Reading 38: Income Taxes-LOS h 习题精选 香蕉, 冰淇淋, 柠檬汁, label, class

1215

Session 9: Financial Reporting and Analysis: Inventories, Long-lived Assets, Income Taxes, and Non-current Liabilities
Reading 38: Income Taxes

LOS h: Compare and contrast a company's deferred tax items.

 

 

Luigi Medici, a level II candidate for the CFA charter, was asked to assist in the analysis of the effective tax rate for Monster Software Inc. The following comments were left with Medici by his superior, Greg Becker.

1. The analyst should estimate expected changes in the effective tax rate based solely on the provided reconciliation, without regard to any additional input from the management of the company.
2. The analysis of trends and forecasting should include all continuous items.
3. The analysis of trends and forecasting should include all sporadic items.
4. The forecast should include expected changes in legislation related to corporate taxation.

Becker is:

A) correct in regard to statements 2 and 4.

B) incorrect in regard to statements 2 and 3.

C) correct in regard to statements 3 and 4.

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The correct statements are 2 and 4. Statement 1 is incorrect because the analysis of the effective tax rate typically requires that the analyst, at a minimum, use the information in the management analysis and discussion (MD&A). Furthermore, it is recommended that the analyst seek additional information from the management if needed. Statement 3 is incorrect because, by definition, sporadic items are not repeated and are difficult to predict. Therefore they will complicate trend analysis and forecasting.

1215

Differences between the effective tax rate and the statutory rate arise due to all of the following EXCEPT:

A) non-deductible expenses.

B) tax credits.

C) deductible expenses.

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Permanent tax differences such as tax credits, non-deductible expenses, and tax differences between capital gains and operating income give rise to differences in the effective and statutory tax rates.

1215

All of the following factors complicate the comparability of effective tax rates across firms EXCEPT:

A) comparisons over relatively short time horizons.

B) volatility in the effective tax rate over the comparison period.

C) changes in the statutory tax rate.

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Comparability decreases when the comparison period is relatively short (e.g. quarters vs. years), with the presence of volatility in the effective tax rate over the comparison period, and operations in different tax jurisdictions.

1215

Bandhu Jayagopal and his wife, Padmini, are the founders and current owners of the Riverview Restaurant and Lounge. They retired several years ago from the day-to-day management, however, turning it over to a nephew, Mehmood Shah. Shah has run the restaurant very profitably, but recent redevelopment of the downtown riverfront area has brought new competition to the Riverview. Jayagopal’s 25 year old grandson, Jeff Patel, thinks the restaurant can leap ahead of the competition and attract a hipper crowd by turning the lounge into a nightclub.

Patel wants to incorporate a new business and lease the restaurant lounge for his nightclub, the Red Monkey. Patel has consulted a contractor who says he can do the renovations for $25,352,000. Patel estimates that the new sound system and décor would be usable for five years before fashions changed enough that it would have to be replaced, at which point it would have no salvage value.

Patel assures his grandfather and uncle that he could generate $14,384,000 in revenue every year once the renovations are complete. For their parts, Jayagopal and Shah are understandably leery of turning over the financial future of the family business to a 25 year old who wants to open a club. Since the new club would face the same 41% tax rate that the restaurant faces, Jayagopal and Shah are not sure that the cash flow from the club would be sufficient to cover the rapid depreciation of the fashionable décor. The fact that Patel also expects them to fund the new company for him doesn’t help. They say no.

Patel returns to his uncle and grandfather armed with financial projections. Patel shows his hoped-for business partners that, if they use the straight-line method in reporting the club’s results, the Red Monkey will report $5,495,024 in after-tax income (ignoring expenses other than depreciation) in the first year.

Jayagopal counters that straight-line depreciation is irrelevant because for tax purposes the depreciation schedule will be accelerated to 35% per year in each of the first two years and 30% in the third year. Jayagopal points out that after-tax income for the club in the first year will be only $3,251,372 on a tax basis (again ignoring expenses other than depreciation).

Shah joins Jayagopal in his objections, adding that the accelerated depreciation schedule used for tax purposes will result in a substantial deferred tax liability, reaching approximately $4,158,000 by the end of year three. Patel replies that the deferred tax liability is merely an accounting entry and the Red Monkey will never have to pay any of it since the club will reinvest in up-to-date décor in five years when the current renovations are out of fashion.

