Analysis and Use of Financial Statements w solutionsch09.docx

Analysis and Use of Financial Statements w solutionsch09.docx

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AnalysisandUseofFinancialStatementswsolutionsch09

Chapter9–Solutions

Overview:

ProblemLengthProblem#s

{S}1-4,6,11,15

{M}5,7-9,13,14,16

{L}10,12

1.{S}Deferredtaxescanbefoundinallofthecategorieslisted.Examplesare:

（i）Currentliabilitiesmayincludedeferredtaxliabilitiesarisingfromaninstallmentsalewithcashpaymentsexpectedwithinoneyear.

（ii）Deferredincometaxcreditsresultingfromtheuseofaccelerateddepreciationfortaxpurposesandstraightlineforfinancialreportingarereportedinlong-termliabilities.

（iii）Thestockholders’equityaccountmayincludethedeferredtaxoffsettothevaluationallowanceforavailable-for-salesecuritiesorthecumulativetranslationadjustmentaccount.

（iv）Thedeferredtaxasset（debit）duetoaccruedcompensationwithcashpaymentexpectedwithinoneyearisacomponentofcurrentassets.

（v）Long-termassetswouldincludedeferredtaxassets（debits）recognized,（forexamplefor,postretirementbenefitsorrestructuringcharges）,butnotexpectedtobefundedwithinoneyear.

2.{S}（i）Correct:

UnderSFAS109,changesintaxlawsmustbereflectedinthedeferredtaxliabilityintheperiodofenactment.

（ii）Correct:

Answerto（i）alsoappliestodeferredtaxassets.

（iii）Correct:

Thetaxconsequencesofeventsthathavenotbeenreflectedinthefinancialstatements（suchasfutureearningsorlosses）arenotrecognized.

（iv）Incorrect:

Seeanswersto（i）and（ii）above.Thisstatementistrueforthedeferralmethod（seefootnote2ontextpage292）.

（v）Incorrect:

Changesindeferredtaxassetsandliabilitiesareincludedinincometaxexpenseexceptforthosechargeddirectlytostockholders’equity.

3.{S}a.Permanentdifferencesareitemsofincomeorexpensethataffecteithertaxreturnincomeorfinancialincome,butnotboth.Examplesinclude:

∙Tax-exemptinterestincome（notreportedonthetaxreturn,

∙Interestexpenseonamountsborrowedtopurchasetax-exemptsecurities（notdeductibleonthetaxreturn）,

∙Taxorothernondeductiblegovernmentpenalties（notreportedonthetaxreturn）,

∙Statutorymineraldepletioninexcessofcostbasisdepletion（notreportedinthefinancialstatements）,

∙Premiumsonkey-personlifeinsurancepolicies（notdeductibleonthetaxreturn）,

∙Proceedsfromkey-personlifeinsurancepolicies（notreportedonthetaxreturn）.

b.Permanentdifferences,dependingontheirnature,eitherincreaseordecreasethefirm’seffectivetaxraterelativetothestatutoryrate.Forexample,tax-exemptinterestincome（thefirstexamplelisted）reducestheeffectivetaxrateasthereisnotaxexpenseassociatedwiththisincome.

4.{S}a.（i）Ifthedeferredtaxliabilityisnotexpectedtoreverse,thereisnoexpectationofacashoutflowandtheliabilityshouldbeconsideredasequity.

（ii）Ifthedeferredtaxliabilityistheresultofatemporarydifferencethatisexpectedtoreverse,withconsequenttaxpayment,itshouldbetreatedasaliability.

b.Becauseboththeamountsandtimingoftaxpaymentsresultingfromthereversalsoftemporarydifferencesareuncertain,deferredtaxesshouldbeexcludedfrombothliabilitiesandequity.

c.Theportionofthedeferredtaxliabilitythatrepresents（thepresentvalueof）expectedpaymentsshouldbetreatedasdebt.Accounting-basedtimingdifferencesthatarenotexpectedtoreverseshouldbetreatedasequity.

5.{M}WebeginbydeterminingthecostofeachassetusingtheinformationaboutassetL.Year2depreciationunderthesum-of-the-years’digitsmethodwithafive-yearlifeis4/15ths.Therefore,thedepreciablebase（cost–salvagevalue）mustbe$12,000/（4/15）=$45,000andthecostmustbe$48,000becausesalvagevalueis$3,000.Wecannowprepareadepreciationscheduleforeachmethod:

DepreciationExpense

AssetK

AssetL

AssetM

Year

Straight-line

SYD2

DDB3

1

$9,000

$15,000

$19,200

2

9,000

12,000

11,520

3

9,000

9,000

6,912

4

9,000

6,000

4,147

5

9,000

3,000

3,221

Total

$45,000

$45,000

$45,000

1Base=$45,000{cost–salvagevalue};expense=$45,000/5=$9,000.

2Base=$45,000;expense=5/15ths,4/15ths,3/15ths,etc.

