Midterm #2

Question 1

Corporations prepare at least two separate sets of financial reports for each period.

Financial Statements:
Tax Return:

Answer 1

Financial Statements: Provide useful into to shareholders for decision-making.

Tax Return: Reporting economic income to determine your tax liability.

Question 2

Financial Accounting (GAAP) and tax Accounting (IRC) reflect contrasting principles of conservatism.

GAAP seeks to “Protect”…
Tax Law Seeks to “Protect”…

Answer 2

GAAP seeks to “Protect”… Shareholders and creditors.
Tax Law Seeks to “Protect”… Government Revenues.

Question 3

The result is that the accounting rules are often different between GAAP and the IRC, so the resulting income numbers are different as well.

Answer 3

Individual items that cause this are called book-tax differences (BTD).

Question 4

What is income tax expense?

Answer 4

The accrual basis tax cost for the period (per GAAP), reported on the income statement.

Includes current and future tax consequences of transactions and events that have already occurred.

Question 5

What is income tax payable?

Answer 5

the current year tax obligation (per the IRC) owed to the tax authority.

Question 6

Book-tax differences make the expense and the payable unequal and give rise to ______ and _________.

Answer 6

deferred tax assets and liabilities.

Question 7

Temporary BTD result when…

Answer 7

recognition of an income or expense item occurs in different years for book vs tax purposes (i.e. they eventually reverse).

So the accounting difference is just a matter of timing.

Question 8

_________ BTD do not reverse in future year

Answer 8

Permament

Nontaxable revenues/gains
nondeductable losses/expenses
taxable income not reported on the income statement
tax deductions not reported on the income statement.

Question 9

_________ BTD give rise to deferred tax assets and liabilities DTL.

Answer 9

Temporary

Question 10

Future “Taxable” Amounts (DTL)

Answer 10

Future financial statement expenses/loss that will not be deductible.

Future taxable revenues/gains that will not appear on the income statement.

FAVORABLE BTD
Book value> Taxable

Question 11

Future “Deductable” Amounts (DTA):

Answer 11

Future tax deductions that will not appear on the income statement.

future financial statement revenues/gains that will not be taxable.

UNFAVORABLE BTD
Book<Tax

Question 12

The DTA must be reducted by any amount of future tax benefits that will…

Answer 12

“more likely than not” ultimately fail to realized.

Rather than reducing the DTA directly, we create a DTA Valuation allowance.

Question 13

What if the tax rate is expected to change in the near future?

Answer 13

Only enacted tax rates can be used for deferred tax calculations.

If a new tax law is expected to be passed that will presumably change the tax rate, any expected new rate(s) are ignored for DTA and DTL calculations.

Question 14

What is NOL?

Answer 14

What is it?- negative taxable income.

the issue is that a company gets no immediate tax benefit for taxable income below zero.

Can use losses against income from other (profitable) years.

Question 15

How do we handle net operating losses (NOLs)?

Answer 15

Generally, a company can carry an NOL forward to future years… indefinitely.

Certain companies (i.e. property and casualty insurance companies) can carry NOLs back for 2 years, then carry the remainder forward.

Question 16

NOL carrybacks affect the amount of _______ or ______

Answer 16

current income tax payable or recievable (i.e. current tax expense).

Immediate refund of prior taxes paid.

Question 17

NOL carryforwards are essentially _______ ________.

Answer 17

Future deductions against taxable income (I.e. deferred tax assets).

Potentially subject to a valuation allowance.

Question 18

Companies generally engage in tax planning to legitimately reduce their income tax burden.

Tax planning strategies vary in __________ and the _______.

Answer 18

aggressiveness and in the likelihood they would be disallowed if audited by the IRS.

Generates uncertainty.

Question 19

How do we deal with this uncertainty in accounting for income taxes?

Answer 19

Is it “more likely than not” that the tax position would be sustained upon audit , based on its techincal merits? (Step 1).

The highest amount that has a >50% cumulative probability of being realized is allowed under GAAP (Step 2).

Any amount that fails the >50% cumulative probability test is recorded as a liability.

Income tax expense XXX
Liability. Uncertain Tax Benefit
(UTB) XXX

Question 20

Reporting Deferred Taxes: Income Statement

Answer 20

Total income tax expense (benefit) is reported on the income statement, and its two components must be disclosed.
Current income tax expense
(benefit)- payable in THIS period
Deferred Income Tax Expense
(Benefit)

Question 21

Reporting Deferred Taxes: Balance Sheet

Answer 21

Income tax payable or receivable is reported as a current liability or asset.

DTAs and DTLs are generally netted, and the net is reported as a non-current asset or liability.

(Uncertain Tax benefit- non-current)

Question 22

Reporting Deferred Taxes: Journal Entries

Answer 22

Income Tax Expense
Deferred Tax Assets and Liabilities
Valuation Allowance
Income Tax Payable

Question 23

Permanent BTD are easy to deal with from accounting perspective.

