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EXAMPLE TEST QUESTIONS

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
a. Accounted for as a timing difference
b. Accounted for as a permanent difference
c. Ignored because it must be based on estimates and assumptions
d. Ignored because it cannot be presumed that all undistributed earnings of a subsidiary will be
transferred to the parent company
Answer a
2.

Income tax allocation procedures are not appropriate when


a. An extraordinary loss will cause the amount of income tax expense to be less than the tax on
ordinary net income
b. An extraordinary gain will cause the amount of income tax expense to be greater than the tax
on ordinary net income
c. Differences between net income for tax purposes and financial reporting occur because tax
laws and financial accounting principles do not concur on the items to be recognized as
revenue and expense
d. Differences between net income for tax purposes and financial reporting occur that will not
reverse.

Answer d
3. Which of the following would cause a deferred tax expense?
a. Writedown of goodwill due to impairment
b. Use of equity method where undistributed earnings of a 30 percent owned investee are
related to probable future dividends
c. Premiums paid on insurance carried by company (beneficiary) on its officers or employees
d. Income is taxed at capital gains rates
Answer b
4. 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
a. Permanent differences
b. Timing differences
c. Intraperiod tax allocation
d. Interperiod tax allocation

Answer a
5. The tax effect of a difference between taxable income and pretax accounting income attributable
to losses of a subsidiary is normally recognized for
a. Neither carrybacks nor carryforwards
b. Both carrybacks and carryforwards
c. Carrybacks but not carryforwards
d. Carryforwards but not carrybacks
Answer b
6. Which of the following is not affected by tax allocation within a period?
a. Income before extraordinary items
b. Extraordinary events
c. Adjustments of prior periods
d. Operating revenues
Answer d
7. Under the comprehensive deferred interperiod method of tax allocation, deferred taxes are
determined on the basis of
a. Tax rates in effect when the timing differences originate without adjustment for subsequent
changes in tax rates
b. Tax rates expected to be in effect when the items giving rise to the timing differences reverse
themselves
c. Net valuations of assets or liabilities
d. Averages determined on an industry-by-industry basis
Answer b
8. The accounting recognition of the benefit from a tax loss carryforward in most situations should
be reported as
a. A reduction of the loss in the year of the loss with an appropriate valuation allowance
b. A prior period adjustment in whichever year the benefit is realized
c. An extraordinary item in the year in which the benefit is realized
d. An item on the retained earnings statement, not the income statement
Answer a
9. Intraperiod tax allocation arises because
a. Items included in the determination of taxable income may be presented in different sections
of the financial statements
b. Income taxes must be allocated between current and future periods
c. Certain revenues and expenses appear in the financial statements either before or after they
are included in taxable income
d. Certain revenues and expenses appear in the financial statements but are excluded from
taxable income
Answer c

10.

Assuming no prior period adjustments, would the following affect net income?
Interperiod
Intraperiod
Income tax
Income tax
Allocation
Allocation
a.
Yes
Yes
b.
Yes
No
c.
No
Yes
d.
No
No

Answer b
11. 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
a. Current liability
b. Current asset
c. Noncurrent liability
d. Noncurrent asset
Answer c
12. 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
a. Accounted for as a timing difference
b. Accounted for as a permanent difference
c. Ignored because it must be based on estimates and assumptions
d. Ignored because Smith holds less than 51 percent of the voting stock of Jones
Answer a
13. 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
a. A single net amount
b. A net current and a net noncurrent amount
c. Four accounts with no netting permitted
d. Valuation adjustments of the related assets and liabilities that gave rise to the deferred tax
Answer b
14. A companys 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?
a. Nonallocation of deferred taxes.
b. Partial allocation of deferred taxes under the asset/liability method.
c. Comprehensive allocation of deferred taxes under the asset/liability method.
d. Comprehensive allocation of deferred taxes under the deferred method.
Answer c
15. Which of the following is not an argument that an advocate of nonallocation of deferred taxes
might use to support his/her position?
a. Income taxes result only from taxable income.
b. Income taxes are an expense of doing business and should be treated the same as other
expenses of doing business under accrual accounting.
c. Income taxes are not levied on individual items of income or expense.
d. The current provision for income taxes is a better predictor of future cash flows than is
income tax expense that includes deferred taxes.
Answer b

