FSA MODULE 35

Question 1

35.1 Why are deferred tax assets / deferred tax liability accounts used?

Answer 1

to reconcile the differences between how and when transactions are recognized for financial reporting purposes relative to tax reporting can give rise to differences in tax expense and related tax assets and liabilities.

Deferred tax assets or liabilities usually arise when accounting standards and tax authorities recognize revenues and expenses at different times. Because timing differences such as these will eventually reverse over time, they are called “temporary differences.”

Question 2

35.1 What are deferred tax assets?

Answer 2

Deferred tax assets or liabilities usually arise when accounting standards and tax authorities recognize revenues and expenses at different times. Because timing differences such as these will eventually reverse over time, they are called “temporary differences.”

Question 3

35.1 What are deferred tax liabilities?

Answer 3

Deferred tax liabilities represent tax expense that has appeared on the income statement for financial reporting purposes, but has not yet become payable under tax regulations.

Question 4

35.1 What is the tax base of an asset or a liability?

Answer 4

The tax base of an asset or liability is the amount attributed to the asset or liability for tax purposes, whereas the carrying amount is based on accounting principles. Such a difference is considered temporary if it is expected that the taxes will be recovered or payable at a future date.

The tax base of an asset is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized and the company recovers the carrying amount of the asset.

The tax base of a liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future.

Question 5

35.1 What is a fundamental principle of determining a tax base of an asset / liability?

Answer 5

In general, a company will recognize a deferred tax asset or liability when recovery/settlement of the carrying amount will affect future tax payments by either increasing or reducing the taxable profit. Remember, an analyst is evaluating not only the difference between the carrying amount and the tax base, but the relevance of that difference on future profits and losses and thus by implication future taxes.

Question 6

35.1 What is the IFRS disclosure regarding income taxes? What is the US GAAP equivalent?

Answer 6

IFRS = IAS 12

US GAAP = FASB ASC TOPIC 740

Question 7

35.1 what is the IFRS guideline of treatment of revenue received in advance? What about US GAAP?

Answer 7

IAS 12 states that the tax base is the carrying amount less any amount of the revenue that will not be taxed at a future date.

Under US GAAP, an analysis of the tax base would result in a similar outcome.

Question 8

35.1 In simple English, what is the carrying value, tax base, and temporary difference?

Answer 8

CV - What is this asset worth according to our financial statements? - A machine originally cost $100. It has depreciated by $30. On the balance sheet it shows as $70.

TB = The value the tax authorities think the asset is worth for tax purposes. In accounting books: value = $70. For tax purposes: maybe the tax authority allowed faster depreciation and says its value is only $60.

TD = A temporary difference happens when:
The carrying value and the tax base are different.
CV - TB = TD

Question 9

35.1 How does a grant affect the tax treatment?

Answer 9

a company may deduct a government grant from the initial carrying amount of an asset or liability that appears on the balance sheet. For tax purposes, such grants may not be deducted when determining the tax base of the balance sheet item.

Question 10

35.1 What is income tax?

Answer 10

Tax on corporate profits

UK - called corporation tax

Question 11

35.1 What is tax payable?

Answer 11

Th figure that you owe the tax authorities

Question 12

35.1 what is the difference between tax reporting and financial accounting?

Answer 12

Tax allowable costs vs accrual-based costs!
- (we account for revenue when it is learnt and we attempt to match costs against revenue)

tax allowable costs are calculated by MODIFIED CASH ACOCUNTING

Question 13

35.1 In financial accounting, what does income tax expense =

Answer 13

change in differed tax assets and deferred tax liabilties

so ADD the DTL increase and SUBTRACT the DTA increase (other way round as is an expense)

Question 14

35.1 What is the equation for straight line depreciation?

Answer 14

(cost of asset - salvage value) / assets useful economic life

Question 15

35.1 What are the timing differences and why are they a source of difference in income tax accounting?

Answer 15

Also referred to as temporary differences

When the same amount will impact the tax returns and amounts, just in different periods.

This is what creates DTA/L

Question 16

35.1 What is a permanent difference in income tax accounting?

Answer 16

Something that goes through the tax returns but never goes through the accounts, or more likely, things that go through the accounts, but never through the tax returns.

