3. inv/llass/tax/ltliab Flashcards
Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred
Costs inlucded in inventory on the balance sheet include:
- purchase cost
- conversion costs
- other costs necessary to bring the inventory to its present location and condition
All of these costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or to ending inventory
Period costs, such as abnormal waste, most storage costs, administrative costs, and selling costs, are expenssed as incurred.
Vindaloo Company manufactures a single product. The following information was taken from the company’s production and cost records last year.
Assuming no abnormal waste is included in conversion cost, calculate the capitalized cost of one unit.
Capitalized inventory cost includes the raw material cost, conversion cost, and freight-in to plant as follows:
Storage cost, abnormal waste, and th efreight-out to customers are expensed as incurred.
Describe different inventory valuation methods (cost formulas)
Inventory cost flow methods:
- FIFO: The cost of the first item purchased is the cost of the first item sold. Ending inventory is based on the cost of the most recent purchases, thereby approximating current cost
- LIFO: The cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. LIFO is prohibited under IFRS
- Weighted average cost: COGS and inventory values are between their FIFO and LIFO values
- Specific identification: Each unit sold is matched with the unit’s actual cost
Calculate the cost of sales and ending inventory using different inventory valuation methods and explain the impact of the inventory valuation method choice on gross profit.
Under LIFO, cost of sales reflects the most recent purchase or production costs, and balance sheet inventory values reflect older outdated costs
Under FIFO, cost of sales reflects the oldest purhcase or production costs for inventory, and balance sheet inventory values reflect the most recent costs
Under weighted average cost method, cost of sales and balance sheet inventory values are between thsoe of LIFO and FIFO
When purhcase or production costs are rising, LIFO cost of sales is higher than FIFO cost of sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is lower than FIFO inventory.
When purchase or production costs are falling, LIFO cost of sales is lower than FIFO cost of sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is higher than FIFO inventory.
In either case, LIFO cost of sales and FIFO inventory values better represent economic reality (replacement costs)
Use the inventory data in the following figure to calculate the cost of goods sold and ending inventory under the FIFO, LIFO, and weighted average cost methods.
- FIFO cogs.* Value the 7 units sold at the unit cost of the first unit purchased. Start with the earliest units purhcased and work down.
- LIFO cogs*. Value the 7 units sold at the unit cost of the last units purchased. Start with the most recently purchase dunits and work up.
- Average cogs.* Value the 7 units at the average unit cost of goods available.
Note that prices and inventory levels were rising over the period and that purchases during the period were the same for all cost flow methods.
Calculate and compare cost of sales, gross profit, and ending inventory using perpetual and periodic inventory systems
In a periodic system, inventory values and COGS are determined at the end of the accounting period. In a perpetual system, inventory values and COGS are updated continuously.
In the case of FIFO and specific identification, ending inventory values and COGS are the same whether a periodic or perpetual system in used. LIFO and weighted average cost, however, can produce different inventory values and COGS depending on whether a periodic or perpetual system is used.
Our earlier cost flow illustration was actually an example of a periodic system. Accordingly, we waited until the end of January to calculate COGS and ending inventory. Now assume the purchases and sales occurred as follows:
Recalculate COGS and ending inventory under the FIFO and LIFO cost flow methods using a perpetual inventory system.
In the case of FIFO, ending inventory and COGS will be the same as with the periodic system illustrated in the earlier example.
FIFO COGS and ending inventory are the same whether a perpetual or periodic system is used because the first-in (and therefore the first-out) values are the same regardless of subsequent purchases.
In the case of LIFO, COGS and ending inventory under a periodic system will be different from those calculated under a perpetual system. In our earlier example, LIFO COGS and ending inventory for January were $31 and $7, respectively, using a periodic system. Using a perpetual system, LIFO CGOS and ending inventory are $26 and $12.
A periodic system matches the total purchases for the month with the total withdrawls of inventory units for the month. Conversly, a perpetual system matches each unit withdrawn with the immediately preceding purchases.
Summary: Notice the relationship of higher CGOS under LIFO and lower ending inventory under LIFO (assuming inflation) still holds whether the firm uses a periodic or perpetual inventory system. The point of this example is the under a perpetual system, LIFO and COGS and ending inventory will differ from those calculated under a periodic system.
Compare and contrast cost of sales, ending inventory, and gross profit using different inventory valuation methods.
