[Level 1] Revision Phase with SAPP

Buổi 11 - FRA - Reading 27: Income Taxes & Reading 28: Non-Current Liabilities

READING 27: INCOME TAXES

Question 27.1: Which of the following definitions used in accounting for income taxes is least accurate?
A) Income tax expense is current period taxes payable adjusted for any changes in deferred tax
assets and liabilities.
B) A valuation allowance is a reserve against deferred tax assets based on the likelihood that those assets will not be realized.
C) A deferred tax liability is created when tax expense is less than taxes payable and the difference is expected to reverse in future years
Explanation
C is correct. Deferred tax liability refers to balance sheet amounts that are created when tax expense is greater than taxes payable.


Question 27.2: When analyzing a company's financial leverage, deferred tax liabilities are best classified as:
A) neither as a liability, nor as equity.
B) a liability or equity, depending on the company's particular situation.
C) a liability
Explanation
B is correct. 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.
(Reading 27, LOS 27.b)

Question 27.3: In 20X8, Oliver Ltd. received $80,000 cash from a customer for goods that it could not deliver until the next year and established a liability for unearned revenue. Oliver reports under U.S. GAAP, faces a 40% tax rate, and is located in a tax jurisdiction where unearned revenue is taxed as received. On their balance sheet for 20X8, what change in deferred tax should Oliver record as a result of this transaction?
A) A deferred tax liability of $32,000.
B) There is no effect on deferred tax items from this transaction.
C) A deferred tax asset of $32,000.
Explanation
C is correct. Oliver has paid tax on the $80,000 revenue in 20X8, but has not recorded the revenue on it for financial statement purposes. This results in a temporary difference of $32,000, which is a deferred tax asset. The tax asset will be realized when the company recognizes the revenue on its financial statements in the subsequent period.
(Reading 27, LOS 27.c)

Question 27.4: Xanos Corporation faced a 50% marginal tax rate last year and showed the following financial and tax reporting information:
Deferred tax asset of $1,000.
Deferred tax liability of $5,000.
Based only on this information and the news that the tax rate will decline to 40%, Xanos Corporation's deferred tax:
A) asset will be reduced by $400 and deferred tax liability will be reduced by $2,000.
B) liability will be reduced by $1,000 and income tax expense will be reduced by $800.
C) asset will be reduced by $200 and income tax expense will be reduced by $1,000.
Explanation
B is correct. There is a 20% reduction in the tax rate [(40% − 50%) / 50% = –0.2]. Hence, the deferred tax asset will be $800 = $1,000(1 − 0.2), the deferred tax liability will be $4,000 = $5,000(1 − 0.2), and the income tax expense will fall by the net amount of the decline in the asset and liability balances ($1,000 – $200 = $800).
(Reading 27, LOS 27.d)

Question 27.5: Longboat, Inc., sold a luxury passenger boat from its inventory on December 31 for $2,000,000. It is estimated that Longboat will incur $100,000 in warranty expenses during its 5-year warranty period. Longboat's tax rate is 30%. To account for the tax implications of the warranty obligation prior to incurring warranty expenses, Longboat should:
A) record a deferred tax asset of $30,000.
B) record a deferred tax liability of $30,000.
C) make no entry until actual warranty expenses are incurred.
Explanation
A is correct. Warranty expense should be recorded when the inventory item covered by the warranty is sold. A deferred tax asset is created when warranty expenses are accrued on the financial statements but are not deductible on the tax returns until the warranty claims are paid.
The full amount of the obligation, $100,000, is recorded as an expense, with a deferred tax asset of $30,000. Note that a deferred tax asset results when taxable income is more than pretax income and the difference is likely to reverse (warranty will be paid) in future years.
(Reading 27, LOS 27.d)

Question 27.6: When an increase in the tax rate is enacted, deferred tax:
A) assets and liabilities both increase in value.
B) assets decrease in value and deferred tax liabilities increase in value.
C) liability and asset accounts are maintained at historical tax rates until they reverse.
Explanation
A is correct. The liability method (SFAS 109 of U.S. GAAP) takes a balance sheet approach and adjusts deferred tax assets and liabilities to future tax rates. An increase in the tax rate increases the value of both deferred tax assets and deferred tax liabilities.
(Reading 27, LOS 27.e)

Question 27.7: A permanent difference between pretax and taxable income is least likely to arise when a firm:
A) receives tax-exempt interest.
B) uses the installment sales method for financial reporting.
C) pays premiums on life insurance of key employees.
Explanation
B is correct. The installment sales method of revenue recognition does not result in permanent differences between pretax and taxable income. Premium payments on life insurance of key employees is an expense on the financial statements, but is not deducted on tax returns. Tax exempt interest is recognized as revenue on the financial statements. These items result in permanent differences between pretax income and taxable income.
(Reading 27, LOS 27.f)

