Chapter 12 Exam Questions Accounting for Income Taxes

Chapter 12

Multiple Choice

1. With respect to the difference between taxable income and pretax accounting income, the tax effect of the undistributed earnings of a subsidiary included in consolidated income should normally be
   1. Accounted for as a timing difference
   2. Accounted for as a permanent difference
   3. Ignored because it must be based on estimates and assumptions
   4. Ignored because it cannot be presumed that all undistributed earnings of a subsidiary will be transferred to the parent company
2. Which of the following would cause a deferred tax expense?
3. Write-down of goodwill due to impairment
4. Use of equity method where undistributed earnings of a 30 percent owned investee are related to probable future dividends
5. Premiums paid on insurance carried by company (beneficiary) on its officers or employees
6. Income is taxed at capital gains rates
7. Differences between taxable income and pretax accounting income arising from transactions that, under applicable tax laws and regulations, will not be offset by corresponding differences or “turn around” in future periods is a definition of
8. Permanent differences
9. Timing differences
10. Intraperiod tax allocation
11. Interperiod tax allocation
12. Taxable income of a corporation differs from pretax financial income because of

Permanent Differences Temporary Differences

• 1. No Yes
  2. Yes Yes
  3. No No
  4. Yes No

1. Which of the following is a permanent difference?
   1. Product warranty liabilities
   2. Installment sales accounted for on an accrual basis
   3. Deductible pension funding exceeding expense
   4. Interest received on state and municipal obligations
2. A major distinction between temporary and permanent differences is

Permanent differences are not representative of acceptable accounting practice

Temporary differences occur frequently, whereas permanent differences occur only once

Once an item is determined to be a temporary difference, it maintains that status; however, a permanent difference can change in status with the passage of time.

Temporary differences reverse themselves in subsequent accounting periods, whereas permanent differences do not reverse

1. Under the comprehensive deferred interperiod method of tax allocation, deferred taxes are determined on the basis of
2. Tax rates in effect when the timing differences originate without adjustment for subsequent changes in tax rates
3. Tax rates expected to be in effect when the items giving rise to the timing differences reverse themselves
4. Net valuations of assets or liabilities
5. Averages determined on an industry-by-industry basis
6. The accounting recognition of the benefit from a tax loss carryforward in most situations should be reported as
7. A reduction of the loss in the year of the loss with an appropriate valuation allowance
8. A prior period adjustment in whichever year the benefit is realized
9. As a component of income from continuing operations in the year in which the benefit is realized
10. An item on the retained earnings statement, not the income statement
11. Intraperiod tax allocation arises because
12. Items included in the determination of taxable income may be presented in different sections of the financial statements
13. Income taxes must be allocated between current and future periods
14. Certain revenues and expenses appear in the financial statements either before or after they are included in taxable income
15. Certain revenues and expenses appear in the financial statements but are excluded from taxable income
16. Assuming no prior period adjustments, would the following affect net income?

