Problems for CFA Level I

Analysis of Income Taxes

1. [Deferred tax classication] 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 nancial 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 rm reports more warranty expenses on the income statement than what is actually claimed by customers. 2. State which of the following statements are correct under SFAS 109. Explain why.

(i) The deferred tax liability account must be adjusted for the eect 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 eect 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 nancial 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 eect at their origin. Answer: Incorrect Deferred tax assets and liabilities must be restated after new laws are enacted to better reect what is expected to be paid or received. (v) Changes in deferred tax assets and liabilities are classied as extraordinary items on the income statement. Answer: Incorrect. These changes are included in the income tax expense. 3. [Permanent versus temporary dierences] (a) Dene permanent dierences and describe two events or transactions that generate such dierences. Answer: Dierences between taxes actually paid and taxes reported that will never reverse. These result from income or expenses that either aect taxable income or nancial income but not both. Examples: Interest income on tax-exempt bonds, premiums paid on ocers life insurance and amortization of goodwill (in some cases) are included in nancial statements but are not reported on the tax return.

 Certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the nancial statements. Interest expense on amounts borrowed to purchase tax-exempt securities (not deductible on the tax return). (b) Describe the impact of permanent dierences on a rms eective tax rate. Answer: Permanent dierences may increase or decrease the eective tax rate, denes as Income taxes paid , Pretax income compared to the statutory tax rate. 4. [Treatment of deferred tax liability] (a) When computing a rms 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. 5. [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 veyear life, and an expected salvage value of $3,000. For nancial reporting, the rm uses 3

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 $12,000 was reported for asset L for nancial reporting purposes in year 2. Using this information: (a) Calculate the tax return depreciation expense for each asset in year 2. Answer: Since sum-of-the-years digits depreciation is used for asset L and the depreciation expense for this asset in year 2 is $12,000, the original cost of each asset is 12, 000 + 3, 000 = $48, 000. (5 2 + 1)/15 For tax return purposes, the double-declining-balance is used and thus the annual depreciation for each asset for tax purposes is 2 (48, 000 Accumulated depreciation) 5 except for the year where the net book value reaches $3,000. This gives Year 1: Year 2: Year 3: Year 4:
2 5 2 5 2 5 2 5

48, 000 = 19, 200 NBV = 28, 800 28, 800 = 11, 520 NBV = 17, 280 17, 280 = 10, 368 = = 6, 912 NBV = 10, 368 4, 147 NBV = 3, 221 NBV = 6, 221 3, 000

Year 5: 3, 221

(b) Calculate the nancial statement depreciation expense for assets K, L and M in year 2. Answer: Annual depreciation for asset K is 45, 000/5 = $9, 000 and the depreciation for asset L in year i is 5i+1 6i ni+1 (48, 000 3, 000) = 45, 000 = 45, 000, n(n + 1)/2 5 6/2 15

which gives Year 1: Year 1: Year 1: Year 1: Year 1:

61 15 62 15 63 15 64 15 65 15

45, 000 = 15, 000 45, 000 = 12, 000 45, 000 = 45, 000 = 45, 000 = 9, 000 6, 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 dierence for asset M . For asset K, we have Year 1: .34 (19, 200 9, 000) = Year 2: .34 (11, 520 9, 000) = Year 3: .34 (6, 912 9, 000) Year 4: .34 (4, 147 9, 000) Year 5: .34 (3, 221 9, 000) For asset L, we have Year 1: .34 (19, 200 15, 000) = 1, 428 Tax liability = 1, 428 Year 2: .34 (11, 520 12, 000) = 163 Tax liability = 1, 265 Year 3: .34 (6, 912 9, 000) Year 4: .34 (4, 147 6, 000) Year 5: .34 (3, 221 3, 000) = 710 Tax liability = = 630 Tax asset = 75 Tax asset = = 555 75 0 = 3, 468 Tax liability = 3, 468 857 Tax liability = 4, 325 710 Tax liability = 3, 615

= 1, 650 Tax liability = 1, 965 = 1, 965 Tax liability = 0

6. [Analysis of deferred tax] On December 29, 2000, Mother Prewitts Handmade Cookies Corp. acquires a numerically controlled chocolate chip-milling machine. Due to dierences in tax and nancial accounting, depreciation for tax purposes is $150,000 more than depreciation in the nancial statements, adding $52,500 to deferred taxes. At the same time, Mother Prewitts sells $200,000 worth of cookies on an installment contract, recognizing the $100,000 prot immediately. For tax purposes, however, $80,000 of the prot will be recognized in 2001, requiring $27,200 of deferred taxes. 5

(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 Prewitts 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 2001, Mother Prewitts tax rate will be 40%. Discuss the adjustments to each of the two deferred tax items in 2001 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.