POI Corp. has an effective tax rate of 29.6% and a statutory tax rate of 35%. The cause of this difference is most likely a. Warranty expense b. accelerated depreciation c. permanently reinvestd earnings of POI’s foreign subsidiary Answer is c. Can anybody explain. I usually get DTL/ DTA/ effects of tax rate change all mixed up. And also, what could sb give a practical example for the application of the alternative tax rate: (taxes payable/pre-tax income)? Thanks!!!
well even i am really scared abt this topic…cant help it…bt frm d top of my head…i remember that d difference between the statutory tax rate and effective tax rate occurs due to permanent differences …and c is clearly evident…think i am correct!!
The examples are in the text books. I could try to help you with the concept a little more I guess. Actually I am trying to help myself clear the concept and make sure I am doing the right thing. 1. Accounting for reporting and tax purposes might differ which causes a difference in the pre-tax income and the taxable income. 2. Now over the lifetime of the asset/liability the difference can reverse. This would cause a lot of fluctuations in the income statement. 3. That is why whenever there is a difference in the pre-tax income and the taxable income we create a deferred tax asset or liability. 4. If taxable income>pre-tax income, it means that we have to pay less taxes later and this creates a deferred tax asset. (opposite for deferred tax liability). Lets see an example where the company makes provision for warranty expenses of $1000 in reporting. However tax laws do not allow recognition of warranty as expenses unless actual warranty is paid. So, taxable income is greater by 1000 than pre-tax income. If tax rate is 50%, the company is paying (0.50x1000)=$500 more taxes. However, in the future when the company will actually pay the warranty money, the company will not be reporting the provision as an expense since it already did that in the past. At that time the opposite will happen. So, the company records a deferred tax asset of $500 initially. couple of more things to look into a. Income Tax Expense = Taxes Payable + change in DTL - change in DTA b. Calculating the tax base of an asset and liability c. what causes permanent differences and what causes temporary differences d. effect of changes in tax rates on deferred tax assets and liabilities I would strongly recommend that you go to someone who knows income taxes. This chapter is very difficult to understand completely by reading the books.
A and B are both temporary differences. That means that they will be reversed in future periods (i.e. once the machine is wholly depreciated on both the tax return and the income statements, and when the actual warranty work is complete). Reinvested earnings of a foreign subsidy is a permanent difference because the company has control over their finances. Permanent differences lead to differences in the stat and effective tax rate, so even without looking at A and B, the answer must be C.
Good article about this in business week 2 weeks ago. Something the administration is going after to try to increase corporate tax revenues.
Hi there, As a quick one , just remember that effective tax rate v/s Statutory is only caused by Permanent differences. Effective tax rate = Tax expense divided by Accounting profit An illustartion below proves this Accounting Net Profit before tax 1000 Add Permanent difference Entertainment costs disallowed 200 Profit re-invest sub -500 Temporary difference Tax depn v/s Accounting depn -110 NBV actg $1,110 , NBV Tax $1,000) Warranty exp. Over accrued 50 ( Accruals $500 and paid only 450) Taxable Income 640 Tax Payable at 30% 192 Statutory tax rate 30% In P&L disclosure Income Tax payable 192 DTA -15 Do not compare it with tax calculation above DTL 33 as we are supposed to look at it from B/sheet Income Tax Expense 210 Effective tax rate 21%
Good reminder rcaus, so, the Income statement tax expense we see when divided by gross EBT is the effective tax rate, which already has provided for change in DTL and DTA, right? This is the way i’ve viewed it previously…
thanks to all, that’s a great help. I was just found this out of the Qbank When analyzing a company’s financial leverage, deferred tax liabilities are best classified as: A) a liability. B) a liability or equity, depending on the company’s particular situation. C) neither as a liability, nor as equity. Answer B. But can somebody explain one of those particular situations? Thanks!
Its a liability when you expect your taxable income to increase in the future. However, if the situation leading to the creation of the deferred tax liability is not expected to revert back, then you are having a sort of a gain. Think this way… DTL of 1000 means that in the future you have to pay additional $1000 taxes (you are making provisions for this now). Then suppose tax rate decreases and DTL decreases to $600. You need to pay $400 less. So this would be an addition to the Equity Directly. An easy way to understand DTA and DTL is to think that DTA is Advance Income Taxes paid and DTL is Taxes that you need to pay in the future.