income taxes(Reading 31)

Exercise Problems:

1. A firm reported higher deferred tax liabilities than deferred tax assets. Using the liability method of accounting for deferred taxes, a growing firm would expect an increase in the statutory tax rate to result in:

A. Increase equity

B. Decrease equity

C. No change in equity

Ans: B

the statutory tax rate↑→tax expense↓→net income and retained earnings↓→equity↓

2. An analyst has correctly recognized the nature of a deferred tax liability under U.S.GAAP when he states that:

A. A permanent difference arises from undistributed earnings of an affiliate.

B. A temporary difference arises due to interest received from an investment in tax-exempt municipal bonds.

C. A temporary difference results from the use of straight-line depreciation for book purposes and an accelerated method for tax purposes.

Ans: C

This situation creates a temporary difference between pretax (book) income and taxable income which results in the recognition of a deferred tax liability in the early years of an asset’s useful life.

A is incorrect. Undistributed earnings of an affiliate generally result in deferred tax liabilities when the investment is accounted for under the equity method. Under the equity method, the investor company reports its share of the net earnings of the affiliate (investee) for financial reporting (book) purposes, but is taxed on earnings only when they are paid (distributed as dividends. This results in a temporary difference between pretax (book) income and taxable income.

B is incorrect. The interest received from an investment in tax-exempt municipal bonds results in a permanent difference that does not reverse.

3. A company records $42,000 more in tax depreciation than in book depreciation. Assuming a 35% tax rate will apply in the future, how much will be record as a deferred tax liability during the year?

A. $14,700.

B. $27,300.

C. $42,000.

Ans: A.

Deferred tax liabilities are taxes that will be paid in the future when temporary differences reverse. Excess (tax) depreciation of $42,000 multiplied by the 35% tax rate shows that $14,700 will be recorded as a deferred tax liability.

4. Ady Auto Group reported pretax income of $48,000 and taxable income of $60,000. The difference of $12,000 is attributed to warranty expenses. The statutory tax rate is 30% and the company reports income taxes payable of $18,000 on its balance sheet. What is the amount of income tax expense that Ady Auto Group should report on its income statement?

A. $6,000.

B. $14,400.

C. 21,600.

Ans: B.

The answer can be derived by creating the journal entry to record the tax expense for the period. The correct tax expense of $14,400 is the plug figure to make the entry balance.

Income tax expense (Plug)                              14,400

Deferred tax asset ($12,000*30%)                    3,600

    Income taxes payable ($60,000 TI*30%)              18,000

Logically, the answer makes sense as well. The estimated warranty expense is accrued for financial reporting purposes, resulting in a temporary difference that will reverse in a future period when the warranty payments are actually made and deducted on the tax return, thus creating a deferred tax asset.

A is incorrect. This answer subtracted the $12,000 difference between pretax income and taxable income from taxes payable, rather than subtracting the $3,600 ($12,000*30%) wax effect of the difference.

C is incorrect. This answer incorrectly reflects the deferred tax impact from the warranty expense as liability, rather than an asset.

5. The following information is available about a company:

The company’s 2012 income tax expense (in thousands) is closest to:

A. $1,000.

B. $1,050.

C. $1,250.

Ans: B.

Income tax expense reported on the income statement

= Income tax payable

 + Net changes in the deferred tax assets and deferred tax liabilities

=1,000+(250-200)

=1,0000+50*

=1,050

* The change in the net deferred tax liability is a $50 increase (indicating that the income tax expense is $50 in excess of the income tax payable [or current income tax expense] and representing an increase in the expense).

6. A company purchased equipment for $50,000 on 1 January 2009. It is depreciating the equipment over a period of 10 years on a straight-line basis for accounting purposes, but for tax purposes, it is using the declining balance method at a rate of 20%. Given a tax rate of 30%, the deferred tax liability as at the end of 2011 is closest to:

A. $420.

B. $2,820.

C. $6,720.

Ans: B.

The deferred tax liability is equal to the tax rate times the difference between the carrying amount of the asset and the tax base.

