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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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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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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

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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.

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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. Gross fixed assets $100,000 Operating revenue 270,000 Tax-exempt interest income 20,000 COGS 85,000 Depreciation (tax basis) 50,000 Taxable income 135,000 Statutory tax rate 30% 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. Operating revenue $270,00 $270,000 Tax-exempt interest income 20,000 COGS (85,000) (85,000) Depreciation (25,000) (25,000) Pretax income $160,000 180,000 Income tax expense 48,000* 48,000 Net income $132,000 132,000 *Income tax expense = 30% x 160,000 = 48,000 Effective tax rate = 48,000/ 180,000 = 26.67%

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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.

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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.

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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.

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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.

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13. The following information relates to a profitable company that offers a warranty on a new product introduced in 2012: Accrued warranty expenses for the warranty in 2012 $300,000 Actual expenditures for repairs under the warranty in 2012 $200,000 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.