Different purposes of tax and accounting systems Tax and accounting systems exist for different reasons. The tax system, through tax laws, exists for the purpose of collecting revenue for the community and sometimes for encouraging or discouraging certain kinds of activities, and as a means of making transfer payments. The end result of an application of tax laws is usually that taxpayers are required to pay money to fund public spending. On the other hand, the accounting system, through accounting concepts and standards, exists for financial reporting reasons (i.e. to contribute to the ability of users of financial reports, like investors, to allocate scarce economic resources, like investment funds). This difference was summarised by the United States Supreme Court in Thor Power Tool Co v Commissioner:
“The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Inland Revenue Service is to protect the public fisc. Consistently with its goal and responsibilities, financial accounting has as its foundation the principle of conservatism, with it’s corollary that “possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets.” In view of the Treasury’s markedly different goal and responsibilities, understatement of income is not destined to be its guiding light. Given this diversity, even contrariety, of objectives, any presumptive equivalence between tax and financial accounting would be unacceptable.”
With these different purposes in mind, it can be argued that rules governing the calculation of profit or loss for income tax purposes (taxable income or tax loss) are necessarily different to those governing the calculation of profit or loss for financial reporting purposes. It might be said, for example, that taxation rules require greater precision because they may result in the compulsory extraction of money from the taxpayer.
In his overview of accounting and taxation in Europe, Hoogendoorn summarises the position as follows:
Czech Republic Belgium
United Kingdom Hungary & Romania
The countries with a strong link between accounting and taxation are listed under the heading ‘Dependence’, although legislation in 1996 removed the link for depreciation, inventory valuations, work in progress and warranty provisions in Sweden.
In recent times there has been a development towards more independence between accounting and taxation. This development is linked to the transition to a market economy for some Eastern European countries, as well as accounting harmonisation which interferes with the basic structure of dependence.
Some commentators argue that the link between taxation and accounting “pollutes” the capability of financial reports to give a ‘true and fair’ view of the economic and financial situation of businesses. The critics of the link say that “development of good accounting is hindered by tax concerns and the influence of the tax authorities who need consistent, well-specified and easy to verify rules instead of the more ‘true and fair’ rules.
A similar conclusion was reached by a 1987 OECD study which found that tax considerations were a major obstacle to greater comparability and harmonisation in accounting practices in member countries.
From a tax perspective, Johnson has argued against ‘Generally Accepted Accounting Principles’ (GAAP) as a tax base because, in many circumstances, corporations can under report their earnings without adverse non-tax consequences.9 He argues that reported GAAP income is sufficiently elastic that taxing it would cause the reporting income to shrivel, which would both reduce tax revenue and also damage the pricing mechanisms of the capital markets.
Also in countries where there is a strong link between accounting and taxation, companies are often allowed to undervalue assets.
On the other hand, for “practical reasons it is easier to work with only one accounting system, and it saves money for the companies to have only one system.”
The Review of Business Taxation found that most of the Group 1 countries it examined had a basic approach to determining taxable income whereby the starting point was accounting practice based on statutory accounts.
The review found that there were two essential differences in the treatment between countries. Firstly most countries had explicit recognition of accounting principles eg. section 446 (a) of the United States Internal Revenue Code. Secondly all countries had variations from accounting standards in their tax provisions. The extent of the adjustments necessary to reconcile the tax and accounting position varied considerably between the countries.
So it seems that the international experience is not uniform in the interface between tax and accounting. While many European countries have a closer link between tax and accounting than does Australia, the link is subject to specific legislation and tax concepts tend to predominate. There are commentators who argue that the dominance of tax detracts from the purpose of accounts of providing a ‘true and fair’ view; and there are commentators who argue that accounting standards are not sufficiently precise to form the basis of taxation.
In relation to the United Kingdom, Lamb concludes:
“Although many voices claim that greater tax conformity would reduce complexity, and thereby cost, it seems likely that the UK tax and accounting rule-making will continue to operate with relative autonomy. While the practices of tax and accounting profit measurement are undeniably interdependent, differences in profit calculations are inevitable as long as the rules remain out of phase and are expressed through independent institutions.”
A similar conclusion seems apt for the current position in Australia. Any substantial move towards convergence of tax and accounting treatments will require a meeting of minds between the accounting and tax professions and government.