7. A company which prepares its financial statements in accordance with IFRS incurred and capitalized €2 million of development costs during the year. These costs were fully deductible immediately for tax purposes, but the company is depreciating them over two years for financial reporting purposes. The company has a long history of profitability which is expected to continue. Which is the most appropriate way for an analyst to incorporate the differential tax treatment in his analysis? He should include it in:

A. liabilities when calculating the company’s current ratio.

B. equity when calculating the company’s return on equity ratio.

C. liabilities when calculating the company’s debt-to-equity ratio.

Ans: C.

The different treatment for tax purposes and financial reporting purposes is a temporary difference and would create a deferred tax liability. Deferred tax liabilities should be classified as debt if they are expected to reverse with subsequent tax payments. The long history of profitability implies the company will likely be paying taxes in the following years and hence an analyst could reasonably expect the temporary difference to reverse. Under IFRS all deferred tax liabilities are non-current and therefore do not affect the current ratio.

8. A company has recently revalued one of its depreciable properties and estimated that its remaining useful life would be another 20 years. The applicable tax rate for all years is 30% and the revaluation of the property is not recognized for tax purposes. Details related to this asset are provided in the table below, with all ￡-values in millions.

The deferred tax liability (in millions) as at the end of 2010 is closest to:

A. ￡690.

B. ￡960.

C. ￡1,650.

Ans: A.

Deferred tax liability = 0.30 x (6,300 – 4,000) = 690

Only the portion of the difference between the tax base and the carrying amount that is not the result of the revaluation is recognized as giving rise to a deferred tax liability. The portion arising from the revaluation surplus is used to reduce the revaluation surplus in equity.

9. Which of the following events will most likely result in a decrease in a valuation allowance for a deferred tax asset under U.S. GAAP (generally accepted accounting principles)? A(n):

A. reduction in tax rates.

B. decrease in interest rates.

C. increase in the carry forward periods available under the tax law.

Ans: C.

Under U.S. GAAP, deferred tax assets must be assessed at each balance sheet date. If there is any doubt whether the deferral will be recovered, the carrying amount should be reduced to the expected recoverable amount. The asset is reduced by increasing the valuation allowance. Should circumstances change, so that it is more probable that the deferred tax benefits will be recovered, the deferred asset account will be increased (and the valuation allowance decreased).

An increase in the carry forward period for tax losses extends the possibility that benefits will be realized from the deferred tax asset and would likely result in a decrease in the valuation allowance and an increase in the deferred tax asset.

10. Under U.S. GAAP what is the most likely effect of the reversal of a valuation allowance related to a deferred tax asset on net income?

A. No effect

B. A decrease

C. An increase

Ans: C.

The reversal of a valuation allowance increases the deferred tax assets and decreases the deferred tax expense, increasing net income.

11. A company purchased a €2,000 million long-term asset in 2009 when the corporate tax rate was 30 percent.

On January 15, 2010 the government lowered the corporate tax rate to 25 percent for 2010 and beyond. The deferred tax liability (€) as at 31 December 2010 is closest to:

A. 130.

B. 156.

C. 205.

Ans: A.

The deferred tax liability equals the difference between the value for accounting and the value for tax times the current tax rate in effect. (1,800 – 1,280) x 0.25 = 520 x 0.25 = 130.

12. A company reports net income of $800,000 for the year. The table below indicates selected items which were included in net income and their associated tax status.

The company’s tax rate is 35 percent. The company’s current income taxes payable (in $) is closest to:

A. 206,500.

B. 276,500.

C. 360,500.

Ans: B.

13. The following information relates to a profitable company that offers a warranty on a new product introduced in 2012:

If the company’s tax rate is 35 percent, which of the following most accurately describes the deferred tax recorded in 2012 with respect to the new product warranty?

A. Deferred tax asset of $35,000.

B. Deferred tax asset of $65,000.

C. Deferred tax liability of $35,000.

Ans: A.

For financial statement purposes, the warranty expense recorded in 2012 is greater than the cash expense they incurred (and that is allowed as a deduction for income tax purposes), resulting in a warranty liability for financial statement purposes, but not for tax purposes. As the carrying amount of the liability is greater than the tax base, the $100,000 temporary difference will give rise to a $35,000 (100,000 x 0.35) deferred tax asset.

