Advanced Accounting Flashcards
How would raising capital through share issuances affect earnings per share (EPS)?
The impact on EPS is that the share count increases, which decreases EPS. But there can be an impact on net income, assuming the share issuances generate cash because there would be higher interest income, which increases net income and EPS. However, most companies’ returns on excess cash are low, so this doesn’t offset the negative dilutive impact on EPS from the increased share count.
Alternatively, share issuances might affect EPS in an acquisition where stock is the form of consideration. The amount of net income the acquired company generates will be added to the acquirer’s existing net income, which could have a net positive (accretive) or negative (dilutive) impact on EPS.
How would a share repurchase impact earnings per share (EPS)?
The impact on EPS following a share repurchase is a reduced share count, which increases EPS. However, there would be an impact on net income, assuming the share repurchase was funded using excess cash. The interest income that would have otherwise been generated on that cash is no longer available, causing net income and EPS to decrease.
But the impact would be minor since the returns on excess cash are low, and would not offset the positive impact the repurchase had on EPS from the reduced share count.
What is the difference between the effective and marginal tax rates?
Effective Tax Rate: The effective tax rate represents the percentage of taxable income corporations must pay in taxes. For historical periods, the effective tax rate can be backed out by dividing the taxes paid by the pre-tax income (or earnings before tax).
- Effective Tax Rate % = Taxes Paid / Earnings Before Tax
Marginal Tax Rate: The marginal tax rate is the taxation percentage on the last dollar of a company’s taxable income. The tax expense depends on the statutory tax rate of the governing jurisdiction and the company’s taxable income, as the tax rate adjusts according to the tax bracket in which it falls.
Why is the effective and marginal tax rate often different?
Effective and marginal tax rates differ because the effective tax rate calculation uses pre-tax income from the accrual-based income statement. Since there’s a difference between the taxable income on the income statement and taxable income shown on the tax filing, the tax rates will nearly always be different. Thus, the “Tax Provision” line item on the income statement rarely matches the actual cash taxes paid to the IRS.
Could you give specific examples of why the effective and marginal tax rates might differ?
Under GAAP, many companies follow different accounting standards and rules for tax and financial reporting.
- Most companies use straight-line depreciation (i.e., equal allocation of the expenditure over the useful life) for reporting purposes, but the IRS requires accelerated depreciation for tax purposes – meaning, book depreciation is lower than tax depreciation for earlier periods until the DTLs reverse.
- Companies that incurred substantial losses in earlier years could apply tax credits (i.e., NOL carry-forwards) to reduce the amount of taxes due in later periods.
- When debt or accounts receivable is determined to be uncollectible (i.e., “Bad Debt” and “Bad AR”), this can create DTAs and tax differences. The expense can be reflected on the income statement as a write-off but not be deducted in the tax returns.
What are deferred tax liabilities (DTLs)?
Deferred tax liabilities (“DTLs”) are created when a company recognizes a tax expense on its GAAP income statement that, because of a temporary timing difference between GAAP and IRS accounting, is not actually paid to the IRS that period but is expected to be paid in the future.
DTLs are often related to depreciation. Companies can use accelerated depreciation methods for tax purposes but elect to use straight-line depreciation for GAAP reporting. This means that for a given depreciable asset, the amount of depreciation recognized in the earlier years for tax purposes will be greater than under GAAP.
Those temporary timing differences are recognized as DTLs. Since these differences are just temporary – under both book and tax reporting, the same cumulative depreciation will be recognized over the life of the asset – at a certain point into the asset’s useful life, an inflection point will be reached where the depreciation expense
for tax reporting will become lower than for GAAP.
What are deferred tax assets (DTAs)?
- Deferred tax assets (“DTAs”) are created when a company recognizes a tax expense on its GAAP income statement that, due to a temporary timing difference between GAAP and IRS accounting rules, is lower than what must be paid to the IRS for that period. These net operating losses (“NOLs”) that a company can carry forward against future income create DTAs.
- For example, a company that reported a pre-tax loss of $10 million will not get an immediate tax refund. Instead, it’ll carry forward these losses and apply them against future profits.
- However, under GAAP, the tax benefit will be recognized from a presumed future tax refund immediately on the income statement, and this difference gets captured in DTAs. As the company generates future profits and uses those NOLs to reduce future tax liabilities, the DTAs gradually reverse.
- Another reason for DTAs is the differences between book and tax rules for revenue recognition. Broadly, tax rules require recognition based on receiving cash, while GAAP adheres rigidly to accrual concepts.
What impact did the COVID-19 Tax Relief have on NOLs?
Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, NOLs that arise beginning in 2018 and through 2020 could be carried back for up to a maximum of five years. The rules for claiming tax losses were changed to assist individuals and corporations negatively impacted by the pandemic.