Patel adds that a change in the tax law to cut tax rates from 41% to 31% is likely in year three, and if that happens the deferred tax liability at the end of the third year will decline to $2.948 million. Jayagopal agrees about the likelihood of a tax cut, saying that such a cut in tax rates would add $1.014 million to the Red Monkey’s reported net income in year three.

Jayagopal and Shah agree to fund the nightclub if the tax cut passes.

What would be the Red Monkey’s projected tax payable (in millions) in year one?

A) $1.909.

B) $2.259.

C) $0.779.

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On a tax basis, first-year depreciation will be ($25.352 million × 0.35) = $8,873,200.
Pre-tax income will be ($14,384,000 – $8,873,200) = $5,510,800.
At a 41% tax rate, tax payable in year one would be ($5,510,800 × 0.41) = $2.259 million.

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Regarding Patel’s and Jayagopal’s statements about the Red Monkey’s after-tax income in the first year, which is CORRECT?

Patel

Jayagopal

A) Correct Correct

B) Incorrect Correct

C) Correct Incorrect

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If the Red Monkey uses straight-line depreciation in its reported results, the annual depreciation expense on financial statements will be ($25.352 million / 5 years) = $5,070,400 per year. Pre-tax income (ignoring depreciation) will be ($14,384,000 revenue ? $5,070,400 depreciation) = $9,313,600. At a 41% tax rate, reported income each year will equal ((1 – 0.41) × $9,313,600) = $5,495,024, ignoring expenses other than depreciation. Patel’s statement is correct.

On a tax basis, first-year depreciation will be ($25.352 million × 0.35) = $8,873,200 and pre-tax income will be ($14,384,000 – $8,873,200) = $5,510,800, again ignoring expenses other than depreciation. At a 41% tax rate, the after-tax income of the Red Monkey will be [(1 – 0.41) × $5,510,800] = $3,251,372. Jayagopal’s statement is also correct.

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1215

Which statement about an analyst’s treatment of deferred tax assets and liabilities is most accurate?

A) Deferred tax assets that are unlikely to be reversed should be added to equity.

B) Deferred tax liabilities are unlikely to reverse should be discounted to present value and treated as liabilities.

C) Deferred tax liabilities that are unlikely to reverse should be treated as equity, without discounting.

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Deferred tax assets that are unlikely to be reversed should be subtracted from equity, not added to it. Deferred tax liabilities should be discounted to present value and treated as liabilities if they are likely, not unlikely, to reverse. If the deferred tax liability is unlikely to reverse, the difference between the reported value and present value is added to equity.

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Regarding Patel’s and Shah’s statements about the Red Monkey’s deferred tax liability, which is CORRECT?

Patel

Shah

A) Incorrect Correct

B) Correct Correct

C) Incorrect Incorrect

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Although it is true that the Red Monkey will be renovating the décor frequently, it will not be investing in décor as rapidly as it depreciates it for tax purposes. In years four and five, the Red Monkey will have no depreciation for tax purposes but will still be depreciating the renovations on its books, and in those years its deferred tax liabilities will become due. Deferred tax liabilities are generally deferred indefinitely only if a company invests consistently. Patel’s statement is incorrect.

In order to calculate the total deferred tax liability for year three, we can calculate the deferred tax charge in years one, two, and three and then add them.

Pre-tax income for the Red Monkey for reporting purposes every year equals ($14,384,000 revenue ? $5,070,400 straight-line depreciation) = $9,313,600.

For tax purposes, pre-tax income in years one and two equals $14,384,000 revenue – ($25,352,000 × 0.35) = $8,873,200 depreciation, or $5,510,800 in net income per year. Thus the deferred tax charge in years one and two equals the difference in income of ($9,313,600 reported income ? $5,510,800 taxable income) = $3,802,800 at a 41% tax rate, or ($3,802,800 × 0.41) = $1,559,148.

For tax purposes, pre-tax income in year three equals $14,384,000 revenue – ($25,352,000 × 0.30) = $7,605,600 depreciation, or $6,778,400 in net income. Thus the deferred tax charge for year three equals the difference in income of ($9,314,000 reported income ? $6,778,400 taxable income) = $2,535,600 at a 41% tax rate, or ($2,535,600 × 0.41) = $1,039,596.