16. Which of the following is an argument that an advocate of interperiod income tax allocation
might use to support his/her position?
a. Income taxes result from taxable income.
b. Income taxes are an expense of doing business and should be treated the same as other
expenses of doing business under accrual accounting.
c. 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.
d. Income taxes are not incurred in anticipation of future benefits, nor are they expirations of
cost to provide facilities to generate revenues.
Answer b
17. A net operating loss carryover that occurs in a companys second year of operations
a. May cause a company to report a tax benefit in the current period income statement.
b. Has no effect on income tax expense of the current period because no taxes are paid.
c. Causes a company to report a deferred income tax liability for taxes that are not paid
currently.
d. Results in future taxable amounts.
Answer a
18. Which of the following will result in a deferred tax asset?
a. Using the installment sales method for tax purposes, while using point of sale for financial
reporting.
b. Reporting an unrealized gain for a trading security.
c. Using accelerated depreciation for tax purposes and straight-line depreciation for financial
reporting.

d. 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.
Answer d
19. Which of the following will result in a deferred tax liability?
a. A net operating loss carryover.
b. Reporting an unrealized gain for a trading security.
c. Reporting an unrealized gain for an available-for-sale security.
d. 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.
Answer b
20. Which of the following causes a permanent difference between taxable income and financial
accounting income?
a. The useful life of an asset is 10 years. The asset is depreciated over 7 years for tax purposes.
b. Rent received in advance is taxable upon receipt.
c. A life insurance premium paid by the corporation on a policy that names the corporation as
the beneficiary.
d. A penalty paid to a bank when a CD is cashed before its maturity date.
Answer c
21. Which of the following approaches to interperiod tax allocation best represents an
example of the matching principle?
a. The deferred method of interperiod income tax allocation
b. Discounting deferred income taxes
c. Nonallocation of income taxes
d. The asset/liability method of income tax allocation.
Answer a
22. 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
a. 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.
b. A current liability for $14,000 and a long-term asset for $9,000.
c. A current asset for $5,000.
d. A current liability for $14,000, a long-term asset for $60,000, and a long-term liability for
$51,000.
Answer b
23. An increase in the deferred income tax asset valuation allowance
a. Occurs when there is an operating loss carryforward.
b. Has no effect on income tax expense.
c. Occurs when there is an expected increase in future taxable icnome.
d. Increases income tax expense.

Answer d
Essay
1. What are the objectives of accounting for income taxes?
The objectives of accounting for income taxes are to recognize the amount of
taxes payable or refundable for the current year and to recognize the future
tax consequences of temporary differences as well as net operating losses
(NOLs) and unused tax credits. To facilitate discussion of the issues raised by
the concept of interperiod tax allocation, we first examine the nature of
differences among pretax financial income, taxable income, and net
operating losses (NOLs).
2. Define the following types of differences between financial accounting income and taxable
income:
a.
Temporary
Most temporary differences between pretax financial accounting income and taxable income
arise because the timing of revenues, gains, expenses, or losses in financial accounting
income occurs in a different period from taxable income. These timing differences result in
assets and liabilities having different bases for financial accounting purposes than for income
tax purposes at the end of a given accounting period. Additional temporary differences occur
because specific provisions of the IRC create different bases for depreciation or for gain or
loss recognition for income tax purposes than are used for financial accounting purposes.
b.
Permanent
Certain events and transactions cause differences between pretax
accounting income and taxable income to be permanent. Most permanent
differences between pretax financial accounting income and taxable
income occur when specific provisions of the IRC exempt certain types of
revenue from taxation or prohibit the deduction of certain types of
expenses. Others occur when the IRC allows tax deductions that are not
expenses under GAAP. Permanent differences arise because of federal
economic policy or because Congress may wish to alleviate a provision of
the IRC that falls too heavily on one segment of the economy.
3. Describe the three types of permanent differences.`
There are three types of permanent differences:
1. 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.

