Financial Statement Analysis. 14 question(s) in this unit's pool
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already answered and when each is next due.
Financial Statement AnalysisAnalysis of Income Taxes
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
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Question 1Exam level
A company uses straight-line depreciation for financial reporting and accelerated depreciation for tax purposes. In Year 1, book depreciation is $20,000 and tax depreciation is $35,000. The tax rate is 30%. Which of the following best describes the income tax consequence in Year 1?
How sure are you?
Correct: B. Accelerated tax depreciation means taxable income is lower than book income in Year 1. The company pays less tax now than its income statement expense implies. The difference will be paid later when tax depreciation falls below book depreciation. DTL = ($35,000 - $20,000) x 30% = $4,500.
A. Tax depreciation exceeds book depreciation this year, so the company pays LESS tax now, not more. That is a future obligation to pay more later (a liability), not an asset.
C. $15,000 is the pre-tax timing difference ($35,000 - $20,000), not the tax effect. The difference must be multiplied by the 30% tax rate: $15,000 x 30% = $4,500.
Unit: analysis-of-income-taxes
Question 2Exam level
A company accrues warranty expense of $50,000 on its income statement. Tax law only permits a deduction when warranty costs are actually paid. No cash has been paid yet. Tax rate is 25%. What is most likely the deferred tax impact?
How sure are you?
Correct: B. Taxable income is HIGHER than book income because the $50,000 expense is recognized on the income statement but not yet deductible for tax. The company overpays tax now and will get the deduction later when cash is paid. DTA = $50,000 x 25% = $12,500.
A. Choosing A might tempt you if you think the company owes more taxes due to the accrued expense, but this confuses the timing difference with a liability; the accrued expense creates a future tax benefit, not a liability, because you will deduct these costs later when paid, leading to a deferred tax asset instead.
C. A permanent difference never reverses, but this one does: the company will get its tax deduction later, once the warranty costs are actually paid in cash. That reversing pattern is the definition of a temporary, timing difference, not a permanent one, and every temporary difference between book and taxable income creates a deferred tax balance, here a deferred tax asset of $12,500, not the absence of one.
Unit: analysis-of-income-taxes
Question 3Exam level
Which of the following is MOST LIKELY a permanent difference for income tax purposes?
How sure are you?
Correct: B. Municipal bond interest is tax-exempt permanently. It will never be taxed. It is recognized as income on the financial statements but never appears in taxable income at any point. A and C are temporary differences: they reverse over time.
A. You might be tempted by the estimated warranty liability because it seems like an expense not yet paid, but this is a temporary difference since the expense will be deductible when paid, unlike the permanently non-taxable nature of municipal bond interest.
C. You might be tempted by accelerated depreciation because it seems like it should be permanent since it affects the tax basis of assets, but remember, this is a temporary difference as the depreciation methods will converge over the asset's life, unlike the permanent non-taxability of municipal bond interest.
Unit: analysis-of-income-taxes
Question 4Exam level
A company's income tax expense is $180,000 and taxes payable is $210,000. Which of the following occurred during the period, most likely?
How sure are you?
Correct: B. Tax expense < taxes payable means the company paid MORE tax than its income statement expense. The excess cash tax paid ($30,000) is a prepaid tax benefit. A deferred tax asset. Income tax expense = taxes payable + change in DTL - change in DTA. $180k = $210k - $30k DTA increase.
A. Choosing A might seem logical if you assume an increase in taxes payable requires a corresponding increase in deferred tax liability, but this overlooks the fact that a higher taxes payable than tax expense indicates a future tax benefit, thus a deferred tax asset, not a liability, would increase.
C. Choosing C might seem logical if you think a decrease in deferred tax liability would reduce the tax expense, but this violates the relationship where a higher taxes payable than tax expense indicates a future tax benefit, thus increasing a deferred tax asset instead of decreasing a deferred tax liability.
Unit: analysis-of-income-taxes
Question 5Exam level
Under GAAP, a company records a $400,000 deferred tax asset but believes it is 'more likely than not' that only $300,000 will be realized. The net deferred tax asset reported on the balance sheet is closest to:
How sure are you?
Correct: B. Under US GAAP (ASC 740), all DTAs are first recognized in full. A valuation allowance is then established for the amount 'more likely than not' (>50% probability) to not be realized. Valuation allowance = $400,000 - $300,000 = $100,000. Net DTA = $400,000 - $100,000 = $300,000.
A. Choosing $400,000 might seem logical if you think the full deferred tax asset is always reported, but under ASC 740, you must account for the valuation allowance for the portion of the DTA that is not expected to be realized, which in this case reduces the net DTA to $300,000.