Interperiod Intraperiod

Income tax Income tax

Allocation Allocation

1. Yes Yes
2. Yes No
3. No Yes
4. No No
5. A machine with a 10-year useful life is being depreciated on a straight-line basis for financial statement purposes, and over 5 years for income tax purposes under the accelerated recovery cost system. Assuming that the company is profitable and that there are and have been no other timing differences, the related deferred income taxes would be reported in the balance sheet at the end of the first year of the estimated useful life as a
6. Current liability
7. Current asset
8. Noncurrent liability
9. Noncurrent asset
10. Smith Corporation owns only 25 percent of the voting stock of Jones Corporation, but exercises significant influence over its operating and financial policies. The tax effect of differences between taxable income and pretax accounting income attributable to undistributed earnings of Jones Corporation should be
11. Accounted for as a timing difference
12. Accounted for as a permanent difference
13. Ignored because it must be based on estimates and assumptions
14. Ignored because Smith holds less than 51 percent of the voting stock of Jones
15. Under the asset-liability method, deferred taxes should be presented on the balance sheet
    1. As one net non-current amount
    2. In two amounts: one for the net current amount and one for the net non-current amount
    3. In two amounts: one for the net debit amount and one for the net credit amount
    4. As reductions of the related asset or liability accounts
16. A deferred tax asset represents a
    1. Future tax expense
    2. Future tax liability.
    3. Future tax benefit
    4. Future taxable amount
17. A company has four “deferred income tax” accounts arising from timing differences involving (1) current assets, (2) noncurrent assets, (3) current liabilities, and (4) noncurrent liabilities. The presentation of these four “deferred income tax” accounts in the statement of financial position should be shown as
18. A single net non-current amount
19. A net current and a net noncurrent amount
20. Four accounts with no netting permitted
21. Valuation adjustments of the related assets and liabilities that gave rise to the deferred tax
22. Which of the following are temporary differences that are normally classified as expenses or losses and are deductible for income tax purposes after they are recognized for financial accounting income?
    1. Product warranty liabilities
    2. Advance rental receipts
    3. Depreciable property
    4. Fines and expenses resulting from a violation of law
23. A company’s only temporary difference results from using double declining balance depreciation for tax purposes and straight-line depreciation for financial reporting. The company purchases new plant assets each year. If currently enacted tax law will result in a higher tax rate for all future tax years, which accounting approach for deferred taxes will result in the lowest net income for this current year?
24. Nonallocation of deferred taxes.
25. Partial allocation of deferred taxes under the asset/liability method.
26. Comprehensive allocation of deferred taxes under the asset/liability method.
27. Comprehensive allocation of deferred taxes under the deferred method.
28. Which of the following is not an argument that an advocate of nonallocation of deferred taxes might use to support his/her position?
29. Income taxes result only from taxable income.
30. Income taxes are an expense of doing business and should be treated the same as other expenses of doing business under accrual accounting.
31. Income taxes are not levied on individual items of income or expense.
32. The current provision for income taxes is a better predictor of future cash flows than is income tax expense that includes deferred taxes.
33. Which of the following is an argument that an advocate of interperiod income tax allocation might use to support his/her position?
34. Income taxes result from taxable income.
35. Income taxes are an expense of doing business and should be treated the same as other expenses of doing business under accrual accounting.
36. Nonallocation of income taxes hides an economic difference between a company that employs tax strategies that reduce current tax payments than one that does not.
37. Income taxes are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues.
38. A net operating loss carryoverforward that occurs in a company’s second year of operations
39. May cause a company to report a tax benefit in the current period income statement.
40. Has no effect on income tax expense of the current period because no taxes are paid.
41. Causes a company to report a deferred income tax liability for taxes that are not paid currently.
42. Results in future taxable amounts.

1. A net operating loss:
   1. Must always be carried back 2 years
   2. Occurs when a company reports a net loss in their income statement
   3. May be carried forward indefinitely
   4. Must always be carried forward 20 years
2. Which of the following will result in a deferred tax asset?
3. Using the installment sales method for tax purposes, while using point of sale for financial reporting.
4. Reporting an unrealized gain for a trading security.
5. Using accelerated depreciation for tax purposes and straight-line depreciation for financial reporting.
6. Reporting an expected loss on from a lawsuit in the income statement, when it cannot be reported on the tax return until it is actually incurred.
7. Which of the following will result in a deferred tax liability?
8. A net operating loss carryover.
9. Reporting an unrealized gain for a trading security.
10. Reporting an unrealized gain for an available-for-sale security.
11. Reporting an expected loss on from a lawsuit in the income statement, when it cannot be reported on the tax return until it is actually incurred.
12. A deferred tax liability represents the:
    1. Increase in taxes payable in future years as a result of taxable temporary differences
    2. Increase in taxes saved in future years as a result of deductible temporary differences
    3. Decrease in taxes saved in future years as a result of deductible temporary differences
    4. Decrease in taxes payable in future years as a result of taxable temporary differences
13. Which of the following causes a permanent difference between taxable income and financial accounting income?
14. The useful life of an asset is 10 years. The asset is depreciated over 7 years for tax purposes.
15. Rent received in advance is taxable upon receipt.
16. A life insurance premium paid by the corporation on a policy that names the corporation as the beneficiary.
17. A penalty paid to a bank when a CD is cashed before its maturity date.
18. Which of the following approaches to interperiod tax allocation best represents an example of the matching principle?
19. The deferred method of interperiod income tax allocation
20. Discounting deferred income taxes
21. Nonallocation of income taxes
22. The asset/liability method of income tax allocation.
23. A company that has both short-term deferred tax assets of $22,000, long-term deferred tax liabilities of $36,000, short-term deferred tax liabilities of $51,000 and short-term deferred tax assets of $60,000 should report
24. A current asset for $22,000, a current liability for $36,000, a long-term asset for $60,000, and a long-term liability for $51,000.
25. A current liability for $14,000 and a long-term asset for $9,000.
26. A non-current liability for $5,000.
27. A current liability for $14,000, a long-term asset for $60,000, and a long-term liability for $51,000.
28. With regard to uncertain tax positions, the FASB requires that companies recognize a tax benefit when
    1. It is probable and can be reasonably estimated
    2. There is at least a 51% probability that the uncertain tax position will be approved by the taxing authorities
    3. It is more likely than not that the tax position will be sustained upon audit
    4. All of the above
29. An increase in the deferred income tax asset valuation allowance
30. Occurs when there is an operating loss carryforward.
31. Has no effect on income tax expense.
32. Occurs when there is an expected increase in future taxable income.
33. Increases income tax expense.