2. 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.
3. 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.
4. List and give examples of the f our types of differences that cause financial accounting
income to be either greater than or less than taxable income.
These four types of differences are:
Current Financial Accounting Income Exceeds Current Taxable Income
1. 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.
2. 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.
Current Financial Accounting Income Is Less Than Current Taxable Income
1. 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.
2. 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.
5. Describe the accounting treatment for net operating losses.
A net operating loss (NOL) occurs when the amount of total tax deductions
and tax-deductible losses is greater than the amount of total taxable
revenues and gains during an accounting period. The IRC allows corporations
reporting NOLs to carry these losses back and forward to offset other
reported taxable income (currently back two years and forward twenty
years).
A NOL carryback is applied to the taxable income of the two preceding
years in the order in which they occurred, beginning with the older year first.
If unused NOLs are still available, they are carried forward for up to twenty

years to offset future taxable income. NOL carrybacks result in the refund of
prior taxes paid. Thus, the tax benefits of NOL carrybacks are currently
realizable and for financial accounting purposes are reported as reductions in
the current period loss. A receivable is recognized on the balance sheet, and
the associated benefit is shown on the current years income statement.
6. Discuss the arguments for and against interperiod tax allocation.
The primary income tax allocation issue involves whether and how to account for the tax effects
of temporary differences between taxable income, as determined by the IRC, and pretax financial
accounting income as determined under GAAP. Some accountants believe that it is inappropriate
to give any accounting recognition to the tax effects of these differences. Others believe that
recognition is appropriate but disagree on the method to use. There is also disagreement on the
appropriate tax rate to use and whether reported future tax effects should be discounted to their
present values. Finally, there is a lack of consensus over whether interperiod tax allocation should
be applied comprehensively to all differences or only to those expected to reverse in the future.
Advocates of nonallocation argue as follows:
1. 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.
2. 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.
3. 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.
4. 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.
5. Reporting a companys income tax expense at the amount paid or
currently payable is a better predictor of the companys future cash
outflows because many of the deferred taxes will never be paid, or will be
paid only in the distant future.
6. 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.
7. 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.

8. The accounting recordkeeping and procedures involving interperiod tax


allocation are too costly for the purported benefits.

On the other hand, the advocates of interperiod tax allocation cite the
following reasons to counter the preceding arguments or to criticize
nonallocation:
1. 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.
2. Income taxes are an expense of doing business and should involve the
same accrual, deferral, and estimation concepts that are applied to other
expenses.
3. 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.
4. Interperiod tax allocation makes a companys net income a more useful
measure of its long-term earning power and avoids periodic income
distortions resulting from income tax regulations.
5. Nonallocation of a companys income tax expense hinders the prediction
of its future cash flows. For instance, a companys future cash inflows
from installment sales collection would usually be offset by related cash
outflows for taxes.
6. 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.
7. 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.
7. Discuss the arguments for comprehensive vs. partial allocation of interperiod taxes.
Under comprehensive allocation, the income tax expense reported in an
accounting period is affected by all transactions and events entering into the
determination of pretax financial accounting income for that period.
Comprehensive allocation results in including the tax consequences of all
temporary differences as deferred tax assets and liabilities, regardless of how