14. Which of the following best describes taxes payable?

A. Total liability for current and future taxes.

B. Tax return liability resulting from current period taxable income.

C. Actual cash outflow for income taxes including payments (refunds) for other years.

Ans: B.

Taxes payable is the current liability resulting from the current period taxable income based on the company’s tax rate and the portion of its income that is subject to income taxes under the tax laws of the jurisdiction.

15. A company records the following two transactions:

I. €300,000 of rental revenue is received in advance on a two-year lease. It is taxed on a cash basis, but deferred for accounting purposes.

II. €500,000 of installment sales. No payments are required for one year after which collections will be made on an equal basis over 12 months and taxed on a cash basis. The entire sale and related profit will be recognized for financial reporting purposes, in the year of sale.

Which of the above transactions will most likely give rise to a deferred tax liability on the balance sheet?

A. I only.

B. II only.

C. Both I and II.

Ans: B.

II represents a deferred tax liability: The accounts receivable for financial statement purposes has a carrying value of €500,000 but with a tax base of €0. The temporary difference creates a deferred tax liability. Alternatively, accounting income tax expense exceeded taxes payable and the firm expects to eliminate this difference over the course of future operations.

Item I represents a deferred tax asset: Rent received in advance creates a liability on the financial statements with a carrying value of €300,000 but with a tax base of €0.

The temporary difference creates a deferred tax asset. Alternatively an excess amount

has been paid for income taxes based on the cash received (taxable income exceeded accounting income) and the company expects to recover this difference during the course of future operations.

16. Which of the following statements most accurately describes a valuation allowance for deferred taxes? A valuation allowance is required under:

A. IFRS on revaluation of capital assets.

B. U.S.GAAP if there is doubt about whether a deferred tax asset will be recovered.

C. both IFRS and U.S.GAAP on tax differences arising from the translation of foreign operations.

Ans: B.

A valuation allowance is required under U.S.GAAP if there is doubt about whether a deferred tax asset will be recovered. Under IFRS the deferred tax asset is written down directly.

17. Under U.S.GAAP, which of the following factors is an analyst least likely to consider when determining if a company’s deferred tax liabilities should be treated as a liabilities or equity?

A. The growth rate of the firm.

B. The average discount rate of liabilities.

C. the expectation that temporary difference will reverse.

Ans: B.

The classification of deferred taxes as liabilities or equity depends on the likelihood, or expectation, of reversal. For growing firms and those using accelerated methods of depreciation, the temporary differences tend not to reverse. If the analyst determined the deferred tax liabilities were likely to reverse, and hence should be classified as liabilities, then it would be appropriate to discount them at the company’s average discount rate, but the discount rate is not a factor in determining if reversal is likely.

18. Company Y has provided the following information from its current year financial statements and tax return. Company Y’s fixed assets have a four-year useful life for financial purpose (which is double the useful life for tax purpose) and are depreciated using the straight-line method.

The effective tax rate for the company is closest to:

A.    30.0%

B.     26.7%

C.     24.0%.

Ans: B.

To calculate the effective tax rate, income tax expense must be calculated without the tax-exempt interest income (and using half of the tax basis depreciation). Then pretax income must be calculated including the tax exempt interest and adjusted depreciation for financial purposes. The effective tax rate is the income tax expense calculated without the tax-exempt interest divided by the pre-tax income including the tax exempt interest income.

*Income tax expense = 30% x 160,000 = 48,000

Effective tax rate = 48,000/ 180,000 = 26.67%

19. At the beginning of the year a company purchased a fixed asset for $500,000 with no expected residual value. The company depreciates similar assets on a straight-line basis over 10 years while the tax authorities allow depreciation at the rate of 15% per year.In both cases the company takes a full year’s depreciation in the first year. At the end of the year, the tax base and temporary difference in the value of the asset, respectively, are closest to:

A. $425,000; $25,000.

B. $425,000; $75,000.

C. $500,000; $25,000.

Ans: A.

The net book value of the asset for accounting purposes (carrying amount) is:

 [500,000 – (500,000/10)] = $450,000.