3Base=$48,000（salvagevalueignored）;rate=40%

Year1expense=.40x$48,000=$19,200,leaving$28,800

Year2expense=.40x$28,800=$11,520,leaving$17,280

Year3expense=.40x$17,280=$6,912,leaving$10,368

Year4expense=.40x$10,368=$4,147,leaving$6,221

Year5expense=$3,221leaving$3,000

a.Thedoubledecliningbalancemethodisusedonthetaxreturnforallthreeassets;year2depreciationexpenseunderthatmethodis$11,520.

b.Financialstatementdepreciationexpenseinyeartwo（fromtableonpreviouspage）is:

AssetK（straightline）$9,000

AssetM（doubledecliningbalance）11,520

c.（i）Attheendofyeartwo,accumulateddepreciationequals（fromtableonpreviouspage）:

AssetK（straightline）$18,000

AssetL（SYD）27,000

AssetM（DDB）30,720

Taxreturn（DDB）30,720

Therefore,thedeferredtaxliabilityis:

AssetK:

.34（$30,720-$18,000）=$4,324.80

AssetL:

.34（$30,720-$27,000）=1,264.80

AssetM:

Nodeferredtaxasthesamemethodisusedforfinancialandtaxreporting.

（ii）Attheendofyearfive,accumulateddepreciationisthesameunderallmethodsandthereisnodeferredtaxassetorliability.

6.{S}a.b.AssumingthatMotherPrewittcontinuestobuymachinesinthefuture,thedepreciationtimingdifferencewillneverreverseandthereisnoexpectedcashconsequence.Inthiscase,thedeferredtaxcanbetreatedasequity.

Iftheinstallmentsaleisnotexpectedtorecur,thetaxonthatsalewillbepaidin2001andwillrequirecash.Forthatreason,the$27,200ofdeferredtaxesshouldbeconsideredaliabilitywhencalculatingliquidity,solvency,andleverageratios.

If,ontheotherhand,installmentsalesareexpectedtorecur,suchsalesarenodifferentfromthedepreciationcase.Thecashconsequencesofdeferredtaxitemsdependontheprobabilityoftheirreversal,notontheirnature.

c.UnderSFAS109（liabilitymethod）,enactedchangesintaxratesarerecognized,andthedeferredtaxliabilitiesmustberestatedtoamountsbasedonthe40%taxrate.Theincrementalliabilityisrecordedasacomponentofincometaxexpenseregardlessofwhen（orif）paid.

7.{S}

YearsendedJune30

Amountsin$millions

1997

1998

1999

2000

Deferredtaxassetsduetodepreciation

$57.7

$40.3

$49.2

$37.7

Effectonfixedassetsof:

Impairmentoflong-livedassets

47.0

Write-downsofoperatingassets

47.0

4.2

26.6

Write-downsofcapitalizedsoftware

-

16.0

-

Totaleffectonfixedassets

$94.0

$20.2

$26.6

Taxrate

34%

35%

35%

a.Expectedeffectondeferredtaxasset

$32.0

$7.1

$9.3

Reportedchangeindeferredtaxasset

（17.3）

8.9

（11.6）

Differencebetweenexpectedeffectand

$49.3

$（1.8）

$20.9

reportedchangeindeferredtaxasset

Write-downsreducethecarryingamountoftheassetsonthefinancialstatementsbuthavenoeffectonthetaxbasis.Evenifthecompanyusesthestraight-linedepreciationmethodforbothtaxandfinancialreporting,taxdepreciationwouldbehigherthanbookdepreciationafterawrite-off,generatingdeferredtaxliabilities（credits）orloweringdeferredtaxassets（debits）.Ineachyear,therefore,write-downsincreasethedeferredtaxassetbutdepreciationexpensetendstoreduceit.

Inthetableabove,wecomputetheeffectoftheassetchangesonthedeferredtaxassetforeachyearbymultiplyingtheimpairmentplusthewrite-offamountbythetaxrateforthatyear.Wethencomparethateffectwiththereportedchangeinthedeferredtaxassetrelatedtodepreciation.

For1998,thenon-cashimpairmentoflong-livedassetsandthewrite-downofoperatingassetswouldgeneratea$32millionincreaseindeferredtaxassets.However,thecompanyreportedadecreaseof$17.3millionindeferredtaxassetsduetodepreciation.Thedifferenceismuchtoohightoresultfromcurrentyeardepreciationexpense.Themostlikelyexplanationisthatthecompanysoldfixedassetsduringtheyear,eliminatingthebook-taxdifferencerelatingtothoseassets.Ifthoseassetshadahighertaxbasisthanbookbasis,salewouldreducethedeferredtaxassetbythatdifferencemultipliedbythetaxrate.

In1999,thedifferenceissmallerandintherightdirection,sincewehaveanexpected$7.1millionincreaseduetowrite-downsandareportedincreaseof$8.9million.Regardlessofwhetherinternal-usesoftwarewascapitalizedonthetaxreturn,itswrite-offshouldgenerateadeferredtaxdebit.Thisdifferenceisprobablyduetoacombinationofcurrentyeardepreciation（reducingthedeferredtaxasset）andassetsales（increasingthedeferredtaxasset）.

In2000,insteadofanincreaseof$9.3million,thecompanyreportsadecreaseof$11.6millionindeferredtaxassets.Asfor1998,assetsalesprovidethemostlikelyexplanation.

8.{M}a.（i）IncometaxexpenseislowerthanitwouldbeifSGIprovidedtaxesontheundistributedearningsofitsforeignsubsidiaries.

（ii）Incometaxpaidwasnotaffectedbecausethoseearningsareundistributed,thatis,SGIdidnotpayU.S.incometaxonthem.

（iii）Theeffectivetaxrateislowerthanitwouldhavebeenbecauseincometaxexpenseislower（seeanswera（i））.

（iv）Earningspersharearehigherbecauseincometaxexpenseislower.

（v）Bookvaluepershareishigherbecauseretainedearnings（andtherefore,equity）arehigher.

b.Intheyearthattheforeignsubsidiariesremittedpreviouslyundistributedearnings:

（i）Pretaxincomewou