When prices are rising and inventory quantities are stable or increasing:
LIFO results in
- higher COGS
- lower gross profit
- lower inventory balances
- higher inventory turnover
FIFO results in
- Iower COGS
- higher gross profit
- higher inventory balances
- lower inventory turnover
Weighted average cost method results in values between LIFO and FIFO
Describe the measurement of inventory at the lower of cost and net realizable value
Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory write-ups are allowed, but only to the extent that a previous writedown to net realizable value was recorded.
realizable value is expected sales less estimated selling costs
Under US GAAP, inventories are valued at the lower of cost or market. Market is usually equal to replacement cost but cannot exceed net realizable value of be less than net realizable value minus a normal profit margin. No subsequent write-up is allowed.
market is the replacement cost
Zoom, Inc. sells digital cameras. Per-unit cost information pertaining to Zoom’s inventory is as follows:
What are the per-unit carrying values of Zoom’s inventory under IFRS and under US GAAP?
Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value. Since original cost of $210 exceed NRV ($225 - $22 = $203), the inventory is written down to the NRV of $203 and a $7 loss ($203 NRV - $210 original cost) is reported in the income statement
Under US GAAP, inventory is reported at the lower of cost or market. In this case, market is equal to replacement cost of $197, since NRV of $203 is greater than replacement cost, and NRV minus a normal profit margin ($203 - $12 = $191) is less than replacement cost. Since the orginal cost exceeds market (replacement cost), the inventory is written down to $197 and a $13 loss ($197 replacement cost - $210 original cost) is reported in the income statement.
Assume that in the year after the writedown in previous example, the NRV and replacement cost both increase by $10. What is the impact of the recovery under IFRS and under US GAAP?
Under IFRS, Zoom write up inventory to $210 per unit and recognize a $7 gain in its income statement. The write-up (gain) is limited to the original writedwon of $7. The carrying value cannot exceed original cost.
Under US GAAP, no write-up is allowed. The per-unit carrying value will remain at $197. Zoom will simply recognize higher profit when the inventory is sold.
Describe the financial statement presentation of and disclosures relating to inventories
Required inventory disclosures
- the cost flow method (LIFO, FIFO etc.) used
- total carrying value of inventory and carrying calue by classification (raw materials, work-in-progress, and finished goods) if appropriate
- carrying calue of inventories reported at fair value less selling costs
- the cost of inventory recognized as an expense (COGS) during the period
- amount of inventory writedowns during the period
- reversals of inventory writedown during the period (IFRS only because US GAAP does not allow reversals
- carrying value of inventories pledged as collateral
Calculate and interpret ratios used to evaluate inventory management
Inventory turnover, days of inventory on hand, and gross profit margin can be used to evaluate the quality of a firm’s inventory management.
Inventory turnover that is too low (high days of inventory on hand) may be an indication of slow-moving or obsolete inventory.
High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled.
High inventory turnover together with high sales growth relative to the industry average suggest that high inventory turnover reflects greater efficiency rather than inadequate inventory.
Viper Corp. is a high-performance bicycle manufacturer. Viper reports its inventory using FIFO cost flow method. Selected ratios compiled from Viper’s financial statement for the year ended 2016 are shown in the table.
Discuss Viper’s performance relative to its peer group in terms of liquidity, activity, solvency, and profitability. Had Viper used the LIFO method instead of FIFO, how would Viper’s results have differed assuming rising prices and stable inventory quantities?
- Liquidity*
- Acitivity*
- Solvency*
- Profitability*
- Liquidity* - Viper’s current ratio exceeds it peer group, indicating greater liquidity. Additional analysis of the components of current assets, primarily inventory and receivables is needed to determine the effectiveness of Viper’s current asset management. Because no receivables data are provided, we will focus on inventory.
- Activity* - Viper’s inventory turnover is less than that of its peer group, indicating that Viper takes longer to sell its goods. In terms of inventory datas (365 / inventory turnover), Viper has 48.0 days of inventory on hand while the peer group has 37.2 days of inventory on average. Too much inventory is costly, as we noted previously, and can indicate slow-moving or obsolete inventory.
- Solvency* - Viper’s adjusted long-term debt-to-equity ratio of 0.6 is in line with its peer group.
- Profitability -* Viper’s gross profit margin is significantly less than its peer group average. Coupled with lower inventory turnover, Viper’s lower gross profit margin ma be an indication that Viper has reduced prices in order to sell its inventory. This is another indication that some of Viper’s inventory may be obsolete. As previously discussed, obsolete (impaired) inventory must be written down.
