Movements in Reserves and Provisions Including the Effects of Taxation

Movements in reserves and provisions including the effects of taxation

Contents

Key to resources

Introduction

Income tax and net profit after tax

Reserves

Dividends

Summary of items affecting the retained earnings or accumulated losses account

Feedback to questions

Key to resources

• Overview, p60
• pro-forma entries, pp60–61
• example 1, p62

• example 2, p69
• question 5.17, p70

• self-assessment question 5C
  (Feedback is provided at the back of the textbook.)
• question 5.23
  (Feedback is provided at the end of this learning guide.)

• Dividends, pp72–74
• example 3, p74

• question 5.27, p76
• question 5.28, p76

• Dividend reinvestment schemes, p74
• example 4, p75

• question 5.29, p76
• question 5.31, p77
• self-assessment question 5D, p78

• question 5.34, p79
• question 5.35, p79
• question 5.37, p80
• question 5.38, p80
• question 5.39, p80

Introduction

The material under this heading introduces a new account—the ‘retained earnings’ account; sometimes called the ‘retained earnings/accumulated losses’ account.

This account is similar to the profit and loss appropriation account met in previous studies of partnership accounting. The retained earnings account will receive the profits (losses) of the company and any distribution or transfer of those profits will also be recorded. The retained earnings account is part of shareholders’ equity.

A summary of the possible items contained in a retained earnings account appears at the end of this document.

Income tax and net profit after tax

Other studies of a sole trader and partnerships may not include the calculation of any income tax payable. Income tax is considered to be a personal expense of the sole trader or partner and not an expense of the business.

Companies, however, pay income tax. Income tax expense will need to be recorded in the books of account. It is important to note that our study purposes in this area are limited to the tax payable method of calculating income tax. It is assumed that all items in the profit and loss account are either assessable or deductible.

Laterstudies will introduce tax effect accounting which will vary the amount of income tax expense.

Under the tax payable method, when the amount of income tax to be paid is known, the accounting entry is:

The entry when the income tax is paid is:

The entry at the end of the financial year when income tax expense is transferred to profit and loss account is:

In example 1, take particular note of these entries:

• the transfer of income tax expense of $15000 to profit and loss account:

• the transfer of profit after tax of $35000 from profit and loss account to an account called ‘retained earnings’:

Note in example 1 the under-provision of income tax of $400.

Any under-provision or over-provision of income tax is found after the end of the financial year and it is too late to adjust the transfer of profit after tax to retained earnings. Under- and over-provisions of tax are carried forward and written off to profit and loss account in the next financial year.

Reserves

Note the following:

• Reserves are part of shareholders’ equity.
• Reserves are created as a result of:

–prudent management practice

–the requirements of an accounting standard.

Prudent management practice

Note the accounting entries to create a reserve and to transfer profits from a reserve back to retained earnings.

Feedback to question 5.15

General journal

Solution (above) is from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

Feedback to question 5.16

General journal

Solution (above) is from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

By transferring funds out of retained earnings, management may be providing for some unknown future contingency. The removal of the funds out of retained earnings may imply that those funds are not available for distribution to shareholders by way of dividends (see next section) and therefore the cash assets of the company are protected. Note, however, that the creation of a reserve does not mean that equivalent cash assets are available.

In example 2, note the effect of the entries on the retained earnings account and the shareholders’ equity.

Reserves created as a result of the requirements of an accounting standard

Our studies are limited to the revaluation of an asset and the possible future issue of bonus shares. Bonus shares are shares issued to existing shareholders free of charge. The issue will be based on the number of shares held,for example one bonus share for every five (one for five) already held. Be aware of the issue price of the share.

Feedback to question 5.19

Generaljournal

Solution (above) is from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

Dividends

Note that usually (but not always) a company will pay two dividends a year: an interim dividend half-way through the company’s financial year and a final dividend after the end of the financial year.

Note that:

• Dividends on ordinary shares are usually declared at so many cents per share. Some types of preference shares are paid at a fixed percentagerate.
• The final dividend is proposed in one financial year and paid in the next financial year.
• Dividends payable (sometimes called proposed final dividend) is a current liability in the balance sheet.
• Both the interim dividend and the dividend payable are debited to retained earnings.

Dividend reinvestment schemes

Note the journal entries in the example.

Dividend reinvestment schemes are popular with some small shareholders as it allows them to build up their shareholding in a company without incurring brokerage charges. Instead of receiving cash for their dividends the shareholders receive additional shares.

Summary of items affecting the retained earnings or accumulated losses account

Retained earnings/Accumulated losses

Note:

(a)Balance brought down would be eithera debit or credit—not both.

(b)Net profit or loss after tax from the profit and loss account—not both.

Feedback to questions

The following solutions in this feedback section are from Company Accounting, Woodford & Mills, LexisNexis Butterworths, 2005. Reproduced with permission.

Question 5.6feedback

Question 5.17feedback

(a)

General journal

(b)

Retained earnings

(c)

Statement of shareholders’ equity

Question 5.23feedback

(a)

General journal

(b)

(i)

Land and buildings

(ii)

Asset revaluation reserve

Question 5.27feedback

General journal

Question 5.28feedback

General journal

Question 5.29feedback

General journal

Question 5.31feedback

(a)

General journal

(b)

Adjusted trial balance

*

Question 5.34feedback

Retained earnings/Accumulated losses account

Question 5.35feedback

Retained earnings/Accumulated losses account

Question 5.37feedback

Profit and loss account

Retained earnings/Accumulated losses account

Question 5.38feedback

Profit and loss account

Retained earnings/Accumulated losses account

Question 5.39feedback

Movements in reserves and provisions including the effects of taxation1

© NSW DET 2006, 2006/053/12/2006 LRR 3874/3875