Essay

1. What are the objectives of accounting for income taxes?
2. Define the following types of differences between financial accounting income and taxable income:
   1. Temporary
   2. Permanent
3. Describe the three types of permanent differences. `
4. Revenue recognized for financial accounting reporting purposes that is never taxable. Examples include interest on municipal bonds and life insurance proceeds payable to a corporation upon the death of an insured employee.
5. Expenses recognized for financial accounting reporting purposes that are never deductible for income tax purposes. An example is life insurance premiums on employees where the corporation is the beneficiary.
6. Income tax deductions that do not qualify as expenses under GAAP. Examples include percentage depletion in excess of cost depletion and the special dividend exclusion.
7. List and give examples of the four types of differences that cause financial accounting income to be either greater than or less than taxable income.
8. Revenues or gains are included in financial accounting income prior to the time they are included in taxable income. For example, gross profit on installment sales is included in financial accounting income at the point of sale but may be reported for tax purposes as the cash is collected.
9. Expenses or losses are deducted to compute taxable income prior to the time they are deducted to compute financial accounting income. For example, a fixed asset may be depreciated by MACRS depreciation for income tax purposes and by the straight-line method for financial accounting purposes.
10. Revenues or gains are included in taxable income prior to the time they are included in financial accounting income. For example, rent received in advance is taxable when it is received, but it is reported in financial accounting income under as it is earned.
11. Expenses or losses are deducted to compute financial accounting income prior to the time they are deducted to determine taxable income. For example, product warranty costs are estimated and reported as expenses when the product is sold for financial accounting purposes, but they are deducted as actually incurred in later years to determine taxable income.
12. Distinguish between an originating temporary difference and a reversing temporary difference.
13. What is the difference between a future taxable amount and a future deductible amount?
14. When is it appropriate to record a valuation account for a deferred tax asset?
15. Describe the accounting treatment for net operating losses.
16. Discuss the arguments for and against interperiod tax allocation.
17. Income taxes result only from taxable income. Whether or not the company has accounting income is irrelevant. Hence, attempts to match income taxes with accounting income provide no relevant information for users of published financial statements.
18. Income taxes are different from other expenses; therefore, allocation in a manner similar to other expenses is irrelevant. Expenses are incurred to generate revenues; income taxes generate no revenues. They are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues.
19. Income taxes are levied on total taxable income, not on individual items of revenue and expense. Therefore, there can be no temporary differences related to these items.
20. Interperiod tax allocation hides an economic difference between a company that employs tax strategies that reduce current tax payments (and is therefore economically better off) and one that does not.
21. Reporting a company’s income tax expense at the amount paid or currently payable is a better predictor of the company’s future cash outflows because many of the deferred taxes will never be paid or will be paid only in the distant future.
22. Income tax allocation entails an implicit forecasting of future profits. To incorporate such forecasting into the preparation of financial information is inconsistent with the long-standing principle of conservatism.
23. There is no present obligation for the potential or future tax consequences of present or prior transactions because there is no legal liability to pay taxes until an actual future tax return is prepared.
24. The accounting recordkeeping and procedures involving interperiod tax allocation are too costly for the purported benefits.
25. Income taxes result from the incurrence of transactions and events. As a result, income tax expense should be based on the results of the transactions or events that are included in financial accounting income.
26. Income taxes are an expense of doing business and should involve the same accrual, deferral, and estimation concepts that are applied to other expenses.
27. Differences between the timing of revenues and expenses do result in temporary differences that will reverse in the future. Expanding, growing businesses experience increasing asset and liability balances. Old assets are collected, old liabilities are paid, and new ones take their place. Deferred tax balances grow in a similar manner.
28. Interperiod tax allocation makes a company’s net income a more useful measure of its long-term earning power and avoids periodic income distortions resulting from income tax regulations.
29. Nonallocation of a company’s income tax expense hinders the prediction of its future cash flows. For instance, a company’s future cash inflows from installment sales collection would usually be offset by related cash outflows for taxes.