Results under LIFO - Had Viper used the LIFO cost flow method instead of FIFO, we would be unable to compare Viper’s results to its peer group without making adjustments to inventory, total assets, shareholders’ equity, COGS, gross profit, and net income.
Under LIFO, Viper’s ending inventory would hav been based on older, lower costs. As a result, ending inventory would have been lower under LIFO compared to FIFO. Lower inventory under LIFO would reduce the current ratio (numberator), total assets, and shareholders’ equity.
Viper’s COGS would have been higher under LIFO because LIFO COGS reflects more recent, higher costs. Higher COGS reduces gross profit, operating profit, and net profit.
A lower ending inventory value under LIFO increases the inventory turnover ratio (lower dats of inventory on hand) compared to the ratio under FIFO
Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred.
When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement for the current period. Capitalizing results in higher assets, higher equity, and higher operating cash flow compared to expensing. Capitalizing also results in higher earnings in the first year and lower earning in subsequent years as the asset is depreciated.
Interest incurred during construction of an asset is generally capitalized. The capitalized interest is added to the asset’s value and depreciated over the life of the aset. Becuase the capitalized interest results in a higher interest coverage ratio (lower denominator), some analysts reverse the transaction and add the capitalized interest to interest expense for the period.
Northwood Corp. purchased new equipment to be used in its manufacutring plant. The cost of the equipment was $250,000 including $5,000 freight and $12,000 of taxes. In addition to the equipment cost, Northwood paid $10,000 to install the equipment and $7,500 to train its eimployees to use the equipment. Over the asset’s life, Northwood paid $35,000 for repair and maintenance. At the end of five years, Northwood extended the life of the asset by rebuilding the quipment’s motors at a cost of $85,000.
What amounts should be capitalized on Northwood’s balance sheet and what amounts should be expensed in the period incurred?
Northwood would capitalize all costs that provide future economic benefits, including the costs that are necessary to get the asset ready for use. Rebuilding the equipment’s motors extended life and thus increased its future benefits.
Costs that do not provide future economic benefits are expensed in the period incurred. The initial training costs are not necessary to get the asset ready for use. Rather, the training costs are necessary to get the employees ready to use the asset. Thus, the training costs are immediatley expensed. Repair and maintenance costs are operating expenditures that do not extend the life of the equipment.
Compare the financial reporting of the following classifications of intangile assets:
purchased, internally developed, acquired in a business combination
The cost of a purchased finite-lived intangible asset is amortized over its useful life.
Indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually.
The cost of internally developed intangible assets is expensed. Except for software, when the product’s technological feasibility has been established, cost are capitalized under IFRS and GAAP.
Under IFRS, research costs are expensed and development costs are capitalized. Under US GAAP, both research and development costs are expensed as incurred.
Only goodwill created in a business combination is capitalized on the balance sheet.
Over a 10-month period, Royal Manufacturing Company expended $2,500 per month to develop software for its own use. For the first three months, Royal could not estimate the probable future benefits of the expenditures. Over the remaining seven months, the expenditures met the capitalization criteria for indentifiable intangible assets in accordance with IFRS. The software was completed on time and is in use today.
What amount of software expenditures should Royal capitalize under IFRS and US GAAP
Under IFRS, Royal can only capitalize the software expenditures that meet the capitalization criteria. The expenditures made before the criteria were met are expensed in the period incurred. Thus Royal will expense $7,500 ($2,500 per month * 3 months) over the first 3 months, and capitalize $17,500 ($2,500 per month * 7 months) over the last 7 months.
Under US GAAP, Royal will capitalize all of the expenditures for software developed for its own use. Thus Royal will capitalize $25,000 ($2,500 per month * 10 months).
Describe the different depreciation methods of property, plant, and equipment, the effect of the choice of depreciation method on the financial statements, and the effects of assumptions converning useful life and residual value on depreciation expense.
Deprciation methods:
- stright-line - equal amounts of expense each period
- accelerated (declining balance) - greater depreciation expense in the early years and less depreciation expense in the later years of an asset’s life
- units of production - expense based on usage rather than time
In the early years of an assets life, accelerated depreciation results in higher depreciation expense, lower net income, and lower ROA and ROE compared to staight-line depreciation. Cash flow is the same assuming tax depreciation is unaffected by the choice of method for financial reporting
Firms can reduce depreciation expense and increase net income by using longer useful lives and higher salvage values.
