Problems for CFA Level I

Transcription

1 Problems for CFA Level I Analysis of Income Taxes 1. [Deferred tax classification] Explain in which of the following caregories deferred taxes can be found. Provide an example for each category in your answer. (i) Current liabilities Answer: Taxes payable. A sale has been recognized on the income statement but the cash payment will be made later, and thus the taxes on the sale will be paid later. (ii) Long-term liabilities Answer: Deferred taxes. Accelerated depreciation is used for income tax reporting and straight-line depreciation is used for financial reporting. (iii) Stockholders equity Answer: Counterpart of the valuation allowance. (iv) Current assets Answer: Taxes receivable. Cash payment due within the year. (v) Long-term assets Answer: Deferred tax asset. The firm reports more warranty expenses on the income statement than what is actually claimed by customers.. State which of the following statements are correct under SFAS 109. Explain why. 1

2 (i) The deferred tax liability account must be adjusted for the effect of enacted changes in the tax laws or rates in the period of enactment. Answer: Correct. If the statements were already prepared when the new law is enacted, past deferred tax assets and liabilities must be restated. (ii) The deferred tax asset account must be adjusted for the effect of enacted changes in tax laws or rates in the period of enactment. Answer: Correct. Same as in (i). (iii) The tax consequences of an event must not be recognized until that event is recognized in the financial statements. Answer: Correct. Of course. Otherwise, what does recognize mean? (iv) Both deferred tax liabilities and deferred tax assets must be accounted for based on the tax laws and rates in effect at their origin. Answer: Incorrect Deferred tax assets and liabilities must be restated after new laws are enacted to better reflect what is expected to be paid or received. (v) Changes in deferred tax assets and liabilities are classified as extraordinary items on the income statement. Answer: Incorrect. These changes are included in the income tax expense. 3. [Permanent versus temporary differences] (a) Define permanent differences and describe two events or transactions that generate such differences. Answer: Differences between taxes actually paid and taxes reported that will never reverse. These result from income or expenses that either affect taxable income or financial income but not both. Examples: Interest income on tax-exempt bonds, premiums paid on officers life insurance and amortization of goodwill (in some cases) are included in financial statements but are not reported on the tax return.

3 Certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the financial statements. Interest expense on amounts borrowed to purchase tax-exempt securities (not deductible on the tax return). (b) Describe the impact of permanent differences on a firm s effective tax rate. Answer: Permanent differences may increase or decrease the effective tax rate, defines as compared to the statutory tax rate. 4. [Treatment of deferred tax liability] Income taxes paid, Pretax income (a) When computing a firm s debt-to-equity ratio, describe the conditions for treating the deferred tax liability: (i) As equity Answer: If the liability is not expected to reverse. (ii) As debt Answer: If the liability is expected to reverse. (b) Provide arguments for excluding deferred tax liabilities from both the numerator and the denominator of the debt-to-equity ratio. Answer: Because of the uncertainty of the reversal. (c) Describe the arguments for including a portion of the deferred taxes as equity and a portion as debt. Answer: The portion expected to reverse should be treated as debt, the rest should be treated as equity.. [Depreciation methods and deferred taxes] The Incurious George Company acquires assets K, L and M at the beginning of year 1. Each asset has the same cost, a fiveyear life, and an expected salvage value of $3,000. For financial reporting, the firm uses 3

4 the straight-line, sum-of-the-years digits, and double-declining-balance depreciation methods for assets K, L and M, respectively. It uses the double-declining-balance method for all assets on its tax return; its tax rate is 34%. Depreciation expense of $1,000 was reported for asset L for financial reporting purposes in year. Using this information: (a) Calculate the tax return depreciation expense for each asset in year. Answer: Since sum-of-the-years digits depreciation is used for asset L and the depreciation expense for this asset in year is $1,000, the original cost of each asset is 1, 000 ( + 1)/1 + 3, 000 = $48, 000. For tax return purposes, the double-declining-balance is used and thus the annual depreciation for each asset for tax purposes is (48, 000 Accumulated depreciation) except for the year where the net book value reaches $3,000. This gives 48, 000 = 19, 00 NBV = 8, 800 Year : 8, 800 = 11, 0 NBV = 17, 80 Year 3: 17, 80 = 6, 91 NBV = 10, 368 Year 4: 10, 368 = 4, 147 NBV = 6, 1 Year : 3, 1 = 3, 1 NBV = 3, 000 (b) Calculate the financial statement depreciation expense for assets K, L and M in year. Answer: Annual depreciation for asset K is 4, 000/ = $9, 000 and the depreciation for asset L in year i is n i + 1 i i (48, 000 3, 000) = 4, 000 = 4, 000, n(n + 1)/ 6/ 1 4

5 which gives , 000 = 1, 000 4, 000 = 1, 000 4, 000 = 9, 000 4, 000 = 6, 000 4, 000 = 3, 000 (c) Calculate the deferred tax credit (liability) or debit (asset) for each asset at the end of each year. Answer: There is no difference for asset M. For asset K, we have.34 (19, 00 9, 000) = 3, 468 Tax liability = 3, 468 Year :.34 (11, 0 9, 000) = 87 Tax liability = 4, 3 Year 3:.34 (6, 91 9, 000) = 710 Tax liability = 3, 61 Year 4:.34 (4, 147 9, 000) = 1, 60 Tax liability = 1, 96 Year :.34 (3, 1 9, 000) = 1, 96 Tax liability = 0 For asset L, we have.34 (19, 00 1, 000) = 1, 48 Tax liability = 1, 48 Year :.34 (11, 0 1, 000) = 163 Tax liability = 1, 6 Year 3:.34 (6, 91 9, 000) = 710 Tax liability = Year 4:.34 (4, 147 6, 000) = 630 Tax asset = 7 Year :.34 (3, 1 3, 000) = 7 Tax asset = 0 6. [Analysis of deferred tax] On December 9, 000, Mother Prewitt s Handmade Cookies Corp. acquires a numerically controlled chocolate chip-milling machine. Due to differences in tax and financial accounting, depreciation for tax purposes is $10,000 more than depreciation in the financial statements, adding $,00 to deferred taxes. At the same time, Mother Prewitt s sells $00,000 worth of cookies on an installment contract, recognizing the $100,000 profit immediately. For tax purposes, however, $80,000 of the profit will be recognized in 001, requiring $7,00 of deferred taxes.

6 (a) Compare the expected cash consequences of the two deferred tax items just described. Answer: If the company continues to buy assets on a regular basis in the future, the associated tax liabilities may never reverse. The installment sale, on the other hand is very likely to reverse. (b) Explain your treatment of deferred taxes when calculating Mother Prewitt s solvency and leverage ratios. Answer: The deferred taxes associated to the purchase of assets oculd be considered as equity whereas the deferred taxes associated to installment sales should be considered as debt. (c) In 001, Mother Prewitt s tax rate will be 40%. Discuss the adjustments to each of the two deferred tax items in 001 because of the change in the tax rate, assuming the use of SFAS 109. Answer: Deferred tax assets and liabilities will have to be restated at the time of the change. (d) Discuss the conditions under which Mother Prewitt would need to recognize a valuation allowance for any deferred tax assets. Answer: The valuation allowance represents the portion of tax assets that is not expected to reverse. 6