mouse123

Christophe Inc. is an electronics manufacturing firm. It owns equipment with a tax basis of $800,000 and a carrying value of $600,000 as the result an impairment charge. It also has a tax loss carryforward of $300,000 that is expected to be utilized within the next year or two. The tax rate on these items is 40% but the tax rate is expected to decrease to 35% for the foreseeable future. Which of the following amounts is closest to the net effect of the change in tax rate on the income statement?

A) Increase in deferred tax expense of $5,000.

B) Decrease in deferred tax expense of $5,000.

C) Increase in deferred tax expense of $25,000.

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The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a deductible temporary difference that leads to a deferred tax asset (DTA) of $80,000 ($200,000 × 40%). The tax loss carryforward of $300,000 also leads to a DTA but for $120,000 ($300,000 × 40%).
The decrease in the tax rate from 40% to 35% will reduce the DTA of the equipment by $10,000 ($200,000 × 5%). It will reduce the DTA of the tax loss carryforward by $15,000 ($300,000 × 5%). In total, the DTA will decrease by $25,000. Therefore, the balancing entry will be to increase deferred tax expense by $25,000.

mouse123

Firm 1 has a deferred tax liability and Firm 2 has a deferred tax asset. With respect to the taxes payable for each firm when these deferred tax items reverse, a decrease in the firms’ tax rates will lead to:

Firm 1

Firm 2

A) Lower taxes payable Lower taxes payable

B) Higher taxes payable Lower taxes payable

C) Lower taxes payable Higher taxes payable

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When the expected tax rate decreases, income will be taxed at a lower rate when a DTL reverses, resulting in lower (cash) taxes payable for Firm 1. In contrast, expenses that will be tax deductible when the DTA reverses will provide less of a benefit when the tax rate is lower, resulting in higher taxes payable for Firm 2.

mouse123

Enduring Corp. operates in a country where net income from sales of goods are taxed at 40%, net gains from sales of investments are taxed at 20%, and net gains from sales of used equipment are exempt from tax.  Installment sale revenues are taxed upon receipt.
For the year ended December 31, 2004, Enduring recorded the following before taxes were considered:

• Net income from the sale of goods was $2,000,000, half was received in 2004 and half will be received in 2005.
• Net gains from the sale of investments were $4,000,000, of which 25% was received in 2004 and the balance will be received in the 3 following years.
• Net gains from the sale of equipment were $1,000,000, of which 50% was received in 2004 and 50% in 2005.

On its financial statements for the year ended December 31, 2004, Enduring should apply an effective tax rate of:

A) 22.86% and increase its deferred tax liability by $1,000,000.

B) 22.86% and increase its deferred tax asset by $1,000,000.

C) 26.67% and increase its deferred tax liability by $1,000,000.

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Total taxes eventually due on 2004 activities were (($2,000,000 × 0.40) + ($4,000,000 × 0.20) =) $1,600,000. Permanent differences are adjusted in the effective tax rate, which is ($1,600,000 / $7,000,000 =) 22.86%. Of the $1,600,000 taxes due, (($2,000,000 × 0.50 × 0.40) + ($4,000,000 × 0.25 × 0.20) =) $600,000 were paid in 2004 and $1,000,000 ($1,600,000 − $600,000) is added to deferred tax liability.

mouse123

Which of the following statements about deferred taxes is least accurate? Deferred taxes:

A) arise primarily due to differences between GAAP and IRS code.

B) may never “reverse” in the case of companies that are growing.

C) can relate to either permanent or temporary differences.

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Permanent difference will not result in deferred taxes since they are not expected to reverse in the future.

mouse123

Which of the following statements regarding differences in taxable and pretax income is CORRECT? Differences in taxable and pretax income that:

A) result in deferred taxes are called temporary differences.

B) increase or reduce the effective tax rate are called temporary differences.

C) are not reversed for five or more years are called permanent differences.

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The permanent differences are never reversed, while there is no time limit on temporary differences to reverse. Permanent differences never result in tax deferrals; temporary differences always result in deferred tax assets or liabilities.

mouse123

Permanent differences in taxable and pretax income:

A) are considered as changes in the effective tax rate.

B) are reported on both tax returns and financial statements.

C) can be deferred in some cases.

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The permanent differences are never deferred but are considered increases or decreases in the effective tax rate. If the only difference between the taxable and pretax incomes were a permanent difference, then tax expense would simply be taxes payable.

mouse123

Which of the following situations will most likely require a company to record a valuation allowance on its balance sheet?

A) To report depreciation, a firm uses the double-declining balance method for tax purposes and the straight-line method for financial reporting purposes.

B) A firm is unlikely to have future taxable income that would enable it to take advantage of deferred tax assets.

C) A firm has differences between taxable and pretax income that are never expected to reverse.

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A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood that the deferred tax assets will never be realized. If a firm is unlikely to have future taxable income, it would be unlikely to ever use its deferred tax assets, and therefore must record a valuation allowance.

mouse123

Which of the following statements best justifies analyst scrutiny of valuation allowances?

A) If differences in taxable and pretax incomes are never expected to reverse, a company’s equity may be understated.

B) Increases in valuation allowances may be a signal that management expects earnings to improve in the future.

C) Changes in valuation allowances can be used to manage reported net income.

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A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood that the deferred tax assets will never be realized. Changes in the valuation allowance have a direct impact on reported income. Because management has discretion with regard to the amount and timing of a valuation allowance, changes in the valuation allowance give management significant opportunity to manage earnings.

mouse123

Which of the following statements best describes the impact of a valuation allowance on the financial statements? A valuation allowance:

A) reduces reported income, increases liabilities, and reduces equity.

B) reduces reported income, reduces assets, and reduces equity.

C) increases reported income, reduces assets, and reduces equity.

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A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood that the deferred tax assets will never be realized. The establishment of a valuation allowance reduces reported income, offsets (reduces) assets, and reduces equity.

mouse123

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.

• 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.
• The analysis of trends and forecasting should include all continuous items.
• The analysis of trends and forecasting should include all sporadic items.
• 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.