Tax, Audit and Corporate Governance
In this module, you will gain an in-depth understanding of Corporation tax, Audit and Corporate Governance.
Corporation tax is the amount of tax a business organisation pays to the government on its profits. However, the accounting profits are often different from the taxable total profit on which the corporation tax is charged because certain incomes and expenditures that are allowed for accounting purposes are often not allowable for the tax purposes.
The value added tax (VAT) is charged by businesses on their products and services. There are three different VAT rates that could apply to the products and the services of a business: standard rate, reduced rate and zero rate. The standard rate VAT is 20% and is charged on most goods and services in the UK.
In this module, a range of tax calculations are explored including: inheritance tax and capital gains tax. Inheritance tax arises when a transfer of chargeable property is made by a chargeable person. HMRC classifies a number of transfers of assets as exempt transfers for the purposes of inheritance tax. Typical examples of exempt transfers include transfer to spouse or civil partner, gift to charities or gift to political parties.
The example below illustrates the calculation of inheritance tax on the death estate (ICAEW, 2012a):
Mr. X dies on 1st July 2016. His estate was as follows:
Funeral expenses incurred upon the death of Mr. X were £20,000 and he had a debt of £20,000 when he died.
Furthermore, Mr. X made a gross chargeable transfer of £41,000 in July 2010 and a potentially exempt transfer of £67,000 in September 2014.
In his will, Mr. X donated £10,000 from his estate to a registered charity and his house and chattel to his wife. Calculate the inheritance tax payable upon Mr. X’s death.
Gross value of estate:
Funeral expenses: (£20,000)
Net value of estate: £793,000
Spouse exemption for house and chattel: (£550,000)
Charity exemption: (£10,000)
Total chargeable estate: £233,000
Nil rate band for 2016: £325,000
Gross transfer of value in 7 years before death:
July 2010: £41,000
September 2014: 67,000
Available nil rate band (£325,000 - £108,000): £217,000
Excess over nil rate band (£233,000 - £217,000): £16,000
Inheritance tax payable: £16,000 * 40% = £6,400
A capital gains tax is paid by a chargeable person on the disposal of a chargeable asset. A chargeable person could be individuals, business partners, trustees or companies (ICAEW, 2012a). Chargeable assets include all capital assets other than those exempted from the capital gains tax. Typical examples of exempt assets include qualifying corporate bonds, national savings certificates and premium bonds, investments held in ISA, gilt edged securities amongst many others.
An illustration of the capital gains tax is provided below:
Mr. X has a taxable income (after personal allowance) of £20,000 and taxable gains of £12,100 from non-residential chargeable assets. What is the capital gain tax liability of Mr. X?
Proceeds from disposal of chargeable assets: £12,100
Less: Allowable cost: Nil
Capital gains: £12,100
Annual exemption: £11,100
Chargeable gains: £1,000
Capital gains tax liability: £1,000*10% = £100
Note: Since adding chargeable gains of £1,000 to taxable income of £20,000 did not make Mr. X a higher rate taxpayer, capital gains tax is charged at the rate of 10% on non-residential chargeable assets.
The module also discusses the concepts of tax avoidance and tax evasion. Where, tax evasion can be defined as concealing information from the tax authorities or deliberately providing them with false information with the motive of evading taxes.
Typical examples of tax evasion include:
- not notifying tax authorities about tax liabilities
- understating incomes or gains
- omitting disclosing facts to the tax authorities with the motive of evading taxes
- overstating expenses and claiming false capital allowances
Since tax evasion is classified as money laundering, the penalties associated with evading taxes could be extreme. Money laundering could be defined as engaging in activities in which the proceeds from illegal means are used. When an individual engages in tax evasion, he could be charged under the money-laundering act.
Although there is no formal definition of tax avoidance, it could be defined as the careful tax planning with a motive of reducing the tax liability in a lawful way. Typical examples of tax avoidance include taking advantage of various exemptions permitted by the HMRC and taking advantage of tax shelters in the form of ISA.
The difference between the tax evasion and tax avoidance is usually apparent, as the intention of an individual who is seeking to avoid taxes is not to mislead HMRC or conceal information from them. Thus, when facing ethical dilemmas with regards to tax evasion and tax avoidance, understanding the intention of an individual could help to resolve the dilemma to a certain extent.
An audit could be defined as the process that enables auditors to express an opinion whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework and reflect a true and fair view of a company’s financial affairs (ICAEW, 2013). True and fair view does not imply that the financial statements are completely accurate without any errors. True and fair view implies that financial statements are free from material errors but could include immaterial errors that are not deemed to be influencing the decision of the users of the financial statements to invest in a company. In this module you will learn about the objectives and importance of auditing and audit independence. Auditing enhances the credibility of the financial statements in the eyes of an external party. For example, banks often rely on audited financial statements to assess the financial stability of a company before making a decision regarding granting of loans. Auditors are required to comply with the code of ethics issued by International Federation of Accountants (IFAC). Independence is a widely discussed code of ethics in the contemporary business environment because auditors often form multiple business relationships with their clients, which often poses a threat to their independence. IFAC has categorised the threats to auditors’ independence into 6 broad categories: Self Interest Threat, Self-Review Threat, Advocacy Threat, Management Threat, Familiarity Threat and Intimidation Threat.
Auditors are primarily concerned with identifying those misstatements that could have a material impact on the financial statements. In other words, if the magnitude of the error is deemed to be so large that it could influence the decision of the investors to invest in a company if the errors were made known to them. The auditors might identify immaterial errors as a result of carrying out the audit procedures, however, one should not expect the auditors to identify such errors. The law does not require auditors to identify all the errors in a financial statement.
