II. Accruals Tax Accounting and Financial Accounting
8.27. Many submissions claim that accruals tax accounting under the Australian law is too rigid. It is said that in determining the net income of a business, tax law should take as its starting-point the results of the business for the period determined by generally accepted principles of financial accounting. Tax law should then require adjustments to the results where a particular rule of tax accounting has no parallel in financial accounting, or where the principle of financial accounting that has been adopted differs from the rule of tax accounting.
8.28. The approach suggested would lessen the rigidity of tax accounting only if financial accounting is more flexible in the choices it offers and adjustments are not required by tax accounting. In the Committee's view flexibility in this sense is desirable in some contexts. However, it is for the tax law to define the choices. The law could not resign its function of determining the base of income tax in favour of the professional bodies and business or trade organisations which play a large part in formulating generally accepted principles of financial accounting.
8.29. The criticism of the rigidity of the existing law may be stated in another way. Accruals tax accounting, it is claimed with real justification in some respects, is much less effective than financial accounting in striking a balance which reflects the true profit or loss of a business activity. To the extent that this is true, the Committee would agree that tax accounting rules should adopt the financial accounting principles. However, a difference between a rule of tax accounting and a rule of financial accounting can be no more than a valid reason for re-examining the rule of tax accounting. It cannot dictate a change in the tax rule.
8.30. The change in approach that is being sought would in any case involve a radical redrafting of the existing law and this should not be contemplated if the purpose of the change can be achieved without it. Old law is, to this extent at least, good law. Overseas experience suggests that a major redrafting of the law would not significantly reduce the complexities of the tax.
8.31. The differences between tax accounting and financial accounting can be overstated. Some of the early pronouncements in legal authorities that tax law is not concerned with the profits from transactions, except where there is some express provision, are contradicted by the treatment the law accords to contracts extending over several years. It has been decided that a charge made to a client of a business, even though it be received, should not be treated as income until the services for which it is the reward have been performed: this is a tax recognition of a principle of financial accounting. The provisions of the Act in regard to the allowance of depreciation and accounting for trading stock are intended to ensure that net income of a business for an accounting period reflects the profits of that business for the same period.
8.32. Attention has tended to focus on those differences between accruals tax accounting and financial accounting that lead
to net income being overstated, which is what happens when a deduction for income tax purposes is deferred until an
expense is paid while for financial purposes it is brought to account as it accrues. On occasions, however, the law allows
a deduction in the year in which the cost or outgoing is met even though, in the particular case, the cost clearly refers
to or is connected with an
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item of income to be derived in a later year. Thus, for example, interest is
generally available as a deduction in the year in which it accrues, irrespective of the fact that it may relate to cost of
establishing a new industrial complex in course of erection or to development land held for resale. Under financial
accounting principles, interest paid in these circumstances will frequently be added to the cost of the asset concerned. A
finance institution may in its financial accounts accrue interest on fixed-interest securities; but it is permitted to
exclude such amounts from tax accounting on the grounds that the income has not in fact been received. A grazier may
purchase a quantity of superphosphate just prior to the end of a financial year and become entitled to deduct the cost
from his net income, even though the whole benefit from his expenditure will not fall to be included in his net income
until a subsequent period.
8.33. Differences between accruals tax accounting and financial accounting which increase net income subject to tax sometimes arise from legal authority limiting the meaning of a cost or outgoing incurred in deriving income so that an anticipated expense or an expense subject to some contingency is not allowed as a deduction. Into this category fall accruing costs of employee benefits such as long-service leave and the extension of depreciation allowances to allow for obsolescence of fixed assets. These are examined in detail later in this chapter, as also are several differences of a permanent nature such as depreciation of buildings.