The net book value for taxes (tax base) is:

 500,000 - 0.15(500,000) = $425,000

The temporary difference is the difference between the net book value of the asset for accounting purposes and the net book value for taxes:

450,000 – 425,000 = $25,000.

19. At the beginning of the year a company purchased a fixed asset for $500,000 with no expected residual value. The company depreciates similar assets on a straight-line basis over 10 years, while the tax authorities allow declining balance depreciation at the rate of 15% per year. In both cases the company takes a full year’s depreciation in the first year and the tax rate is 40%. Which of the following statements concerning this asset at the end of the year is most accurate?

A. The tax base is $500,000.

B. The deferred tax asset is $10,000.

C. The temporary difference is $25,000.

Ans: C.

The net book value of the asset for accounting purposes (carrying amount) is:

 [500,000 – (500,000/10)] = $450,000.

The net book value for taxes (tax base) is:

 500,000 - 0.15(500,000) = $425,000

The temporary difference is the difference between the net book value of the asset for accounting purposes and the net book value for taxes:

450,000 – 425,000 = $25,000.

A is incorrect. The tax base is:

500,000 - 0.15(500,000) = $425,000.

B is incorrect. When the carrying amount of an asset is greater than the tax base of an asset, deferred tax liability should be recorded on the balance sheet.

And the amount of the deferred tax liability is:

25,000x0.4=$10,000

20. A company incurred and capitalized €2 million of development costs during the year. These costs were fully deductible immediately for tax purposes, but the company is depreciating them over two years for financial reporting purposes. The company has a long history of profitability. When calculating the company’s debt-to-equity ratio, the most appropriate way for an analyst to incorporate the differential tax treatment is to:

A. include it in equity.

B. include it in liabilities.

C. not include it in either equity or liabilities.

Ans: B.

The different treatment for tax purposes and financial reporting purposes is a temporary difference and would create a deferred tax liability. Deferred tax liabilities should be classified as debt if they are expected to reverse with subsequent tax payments. The long history of profitability implies the company will likely be paying taxes in the following years and hence an analyst could reasonably expect the temporary difference to reverse.

21. Which of the following statements regarding deferred taxes is least accurate?

A. A permanent difference is a difference between taxable income and pretax income that will not reverse.

B. A deferred tax asset is created when a temporary difference results in taxable income that exceeds pretax income.

C. Deferred tax assets and liabilities are not adjusted for changes in tax rates.

Ans: C.

Deferred tax assets and liabilities are adjusted for changes in expected tax rates under the liability method.

22. Which of the following definitions used in accounting for income taxes is least accurate?

A. Income tax expense is based on current period pretax income adjusted for any changes in deferred tax assets and liabilities.

B. A valuation allowance is a reserve against deferred tax assets based on the likelihood that those assets will not be realized.

C. A deferred tax liability is created when tax expense is less than taxes payable and the difference is expected to reverse in future years.

Ans: C.

Deferred tax liability refers to balance sheet amounts that are created when tax expense is greater than taxes payable.

23. When the expected tax rate changes, deferred tax:

A. expense is calculated using current tax rates with no adjustments.

B. liability and asset accounts are adjusted to reflect the new expected tax rate.

C. liability and asset accounts are maintained at historical tax rates until they reverse.

Ans: B.

The liability method (SFAS 109 of U.S.GAAP) takes a balance sheet approach and adjusts deferred tax assets and liabilities to future tax rates.

24. A permanent difference in pretax and taxable income is least likely to result when:

A. tax-exempt interest is received.

B. the installment sales method is used.

C. premiums are paid on life insurance of key employees.

Ans: B.

The installment sales method of revenue recognition does not result in permanent differences between pretax and taxable income. Premium payments on life insurance of key employees is an expense on the financial statement, but is nor deducted on tax returns. Tax exempt interest is recognized as revenue on the financial statements. These items result in permanent differences between pretax income and taxable income.

25. A firm needs to adjust the financial statements for a change in the tax rate. Taxable income if $80,000 and pretax income is $100,000. The current tax rate is 50%, and the new tax rate is 40%. The difference in taxes payable between the two rates is closest to:

A. $8,000.

B. $9,000.

C. $10,000.

Ans: A.

