WALL STREET PREP: ADVANCED
ACCOUNTING EXAM WITH CORRECT
SOLUTIONS
1. How would raising capital through share issuances affect earnings per share
(EPS)? - ANSWER-The impact on EPS is that the share count increases, which
decreases EPS. But there can be an impact on net income, assuming the share
issuances generate cash because there would be higher interest income, which
increases net income and EPS. However, most companies' returns on excess cash
are low, so this doesn't offset the negative dilutive impact on EPS from the
increased share count.
2. Alternatively, share issuances might affect EPS in an acquisition where stock is the
form of consideration. The amount of net income the acquired company generates
will be added to the acquirer's existing net income, which could have a net positive
(accretive) or negative (dilutive) impact on EPS.
3. How would a share repurchase impact earnings per share (EPS)? - ANSWER-The
impact on EPS following a share repurchase is a reduced share count, which
increases EPS. However, there would be an impact on net income, assuming the
share repurchase was funded using excess cash. The interest income that would
have otherwise been generated on that cash is no longer available, causing net
income and EPS to decrease.
4. But the impact would be minor since the returns on excess cash are low, and
would not offset the positive impact the repurchase had on EPS from the reduced
share count.
,5. What is the difference between the effective and marginal tax rates? - ANSWER-
Effective tax rate: % corporations must by in taxes
6. Effective tax rate = Taxes paid / earnings before tax
7. Marginal tax rate: % on the last dollar of a company's taxable income.
8. Why is the effective and marginal tax rate often different? - ANSWER-Effective
and marginal tax rates differ because the effective tax rate calculation uses pre-tax
income from the accrual-based income statement. Since there's a difference
between the taxable income on the income statement and taxable income shown
on the tax filing, the tax rates will nearly always be different. Thus, the "Tax
Provision" line item on the income statement rarely matches the actual cash taxes
paid to the IRS.
9. Could you give specific examples of why the effective and marginal tax rates might
differ? - ANSWER-Under GAAP, many companies follow different accounting
standards and rules for tax and financial reporting.
i. Most companies use straight-line depreciation (i.e., equal allocation of
the expenditure over the useful life) for reporting purposes, but the
IRS requires accelerated depreciation for tax purposes - meaning,
book depreciation is lower than tax depreciation for earlier periods
until the DTLs reverse.
ii. Companies that incurred substantial losses in earlier years could apply
tax credits (i.e., NOL carryforwards) to reduce the amount of taxes due
in later periods.
iii. When debt or accounts receivable is determined to be uncollectible
(i.e., "Bad Debt" and "Bad AR"), this can create DTAs and tax
differences. The expense can be reflected on the income statement as a
write-off but not be deducted in the tax returns.
, 10. What are deferred tax liabilities (DTLs)? - ANSWER-Deferred tax liabilities
("DTLs") are created when a company recognizes a tax expense on its GAAP
income statement that, because of a temporary timing difference between GAAP
and IRS accounting, is not actually paid to the IRS that period but is expected to
be paid in the future.
11. DTLs are often related to depreciation. Companies can use accelerated
depreciation methods for tax purposes but elect to use straight-line depreciation
for GAAP reporting. This means that for a given depreciable asset, the amount of
depreciation recognized in the earlier years for tax purposes will be greater than
under GAAP.
12. Those temporary timing differences are recognized as DTLs. Since these
differences are just temporary - under both book and tax reporting, the same
cumulative depreciation will be recognized over the life of the asset - at a certain
point into the asset 's useful life, an inflection point will be reached where the
depreciation expense for tax reporting will become lower than for GAAP.
13. What are deferred tax assets (DTAs)? - ANSWER-Deferred tax assets ("DTAs") are
created when a company recognizes a tax expense on its GAAP income statement
that, due to a temporary timing difference between GAAP and IRS accounting
rules, is lower than what must be paid to the IRS for that period. These net
operating losses ("NOLs") that a company can carry forward against future
income create DTAs.
14. For example, a company that reported a pre-tax loss of $10 million will not get an
immediate tax refund. Instead, it'll carry forward these losses and apply them
against future profits.