Question 27.8: For 20X1, Belcher Motors reported a decrease in its deferred tax liabilities, a decrease in its deferred tax assets, and an increase in its
valuation allowance. To an analyst, this would most likely suggest that the company has:
A) decreased its estimate of future profitability.
B) increased the estimated useful life of some capitalized assets.
C) increased its estimate of the period over which unearned revenue will be recognized
Explanation
A is correct. The increase in the valuation allowance tells us that the company has decreased its estimate of its future profitability and thus its ability to realize the benefits of its deferred tax assets. A longer period for recognition of unearned revenue would not affect the temporary differences reflected in deferred tax assets. Increasing the estimate of assets' useful lives would tend to slow financial statement depreciation relative to depreciation for tax, which would increase deferred tax liability going forward, other things constant. Decreases in the carrying values of both a DTL and a DTA may reflect a decrease in the tax rate.
(Reading 27, LOS 27.g)

Question 27.9: Deferred tax items should be measured based on the:
A) tax rate that will apply when the temporary difference reverses.
B) Firm’s effective tax rate at the time when the temporary difference reverses.
C) statutory tax rate at the time when the temporary difference is recognized.
Explanation
A is correct. Measurement of deferred tax items is based on the tax rate that will apply when the temporary difference reverses. In some cases this may depend on how a temporary dierence is settled, which determines whether a capital gains tax rate or income tax rate will apply
(Reading 27, LOS 27.h)

Question 27.10: Deferred taxes must be recognized for undistributed earnings from an investment in an associate firm under:
A) U.S. GAAP only.
B) both IFRS and U.S. GAAP.
C) neither IFRS nor U.S. GAAP.
Explanation
A is correct. Deferred taxes must be recognized for undistributed earnings from an investment in an associate firm under U.S. GAAP. Under IFRS, no deferred taxes are reported for undistributed earnings if the investor firm controls the sharing of profits and it is probable the temporary difference will not be reversed in the future.
(Reading 27, LOS 27.j)

READING 28: NON-CURRENT LIABILITY


Question 28.1: Under U.S. GAAP, which of the following statements about the financial statement effects of issuing bonds is least accurate?
A) Issuance of debt has no effect on cash flow from operations.
B) Periodic interest payments decrease cash flow from operations by the amount of interest paid.
C) Payment of debt at maturity decreases cash flow from operations by the face value of the debt.
Explanation
C is correct. Issuing debt results in a cash inflow from financing. Payment of debt at maturity has no effect on cash flow from operations but decreases cash flow from financing by the face value of the debt.
(Reading 28, LOS 28.a, 28.b)

Question 28.2: A firm issues a 4-year semiannual-pay bond with a face value of $10 million and a coupon rate of 10%. The market interest rate is 11%
when the bond is issued. The balance sheet liability at the end of the first semiannual period is closest to:
A) $9,650,700.
B) $9,683,250.
C) $9,715,850.
Explanation
C is correct.
The initial liability is the amount received from the creditor, not the par value of the bond.
N = 8; I/Y = 11/2 = 5.5; PMT = 500,000; FV = 10,000,000; CPT → PV = $9,683,272.
The interest expense is the effective interest rate (the market rate at the time of issue) times the balance sheet liability. $9,683,272 × 0.055 = $532,580.
The value of the liability will change over time and is a function of the initial liability, the interest expense and the actual cash payments.
In this case, it increases by the difference between the interest expense and the actual cash payment: $532,580 – $500,000 = $32,580 + $9,683,272 = $9,715,852. Tip: Knowing that the liability will increase is enough to select choice C without performing this last calculation. Entering N = 7 and solving for PV also produces $9,715,852.
(Reading 28, LOS 28.b)

Question 28.3: Ivo Company has a $10 million face value bond issue outstanding. These bonds include a call option that permits Ivo to redeem the bonds at any time for 101% of par. These bonds were issued at a premium and have a carrying value of $10,200,000. If Ivo calls the bonds, its income statement will reflect:
A) a loss on redemption.
B) a gain on redemption.
C) neither a gain nor a loss on redemption.
Explanation
B is correct. The firm can call the bonds for 101% of $10 million, or $10,100,000. Redeeming bonds for less than the carrying value of the bond liability results in a gain
(Reading 28, LOS 28.c)
LOS 28.c: Explain the derecognition of debt
When bonds are redeemed before maturity, a gain or loss is recognized by subtracting the
redemption price from the book value of the bond liability at the reacquisition date. For
example, consider a firm that reacquires $1 million face amount of bonds at 102% of par
when the carrying value of the bond liability is $995,000. The firm will recognize a loss of
$25,000 ($995,000 carrying value − $1,020,000 redemption price). Had the carrying value
been greater than the redemption price, the firm would have recognized a gain.
If the redeemed bonds’ issuance costs were capitalized, any remaining unamortized costs
must be written off and included in the gain or loss calculation. No separate entry is necessary
if the issuance costs were accounted for in the initial bond liability, because in that case no
separate asset representing unamortized issuance costs would have been created.