C. Choosing $100,000 might seem logical if you think it represents the amount of the deferred tax asset that will not be realized, but this overlooks the requirement to report the net realizable value of the deferred tax asset, which is $300,000 after applying the valuation allowance.
Unit: analysis-of-income-taxes
Question 6Exam level
A company has pretax income of $500,000. The statutory tax rate is 21%. Tax expense reported is $130,000. The effective tax rate is closest to:
How sure are you?
Correct: B. Effective tax rate = Income tax expense / Pretax income = $130,000 / $500,000 = 26.0%. This exceeds the statutory rate of 21%, suggesting the company has permanent differences that INCREASE taxable income relative to book income (e.g., non-deductible fines, non-deductible meals). An ETR > statutory rate is a red flag for analysts.
A. Choosing 21.0% might seem logical if you assume the effective tax rate equals the statutory rate, but this ignores the actual tax expense reported, which indicates a higher effective rate due to factors that increase taxable income beyond the statutory rate.
C. Choosing 9.0% might tempt you if you mistakenly divide the tax expense by the statutory rate, but this approach violates the formula for calculating the effective tax rate, which requires dividing the tax expense by pretax income, leading to the correct rate of 26.0%.
Unit: analysis-of-income-taxes
Question 7Exam level
Which of the following changes would most likely INCREASE a company's deferred tax liability?
How sure are you?
Correct: C. When tax depreciation exceeds book depreciation, taxable income falls below book income. The company pays less tax now but will pay more later. A deferred tax liability. DTL increases by $200,000 x applicable tax rate. Option A would DECREASE DTL (lower rate on same temporary difference). Option B creates a DTA (taxes paid now, deduction later).
A. You might think a lower tax rate increases deferred tax liability by reducing current tax payments, but in reality, a decrease in the tax rate from 25% to 21% reduces the future tax liability on existing temporary differences, thus decreasing deferred tax liability rather than increasing it.
B. You might think that accruing restructuring charges creates a deferred tax liability because it seems like a future tax benefit, but in reality, it creates a deferred tax asset as the tax deduction will be claimed in the future, reducing future tax payments, which is the opposite of what increases a deferred tax liability.
Unit: analysis-of-income-taxes
Question 8Harder
A company's deferred tax liability has been growing for 10 consecutive years with no sign of reversal. How should an analyst treat this DTL for financial analysis purposes, most likely?
How sure are you?
Correct: B. When a company continuously grows and adds new assets, old DTLs from depreciation reverse but new, larger DTLs replace them. If the DTL balance has grown every year for a decade, it functionally never requires cash payment. Analysts reclassify it as equity-like in ratio analysis (e.g., removing from debt in leverage ratios). This is the 'Tax Rate Trap' concept for financial analysis.
A. Choosing A might seem logical if you think all deferred tax liabilities will reverse eventually, but this overlooks the "Tax Rate Trap" concept, where continuously growing DTLs effectively become permanent, thus should be treated as equity rather than a liability that will reverse and require cash payment.
C. Ignoring DTLs because they always reverse is a common misconception; in reality, if DTLs from depreciation consistently grow without reversing, they effectively become a permanent benefit, akin to equity, rather than a liability that will require cash outflow.
Unit: analysis-of-income-taxes
Question 9Exam level
Under IFRS, a deferred tax asset for a tax loss carryforward is most likely recognized when:
How sure are you?
Correct: B. Under IAS 12, a DTA is recognized only to the extent it is probable (>50% likely) that sufficient future taxable income will exist to utilize it. IFRS does not use a 'valuation allowance' mechanism. Instead, it simply limits initial recognition. This contrasts with GAAP, which recognizes the full DTA then applies a valuation allowance.
A. You might be tempted by certainty, thinking that absolute assurance is required, but IFRS actually requires only a probable (>50%) likelihood of future taxable profits, not absolute certainty, to recognize a deferred tax asset.
C. You might be thinking that a valuation allowance offsets the full DTA amount, which is a concept under GAAP, but under IFRS, a DTA is recognized based on the probability of future taxable profits, not through a valuation allowance mechanism.
Unit: analysis-of-income-taxes
Question 10Exam level
At year-end, the enacted tax rate changes from 30% to 25% effective next year. A company has an existing DTL of $90,000 measured at 30%. What happens to the DTL balance, most likely?
How sure are you?
