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The Importance Of Differences Between Taxation And Accounting Rules

 


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Enterprises in Albania must follow financial accounting and reporting rules aimed at providing investors with a true and fair view of the financial situation of the enterprise. These rules increase transparency and international comparability of the results of an enterprise or a group, and are a strong step into the foreigner market. International Accounting Standards (IAS) and National Accounting Standards (NAS) are widely used by Multinational Enterprises (MNEs).

Financial accounting and reporting rules are quickly shifting away from traditional legal concepts applied in commercial and fiscal laws. They are increasingly based on a fair presentation approach. The results shown for financial purposes may differ considerably from the profits shown in the books of single enterprises or in the tax returns. MNEs therefore risk being confronted with unwarranted requests for tax profits adjustments or with the requirement that profits shown for financial purposes in a given country be taxable in that country. The national and international business community is of the view that it is important for tax authorities and policy makers to understand the reasons why the results shown in financial statements of an enterprise or a group differs from the taxable results of such enterprise or group.

Different approaches followed to determine taxable profits Some countries in Europe follow the concept of dependence in determining the taxable results. This means that the profits resulting from the commercial accounts are taken as the primary basis for tax assessment. Subject to the relevant taxation rules, certain fiscal adjustments have to be made in order to calculate the taxable profits.

Other countries, in particular those with a common law tradition, follow the concept of independence. Two separate sets of rules are applied, one for the commercial results and another for tax purposes. Such countries do not rely heavily on commercial accounting rules for taxation, which may have as a consequence that the two systems differ considerably. Both systems have advantages and shortcomings. With separate taxation rules, two sets of rules must be applied, which may increase the compliance burden for enterprises. It may also be easier to deviate for tax purposes from certain principles followed in commercial accounting. However, even when taxation is based on the commercial accounts, certain tax adjustments are unavoidable.

For the time being, it would be unrealistic to ask for a common approach in this respect. Each country is free to decide whether the determination of the taxable results should be based primarily on commercial accounts or derived from the application of a separate set of taxation rules. Countries have the right to follow different approaches with respect to the relationship between commercial and tax accounting (dependence/independence). Both approaches have advantages and shortcomings. However, in both cases, well-established principles of taxation must not be disregarded.

Differences between commercial accounting and capital market rules Commercial law prescribes how the financial results of a single enterprise are determined. These rules are often set out in specific accounting laws. Accounting and reporting rules are based on the principle of fair presentation and are mainly designed to increase transparency for investors. The standards must be applied consistently to the whole group. Sometimes, enterprises are given a choice with regard to the application of a given method or rule. The uniform application is examined by external auditors and is enforceable by supervisory bodies. Specific accounting and reporting standards for companies increase transparency and comparability, mainly for investors. A convergence of the principles governing existing accounting and reporting standards is desirable in order to increase comparability and to facilitate multiple listings. However, possible tax implications for companies, especially in countries relying on commercial accounts as primary basis for tax assessment, have to be kept in mind, and the convergence should not deteriorate the tax position of enterprises.

Different approaches and different purposes
Commercial, financial and taxation rules serve their own purposes and, as a consequence, differences in the results should be expected and accepted.

  • Commercial accounting rules are used to determine the commercial results of a single entity. They establish, in particular, whether a profit or a loss has resulted for a given period. The rules may form part of a country's commercial or company law. They are intended to protect the rights of shareholders and creditors and, as a consequence, the prudence principle occupies an important place.

  • Financial accounting and reporting rules are part of a country's capital market regulations. Their objective is to give investors (and other stakeholders) a reliable and, as accurate as possible, picture of the financial situation of the economic entity (group) at a given moment (financial position, performance, cash flows). The guiding principle is “fair presentation" or “true and fair view". Other important rules in this respect are “substance over form", “market value measurement", and - as a consequence of true and fair - the factual prohibition of hidden reserves.

  • Taxation rules are used to determine taxable profits. Their objective is to define the tax liability of enterprises to the tax administration for a given year. The rules must be susceptible to compliance by taxpayers and control and enforcement by tax authorities. Taxation rules for companies are usually designed to preserve economic neutrality, so that business decisions are not unduly influenced by fiscal measures. The rules may also provide for non-fiscal objectives. Tax laws reflect general principles of taxation, such as non-discrimination or taxation according to economic capacity, but also practicalities, such as availability of funds for payment of the liability (realization), fairness between different categories of taxpayers (neutrality), the annual character of the liability (loss carryovers, standardized depreciations), long-term profitability (prudence, imparity, valuation below market value) and other such factors. For example, tax systems may prescribe special timing rules for the recognition (or deferral) of income, loss carryovers from other years and other rules peculiar to the field of taxation.

    The approaches followed for the calculation of commercial, financial and taxation statements serve different purposes. Although the respective rules are focused on the same general object (the results of a business entity in a given period), it is important to understand that, under existing concepts, the rules applied in financial accounting and those applied for tax purposes should not be expected to be strictly comparable.

    The good of interactions between accounting and taxation rules
    As a result of demands by international capital markets (globalization), widely used accounting and reporting standards are expected to lead to a certain harmonization in the area of accounting and reporting. On the other hand, so long as each country imposes its own taxes, implementing its own tax policies, a similar degree of harmonization of taxation rules is not to be expected. At the same time, the more the rules used for financial accounting differ from those used in the field of taxation, and the more the results of a group become transparent, the more obvious the differences that result from the application of the two sets of rules become. Tax authorities should not use the financial results of an entity (in the same country or in third countries) as a pretext for an adjustment of the taxable profits of an enterprise or to justify transfer pricing corrections. The rules applied for financial accounting and those used for tax purposes may differ considerably and may lead to results that cannot reasonably be compared. Tax authorities and policy makers should accept that the underlying principles of financial accounting are not always compatible with basic principles and practices used in the field of taxation. From a tax policy perspective, it is important that taxation rules are not undermined by an inappropriate extension of financial reporting requirements.

    Internationally recognized accounting standards can be seen as a coherent set of rules for accounting and reporting that should give investors a “true and fair view" of the financial situation (balance sheet), performance (income statement) and changes in the financial position (cash flow) of an economic entity at a given moment.

    In the field of taxation, some widely accepted principles clearly deviate from concepts used for financial accounting and reporting purposes. In addition, tax laws often provide for non-fiscal objectives, e. g. the granting of specific incentives (for R&D, for special reserves, to promote self-financing, to attract certain business activities, etc. ). They may be designed to influence the behavior of enterprises by granting incentives or using disincentives (e. g. environmental taxes or relieves). Furthermore, a country's taxation system is the result of a political decision-making process and therefore, in many cases, neither neutral for businesses nor fully internally consistent. Taxation and financial accounting rules serve different purposes, have different objectives and are based on different principles. Although both sets of rules are used to measure the annual results of an enterprise, differences in the results or in the methods applied have to be accepted. Financial accounting looks at the enterprise as an economic entity, whereas taxation is normally based on a separate entity approach.

    Policy makers in the fields of taxation and accounting must be aware of these differences. Tax authorities must respect them and refrain from using companies’ financial results for tax adjustments.

    By Eduart GJOKUTAJ

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