“Pretax income” denotes earnings before taxes for financial reporting. “Taxable income” is earning before taxes for computing taxes payable, where taxes payable refers to the actual tax liability to the government. (The difference between the two is due to accounting for inventories and depreciation). Since taxable income is $80,000, the difference in taxes payable is ($80,000)(0.5)-($80,000)(0.4)=$8,000.

26. Bao Inc. sold a luxury passenger boat from its inventory on December 31 for $2,000,000. It is estimated that Bao will incur $100,000 in warranty expenses during its 5-year warranty period. Bao’s tax rate is 30%. To account for the tax implications of the warranty obligation prior to incurring warranty expenses, Bao should:

A. record a deferred tax asset of $30,000.

B. record a deferred tax asset of $30,000.

C. make no entry until actual warranty expenses are incurred.

Ans: A.

Warranty expense should be recorded when the inventory item covered by the warranty is sold. A deferred tax asset is created when warranty expenses are accrued on the financial statements but are nor deductive on the tax returns until the warranty claims are paid. The full amount of the obligation, $100,000, is recorded as an expense, with a deferred tax asset of $30,000. Note that a deferred tax asset results when taxable income is more than pretax income and the difference is likely to reverse (warranty will be paid) in future years.

27. On January 2, a company acquires some state-of-the-art production equipment at a net cost of $14 million. For financial reporting purposes, the firm will depreciate the equipment over a 7-year life using straight-line depreciation and a zero salvage value; for tax reporting purposes, however, the firm will use 3-year accelerated depreciation. Given a tax rate of 35% and a first-year accelerated depreciation factor of 0.333, by how much will the company’s deferred tax liability increase in the first year of the equipment’s life?

A. $931,700.

B. $1,064,800.

C. $1,730,300.

Ans: A.

Straight-line depreciation:=$2.0 million

Accelerated depreciation:

$14 million x 0.333=$4.662million

Difference in depreciation:

$4.662 million - $2.0 million=         $2.662 million.

 x Tax rate                                                 0.35

Increase in deferred tax liability          $931,700

28. Bao Corporation faced a 50% marginal tax rate last year and showed the following financial and tax reporting information:

·         Deferred tax asset of $1,000.

·         Deferred tax liability of $5,000.

Based only on this information and the news that the tax rate will decline to 40%, Bao Corporation’s:

A. deferred tax asset will be reduced by $400 and deferred tax liability will be reduced by $2,000.

B. deferred tax liability will be reduced by $1,000 and income tax expense will be reduced by $800.

C. deferred tax asset will be reduced by $200 and income tax expense will be reduced by $1,000.

Ans: B.

There is a 20% reduction in the tax rate:

 = -0.2

Hence, the deferred tax asset will be $1,000x(1-0.2)=$800;

the deferred tax liability will be $5,000x(1-0.2)=$4,000,

and the income tax expense will fall by the net amount of the decline in the asset and liability balances.

29. When the Bao Company filed its corporate tax returns for the first quarter of the current year, it owed a total of $6.7 million in corporate taxes. Bao paid $4.4 million of the tax bill, but still owes $2.3 million. It also received $478,000 in the second quarter as a down payment towards $942,000 in custom-built products to be delivered in the third quarter. Its financial accounts for the second for the second quarter most likely show the $2.3 million and the $478,000 as:

Ans: A.

The $478,000 is unearned revenue, a liability. The $2.3 million owned to the government but not yet paid is income tax payable, also a liability. Deferred tax accounts arise from temporary differences between tax reporting and financial reporting.

30. A financial analyst would classify deferred tax liabilities as equity (versus a liability) when:

A. the deferred tax liabilities are expected to decline over time.

B. the deferred tax liabilities are predominantly comprised of permanent differences.

C. a change in tax law may result in the deferred taxes never being paid by the company.

Ans: C.

If a change in tax law or a change in operations results in deferred taxes never being paid by the company, the deferred tax liabilities would be treated as equity by the financial analyst.

A is incorrect. A financial analyst would treat deferred tax liabilities that are expected to decline over time as a legitimate liability.

B is incorrect. Permanent differences are not included in deferred taxes.