Calculate depreciation expense
IFRS requires component depreciation, in which significant parts of an asset are identified and depreciated separately.
Sackett Laboratories purchases chemical processing machinery for $550,000. The equipment has an estimated useful life of five years and an estimated salvage value of $50,000. The company expects to produce 20,000 units of output using this machinery, with 6,000 units in each of the first two years, 3,000 units in the next two years, and 2,000 units in the fifth year. The company’s effective tax rate is 30%. Revenues are $600,000 per year, and expenses other than depreciation are $300,000 in each year.
Calculate Sackett’s net income and net profit margin if the company depreciates the machinery using (a) the stright-line method, (b) the double declining balnce method, changing to the straight-line method after two years, and (c) the units of production method.
Using the straight-line method, depreciation expense in each year is ($500,000 - $50,000) / 5 = $100,000
Using the double declining method, each year’s depreciation is 2/5 of the book value. In year 1, depreciation expense is $550,000 * 2/5 = $220,000, and in year 2, depreciation expense is ($550,000 - $220,000 * 2/5 = $132,000. Straight line depreciation expense for the remaining three years is ($550,000 - $220,000 - $132,000 - $50,000) / 3 = $49,333
Using the units of production method, depreciation expense in the first two years is (6,000 / 20,000) * ($550,000 - $50,000) = $150,000, in the next two years is (3,000 / 20,000) * ($550,000 - $50,000) = $75,000, and in the fifth year is (2,000 / 20,000) * ($550,000 - $50,000) = $50,000
The accelerated depreciation methods result in pretax income, tax expense, net income, and net profit margins that are lower in the early years and higher in the later years, compared to staight-line depreciation. Over the entire period, however, depreciation expense, tax expense, pretax income, net income, and net profit margin are unaffected by the depreciation method chosen.
Alpine Company purchased machinery for $20,000 with an estimated useful life of five years and a salvage value of $40,000. Alpine uses the straight-line depreciation method. At the beginning of the third year, Alpine reduces its salvage value estimate to $1,600. Determine the depreciation expense for each year.
For the first two years, straight line depreciation expense is [($20,000 original cost - $4,000 salvage value) / 5-year life] = $3,200 each year. At the beginning of the third year, the asset’s carrying value on the balance sheet is $20,000 original cost - $6,400 accumulated depreciation = $13,600.
To calculate straight-line depreciation expense for the remaining years, simply begin with the carrying value and depreciate over the remaining useful life using the new salvage value estimate. Depreciation expense for the last three yeasr is [($13,600 carrying value - $1,600 revised salvage value) / 3 years remaining life] = $4,000 each year.
Global Airlines purchased a new airplane with an all-inclusive cost of $50 million. The estimated life of the airplane is 30 years and the estimated salvage value is $5 million. Global expects to replace the interior of the aircraft after 15 years. The component cost of the interior is estimated at $3 million.
Calculate the depreciation expense in Year 1 using the straight-line method, both assuming the interior is a separate component and assuming the component method is not used.
Depreciation expense is lower by $100,000 each year ($1,600,000 - $1,500,000) for the first 15 years without the component method. However, at the end of Year 15, Global will spend $3,000,000 to replace the interior. Thus, additional depreciation expense of $3,000,000 / 15 years = $200,000 each year is required for the last 15 years of the asset’s life.
Under both scenarios, Global will have expended a total of $53,000,000 and recognized $48,000,000 of deprciation expense over the airplane’s life:
Componenet method - $1,600,000 * 30 years = $48,000,000
Non-component method - ($1,500,000 * 30 years) + ($200,000 * 15 years) = $48,000,000
Describe the different amortization methods for intangible assets with finite lives, teh effect of the choice of amortization method on the financial statements, and the effects of assumptions concerning useful life and residual value on amortization expense.
Amortization for intangible assets is identical to the depreciation of tangible assets. It is also necessary to estimate useful lives and salvage values for amortization. However, estimating useful lives is complicated by any factors that limit the use of the intangible assets, such as legal, regulatory, contractual, competitive, and economic factors.
At the beginning of this year, Brandon Corporation entered into business acquisition. As a result of the acquisition, Brandon reported the following intangible assets (figure):
The patent expires in 12 years. The franchise agreement expires in 7 years but can be renewed indefinitely at a minimal cost. The copyright is expected to be sold at the end of 20 years for $30,000. Use the straight-line amortization method to calculate the total carrying value of Brandon’s intangible assets at the end of the year.