Things like tax exempt expenses (like client entertainment)

DO NOT RESULT IN DTL/A
- but they do mean that our statutory tax rate does not equal our effective tax rate!

Question 17

35.1 Describe the characteristics of temporary timing differences:

Answer 17

There will be a difference between the amount going through the financial statements and the tax returns in any one year
- HOWEVER the same amount goes through in total
- there will be a difference going through the IS - but that difference will reverse over time
- this is what causes us to see deferred tax

Question 18

35.1 What is DDB?

Answer 18

DDB stands for Double Declining Balance — it’s a method of accelerated depreciation.

Question 19

35.1 Describe how a DTL comes to be:

Answer 19

Question 20

35.1 What is tax depreciation?

Answer 20

Tax depreciation = the depreciation amount the tax authorities allow you to deduct when calculating taxable income.
It determines how much of the asset’s cost you can subtract from your profit to reduce your tax bill.

Question 21

35.1 Describe the characteristics of a DTA:

Answer 21

so TP + change DTL - change DTA

Question 22

35.1 If CV > Tax base …

Answer 22

= DTL !

and also, if CV < TB = DTA

Question 23

35.1 How do you calculate the DTL under the tax base approach?

Answer 23

DTL = (CV - TB) x Tax rate

Question 24

35.1 Show me a table of the treatment of temporary differences:

Answer 24

only need to remember the top one really

Question 25

35.1 Are donations taxable? Are principal flows on debt taxable?

Answer 25

NO

Question 26

35.1 what is the effective tax rate equation?

Answer 26

Question 27

Answer 27

C - this is a permanent difference

Question 28

35.1 Impacts of tax rate changes:

Answer 28

Question 29

35.2 What is the tax expense equation

Answer 29

tax expense = tax payable + change in DTL - change in DTA

Question 30

35.2 What is the difference between tax expense and tax payable?

Answer 30

TE factors in DTA and DTL

Question 31

35.2 What is a valuation allowance?

Answer 31

a valuation reduces a deferred tax asset if we think that the company's future profitability will be insufficient to use it when it is reversed. It is the amount that we take away from the total DTA to make Net DTA - because we dont think the company's profitability will allow us to benefit from it. So we won't be benefitting from it. ONLY SEE THEN UNDER US GAAP

Question 32

35.2 What happens if the DTAs or DTLs will not be realised in future?

Answer 32

They are reversed

Question 33

Answer 33

note: if it is not likely to reverse soon, then it is not likely to lead to a cash outflow

Question 34

35.3 What is the statutory rate?

Answer 34

= corporate income tax rate in which the company is domiciled

Question 35

35.3 What is the equation for effective tax rate? What is the equation for cash tax rate?

Answer 35

cats taxes paid = physical cash gone to tax authorities

Question 36

35.3 Effective tax rate does not equal the statutory rate - why?

Answer 36

timing diff - does impact taxable income, but because it is tax exempt, it does not impact the tax expense overseas ops - all paying different tax rates changes in tax rates - obvs require reconciliation - can be done either in monetary amounts, or in percentage terms

Question 37

Answer 37

Question 38

35.4 A current or past loss in a tax return most likely will result in a: + what is a tax loss carry forward?

Answer 38

DTA! = A tax loss carryforward is a rule that lets a company use a loss from one year to reduce taxes in future years. eg: Year 1 Loss = –$50 No tax is paid. Year 2 Profit = $120 Normally tax would apply to $120. But the company can use the previous loss: 120 − 50 =70 120−50=70 So tax is only paid on $7 Kaplan explanation = A tax loss carryforward can offset future taxable income, thereby reducing taxes payable. This will be recorded as a deferred tax asset to the extent that the firm expects this to reverse in the future.

Question 39

35.4 If a firm uses accelerated depreciation for tax purposes and straight-line depreciation for financial reporting, is it likely to create a permanent difference between tax and financial reporting?

Answer 39

NO - A permanent difference between tax and financial reporting is a difference that is expected to not reverse itself. Under normal circumstances, the effects of the different depreciation methods will reverse.