Current use of accounting practice in the income tax law
In Australia there is no systematic connection between the income tax law and accounting concepts or standards. However, the two interrelate in various ways.
Timing of recognition of ordinary income and general deductions
Accounting practice has sometimes been drawn upon by the courts in interpreting income tax law, particularly in relation to the timing of recognition of income and outgoings under the ordinary income and general deduction rules.
In determining when ordinary income is ‘derived’, the courts have drawn upon business conceptions and the principles and practices of accountancy.
Hill and Heerey JJ recently summarised the position as follows:
“Perhaps the only relevance Ballarat Brewing has for the present case is that it adds to the quite substantial case law in which the High Court has made it clear that where the question at issue is the derivation of gross income that, being a matter for which the ITA Act makes no specific provision, the Court will have regard to the conceptions of business and the principles and practices of commercial accountancy. The case also makes it clear that the Court would be reluctant to apply to income tax a method of accounting which would produce a misleading result in the absence of a specific statutory provision which required that.
Before turning to the accounting evidence in the present case it is important to note that while the earlier cases, such as Carden, Arthur Murray and Henderson, may be thought to have suggested that business and accounting principles are to be applied by the Court in determining questions of derivation, some later cases, for example the Australian Gas Light Company case in this Court have made the point that accounting principles are not determinative, although they may be persuasive.
Certainly where the question is whether a loss or outgoing is incurred for the purposes of s 51(1) it is clear that accounting principles are not determinative, cf Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492, Nilsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (1981) 144 CLR 616. Indeed, in the latter case Barwick CJ expressed the view that the “prudence and commercial propriety of such a course [accruing annual or long leave] has little bearing on the question whether there is present in the year of income a loss or outgoing within the meaning of s 51(1) where a jurisprudential analysis prevails over a commercial view, that accounting and business practice will not always be irrelevant and may indeed provide useful assistance to the Court: Coles Myer Finance Ltd v Federal Commissioner of Taxation (1992-3) 176 CLR 640 at 666 per Mason CJ, Brennan, Dawson, Toohey and Gaudron JJ.
It is not necessary in the present case to decide if there is really a difference between the emphasis put on accounting practices in the early cases and the views expressed in the later cases. It suffices here to say that on either view of the law the business and accounting practices assist the Court in the working out of the principles behind the statutory language of “income derived.”
In determining when losses or outgoings are ‘incurred’, sometimes the courts have tended towards approaches that produce results like those found in accounting.
For example, in Coles Myer Finance Ltd v FC of T 93 ATC 4214; (1993) 25 ATR 524, the High Court referred to commercial and accounting principles in deciding that a deduction for discounts on certain debt instruments should be spread over 2 years (the period of the instruments).
Another example is the recognition by the courts that unreported insurance claims are presently existing liabilities of an insurer and that the provisions a general insurer makes in its accounts for them are an allowable deduction if they represent a reasonable actuarial estimate. This recognises provisions for ‘incurred but not reported’ claims, but not provisions for events that have not yet occurred.
Nevertheless, the courts have made it clear that the interpretation of tax law ultimately involves a jurisprudential analysis of relevant provisions. For example, expenses are not necessarily recognised for income tax purposes at the same time as they are for accounting purposes and the cost of trading stock must be ascertained from the meaning apparent from the statute rather than accounting (although the two may well coincide).
Hanlan and Nethercott have argued that “the merits of comparability between accounting practice and taxation law have been recognised by academics, courts of law and governments...[but] While Australian courts have endorsed the importance of accounting concepts, principles and practices, such factors are not determinative in reaching a decision. That is, accounting practice, while relevant must be used solely as an aid assisting in the interpretation of the Tax Act (1936) and (1977), and cannot be substituted for legal or jurisprudential analysis itself.”
On this basis the approach of the courts in interpreting the law will affect the extent of divergence between accounting and tax concepts. The less formalistic is the approach to judicial interpretation the more likely it is that the outcome will reflect the commercial substance of a matter.
Another observation that can be made is that the system of precedent applied in our system of law means that income tax law may not keep pace with developments in accounting concepts and standards. A court decision many years ago which drew upon accounting practice at that time may still represent the law now, even though the accounting practice upon which the decision was based may have changed.