Goodwill is an indefinite-lived asset and is not amortized. Because the franchise agreement can be renewed indefinitely at minimal cost, it is also considered an indefinite-lived asset and is not amortized.
Using straight-line method, amortization expense is $46,000 as follows:
And the carrying value at the end of the first year is $1,484,000 as follows:
Describe the revaluation model
Under IFRS, firms have the option to revalue assets based on fair value under the revaluation model. US GAAP does not permit revaluation.
The impact of revaluation on the income statement depends on whether the initial revaluation resulted in a gain or loss. If the initial revaluation resulted in a loss (decrease in carrying value), the initial loss would be recognized in the income statement only to the extent of the previously reported loss. Revaluation gains beyond the initial loss bypass the income statement and are recognized in shareholder’s equity as a revaluation surplus.
If the revaluation resulted in a gain (increase in carrying value), the initial gain would bypass the income statement and be reported as a revaluation surplus. Later revaluation losses would first reduce the revaluation surplus.
Information related to equipment owned by Brownfield Company follows (figure):
Assuming Brownfield will continue to use the equipment, test the asset for impairment under both IFRS and US GAAP and discuss the results.
The carrying value of the equipment is $900,000 original cost - $100,000 accumulated depreciation = $800,000, and the recoverable amount under IFRS is $785,000 (greater of the $785,000 value in use and $760,000 fair value less selling costs). Under IFRS, the asset is written down on the balance sheet to the $785,000 recoverable amount and a $15,000 loss ($800,000 carrying value - $785,000 recoverable amount) is recognized in the income statement.
Under US GAAP, the asset is not impaired because the $825,000 expected future cash flows exceed the $800,000 carrying value.
Compare the financial reporting of investment property with that of property, plant, and equipment
Under IFRS (but not US GAAP), investment property is defined as property owned for the purpose of earning rent, capital appreciation, or both. Firms can account for investment property using the cost model or the fair value model. Unlike the revaluation model for property, plant, and equipment, increases in the fair value of investment property above its historical cost are recognized as gains on the income statement if the firm uses the fair value model.
Assume the original cost of an asset is $600,000. The asset has a 3-year life and no salvage value is expected. For tax purposes, the asset is depreciated using an accelerated depreciation method with tax return depreciation of $300,000 in year 1, $200,000 in year 2, and $100,000 in year 3. The firm recognizes straight-line (SL) depreciation expense of $200,000 each year in its income statements. EBITDA is $500,000 each year. The firm’s tax rate is 40%. Calculate the firm’s income tax expense, taxes payable, and deferred tax liability for each year of the asset’s life.
- In year 1, the firm recognizes $120,000 of income tax expense on the income statement but taxes payable (tax return) are only $80,000. So income tax expense is initially higher than taxes payable. The $40,000 difference is deferred to a future period by using an accelerated depreciation method for tax puposes. The $40,000 is reported on the balance sheet by creating a DTL.
- The tax base and the carrying value of the asset are used to calculate the balance of the DTL. At the end of year 1, the carrying value of the asset is $400,000 and the tax base of the asset is $300,000. By multiplying the $100,000 difference by the 40% tax rate, we get the balance of the DTL of $40,000
- We can reconcile income tax expense and taxes payable with the change in the DTL. In this example, the DTL increased $40,000 (from zero to $40,000) during year 1. Thus, income tax expense in year 1 is $120,000 ($80,000 taxes payable + $40,000 change in the DTL).
- In year 2, depreciation expense is the same on the tax return and the income statement. Thus taxable income is equal to pretax income and there is no change in the DTL. Income tax expense in year 2 is $120,000 ($120,000 taxes payable + zero change in the DTL)
- In year 3, the firm recognizes income tax expense of $120,000 on the income statement but $160,000, in taxes payable (tax return). The $40,000, deferred tax liability recognized at the end of year 1 has reversed as a result of lower depreciation expense, using the accelerated method on the tax return. In year 3, income tax expense is $120,000 [$160,000 taxes payable + (-$40,000 change in DTL)
- Note that over the useful life of the asset, total depreciation, total taxable (and pretax) income, and total taxes payable (and income tax expense) are the same on the financial statements and the tax return. Also, at the end o fyear 3, both the tax base and the carrying value of the asset are equal to zero. By using accelerated depreciation for tax purposes, the firm deferred $40,000 of taxes from year 1 to year 3.