ACCOUNTING EXAM WITH CORRECT
SOLUTIONS
1. How would raising capital through share issuances affect earnings per share
(EPS)? - ANSWER-The impact on EPS is that the share count increases, which
decreases EPS. But there can be an impact on net income, assuming the share
issuances generate cash because there would be higher interest income, which
increases net income and EPS. However, most companies' returns on excess cash
are low, so this doesn't offset the negative dilutive impact on EPS from the
increased share count.
2. Alternatively, share issuances might affect EPS in an acquisition where stock is the
form of consideration. The amount of net income the acquired company generates
will be added to the acquirer's existing net income, which could have a net positive
(accretive) or negative (dilutive) impact on EPS.
3. How would a share repurchase impact earnings per share (EPS)? - ANSWER-The
impact on EPS following a share repurchase is a reduced share count, which
increases EPS. However, there would be an impact on net income, assuming the
share repurchase was funded using excess cash. The interest income that would
have otherwise been generated on that cash is no longer available, causing net
income and EPS to decrease.
4. But the impact would be minor since the returns on excess cash are low, and
would not offset the positive impact the repurchase had on EPS from the reduced
share count.
,5. What is the difference between the effective and marginal tax rates? - ANSWER-
Effective tax rate: % corporations must by in taxes
6. Effective tax rate = Taxes paid / earnings before tax
7. Marginal tax rate: % on the last dollar of a company's taxable income.
8. Why is the effective and marginal tax rate often different? - ANSWER-Effective
and marginal tax rates differ because the effective tax rate calculation uses pre-tax
income from the accrual-based income statement. Since there's a difference
between the taxable income on the income statement and taxable income shown
on the tax filing, the tax rates will nearly always be different. Thus, the "Tax
Provision" line item on the income statement rarely matches the actual cash taxes
paid to the IRS.
9. Could you give specific examples of why the effective and marginal tax rates might
differ? - ANSWER-Under GAAP, many companies follow different accounting
standards and rules for tax and financial reporting.
i. Most companies use straight-line depreciation (i.e., equal allocation of
the expenditure over the useful life) for reporting purposes, but the
IRS requires accelerated depreciation for tax purposes - meaning,
book depreciation is lower than tax depreciation for earlier periods
until the DTLs reverse.
ii. Companies that incurred substantial losses in earlier years could apply
tax credits (i.e., NOL carryforwards) to reduce the amount of taxes due
in later periods.
iii. When debt or accounts receivable is determined to be uncollectible
(i.e., "Bad Debt" and "Bad AR"), this can create DTAs and tax
differences. The expense can be reflected on the income statement as a
write-off but not be deducted in the tax returns.
, 10. What are deferred tax liabilities (DTLs)? - ANSWER-Deferred tax liabilities
("DTLs") are created when a company recognizes a tax expense on its GAAP
income statement that, because of a temporary timing difference between GAAP
and IRS accounting, is not actually paid to the IRS that period but is expected to
be paid in the future.
11. DTLs are often related to depreciation. Companies can use accelerated
depreciation methods for tax purposes but elect to use straight-line depreciation
for GAAP reporting. This means that for a given depreciable asset, the amount of
depreciation recognized in the earlier years for tax purposes will be greater than
under GAAP.
12. Those temporary timing differences are recognized as DTLs. Since these
differences are just temporary - under both book and tax reporting, the same
cumulative depreciation will be recognized over the life of the asset - at a certain
point into the asset 's useful life, an inflection point will be reached where the
depreciation expense for tax reporting will become lower than for GAAP.
13. What are deferred tax assets (DTAs)? - ANSWER-Deferred tax assets ("DTAs") are
created when a company recognizes a tax expense on its GAAP income statement
that, due to a temporary timing difference between GAAP and IRS accounting
rules, is lower than what must be paid to the IRS for that period. These net
operating losses ("NOLs") that a company can carry forward against future
income create DTAs.
14. For example, a company that reported a pre-tax loss of $10 million will not get an
immediate tax refund. Instead, it'll carry forward these losses and apply them
against future profits.