Thus the total deferred tax liability at the end of year 3 equals ($1.559 million + $1.559 million + $1.040 million) = $4.158 million. Shah’s statement is correct.

Alternately, we could do this more quickly by recognizing that, in year three, the renovations will be completely depreciated for tax purposes, so that taxable depreciation will have reached their full cost, $25,352,000. We also can calculate that, because the renovations are being depreciated on a straight-line basis over five years, by year three Red Monkey will have depreciated (3 years charged / 5-year asset life) = 60% of their total cost on its books. Thus, the deferred tax liability in year three will be based on the [($25,352,000)× (1 – 0.60)] = $10.141 million in cost not yet depreciated. At a 41% tax rate, the deferred taxes on the cost not yet depreciated will equal ($10.141 million × 0.41) = $4.158 million.

Note that calculating a deferred tax liability directly is often much faster than doing it year by year.

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Regarding Patel’s and Jayagopal’s statements about the effect of a tax cut from 41% to 31% in year three on Red Monkey, which is CORRECT?

Patel

Jayagopal

A) Incorrect Incorrect

B) Correct Correct

C) Incorrect Correct

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Using the information we calculated in question 4, we can recalculate the deferred tax liability for years one, two, and three using the lower tax rate:

Deferred tax liability for years one and two equals [($9.314 ? $5.511) × 0.31] = $1.179 million. Deferred tax liability for year three equals ($9.314 ? $6.778) × 0.31 = $0.786 million. Thus the deferred tax liability on Red Monkey’s balance sheet at the end of year three, after the change in tax rate, will be ($1.179 million + $1.179 million + $0.786 million) = $3.144 million. Alternately, we can calculate the deferred tax liability for year three directly as ($10.141 million × 0.31) = $3.144 million. Using either approach, Patel’s statement is incorrect.

We calculated in question 4 that the deferred tax liability in year three will equal $4.158 million. Thus, Red Monkey’s deferred tax liability will decrease by ($4.158 ? $3.144) = $1.014 million due to the new lower tax rate. Thus, Red Monkey will have to make an adjustment of $1.014 million in tax expense in year three, which will result in an increase in net income of $1.014 million. Jayagopal’s statement is correct.

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When analyzing a firm’s reconciliation between its effective tax rate and the statutory tax rate, which of the following is least likely a potential cause for the difference between the effective rate and the statutory rate?

A) Use of accelerated depreciation for tax purposes and straight-line depreciation for reporting purposes.

B) Differential tax treatment between capital gains and operating income.

C) Deferred taxes provided on the reinvested earnings of unconsolidated domestic affiliates.

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Potential reasons for a difference between a firm’s statutory and effective tax rates include tax credits, differential tax treatment between capital gains and operating income, and deferred tax provisions on reinvested earnings of unconsolidated domestic affiliates. The difference in depreciation schedules for tax and reporting purposes affects the level of deferred taxes but not the tax rate at which they are calculated.

1215

Markham Inc. is a profitable non-U.S. firm that uses the LIFO inventory cost-flow assumption for tax purposes and the FIFO cost-flow assumption for financial statement purposes. When prices are declining, which of the following statements is most accurate regarding the deferred tax implications relating solely to the choice of inventory cost-flow assumptions?

A) If a profitable firm uses LIFO for tax purposes and FIFO for financial statement reporting, a deferred tax liability will result.

B) Neither IFRS nor U.S. GAAP allows firms to use different inventory cost-flow assumptions for tax purposes and financial statement purposes.

C) If a profitable firm uses LIFO for tax purposes and FIFO for financial statement reporting, a deferred tax asset will result.

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Some jurisdictions allow companies to use different inventory cost-flow methods for financial statement purposes and for tax purposes. Where this is permissible (which is determined by each country’s tax laws, not by the accounting standard-setting bodies), temporary differences will arise.

LIFO (tax): when prices are declining, the most recent (lower) prices are included in COGS. This results in a higher inventory value, and hence a higher tax base, compared to FIFO.

FIFO (financial statements): when prices are declining, the oldest (higher) prices are included in COGS. This results in a lower inventory value, and hence a lower carrying value for financial statement purposes, compared to LIFO.

Therefore, there is a deductible temporary difference since the higher tax base results in an excess of taxes payable over income tax expense. This gives rise to a deferred tax asset.

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