mouse123

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) Incorrect Correct

B) Correct Incorrect

C) Correct Correct

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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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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) Incorrect Correct

C) Correct 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 rateeferred 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) Differential tax treatment between capital gains and operating income.

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

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

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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.

mouse123

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

A) comparisons over relatively short time horizons.

B) changes in the statutory tax rate.

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

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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.

mouse123

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.

mouse123

While evaluating the financial statements of Omega, Inc., the analyst observes that the effective tax rate is 7% less than the statutory rate. The source of this difference is determined to be a tax holiday on a manufacturing plant located in South Africa. This item is most likely to be:

A) sporadic in nature, and the analyst should try to identify the termination date and determine if taxes will be payable at that time.

B) sporadic in nature, but the effect is typically neutralized by higher home country taxes on the repatriated profits.

C) continuous in nature, so the termination date is not relevant.

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As the name suggests, a tax holiday is usually a temporary exemption from having to pay taxes in some tax jurisdiction. Because of the temporary nature, the key issue for the analyst is to determine when the holiday will terminate, and how the termination will affect taxes payable in the future.

mouse123

An analyst gathered the following information about a company:

• Pretax income = $10,000.
• Taxes payable = $2,500.
• Deferred taxes = $500.
• Tax expense = $3,000.

What is the firm's reported effective tax rate?

A) 25%.

B) 5%.

C) 30%.

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Reported effective tax rate = Income tax expense / pretax income
= $3,000 / $10,000
= 30%

mouse123

Year:		2002	2003	2004
Income Statement:
	Revenues after all expenses other than depreciation	$200	$300	$400
	Depreciation expense	50	50	50
	Income before income taxes	$150	$250	$350
Tax return:
	Taxable income before depreciation expense	$200	$300	$400
	Depreciation expense	75	50	25
	Taxable income	$125	$250	$375

Assume an income tax rate of 40%.
The company's income tax expense for 2002 is:

A) $50.

B) $60.

C) $0.

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Effective tax rate = Income tax expense / pretax income
Income tax expense = Effective tax rate × pretax income
= $150(0.40)
= $60

mouse123

A firm purchased a piece of equipment for $6,000 with the following information provided:

• Revenue will be $15,000 per year.
• The equipment has a 3-year life expectancy and no salvage value.
• The firm's tax rate is 30%.
• Straight-line depreciation is used for financial reporting and double declining is used for tax purposes.

Calculate taxes payable for years 1 and 2.

Year 1

Year 2

A) 3,300 4,100

B) 600 -200

C) 3,900 3,900

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Using DDB:

	Yr. 1	Yr. 2
Revenue	15,000	15,000
Depreciation	4,000	1,333
Taxable Income	11,000	13,667
Taxes Payable	3,300	4,100

An asset with a 3-year life would have a straight line depreciation rate of 0.3333 per year. Using DDB the depreciation rate is twice this amount or 0.66667. $2,000 is the amount of depreciation left on the equipment in year 2 ($6,000 − $4,000). Therefore, the amount of depreciation in the 2nd year is (0.66667)(2,000) = $1,333

mouse123

Which of the following statements regarding the disclosure of deferred taxes in a company’s balance sheet is most accurate?

A) There should be a combined disclosure of all deferred tax assets and liablities.

B) Current deferred tax liability, current deferred tax asset, noncurrent deferred tax liability and noncurrent deferred tax asset are each disclosed separately.

C) Current deferred tax liability and noncurrent deferred tax asset are netted, resulting in the disclosure of a net noncurrent deferred tax liability or asset.

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Deferred tax assets and liabilities must be separated between current and noncurrent accounts.

mouse123

A tax rate that has been substantively enacted is used to determine the balance sheet values of deferred tax assets and deferred tax liabilities under:

A) U.S. GAAP only.

B) IFRS only.

C) both IFRS and U.S. GAAP.

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Under IFRS, a tax rate that has been enacted or substantively enacted is used to measure deferred tax items. Under U.S. GAAP, only a tax rate that has actually been enacted can be used

mouse123

One major difference between the presentation of deferred tax assets and liabilities under IFRS and under U.S. GAAP is that:

A) all deferred tax assets and liabilities are classified as noncurrent under IFRS.

B) a valuation allowance is presented only under U.S. GAAP.

C) under IFRS deferred tax assets and liabilities are not adjusted for changes in the the firm’s actual tax rate.

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Under U.S. GAAP, deferred tax assets and liabilities are classified as current or non-current according to the classification of the underlying asset or liability. Under IFRS, deferred tax assets and deferred tax liabilities are all classified as noncurrent, with footnote disclosure about the expected timing of reversals.