as for initial study of the material. The amount of notional study time for any subject is the minimum estimated time that students will need to achieve the specified learning outcomes set out earlier in this chapter. This time includes all appropriate learning activities, for example, face-to-face tuition, private study, directed home study, learning in the workplace, revision time, etc. You may find it helpful to read Better exam results by Sam Malone, CIMA Publishing, ISBN: 075066357X. This book will provide you with proven study techniques. Chapter by chapter it covers the building blocks of successful learning and examination techniques. The notional study time for Managerial level – Financial Accounting and Tax Principles is 200 hours. Note that the standard amount of notional learning hours attributed to one full-time academic year of approximately 30 weeks is 1200 hours. By way of example, the notional study time might be made up as follows: Hours Face-to-face study: up to 60 Personal study: up to 100 ‘Other’ study – e.g. learning in the workplace, revision, etc.: up to – 140 200 Note that all study and learning-time recommendations should be used only as a guideline and are intended as minimum amounts. The amount of time recommended for face-to- face tuition, personal study and/or additional learning will vary according to the type of course undertaken, prior learning of the student, and the pace at which different students learn. Now split your total time requirement over the weeks between now and the examination. This will give you an idea of how much time you need to devote to study each week. Remember to allow for holidays or other periods during which you will not be able to study (e.g. because of seasonal workloads). With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and final question practice. Prepare a written schedule summarising the above – and stick to it! The amount of space allocated to a topic in the study material is not a very good guide as to how long it will take you. For example, ‘Summarising and Analysing Data’ has a weight of 25 per cent in the syllabus and this is the best guide as to how long you should spend on 2006.1
  20. 20. xx FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 THE CIMA LEARNING SYSTEM it. It occupies 45 per cent of the main body of the text because it includes many tables and charts. It is essential to know your syllabus. As your course progresses you will become more familiar with how long it takes to cover topics in sufficient depth. Your timetable may need to be adapted to allocate enough time for the whole syllabus. Tips for effective studying (1) Aim to find a quiet and undisturbed location for your study, and plan as far as possible to use the same period of time each day. Getting into a routine helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to min- imise interruptions. (2) Store all your materials in one place, so that you don’t waste time searching for items around the house. If you have to pack everything away after each study period, keep them in a box, or even a suitcase, which won’t be disturbed until the next time. (3) Limit distractions. To make the most effective use of your study periods you should be able to apply total concentration, so turn off the TV, set your phones to message mode, and put up your ‘do not disturb’ sign. (4) Your timetable will tell you which topic to study. However, before diving in and becoming engrossed in the finer points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your books. With experience, you will learn to assess the pace you need to work at. You should also allow enough time to read relevant articles from newspapers and journals, which will supplement your knowledge and demonstrate a wider perspective. (5) Work carefully through a chapter, making notes as you go. When you have covered a suitable amount of material, vary the pattern by attempting a practice question. Preparing an answer plan is a good habit to get into, while you are both studying and revising, and also in the examination room. It helps to impose a structure on your solu- tions, and avoids rambling. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered only skimpily. (6) Make notes as you study, and discover the techniques that work best for you. Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’, or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. (7) Organise your paperwork. There are now numerous paper storage systems available to ensure that all your notes, calculations and articles can be effectively filed and easily retrieved later. 2006.1