8.34. There is one other difference operating in favour of the taxpayer which must be mentioned because of its fairly general application. It relates to the failure to take to account the value of work in progress in certain professional activities. The professions mainly concerned are those of solicitors, accountants and architects. In those cases where a large staff is employed, the costs incurred in any year will frequently relate in substantial degree to services rendered which have not been billed by the end of the year. Work in progress and unrendered charges and costs may constitute the largest asset of the business and its existence needs to be taken to account to arrive at profits for financial accounting purposes. There is little reason why it should not be similarly taken into account in reaching net income.
8.35. Clearly it is not practicable to seek to eliminate every difference currently arising or to correct the lack of symmetry in every business transaction. Some of the differences spill over to the taxation of income outside the business area. For example, the deduction allowed a finance company for interest accrued but unpaid on debenture loans would require each debenture-holder to include in his net income accrued interest as at the end of a tax year if symmetry were to be achieved. This obviously is not feasible.
8.36. However, several of the differences referred to in this section appear to call for legislative action.
Holding Charges
8.37. The Committee recommends that holding charges (in the form of interest, rates, land tax, etc.) on land held for resale, being akin to trading stock, should not be allowable as a deduction to the extent that the charges relate to land held at the end of an income year. The charges so excluded would form part of the value of trading stock.
Work in Progress
8.38. The fact that professional firms do not bring to account the value of work in progress or unrendered charges,
except where the work performed at a year end has
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given rise to a recoverable debt, results in their net
income being computed on a quasi-accruals method.
8.39. One result is that net income tends to be understated under normal conditions when activities are increasing and costs rising. An associated problem is the considerable room for dispute as to whether the services performed or work carried out at the year end have in fact given rise to a recoverable debt the value of which needs to be included in net income of that year.
8.40. Those professional firms which base their charges to clients on time incurred on the assignment by principals and staff now maintain records from which the value of work in progress is computed at regular intervals for purposes of internal management. There are probably many other firms, however, which do not now find it necessary to keep these additional records. Accordingly, to require all professional persons or firms to bring to account a value for work in progress in determining net income would be onerous and add significantly to administrative costs for at least some taxpayers. But there seems no good reason why a professional person or firm should be debarred from computing net income on a full accruals basis as a matter of choice.
8.41. The Committee recommends that professional persons or firms, whether incorporated or not, be given the right to elect to take account of the value at cost of work in progress at the beginning and end of an income year.
8.42. The Committee proposes that the principle set out in paragraph 8.24 relating to changes prior to a specified date should apply to an election to bring in work in progress.
8.43. This procedure will, it is true, result in the opening value of work in progress escaping tax. But the change in basis for treating work in progress for those firms which elect will tend in most instances to increase their net income and the taxes payable without lifting the cash flow of profits available to taxpayers. Also the change will tend to increase annual taxation revenue, despite the failure to tax the opening value of work in progress.
8.44. Where a firm makes an election to bring in work in progress after the specified date, it is proposed that the opening value of work in progress should fall to be taxed by the spreading procedure, outlined in paragraph 8.25, to be applied when a taxpayer changes from a cash to an accruals basis.
Tax on Basis of Financial Accounting Principles
8.45. While the decision in the Arthur Murray Casenote has led to a more factual approach to the determination of income of a year, there remain elements of rigidity in the present law. This rigidity has already been referred to, as has also the claim that on occasions accruals tax accounting fails to arrive at a balance reflecting the true result from a business activity.
8.46. While the Committee rejects the proposal that net income be computed using generally accepted accounting principles, it acknowledges that it might well be in the interests of both the Revenue and taxpayers if the Act were more flexible in its requirements both as to computation of gross income and as to deductions for related expenses. In practice, flexibility has been given by administrative decision of the Commissioner and his officers.
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8.47. The Committee feels it would be desirable for the Commissioner to have statutory authority to compute the net income from a business activity using one or more of the generally accepted accounting principles approved by recognised Australian professional accounting bodies, where the taxpayer so requests and the Commissioner is of opinion that to do so would be reasonable having regard to all the circumstances.