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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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.

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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: $2.3 million $478,000 A. Income tax payable Unearned revenue B. Income tax payable Accrued revenue C. Deferred tax liability Accrued revenue

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.