30. A company is a going concern, and income taxes that are currently deferred will eventually be paid. The validity of other assets and liabilities reported in the balance sheet depends on the presumption of a viable company and hence the incurrence of future net income.
31. Temporary differences are associated with future tax consequences. For example, reversals of originating differences that provide present tax savings are associated with higher future taxable incomes and therefore higher future tax payments. In this sense, deferred tax liabilities are similar to other contingent liabilities that are currently reported under GAAP. However, one could argue that the recognition and measurement of other contingent liabilities hinges on the probability of their incurrence, whereas probability of future tax consequences is not a consideration.
32. Discuss the arguments for comprehensive vs. partial allocation of interperiod taxes.
33. Individual temporary differences do reverse. By definition, a temporary difference cannot be permanent; the offsetting effect of future events should not be assumed. It is inappropriate to look at the effect of a group of temporary differences on income taxes; the focus should be on the individual items comprising the group. Temporary differences should be viewed in the same manner as accounts payable. Although the total balance of accounts payable may not change, many individual credit and payment transactions affect the total.
34. Accounting is primarily historical. It is inappropriate to offset the income tax effects of possible future transactions against the tax effects of transactions that have already occurred.
35. The income tax effects of temporary differences should be reported in the same period as the related transactions and events are reported in pretax financial accounting income.
36. Accounting results should not be subject to manipulation by management. That is, a company’s management should not be able to alter the company’s results of operations and ending financial position by arbitrarily deciding what temporary differences will and will not reverse in the future.
37. All groups of temporary differences are not similar to certain other groups of accounting items; such as accounts payable. Accounts payable “roll over” as a result of actual individual credit and payment transactions. Income taxes, however, are based on total taxable income and not on the individual items constituting that income. Therefore, consideration of the impact of the group of temporary differences on income taxes is the appropriate viewpoint.
38. Comprehensive income tax allocation distorts economic reality. The income tax regulations that cause the temporary differences will continue to exist. For instance, Congress is not likely to reduce investment incentives with respect to depreciation. Consequently, future investments are virtually certain to result in originating depreciation differences of an amount to at least offset reversing differences. Thus, consideration should be given to the impact of future, as well as historical, transactions.
39. Assessment of a company’s future cash flows is enhanced by using the partial allocation approach. Since the deferred income taxes (if any) reported on a company’s balance sheet under partial allocation should actually reverse rather than continue to grow, partial allocation would better reflect future cash flows.
40. Accounting results should not be distorted by the use of a rigid, mechanical approach, such as comprehensive tax allocation. Furthermore, an objective of the audit function is to identify and deter any management manipulation.
41. Discuss the arguments for and against discounting deferred taxes.
42. Define the following:
    1. Deferred method of income tax allocation
    2. Asset-liability method of income tax allocation
    3. Net-of-tax method
43. Discuss how SFAS No. 109, now FASB ASC 740, changed the accounting for deferred tax assets.
44. Describe the use of the valuation allowance for deferred tax assets.
45. Describe accounting for uncertain tax positions under FIN No. 48, now FASB ASC 740-10-25.
46. Recognition. A firm determines whether it is more likely than not that a tax position will be sustained upon examination by the IRS based on the technical merits of the position. In evaluating whether a tax position has merit, a firm is to use a more-likely-than-not recognition threshold. This evaluation should presume that the IRS would have full knowledge of all relevant information.
47. Measurement. A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest cumulative amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.
48. How is the earnings conservatism ratio calculated? Discuss the rationale behind the calculation of a company’s earnings conservatism ratio.

The earnings conservatism ratio is calculated pretax accounting income/taxable income. The rationale for the earnings conservatism ratio is that most companies will use the most conservative revenue and recognition criteria for income tax reporting purposes while attempting to maximize their deductible expenses in order to minimize income taxes. On the other hand, management is under constant pressure to report favorable financial accounting earnings. As a result, it may choose accounting methods and estimations that maximize financial accounting income. In interpreting the results of this calculation, amounts in excess of 1.0 will indicate that a company is being more aggressive in its use of accounting choices for financial reporting than it is in calculating its income taxes.