  21. 21. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xxi Paper P7 – Financial Accounting and Tax Principles THE CIMA LEARNING SYSTEM First examined in May 2005 Syllabus outline The syllabus comprises: Topic Study Weighting A Principles of Business Taxation 20% B Principles of Regulation of Financial Reporting 10% C Single Entity Financial Accounts 45% D Managing Short-term Finance 25% Learning aims Students should be able to: ● describe the types of business taxation rules and requirements likely to affect an enter- prise (in respect of itself and its employees); ● describe and discuss how financial reporting can be regulated and the system of International Accounting Standards; ● prepare statutory accounts in appropriate form for a single enterprise; ● assess and control the short term financial requirements of a business entity. Assessment strategy There will be a written examination paper of 3 hours, with the following sections. Section A – 50 marks A variety of compulsory objective test questions, each worth between 2 and 4 marks. Mini-scenarios may be given, to which a group of questions relate. Section B – 30 marks Six compulsory short answer questions, each worth 5 marks. A short scenario may be given, to which some or all questions relate. Section C – 20 marks One question, from a choice of two, worth 20 marks. Short scenarios may be given, to which questions relate. Learning outcomes and syllabus content A – Principles of Business Taxation – 20% Learning outcomes On completion of their studies students should be able to: (i) identify the principal types of taxation likely to be of relevance to an incorporated business in a particular country, including direct tax on the enterprise’s trading prof- its and capital gains, indirect taxes collected by the enterprise, employee taxation, withholding taxes on international payments; 2006.1
  22. 22. xxii FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 THE CIMA LEARNING SYSTEM (ii) describe the features of the principal types of taxation likely to be of relevance to an incorporated business in a particular country (e.g. in terms of who ultimately bears the tax cost, withholding responsibilities, principles of calculating the tax base); (iii) describe the likely record-keeping, filing and tax payment requirements associated with the principal types of taxation likely to be of relevance to an incorporated busi- ness in a particular country; (iv) describe the possible enquiry and investigation powers of taxing authorities; (v) identify situations in which foreign tax obligations (reporting and liability) could arise and methods for relieving foreign tax; (vi) explain the difference in principle between tax avoidance and tax evasion; (vii) describe sources of tax rules and explain the importance of jurisdiction; (viii) explain and apply the accounting rules contained in IAS 12 for current and deferred taxation. Syllabus content ● Concepts of direct versus indirect taxes, taxable person and competent jurisdiction. ● Sources of tax rules (e.g. domestic primary legislation and court rulings, practice of the relevant taxing authority, supranational bodies, such as the EU in the case of value- added/sales tax, and international tax treaties). ● Direct taxes on enterprise profits and gains: – the principle of non-deductibility of dividends and systems of taxation defined according to the treatment of dividends in the hands of the shareholder (e.g. classical, partial imputation and imputation); – the distinction between accounting and taxable profits in absolute terms (e.g. disallow- able expenditure on revenue account, such as entertaining, and on capital account, such as formation and acquisition costs) and in terms of timing (e.g. deduction on a paid basis, tax depreciation substituted for book depreciation); – the nature of rules recharacterising interest payments as dividends; – potential for variation in rules for calculating the tax base dependent on the nature or source of the income (schedular systems); – the need for rules dealing with the relief of losses; – the concept of tax consolidation (e.g. for relief of losses and deferral of capital gains on asset transfers within a group). ● Indirect taxes collected by the enterprise: – in the context of indirect taxes, the distinction between unit taxes (e.g. excise duties based on physical measures) and ad valorem taxes (e.g. sales tax based on value); – the mechanism of value-added/sales taxes, in which businesses are liable for tax on their outputs less credits for tax paid on their inputs, including the concepts of exemp- tion and variation in tax rates depending on the type of output and disallowance of input credits for exempt outputs. ● Employee taxation: – the employee as a separate taxable person subject to a personal income tax regime; – use of employer reporting and withholding to ensure compliance and assist tax collection. ● The need for record-keeping and record retention that may be additional to that required for financial accounting purposes. ● The need for deadlines for reporting (filing returns) and tax payments. ● Types of powers of tax authorities to ensure compliance with tax rules: 2006.1