The module also explains the audit implication on the efficient market hypothesis. Subsequently, the audit process is explored. The stages are listed below:
- Engagement acceptance: This stage involves assessing the reputation of the client and the risk associated with accepting a client. For instance, most auditors would avoid a business that has had notoriously bad reputation, as auditors often don’t want to accept clients that could endanger their reputation. Furthermore, accepting clients with bad reputation also entails a greater risk of fraud and getting an incorrect audit opinion. It is also mandatory at this stage to perform anti money laundering checks on the clients.
- Quality control is at the heart of all stages of the auditing process. At the stage of accepting engagements, existence of strong quality control procedures would be evident in the form of policies and procedures designed to ensure that only appropriate clients are accepted. During planning, performance and completion stages, appropriate quality control procedures include documentation of all significant matter, ensuring proper communication within the team, adequate supervision and review of work. There are six elements of a quality control system:
- Ethical requirements
- Acceptance and continuance of client relationship
- Human resources
- Engagement performance
- Planning: This stage involves planning the audit engagement. Typical activities include identifying key audit risks, agreeing on the scope of the work, deadlines and arranging human resource to perform the work.
- Programming and performance: This stage involves carrying out the audit procedures in response to the audit risks identified at the planning stage.
- Audit completion: This stage involves issuing the audit report, ensuring the independence and other regulatory requirement are not breached between accepting the engagement and completion stage and making sure that all the assessed risks at the planning stage have been adequately responded to.
The UK corporate governance code was formulated in 1992 with the objective of improving the governance in businesses. Since shareholders do not actively participate in the day-to-day management of a business and rely on the directors to run the company, the purpose of the UK corporate governance code is to ensure that the interest of the shareholders is protected.
The primary objective of the UK corporate governance code is to protect the interest of the shareholders of the company by governing and monitoring individuals that manage the resources owned by the shareholders. The UK Corporate governance code seeks to ensure that the auditors are independent of the business. The UK Corporate governance code also seeks to ensure a suitable balance of power on the board of directors by ensuring appointment of independent non-executive directors.
The UK corporate code of governance offers a lot of flexibility to the board of directors in terms of how they choose to govern the company. The explain approach allows the businesses to choose not to apply the principles of the code if good governance could be achieved by applying alternative principles, however, in such a scenario the management should provide a careful explanation to the shareholders of the company for the reasons of the departure from the corporate code of governance and how the chosen principles contribute to good governance and attainment of business objectives.
You will gain a comprehensive understanding of the five principles of the corporate governance code, which are the following:
- Leadership- This principle states that every business should be led by an effective team of leaders in the form of board of directors.
- Effectiveness- The board of a company should have a formal procedure for the appointment of new directors and all directors of the company should devote sufficient time to execute business strategies.
- Accountability- The board of directors is accountable to the shareholders of the company for the performance of a business.
- Remuneration - The board of directors is responsible for ensuring a remuneration policy that is good enough to attract, retain and motivate directors
- Relations with shareholders- The board of directors is responsible for ensuring effective communication and maintaining relationship with the shareholders Annual general meetings should be used to communicate with them and board should take steps to encourage the participation of the shareholders.
Lastly, you will learn the differences between the UK code of corporate governance and the US code of corporate governance. The primary difference between the UK code of corporate governance and that of the US is that the former is driven by comply or explain approach, whereas the latter is driven more by regulation. Following the Enron scandal, the Sarbanes-Oxley act was passed to improve the quality of financial reporting in the United States of America. Another key difference between the UK and the US code of corporate governance is that chief financial officer and the chief executive officer of the company should attest to the veracity of the financial statements in the United States (ICAEW, 2013). Thirdly, much greater disclosures are required if any amendments are made to the financial statements during the audit process in the United Stated than when adjustments are made during the audit in the United Kingdom.
FRC, 2016, The UK Corporate Governance Code. Accessed on 23rd October 2016 at: https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-April-2016.pdf
Gov.Uk, 2015, Corporation Tax: Main Rate. Accessed on 25th October 2016 at: https://www.gov.uk/government/publications/corporation-tax-main-rate/corporation-tax-main-rate
Gov.UK, 2016a, Businesses and charging VAT. Accessed on 25th October 2016 at: https://www.gov.uk/vat-businesses/vat-rates
Gov.UK, 2016b, Capital Gains Tax. Accessed on 27th October 2016 at: https://www.gov.uk/capital-gains-tax/what-you-pay-it-on
Gov.UK, 2016c, Inheritance Tax. Accessed on 26th October 2016 at: https://www.gov.uk/inheritance-tax/gifts
Hines, R., 2012, The usefulness of annual reports: the Anomaly between the efficient markets hypothesis and shareholder surveys, Accounting and Business Research, vol. 12 (no. 48), pp. 296-309.
HM Revenue & Customs, 2016, Inheritance tax nil rate bands, limits and rates. Accessed on 26th October 2016 at: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/497789/IHT400Rates_tables.pdf
ICAEW, 2012, Financial Management Study Manual, 6th Edition, Exeter, Polestar Wheatons.
ICAEW, 2012a, Taxation FA2012 Study Manual, 7th Edition, Exeter, Polestar Wheatons.
ICAEW, 2013, Audit and Assurance, 7th Edition, Exeter, Polestar Wheatons.
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