For tax years beginning after 2020, the CARES Act would allow NOLs deduction equal to the sum of:
1. All NOL carryovers from pre-2018 tax years
2. The lesser amount between 1) all NOL carryovers from post-2017 tax years or 2) 80% of remaining taxable income after deducting NOL carryovers from pre-2018 tax years
Previously, NOLs arising in tax years ending after 2017 could not be carried back to earlier tax years and offset taxable income. NOLs arising in tax years post-2017 could only be carried forward to later years. But the key benefit was that the NOLs could be carried forward indefinitely until the loss was fully recovered (yet limited to 80% of the taxable income in a single tax period).
What are the notable takeaways from Joe Biden’s proposed tax plans?
- The corporate tax rate will rise from the Trump Era’s - Tax Cuts and Jobs Act (“TCJA”) rate of 21% to 28%; estimated to increase the government’s tax revenue from $2 trillion to $3 trillion over the next decade.
- The top tax rate for individuals with a taxable income of $400k+ will rise from 37% to 39.6%.
A 12.4% payroll tax will be imposed on those earning $400k+ and to be split evenly between employers and employees. - Minimum tax on corporations with book profits of $100+ million, which would be structured so that corporations would pay the greater amount between 1) their regular corporate income tax or 2) the 15% minimum tax with net operating loss (NOL) and foreign tax credits allowed.
Does a company truly not incur any costs by paying employees through stock-based compensation rather than cash?
Stock-based compensation is a non-cash expense that reduces a company’s taxable income and is added-back on the cash flow statement.
However, SBC incurs an actual cost to the issuer by creating additional shares for existing equity owners. The issuing company, due to the dilutive impact of the new shares, becomes less valuable on a per-share basis to existing shareholders.
Could you define contra-liability, contra-asset, and contra-equity with examples of each?
Contra-Liability: A contra-liability is a liability account that carries a debit balance. While classified as a liability, it functions closer to an asset by providing benefits to the company. An example would be financing fees in M&A. The financing fees are amortized over the debt’s maturity, which reduces the annual tax burden and results in tax savings until the end of the term.
Contra-Asset: A contra-asset is an asset that carries a credit balance. An example would be depreciation, as it reduces the fixed asset’s carrying balance while providing tax benefits to the company. There is often a line called “Accumulated Depreciation,” which is the contra-asset account reflected on the balance sheet.
Contra-Equity: A contra-equity account has a debit balance and reduces the total amount of equity held by a company. An example would be treasury stock, which reduces shareholders’ equity. Since treasury stock reduces the total shareholders’ equity, treasury stock is shown as negative on the balance sheet.
What is an allowance for doubtful accounts on the balance sheet?
Under US GAAP, the allowance for doubtful accounts estimates the percentage of uncollectible accounts receivable. This line item is considered a contra-asset because it reduces the accounts receivable balance. The allowance, often called a bad debt reserve, represents management’s estimate of the amount of A/R that appears unlikely to be paid by customers. In effect, a more realistic value for A/R that’ll actually be turning into cash is shown on the balance sheet, while preventing any sudden decreases in the company’s A/R balance.
What is the difference between a write-down and a write-off?
Write-Downs: In a write-down, an adjustment is made to an asset such as inventory or PP&E that has become impaired. The asset’s fair market value (FMV) has fallen below its book value; hence, its classification as an impaired asset. Based on the write-down amount deemed appropriate, the value of the asset is decreased to reflect its true value on the balance sheet. Examples of asset write-downs would include damages caused by minor fires, accidents, or sudden value deterioration from lower demand.
Write-Offs: Unlike a write-down in which the asset retains some value, a write-off reduces an asset’s value to zero, meaning the asset has been determined to hold no current or future value (and should therefore be removed from the balance sheet). Examples include uncollectible AR, “bad debt,” and stolen inventory
How would a $100 inventory write-down impact the three financial statements?
IS: The $100 write-down charge will be reflected in the cost of goods line item. The expense would decrease EBIT by $100, and net income would decline by $70, assuming a 30% tax rate.
CFS: The starting line item, net income, will be down $70, but the $100 write-down is an add-back since there’s no actual cash outflow from the write-down. The net impact to the ending cash will be a $30 increase.
BS: On the asset side, cash is up $30 due to inventory being written down $100. This will be offset by the decrease of $70 in net income that flows through
retained earnings on the equity section. Both sides of the balance sheet will be down by $70 and remain in balance.
How does buying a building impact the three financial statements?
IS: Initially, there’ll be no impact on the income statement since the purchase of the building is capitalized.
CFS: The PP&E outflow is reflected in the cash from investing section and reduces the cash balance.
BS: The cash balance will go down by the purchase price of the building, with the offsetting entry to the cash reduction being the increase in PP&E.
Throughout the purchased building’s useful life, depreciation is recognized on the income statement, which reduces net income each year, net of the tax expense saved (since depreciation is tax-deductible).