Consider warranty guarantees and associated expenses. Pretax income (financial reporting) includes an accrual for warranty expense, but warranty cost is not deductible for taxable income until the firm has made actual expenditures to meet warranty claims.
Suppose:
- the firm has sales of $5,000 for each of two years
- the firm estimates that warranty expeense will be 2% of annual sales ($100)
- the actual expenditure of $200 to meet all warranty claims was not made until the second year
- assume a tax rate of 40%
Calculate the firm’s income tax expense, taxes payable, and deferred tax assets for year 1 and year 2
- In year 1, th efirm reports $1,960 of tax expense in the cincome statement, but $2,000 of taxes payable are reported on the tax return. In this example, taxes payable are initially higher than tax expense and the $40 difference is reported on the balance sheet by creating a DTA
- The tax base and the carrying value of the warranty liabilyt are used to calculate the balance of the DTA. At the end of year1, the carrying value of the warranty liability is $100 (the warranty expense has been recognized in the income statement but it has not been paid), and the tax base of the liability is zero (the warranty expense has not been recognized on the tax return). By multiplying the $100 difference by 40% tax rate, we get the balance of the DTA of $40 [$100 difference by the 40% tax rate, we get the balance of the DTA of $40 [($100 carrying value - zero tax base * 40%)]
- In year 2, the firm recognizes $1,960 of tax expense in the income statement but only $1,920 is reported on the tax return (taxes payable). The $40 deferred tax asset recognized at the end of year 1 has reversed as a result of the warranty expense recognition on the tax return. So, in year 2, income tax expense is $1,960 ($1,920 paxes payable + $40 decrease in DTA).
Using the following table and the examples of determining the tax base of assets and liabilites presented earlier, identify the type of difference (taxable temporary, deductible temporary, or permanent), and determine if the resulting difference creates a DTA or DTL).
Depreciable equipment. Accelerating depreciation expense on the tax return will result in a taxable temporary difference. Taxable income will be higher in the future because accelerated depreciation will be lower when the reversal occurs. Since the carrying value of the asset is greater than the tax base, a DTL is created.
R&D. Capitalized R&D for tax purposes will result in a deductible temporary difference as taxable income will be lower in the future when the reversal occurs. Since the tax base of the asset is greater than the carrying value, a DTA is created.
Accounts receivable. Delyaing bad debt expense for tax purposes will result in a deductible temporary difference as taxable income will be lower in the future when the reversal occurs. Since the tax base of the asset is greater than the carrying value, a DTA is created.
Municipal bond interest. Since municipal bond interest is typically not taxable, it results in a permanent difference. No dferred taxes are recognized.
Customer advance. Recognizing the customer advance on the tax return will result in a deductible temporary difference as COGS is included in taxable income in the future when goods are delivered. Since the carrying value of the liablity is greater than the tax base, a DTA is created.
Warranty liability. Delaying warranty expense for tax purposes will result in a deductible temporary difference as taxable income will be lower in the future when the reversal occurs. Since the carrying value of the liability is greater than the tax base, a DTA is created.
Officers’ life insurance. Since officers’ life insurance is not tax deductible, it results in a permanent difference. No deferred taxes are recognized.
Note payable and interest paid. No temporary differences result from the note payable or the interest paid on the note. No deferred taxes are recognized.
WCCO, Inc.s income tax expense has consistently been larger than taxes payable over the last three years. WCCO disclosed in the footnotes to its 2015 financial statements the major items recorded as deferred tax assets and liabilities (in million of dollars), as shown in the table.
Use the table to explain why income tax expense has exceeded taxes payable over the last three years. Also explain the effect of the change in th evaluation allowance on WCCO’s earnings for 2015.
The company’s deferred tax asset balance results from international tax loss carryforwards and employee benefits (most likely pension and other post-retirement benefits), offset by a valuation allowance. The company’s deferred tax liability balance results from property, plant, and equipment (most likely from using accelerated depreciation methods for tax purposes and straight-line on the financial statements) and unrealized gains on securitites classified as available-for-sale (because the unrealized gain is not taxable until realized).
Income tax expense is equal to taxes payable plys deferred income tax expense. Because deferred tax liabilities hav ebeen growing faster than deferred tax assets, deferred income tax expense has been positive, resulting in income tax expense being higher than taxes payable.