significant or recurrent they are. Proponents of comprehensive allocation view


all transactions and events that create temporary differences as affecting
cash flows in the accounting periods when the future tax consequences of
temporary differences are realized. Under this view, the future tax
consequence of a temporary difference is analogous to an unpaid accounts
receivable or accounts payable invoice, which in the future is collected or
paid.
In contrast, under partial allocation, the income tax expense reported in an
accounting period would not be affected by those temporary differences that
are not expected to reverse in the future. That is, proponents of partial
allocation argue that, in certain cases, groups of similar transactions or
events may continually create new temporary differences in the future that
will offset the realization of any taxable or deductible amounts, resulting in an
indefinite postponement of deferred tax consequences. In effect, partial
allocationists argue that these types of temporary differences are more like
permanent differences. Examples of these types of differences include
depreciation for manufacturing companies with large amounts of depreciable
assets and installment sales for merchandising companies.

Advocates of comprehensive allocation raise the following arguments:


1. 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.
2. 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.
3. 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.
4. Accounting results should not be subject to manipulation by management.
That is, a companys management should not be able to alter the
companys results of operations and ending financial position by arbitrarily
deciding what temporary differences will and will not reverse in the future.

In contrast, advocates of partial income tax allocation argue that

1. 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.
2. 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.
3. Assessment of a companys future cash flows is enhanced by using the
partial allocation approach. Since the deferred income taxes (if any)
reported on a companys balance sheet under partial allocation should
actually reverse rather than continue to grow, partial allocation would
better reflect future cash flows.
4. 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.
8. Discuss the arguments for and against discounting deferred taxes.
Proponents of reporting deferred taxes at their discounted amounts argue
that the company that reduces or postpones tax payments is economically
better off. It is their belief that by discounting deferred taxes, a company best
reflects the operational advantages of its tax strategies in its financial
statements. Proponents also feel that discounting deferred taxes is consistent
with the accounting principles established for such items as notes receivable
and notes payable, pension costs, and leases. They argue that discounted
amounts are considered to be the most appropriate indicators of future cash
flows.
Critics of discounting counter that discounting deferred taxes mismatches
taxable transactions and the related tax effects. That is, the taxable
transaction would be reported in one period and the related tax effects over
several periods. They also argue that discounting would conceal a companys
actual tax burden by reporting as interest expense the discount factor that
would otherwise be reported as part of income tax expense. Furthermore,
deferred taxes may be considered as interest-free loans from the government
that do not require discounting because the effective interest rate is zero.
Although this argument has conceptual merit, a plausible counterargument
would be that the time value of money is important to the well-being of

companies, and because of this aspect, GAAP requires interest to be imputed


for non-interest-bearing financial instruments. It follows that the time value of
money is enhanced by postponing tax payments, thus, consistency under
GAAP would require imputing interest on deferred taxes.
9. Define the following:
a. Deferred method of income tax allocation
The deferred method of income tax allocation is an income statement
approach. It is based on the concept that income tax expense is related
to the period in which income is recognized. The deferred method
measures income tax expense as though the current period pretax
financial accounting income is reported on the current years income tax
return. The tax effect of a temporary difference is the difference between
income taxes computed with and without inclusion of the temporary
difference. The resulting difference between income tax expense and
income taxes currently payable is a debit or credit to the deferred income
tax account.
The deferred tax account balance is reported in the balance sheet as
deferred tax credit or deferred tax charge. Under the deferred method,
the deferred tax amount reported on the balance sheets is the effect of
temporary differences that will reverse in the future and that are
measured using the income tax rates and laws in effect when the
differences originated. No adjustments are made to deferred taxes for
changes in the income tax rates or tax laws that occur after the period of
origination. When the deferrals reverse, the tax effects are recorded at
the rates that were in existence when the temporary differences
originated.
b. Asset-liability method of income tax allocation
The asset/liability method of income tax allocation is balance sheet
oriented. The intent is to accrue and report the total tax benefit or taxes
payable that will actually be realized or assessed on temporary
differences when their respective future taxable or deductible amounts
are expected to occur. A temporary difference is viewed as giving rise to
either a tax benefit that will result in a decrease in future tax payments
or a tax liability that will be paid in the future at tax rates that are then
current. Theoretically, the future tax rates used should be estimated,
based on expectations regarding future tax law changes. However, GAAP
requires that the future tax rates used to determine current period
deferred tax asset and liability balances be based on currently enacted
tax law.