  23. 23. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xxiii – power to review and query filed returns; THE CIMA LEARNING SYSTEM – power to request special reports or returns; – power to examine records (generally extending back some years); – powers of entry and search; – exchange of information with tax authorities in other jurisdictions. ● International taxation: – the concept of corporate residence and the variation in rules for its determination across jurisdictions (e.g. place of incorporation versus place of management); – types of payments on which withholding tax may be required (especially interest, div- idends, royalties and capital gains accruing to non-residents); – means of establishing a taxable presence in another country (local enterprise and branch); – the effect of double tax treaties (based on the OECD Model Convention) on the above (e.g. reduction of withholding tax rates, provisions for defining a permanent establishment); – principles of relief for foreign taxes by exemption, deduction and credit. ● The distinction between tax avoidance and tax evasion, and how these vary among juris- dictions (including the difference between the use of statutory general anti-avoidance provisions and case law based regimes). ● Accounting treatment of taxation and disclosure requirements under IAS 12. Note: Examples of general principles should be drawn from a ‘benchmark’ tax regime (e.g. the UK, USA, etc.) or an appropriate local tax regime. Details of any specific tax regime will NOT be examined. B – Principles of Regulation of Financial Reporting – 10% Learning outcomes On completion of their studies students should be able to: (i) explain the need for regulation of published accounts and the concept that regulatory regimes vary from country to country; (ii) explain potential elements that might be expected in a regulatory framework for pub- lished accounts; (iii) describe the role and structure of the International Accounting Standards Board (IASB) and the International Organisation of Securities Commissions (IOSCO); (iv) explain the IASB’s Framework for the Presentation and Preparation of Financial Statements; (v) describe the process leading to the promulgation of an international accounting stan- dard (IAS); (vi) describe ways in which IAS’s can interact with local regulatory frameworks; (vii) explain in general terms, the role of the external auditor, the elements of the audit report and types of qualification of that report. Syllabus content ● The need for regulation of accounts. ● Elements in a regulatory framework for published accounts (e.g. local law relating to enterprises, local GAAP, review of accounts by public bodies). 2006.1
  24. 24. xxiv FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 THE CIMA LEARNING SYSTEM ● GAAP based on prescriptive versus principles-based standards. ● The role and structure of the IASB and IOSCO. ● The IASB’s Framework for the Presentation and Preparation of Financial Statements. ● The process leading to the promulgation of a standard practice. ● Ways in which IAS’s are used: adoption as local GAAP, model for local GAAP, persua- sive influence in formulating local GAAP. ● The powers and duties of the external auditors, the audit report and its qualification for accounting statements not in accordance with best practice. C – Single Entity Financial Accounts – 45% Learning outcomes On completion of their studies students should be able to: (i) prepare financial statements in a form suitable for publication, with appropriate notes; (ii) prepare a cash flow statement in a form suitable for publication; (iii) explain and apply the accounting rules contained in IAS’s dealing with reporting per- formance, tangible non-current assets and inventories; (iv) explain the accounting rules contained in IAS’s governing share capital transactions; (v) explain the principles of the accounting rules contained in IAS’s dealing with disclo- sure of related parties to a business, construction contracts (and related financing costs), research and development expenditure, intangible non-current assets (other than goodwill on consolidation), impairment of assets, post-balance sheet events, con- tingencies and leases (lessee only). Syllabus content ● Preparation of the financial statements of a single enterprise, including the statement of changes in equity (IAS 1). ● Preparation of cash flow statements (IAS 7). ● Reporting performance: recognition of revenue, measurement of profit or loss, extraor- dinary items, prior period items, discontinuing operations and segment reporting (IAS 1, 8, 14, 18 & IFRS 5). ● Property, Plant and Equipment ( IAS 16): The calculation of depreciation and the effect of revaluations, changes to economic useful life, repairs, improvements and disposals. ● Inventories (IAS 2). ● Issue and redemption of shares, including treatment of share issue and redemption costs (IAS 32 and IAS 39), the share premium account, the accounting for maintenance of capital arising from the purchase by an enterprise of its own shares. ● The disclosure of related parties to a business (IAS 24). ● Construction contracts and related financing costs (IAS 11 & 23): determination of cost, net realisable value, the inclusion of overheads and the measurement of profit on uncom- pleted contracts. ● Research and development costs (IAS 38): criteria for capitalisation. ● Intangible Assets (IAS 38) and goodwill (excluding that arising on consolidation): recog- nition, valuation and amortisation. ● Impairment of Assets (IAS 36) and its effect on the above. ● Post-balance sheet events (IAS 10). 2006.1