Management decreased the valuation allowance by $33 million in 2015. This resulted in a reduction in deferred income tax expense and an increase in reported earnings for 2015.
Novelty Distribution Company does business in the US and abroad. The company’s reconciliation between effective and statutory tax rates over the three years are shown. Analyze the trend in effective tax rates over the three years shown.
For some trend analysis, the analyst may want to convert the reconcilitation from percentages to absolute numbers. However, for this example, the trends can be analyzed simply by using the percentages.
The effective tax rate is upward trending over the 3-year period. Contributing to the upward trend is an increase in the state income tax rate and the loss of benefits related to taxes on foreign income. In 2014, a loss related to the sale of assets partially offset an increase in taxes created by special items. In 2013 and 2015, the special items and the other items also offset each other. The fact that the special items and other items are so volatile over the 3-year period suggest that it will be difficult for an analyst to forecast the effective tax rate for NDC for the foreseeable future without additional information. This volatitliy also reduces comparability with other firms.
Identify the key provisions of and differences between income tax accounting under IFRS and US GAAP.
The accounting treatment of income taxes under US GAAP and their treatment under IFRS are similar in most respects. On emajor difference relates to the revaluation of fixed assets and intangible assets. US GAAP prohibits upward revaluations, but they are permitted under IFRS and any resulting effects on deferred tax are recognized in equity.
On December 31, 2012, a company issued a 3-year, 10% annual coupon bond with a face value of $100,000. Calculate the book value of the bond at year-end 2012, 2013 and 2014, and the interest expense for 2013,2014, and 2015, assuming the bond was issued at a market rate of interest of (a) 10%, (b) 9%, and (c) 11%
(a) Bond issued at par. If the market rate of interest at issuance is 10%, the book value of the bonds will always be $100,000, and the interest expense will always be $10,000, which is equal to the coupon payment of 0.10 / $100,000. There is no discount or premium to amortize.
(b) Premium bond. If the market rate of interest is 9%, the present value of the cash payments (a 3-year annunity of $10,000 and a payment in three years of $100,000) is $102,531
N = 3; PMT = 10,000; FV = 100,000; I/Y = 9 CPT PV = $102,531
Figure. Note the premium has been fully amortized upon maturity so that the book value of the bond equal par value
(c) Discount bond. If the market rate of interest is 11%, the present value of the cash payments (a 3-year annuity of $10,000, and a payment in three years of $100,000) is $97,556
N = 3; PMT = 10,000; FV = 100,000; I/Y = 11 CPT PV = $97,556
Figure. Discount is fully amortized upon maturity, when the book value of the bond equals par value.
Summarize the financial statement effects of issuing a bond
Affordable Leasing Company leases a machine for its own use for four years with annual paymbents of $10,000. At the end of the lease, the machine is returned to the lessor, who will sell it for its scrap value. The appropriate interest rate is 6%.
Calculate the impact of the lease on Affordable Leasing’s balance sheet and income statement for each of the four years, including the immediate impact. Affordable Leasing depreciates all assets on a straight-line basis. Assume the lease payments are made at the end of the year.
The leas is classified as a finance lease because the asset is being leased for 75% or more of its useful life (we know this because at the end of the lease term, the asset will be sold for scrap). The PV of the lease payments at 6% is $34,651
N = 4; I/Y = 6; PMT = -10,000; FV = 0; CPT PV = $34,651
The amount is immediately recorded as both an asset and a liability on the lessee’s balance sheet. (watchout for annunity due for the exam!)
Over the next four years, depreciation will be $34,651 / 4 = $8,663 per year. The book value of the asset will decline each year by the depreciation expense.
The interest expense and liability values are shown in the following table. Note that the principal repayment amount each period is equal to the lease payments minus the interest expense for the period (6% times the liability at the beginning of the period).
(Figure)
Column 5 shows the ending book value of the leased asset each year. Note that, initially, depcreciation is greater than the amortization (principal repayment) of the loan, so the asset’s book value declines more rapidly than the lease liability. In the later years of the lease term, annual interest expense is less and the amortization of the lease liability is greater. The book value of the leased asset and the lease liability are again equal (both to zero) at the end of the lease term.