Question 40

35.4 What is most likely to result in a DTA being created? 1. A decrease in the enacted tax rate 2. Depreciation 3. Unearned revenue

Answer 40

Unearned revenue! Unearned revenue is usually taxable at the point of sale, even if not recognized in the income statement until a later period—resulting in higher current taxes payable, and a deferred tax asset being created. Depreciation commonly results in a deferred tax liability (e.g., when the tax return uses accelerated depreciation, while the income statement uses straight-line depreciation), although it could result in either a DTA or a DTL, depending on the method used. A decrease in the enacted tax rate will only decrease any existing deferred tax asset or liability.

Question 41

35.4 Grace Ltd. develops flying discs for use in sport. Grace currently expenses all R&D when incurred. The tax authorities require R&D expenditures to be capitalized and amortized. The differing accounting and tax treatment of R&D will result in:

Answer 41

The creation of a DTA. Expensing R&D results in a balance sheet carrying value of zero. The tax base of the asset will be the amortization passing through the tax return in future periods. Carrying value less than the tax base results in a DTA. (Module 35.1, LOS 35.a)

Question 42

35.4 What are deferred taxes disclosed as in the balance sheet?

Answer 42

Deferred tax assets and liabilities are classified as noncurrent.

Question 43

35.4 When analyzing a company's financial leverage, deferred tax liabilities are best classified as:

Answer 43

A liability or equity, depending on the company's particular situation: The recommended analyst treatment of deferred tax liabilities is to treat them as liabilities if they are expected to reverse or as equity if they are not expected to reverse.

Question 44

35.4 A tax loss carryforward is best described as the:

Answer 44

Net taxable loss that can be used to reduce taxable income in the future.

Question 45

35.4 Is this correct? Income tax expense equals pretax income times the statutory tax rate.

Answer 45

NO - Pretax income and income tax expense are not always linked because of temporary and permanent differences.

Question 46

35.4 If the tax base of an asset is less than the carrying value of the asset and the difference is not expected to reverse in the future, this will result in:

Answer 46

neither the creation of a DTA nor a DTL. Timing differences that do not reverse, referred to as permanent differences, do not result in the creation of DTAs or DTLs. If the timing difference was expected to reverse, a DTL would be created because carrying value > tax base.

Question 47

35.4 Sidewinder Corporation has a year-end accounts receivable carrying value of $500,000 after including a doubtful debt provision of 5% of year-end receivables. In the tax returns, bad debt is only deducted when it is written off. This treatment will most likely result in:

Answer 47

The creation of a DTA The doubtful debt provision reduces the balance sheet carrying value, but not the tax base of receivables. If the tax base of the asset is greater than the carrying value, this results in a DTA.

Question 48

35.4 An increase in the tax rate causes the balance sheet value of a DTA to:

Answer 48

Increase An increase in the tax rate will increase any DTAs and DTLs!!!

Question 49

35.4 What is the difference between tax allowable depreciation and accounting depreciation

Answer 49

That 6$ will become a DTL by this, because taxable income = revenue - expenses, there is less to tax in the first years, and a creation of DTLs in the first years, and then so more to tax later DTLs are created when tax depreciation > accounting depreciation

Question 50

35.4 If the tax base of an asset exceeds the asset's carrying value and a reversal is expected in the future, then.. also, what does it mean when tax base > carrying value?

Answer 50

a DTA is created - If the tax base of an asset exceeds the carrying value, a DTA is created. Taxable income will be lower in the future when the reversal occurs. When tax base > carrying value: - Tax rules let you deduct more in the future than the asset’s carrying value shows. - In other words: future tax savings are expected.

Question 51

35.4 An analyst is comparing a firm to its competitors. The firm has a DTL that results from accelerated depreciation for tax purposes. The firm is expected to continue increasing its purchases of PP&E in the foreseeable future. How should the liability be treated for analysis purposes?

Answer 51

It should be treated as equity at its full value. Key idea: If the company is expected to continue buying a lot of PP&E, the DTL will keep growing because: Accelerated tax depreciation will always exceed accounting depreciation in the early years of new assets. The “future tax payments” may never actually hit cash in the way a normal liability would, because the company keeps replacing assets and maintaining the same pattern. In other words: the DTL is a permanent timing difference that doesn’t represent a real cash outflow in practice.