  25. 25. FINANCIAL ACCOUNTING AND TAX PRINCIPLES P7 xxv Provisions and contingencies ( IAS 37). THE CIMA LEARNING SYSTEM ● ● Leases (IAS 17) – Operating and finance leases in the books of the lessee. D – Managing Short-term Finance – 25% Learning outcomes On completion of their studies students should be able to: (i) calculate and interpret working capital ratios for business sectors; (ii) prepare and analyse cash flow forecasts over a 12-month period; (iii) identify measures to improve a cash forecast situation; (iv) compare and contrast the use and limitations of cash management models and iden- tify when each model is most appropriate; (v) analyse trade receivable information; (vi) evaluate receivable and payable policies; (vii) evaluate appropriate methods of inventory management; (viii) identify alternatives for investment of short-term cash surpluses; (ix) identify sources of short-term funding; (x) identify appropriate methods of finance for trading internationally. Syllabus content ● Working capital ratios (e.g. receivable days, inventory days, payable days, current ratio, quick ratio) and the working capital cycle. ● Working capital characteristics of different businesses (e.g. supermarkets being heavily funded by payables) and the importance of industry comparisons. ● Cash flow forecasts, use of spreadsheets to assist in this in terms of changing variables (e.g. interest rates, inflation) and in consolidating forecasts. ● Variables that are most easily changed, delayed or brought forward in a forecast. ● The link between cash, profit and the balance sheet. ● The Baumol and Miller–Orr cash management models. ● The credit cycle from receipt of customer order to cash receipt. ● Evaluation of payment terms and settlement discounts. ● Preparation and interpretation of age analyses of receivables and payables. ● Establishing collection targets on an appropriate basis (e.g. motivational issues in manag- ing credit control). ● The payment cycle from agreeing the order to make payments. ● Centralised versus decentralised purchasing. ● The relationship between purchasing and inventory control. ● Principles of the economic order quantity (EOQ) model and criticisms thereof. ● Types and features of short-term finance: trade payables, overdrafts, short-term loans and debt factoring. ● Use and abuse of trade payables as a source of finance. ● The principles of investing short term (i.e. maturity, return, security, liquidity and diversification). ● Types of investments (e.g. interest-bearing bank accounts, negotiable instruments includ- ing certificates of deposit, short-term treasury bills, and securities). ● The difference between the coupon on debt and the yield to maturity. ● Export finance (e.g. documentary credits, bills of exchange, export factoring, forfaiting). 2006.1
  26. 26. Principles of Business Taxation – Introduction 1 LEARNING OUTCOMES After completing this chapter you should be able to: describe the features of the principal types of taxation likely to be of relevance to an incorporated business in a particular country (e.g. in terms of who ultimately bears the tax cost, withholding responsibilities, and principles of calculating the tax base); describe sources of tax rules and explain the importance of jurisdiction. Learning aims The learning aim of this part of the syllabus is that students should be able to ‘describe the types of business taxation rules and requirements likely to affect an entity (in respect of itself and its employees)’. The topics covered in this chapter are as follows: ● concepts of direct versus indirect taxes, taxable person and competent jurisdiction; ● sources of tax rules. 1.1 Introduction Principles of business tax account for 20 per cent of the Financial accounting and tax prin- ciples syllabus and therefore 20 per cent of the examination paper. In the first six chapters of this text we will cover general principles of taxation. General principles should apply in most countries and are not specific to any one country. In your studies you can use exam- ples of general principles drawn from a ‘benchmark’ tax regime (e.g. the UK, USA, etc.) or an appropriate local tax regime. This text mainly refers to the UK tax system, but any system could be used to illustrate general principles. 1 2006.1