Question 28.4: Shelby Enterprises recently entered into a new $500 million revolving credit facility. The provisions of the facility require Shelby to repay the loan before any other debt can be retired. In addition, if the company's debt-to-capital ratio is higher than 1.0 or its equity falls below $2 billion, Shelby will be prohibited from paying any dividends. Shelby would most likely agree to these covenants because they reduce:
A) risk to bondholders.
B) the company’s interest cost.
C) risk to shareholders.
Explanation
B is correct. Shelby's management will agree to the lending covenants to lower the interest rate on the credit facility. The existing bondholders and shareholders may have more risk since their respective interests are subordinate to the credit facility.
(Reading 28, LOS 28.d)

Question 28.5: If market interest rates have changed materially since a firm issued a bond, and the firm uses the effective interest rate method, how is a change in the market value of the firm's debt most likely to be reported in the firm's financial statements?
A) The gain or loss in market value must be calculated and disclosed in the footnotes to the financial statements.
B) Net income and equity are unaffected, but the change may be discussed in management’s commentary.
C) Net income is unaffected, but the change in market value is recorded in other comprehensive income.
Explanation
B is correct. Material changes in the firm's cost of debt capital should be included in the Management Discussion and Analysis section of the financial statements. If the firm does not use fair value reporting of debt obligations, net income and shareholders' equity are not affected by changes in the market value of the firm's debt, and disclosing its gain or loss in market value is not required.
(Reading 28, LOS 28.e)
LOS 28.e: Describe the financial statement presentation of and disclosures relating to
debt.
A discussion of the firm’s long-term debt is also found in the Management Discussion and
Analysis section. This discussion is both quantitative, such as identifying obligations and commitments that are due in the future, and qualitative, such as discussing capital resource
trends and material changes in the mix and cost of debt.

Question 28.6: A firm is most likely to lease an asset rather than purchasing it if the asset:
A) is costly to move from place to place.
B) has a high salvage value relative to its cost.
C) may be made obsolete by rapid technological advances
Explanation
C is correct. One of the motivations for leasing assets instead of purchasing them is that a leased asset that has been made obsolete by new technology can be returned to the lessor at the end of the lease. Neither of the other choices is a motivation for leasing assets instead of purchasing them
(Reading 28, LOS 28.f)
LOS 28.f: Explain motivations for leasing assets instead of purchasing them
The advantages of leasing rather than purchasing an asset may include the following:
1. Less costly financing. The interest rate implicit in a lease contract may be less than the
interest rate on a loan to purchase the asset, and typically no down payment is required.
2. Less restrictive provisions. Compared to other borrowing (bank loans or bond
issuance), the terms of a lease may be less restrictive. The lessor will typically not
require all the covenants that are included in most loan agreements or bond indentures.
3. Less risk of obsolescence. At the end of a lease, the lessee often returns the leased asset
to the lessor and therefore does not bear the risk of an unexpected decline in the asset’s
end-of-lease value.

Question 28.7: An IFRS reporting company and a U.S. GAAP reporting company have entered into identical leases of significant value, as the lessees. Compared to the impact of reporting the lease under IFRS, reporting the lease under U.S. GAAP as an operating lease will:
A) add less assets to their balance sheet.
B) decrease operating cash flows by a greater amount.
C) decrease financing cash flows by a greater amount.
Explanation
B is correct. An IFRS company will report the interest portion of the lease payment and depreciation of the lease asset separately as expenses on the income statement. Only the interest payment represents an operating cash outflow (and may be treated as a financing cash
outflow). For an operating lease, a U.S. GAAP company will report the entire lease payment as an expense on their income statement,and as an operating cash outflow. Both companies will report the same lease asset on their balance sheets. The lease will not affect the U.S. GAAP company's cash flow from financing. The principal portion of the lease payment will be reported as a financing cash outflow by the IFRS company.
(Reading 28, LOS 28.g)

Question 28.8: Under IFRS, a lessor will remove the leased asset from its balance sheet and record interest income from the lease only if the lease is classified as:
A) a finance lease.
B) a sales-type lease.
C) an operating lease.
Explanation
A is correct. Under IFRS, a lessor will classify a lease as either an operating lease or a finance lease. If it is classified as a finance lease, the leased asset is removed from the lessor's balance sheet and interest income is recognized over the life of the lease.
(Reading 28, LOS 28.h)

Question 28.9: In accounting for a defined benefit pension plan, the amount reported as "prior service cost" refers to:
A) the total value of benefits already paid to retirees who are still receiving pension payments.
B) the present value of the pension benefits due to employees based on their employment up to the date of the statement.
C) the present value of the increase in future pension benefits from a change in the terms of the pension plan.
Explanation
C is correct. Prior service costs arise when changes in the terms of a defined benefit pension plan increase the future benefits due to employees based on their prior employment with the company.
(Reading 28, LOS 28.i)

28.10: Other things equal, and ignoring issuance costs, a firm that raises cash by issuing a new bond is most likely to:
A) decrease its leverage ratios and increase its coverage ratios.
B) increase its leverage ratios and decrease its coverage ratios.
C) increase its leverage ratios and increase its coverage ratios.
Explanation
B is correct. Leverage ratios will increase because debt increases while equity remains unchanged, and (assuming equity is positive) debt increases proportionally by more than assets. Coverage ratios decrease because interest payments increase while EBIT is unchanged