WALL STREET PREP ADVANCED TEST
COMPREHENSIVE EXAM QUESTIONS
ACCURATE ANSWERS
◉ What is the difference between the effective and marginal tax
rates? Answer: Effective tax rate: % corporations must by in taxes
Effective tax rate = Taxes paid / earnings before tax
Marginal tax rate: % on the last dollar of a company's taxable
income.
◉ 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.
◉ 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.
◉ 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.
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.
, 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.
◉ 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.
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.
However, under GAAP, the tax benefit will be recognized from a
presumed future tax refund immediately on the income statement,
and this difference gets captured in DTAs. As the company generates
future profits and uses those NOLs to reduce future tax liabilities,
the DTAs gradually reverse.
Another reason for DTAs is the differences between book and tax
rules for revenue recognition. Broadly, tax rules require recognition
COMPREHENSIVE EXAM QUESTIONS
ACCURATE ANSWERS
◉ What is the difference between the effective and marginal tax
rates? Answer: Effective tax rate: % corporations must by in taxes
Effective tax rate = Taxes paid / earnings before tax
Marginal tax rate: % on the last dollar of a company's taxable
income.
◉ 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.
◉ 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.
◉ 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.
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.
, 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.
◉ 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.
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.
However, under GAAP, the tax benefit will be recognized from a
presumed future tax refund immediately on the income statement,
and this difference gets captured in DTAs. As the company generates
future profits and uses those NOLs to reduce future tax liabilities,
the DTAs gradually reverse.
Another reason for DTAs is the differences between book and tax
rules for revenue recognition. Broadly, tax rules require recognition