Answer 23

Income tax payable is computed based on IRC

So tax expense=tax payable with respect to permanent BTD.

BUT< permanent BTD do affect the company’s effective tax rate (ETR)
ETR=tax expense/pretax income

Question 24

What is a stock compensation plan?

Answer 24

a plan through which employees are compensated, at least in part, with stock.

e.g. stock options, restricted stock, and purchase plans.

Question 25

why would a company compensate employees with stock?

Answer 25

employees get equity-then they are now shareholders, and will have motivation like a shareholder.

saves on cash

Question 26

How to account for stock compensation plans, in general?

Answer 26

Fair Value Method (GAAP)
Amount of comensation expense-
generally FMV of the date of the
“grant”
Timing of recognition of
compensation expense-
generally allocated over
period services are
performed.

Question 27

Restricted stock: on the grant date employees are awarded actual shares of stock, but with certain restrictions attached to them.

Answer 27

Restrictions:
Can’t leave the company
can’t sell the shares

Question 28

Restricted stock: can be done in actual shares OR “restricted stock units”.

Answer 28

Restricted stock units- when the company doesn’t actually give them shares but keeps a separate record of stocks awarded. doesn’t have to be the physical swapping of shares.

The company decides vesting time frame, after vesting period, the restrictions are lifted.

THE ACCOUNTING IS IDENTICAL FOR BOTH ACTUAL SHARES AND RESTRICTED STOCK UNITS

Question 29

How to account for restricted stock at the grant date?

Answer 29

NO JE

Question 30

Stock Options: on the grant date, employees are awarded the option to purchase stock in the future at…

Answer 30

a predetermined price per share.

The options can be exercised after a vesting period at any point over a pretereminded range of time.

once the employees exercise the options, they simply own shares of stock.

Question 31

How to account for stock options at grant date?

Answer 31

No entry, but need to determine FMV of the options.

These are not shares, so must use an option pricing model.

typically adjusted for estimated forfeitures (before vesting).

Question 32

What are stock purchase plans?

Answer 32

Employees allowed to purchase stock at a discounted price for a period of time.

Question 33

Stock purchase plans are not considered compensation if the following are true:
Substantially equal access to all
full-time employees.
Discount is small (<_5%)
Plan has no substantive option
feature (1 month threshold).

Answer 33

What if these things are not true? there will be compensation expense equal to the discount.

Question 34

Stock compensation plan disclosures: required disclosures related to stock compensation plans include:

Answer 34

• the nature of the arrangement/plans
• the effects of the plan on compensation costs reflected on the income statement.
• The effects of the plans on cash flow.
• Method of estimating fair value
  (there will have to be a footnote explaining all of these things).

Question 35

Recall that EPS must be disclosed on…

Answer 35

The income statement.

Question 36

There are a couple commonly used versions of EPS, each reflecting different characteristics of the firms capital structure. What are they?

Answer 36

Simple capital structure- everything is going to stay what it is. right-hand side of balance sheet.

Complex capital stucture- you have securities on the balance sheet aren’t common stock but might become common stock.

Question 37

Basic EPS:

Answer 37

Applicable to a simple capital structure.

EPS=(net income-pref. dividends)/WASO

Question 38

Why do we subtract preferred dividends in basic eps?

Answer 38

they are a priorty shareholder, they are paid first.

what event causes us to subtract them?- once the preferred dividend is declared.

What about cumulative preferred dividends not declared?- we will calculate dividends for the year even if they haven’t been declared yet.

Question 39

Basic EPS: WASO

Answer 39

shares must be weighted by the fraction of the period they were outstanding.

Question 40

Recall that companies with a _________ have outstanding securities that could ultimately become additional shares of common stock.

Answer 40

Complex Capital Stucture.

What kind of securities are these:
- convertible debt
- convertible preferred stock
- warrants and options

Question 41

Impact of convertibles on securities (diluted EPS):

Answer 41

to compute EPS, securities are assumed to be converted to common stock as of the beginning of the period or as of the issue date, whichever is later.

Question 42

Impact of convertible securities on the numerator and denominator:

Answer 42

Numerator effect:
For convertible debt, add back net of
tax interest expense.
For convertible preferred stock, add
back preferred dividends.

Denominator effect:
Convertible debt- add common share
convertible into
convertible preferred stock- add
common shares convertible into

Question 43

Impact of options and warrants: to compute diluted EPS, two things are assumed.

Answer 43

1. options/warrants are exercised as of the beginning of the period or as of the issue date, whichever is later AND
2. the company used those proceeds to purchase treasury stock.

Question 44

What if the security is anti-dilutive(i.e. results in a potential increase in EPS).

Answer 44

if it is actually converted or options were exercised- it would increase EPS.

WE IGNORE/EXCLUDE IN THE COMPUTATION OF DILUTED EPS.

Question 45

In what order do we add securities to the calculation to assess whether they are anti-dilutive?

Answer 45

add in order of incremental dilution effect… most to least dilutive.

any security you add, you can calculate a mini EPS for that security.