Under the asset/liability method, the deferred tax amount reported on


the balance sheet measures the future tax consequences of existing
temporary differences using the currently enacted tax rates and laws that
will be in effect when those tax consequences are expected to occur. At
the end of each accounting period, or when the temporary differences
that caused the company to report a deferred tax asset or liability no
longer exist, companies adjust their deferred tax asset and liability
account balances to reflect any changes in the income tax rates. Stated
differently, at year-end companies report deferred tax asset and liability
balances that measure the future tax consequences of anticipated
deductible and taxable amounts that were caused by current and prior
period temporary differences. The reported amounts are measured using
tax rates that under currently enacted tax law will be in effect in those
years when the deductible and taxable amounts are expected to occur.
This practice results in reporting deferred tax assets and liabilities at their
expected realizable values.
c. Net-of-tax method
The net-of-tax method is more a method of disclosure than a different
method of calculating deferred taxes. Under this method, the income tax
effects of temporary differences are computed by applying either the
deferred method or the asset/liability method. The resulting deferred
taxes, however, are not separately disclosed on the balance sheet.
Instead, under the net-of-tax method the deferred charges (tax assets) or
deferred credits (tax liabilities) are treated as adjustments of the
accounts to which the temporary differences relate. Generally, the
accounts are adjusted through the use of a valuation allowance rather
than directly. For instance, if a temporary difference results from
additional tax depreciation, the related tax effect would be subtracted (by
means of a valuation account) from the cost of the asset (along with
accumulated depreciation) to determine the carrying value of the
depreciable asset. Similarly, the carrying value of installment accounts
receivable would be reduced for the expected increase in income taxes
that will occur when the receivable is collected (and taxed). Reversals of
temporary differences would reduce the valuation allowance accounts.
10. Discuss how SFAS No. 109, now FASB ASC 740, changed the accounting for deferred tax
assets.
The FASB was convinced by the critics of SFAS No. 96 that deferred tax assets should be treated
similarly to deferred tax liabilities and that the scheduling requirements of SFAS No. 96 were
often too complex and costly. However, the Board did not want to return to the deferred method

and remained committed to the asset/liability approach. SFAS No. 109 (See FASB ASC 740)
responded to these concerns by allowing the separate recognition and measurement of deferred
tax assets and liabilities without regard to future income considerations, using the average
enacted tax rates for future years. The deferred tax asset is to be reduced by a tax valuation
allowance if available evidence indicates that it is more likely than not (a likelihood of more than
50 percent) that some portion or all of the deferred tax asset will not be realized.
11. Describe the use of the valuation allowance for deferred tax assets.
The deferred tax asset measures potential benefits to be received in future years arising from
temporary differences, NOL carryovers, and unused tax credits. Because there may be insufficient
future taxable income to actually derive a benefit from a recorded deferred tax asset, SFAS No.
109 requires a valuation allowance sufficient to reduce the deferred tax asset to the amount that is
more likely than not to be realized.
12. Describe accounting for uncertain tax positions under FIN No. 48, now FASB ASC 740-1025.
The validity of a tax position is a matter of tax law, and it is not controversial
to recognize the benefit of a tax position in a firms financial statements when
there is a high degree of confidence that a particular tax position will be
sustained after examination by the IRS. However, in some cases, tax law is
subject to varied interpretations, and whether a tax position will ultimately be
sustained may be uncertain.
The evaluation of a tax position under FIN No. 48 (See FASB ASC 740-10-25)
is a two-step process:
1. 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.
2. 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.
13. Discuss the rationale behind the calculation of a companys earnings conservatism ratio.
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.