  27. 27. 2 STUDY MATERIAL P7 PRINCIPLES OF BUSINESS TAXATION Knowledge of specific tax regimes is NOT REQUIRED and details of any specific tax regime will NOT be examined. If an examination question requires a tax com- putation the question will be based on a fictitious country with fictitious tax rules and tax rates. The question will provide all the information, including tax rates, required to prepare the answer. In the first part of this chapter we will consider general principles of taxation, basic tax terminology and the classification of taxes. The chapter will then conclude with a consid- eration of the sources of tax rules in a country. 1.2 Taxation as a source of government revenue It has been said that ‘what the government gives it must first take away’. The economic resources available to society are limited, so an increase in a government’s expenditure will mean a reduction in the spending capacity of the private sector. Taxation is the main means by which a government raises revenue to meet its expenditure. Taxation may also be used by a government as a means of influencing economic decisions or controlling the economy; in this way taxation will also reflect prevailing social values and priorities in a country. This char- acteristic helps explain why no two countries’ tax systems will be identical in every respect and it also explains why governments continually change their tax systems. Revenue raised from taxation is needed to finance government expenditure on items such as the health service, retirement pensions, unemployment benefit and other social ben- efits, education, financing government borrowing (interest on government stocks), etc. 1.3 Principles of taxation No tax system is perfect, but an ‘ideal’ tax should conform to certain principles if it is to achieve its objectives without producing negative effects. 1.3.1 Canons of taxation In 1776 Adam Smith in his book The Wealth of Nations proposed that a ‘good’ tax should have the following characteristics: ● Equity. It should be fair to different individuals and should reflect a person’s ability to pay. ● Certainty. It should not be arbitrary, it should be certain. ● Convenience. It should be convenient in terms of timing and payment. ● Efficiency. It should be administratively efficient with a relatively small cost of collection as a proportion of the revenue raised. It should not cause economic distortion by affect- ing the behaviour of taxpayers. These principles still apply today, in a modern tax system the three major principles of tax- ation are: ● Efficiency. A tax should be easy and cheap to collect. It is in pursuit of this objective that so much tax is collected ‘at source’, by deduction from income as it arises. The UK PAYE ( pay-as-you-earn) tax on salaries and wages is an example. 2006.1
  28. 28. FINANCIAL ACCOUNTING AND TAX PRINCIPLES 3 Equity. It is important that tax should be fairly levied as between one taxpayer and another. PRINCIPLES OF BUSINESS TAXATION ● For example, in the UK, tax legislation is often very complex, both to reduce the oppor- tunities to avoid the tax and to promote fairness, although this is not always achieved. ● Economic effects must be considered. The ways in which tax is collected can have profound eco- nomic effects which must be taken into account when formulating a tax policy. Tax reliefs can stimulate one sector, while the imposition of a heavy tax can stifle another. For example, special allowances for capital expenditure may encourage investment in industry, while imposing heavy taxes on cigarettes and alcoholic drink may operate to discourage sales. 1.3.2 The American Institute of Certified Public Accountants’ (AICPA) statement – Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals The AICPA’s Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals, lists 10 principles for determining if an existing tax or a proposal to modify a tax rule follows good tax policy. The framework also recognises that it is not always possible to incorporate all ten principles into tax systems and that some balancing is needed. The 10 principles are: 1. equity and fairness, 2. transparency and visibility, 3. certainty, 4. convenience of payment, 5. economy in collection, 6. simplicity, 7. appropriate government revenues, 8. minimum tax gap, 9. neutrality, 10. economic growth and efficiency. Most of these are included in Section 1.3.1, those that need additional explanation are: ● Appropriate government revenues: The tax system should enable the government to determine how much tax revenue is likely to be collected and when. ● Minimum tax gap: The tax gap is the difference between the amount of tax owed and the amount of tax collected. A tax should be structured to minimise non-compliance. 1.4 Basic tax terminology This section explains some basic taxation terms that are used in the following chapters and that you need to understand and possibly use to answer questions in the examination. 1.4.1 Direct taxes A direct tax is one that falls directly on the person or entity who is expected to pay it. For example, the UK corporation tax is a direct tax. The formal incidence and effective incidence 2006.1