Correct: B. Both IFRS (IAS 12) and GAAP (ASC 740) require deferred taxes to be remeasured using the ENACTED tax rate that will apply when the temporary difference reverses. A rate decrease from 30% to 25% means the DTL is restated to reflect lower future taxes. The temporary difference itself is $300,000 ($90,000 / 30%). New DTL = $300,000 x 25% = $75,000. The $15,000 reduction flows through tax expense (income tax benefit).
A. You might be thinking that the original tax rate at the time of DTL creation should lock in the DTL balance, but this overlooks the requirement to remeasure deferred taxes using the enacted tax rate that will apply when the temporary difference reverses, as per both IFRS and GAAP.
C. You might be tempted to average the old and new tax rates, thinking it smooths the transition, but tax standards like IFRS and GAAP mandate remeasurement at the enacted future rate, not an average, ensuring consistency with the future tax environment.
Unit: analysis-of-income-taxes
Question 11Exam level
Which of the following creates a TEMPORARY difference that most likely results in a deferred tax ASSET?
How sure are you?
Correct: B. Rent received in advance is taxed immediately (cash basis for tax) but recognized as revenue over time on the income statement. In Year 1, taxable income > book income. The company overpays tax relative to its income statement. This creates a DTA that reverses as rent revenue is recognized in future periods. Option A is a permanent difference (or complex goodwill scenario). Option C is a permanent difference. Fines are NEVER deductible.
A. Option A is a permanent difference (or complex goodwill scenario).
C. Option C is a permanent difference. Fines are NEVER deductible.
Unit: analysis-of-income-taxes
Question 12Exam level
A company's statutory tax rate is 21%. Its effective tax rate is 15%. Which of the following is the MOST LIKELY explanation?
How sure are you?
Correct: B. Effective tax rate < statutory rate means the company's actual tax burden is lower than the rate would imply. This happens when the company has income that is permanently exempt from tax (e.g., municipal bond interest, tax credits, R&D credits). Option A would make ETR > statutory. Option C affects timing of taxes but not the permanent ratio of tax to pretax income.
A. You might think non-deductible expenses reduce taxable income, but in reality, they increase the effective tax rate since they are added back to taxable income, thus violating the scenario of a lower effective tax rate compared to the statutory rate.
C. You might think that a large deferred tax liability indicates lower current taxes, but deferred tax liabilities affect the timing of tax payments, not the effective tax rate permanently; tax-exempt income, as in the correct answer, directly reduces the taxable income, lowering the effective tax rate permanently.
Unit: analysis-of-income-taxes
Question 13Above the exam
A company has a deferred tax asset of $200,000 related to warranty expense accruals not yet deductible for tax purposes. Management determines that, based on a history of losses, it is more likely than not that only 40% of this deferred tax asset will actually be realized. Combining the valuation allowance concept with its effect on the balance sheet and income statement, the company should most likely:
How sure are you?
Correct: B. When it is more likely than not that a portion of a deferred tax asset will NOT be realized, a valuation allowance must be recorded to reduce the asset to its expected realizable amount. If only 40% ($80,000) is expected to be realized, a valuation allowance of 60% x $200,000 = $120,000 is recorded, reducing the net deferred tax asset to $80,000; recording the allowance increases income tax expense (reduces net income) in the period it is established.
A. Leaving the deferred tax asset unchanged ignores the required valuation allowance assessment; accounting standards specifically require a valuation allowance whenever it is more likely than not that some or all of a deferred tax asset will not be realized, which is exactly the situation described.
C. A valuation allowance reduces the NET carrying amount of the deferred tax asset; it does not eliminate the gross deferred tax asset from the accounting records entirely, and it certainly does not create an unrelated tax refund receivable, which is not part of this mechanism at all.
Unit: analysis-of-income-taxes
Question 14Above the exam
A company has a temporary difference that creates a deferred tax liability, and the government has just enacted a change in the statutory tax rate from 25% to 21%, effective immediately. Combining the treatment of enacted (not merely proposed) tax rate changes with the deferred tax liability's balance, the company should most likely:
How sure are you?
Correct: B. Deferred tax assets and liabilities must be remeasured whenever a new tax rate is ENACTED (not merely proposed), using the rate expected to apply when the temporary difference reverses. The remeasurement is recognized immediately, in the period the rate change is enacted, as an adjustment to income tax expense, not deferred until the rate is actually paid in cash.
A. Deferred tax balances are remeasured at the point of ENACTMENT, not deferred until cash actually changes hands; waiting for the future cash payment ignores the accounting requirement to reflect the best available (now enacted) rate immediately.
C. Deferred tax balances are explicitly NOT fixed at the historical rate that applied when the temporary difference originated; they must be remeasured for enacted rate changes, which is precisely the scenario and requirement this LOS tests.