What are the financial statement and ratio effects of operating and finance leases
Financial statement impact: assets, liabilities (current and long-term), net income (in the early years), net income (later years), total net income, EBIT, cash flow from operations, cash flow from financing, total cash flow
Ratio impact: Current ratio (CA/CL), working capital, (CA-CL), asset turn over (revenue/TA), return on assets* (NI/TA), return on equity* (NI/SE), debt/assets, debt/equity
Balance sheet - a finance lease results in a reported asset and a liability
Income statement - EBIT (operating income) will be higher with a finance lease relative to an operating lease
Cashflow - total cash flow is unaffected
In sum, all ratios are worse when the lease is capitalized. The only improvements from a finance lease are
- higher EBIT (because interest is not subtracted in calculated EBIT),
- higher CFO (becuase principal repayment is CFF),
- and higher net income in the later years of the lease (because interest plus depreciation is less than the lease payment in the later years)
Assume Johnson Company purchases an asset for $69,302 to lease to Carver, Inc. for four years with an annual lease payment of $20,000 at the end of each year. At the end of the lease, Carver will own the asset for no additional payment. The implied interest rate in the lease is 6% (N =4, PV = -69,302, PMT = 20,000, FV = 0, CPT I/Y = 6). Determine how Johnson should account for the lease payments from Carver.
Since the present value of lease payments of $69,302 is equal to the carrying value of the asset, Johnson treats the lease as a direct financing lease. Johnson removes the leased asset from the balance sheet and records a lease receivable of $69,302 is equal to the carrying value of the asset, Johnson treats the lease as a direct financing lease. John removes the leased asset from the balance sheet and records a lease receivable of $69,302. The lease payments are recrded as follows (figure):
Interest income received each year will increaes earning. In the cash flow statement, the interest income is reported as an inflow from operating activities. The principal reduction (column 3 - col 2) reduces the lease receivable and is treated in the cash flow statement as an inflow from investing activities.
If Johnson had manufactured the equipment with a cost of goods of $60,000, it would have recorded a gross profit of $69,302 - $60,000 = $9,302 at lease inception, put a lease receivable of $69,302 on its balance sheet , and then accounted for the interest income portion of the lease payments just as in the table above.
Compare the presentation and disclosure of defined contribtuion and defined benefit pension plans
A firm reports a net pension liability on its balance sheet if the fair value of a defined benefit plan’s assets is less than the estimated pension obligation, or a net pension asset if the fair value of the plan’s asssets is greater than the estimated pension obligation. The change in the net pension asset or liability is reflected in a firm’s comprehensive income each year.
Under IFRS, service costs and interest income or expense on the beginning plan balance are included in pension expense on the income statement. Remasurements are recorded in the other comprehensive income. These include actuarila gains or losses and the difference between the actual return and the expected return on plan assets.
Under US GAAP, service costs, interest income or expense, and the expected return on plan assets are included in pension expense. Past service costs and actuarial gains or losses are recorded in other comprehensive income and amortized over time to the income statement.
Pension expense for a defined contribution pension plan is equal to the employer’s contributions
Westcliff Corporation is a hardware wholesaler. The following table shows selected information from Westcliff’s most recent financial statements
Discuss Westcliff’s solvency using the appropriate leverage and coverage ratios
When evaluating solvency, accounts payable and accrued liabilites are not considered debt. Debt only includes interest bearing obligations:
(figure)
Westcliff’s leverage and coverage ratios are calculated as follows:
Debt-to-assets 2009: 1,185,200 debt / 2,363,600 assets = 50.1%
Debt-to-assets 2008: 1,181,100 debt / 588,700 assets = 53.7%
Debt-to-equity 2009: 1 185,200 debt / 727,600 equity = 1.6
Debt-to-equity 2008: 1,181,100 debt / 588,700 equity = 2.0
Debt-to-total capital 2009: 1,185,200 debt / 1,912,800 total capital = 62.0%
Debt-to-total capital 2008: 1,181,100 debt / 1,769,800 total capital = 66.7%
(total capital = total debt + shareholder equity)
Fixed interest coverage 2009:
(399,500 EBIT + 24,000 lease payments) / 168,000 interest expense + 24,000 lease payments) = 2.2
Fixed charge coverage 2008:
(380,800 EBIT + 22,800 lease payments) / (116,100 interest expense + 22,800 lease payments) = 2.9Leverage declined in 2009 using all three measures, mainly as a result of an increase in shareholders’ equity. On the other hand, both coverage ratios decline in 2009 as a result of higher interest expense. One possible explanation for the increase in interest expense, given lower leverage, is that interest rates are increasing.
