CHAPTER 13

USING INCOME TAX INFORMATION

LEARNING OBJECTIVES
1. The differences between statutory, marginal, and effective tax rates.
2. The basic financial reporting and disclosure standards for income taxes.
3. What loss carrybacks and loss carryforwards are.
4. How loss carryforwards affect a valuation.
5. How to use the income tax footnote to gather information for a valuation analysis.
6. How to calculate the effective tax rate on core operations.

TRUE/FALSE QUESTIONS
1. Since most companies operate in many states, the reported state tax burden will be an average state rate
(net of any federal benefit) for all the states in which the firm operates.
(easy, L.O. 1, Section 1, true)

2. The current federal statutory tax rate for major corporations is currently 35%, which was increased from
34% in 1994.
(moderate, L.O. 1, Section 1, true)

3. In valuation forecasts analysts use the income tax rate that is related to core operations, divided by pretax
income related to core operations.
(moderate, L.O. 1, Section 1, true)

4. Book-tax conformity means the same accounting methods and estimates must be used for both financial
accounting and income tax calculations.
(moderate, L.O. 2, Section 2, true)

5. Expense under SFAS No. 106 for a postemployment benefit plan recorded over employment life for
GAAP is an example of a permanent difference for tax purposes.
(difficult, L.O. 2, Section 2, false)

6. Municipal bond interest is an example of a temporary difference.

(easy, L.O. 2, Section 2, false)

7. Deferred taxes arise when a firm chooses different accounting methods for financial reporting and income
tax reporting purposes.
(moderate, L.O. 2, Section 2, true)

8. Because the amount of deferred taxes is not paid in the current period, it is not a reconciling item on the
cash flow statement.
(moderate, L.O. 2, Section 2, false)

9. Since the deferred tax provision is due to temporary differences, it is reported in the firm’s income
statement for the period in which the differences occur.
(easy, L.O. 2, Section 2, false)

10. Most firms elect to carry losses forward to future periods since it will allow future tax savings.
(moderate, L.O. 3, Section 3, false)

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11. A loss carryforward is recorded as a deferred tax asset in the year of the loss.
(moderate, L.O. 2, Section 4, true)

12. The part of the income tax footnote known as the tax provision summary shows temporary differences
that have not yet reversed as of the balance sheet date.
(moderate, L.O. 4, Section 5, false)

13. When a firm owns more than 20% of another firm from which it receives dividend income, 20% of the
dividend income it receives is permanently excluded for tax purposes.
(moderate, L.O. 6, Section 6, false)

14. Just as important as what is disclosed in an income tax reconciliation footnote is what is not there.
(moderate, L.O. 6, Section 6, true)

15. An analyst will calculate several years of historical effective tax rates on operations to forecast the
effective tax rate on core operations going forward, while taking into account any reasons why the
effective tax rate might change in the future.
(moderate, L.O. 6, Section 6, true)

MULTIPLE CHOICE QUESTIONS

16. The statutory tax rate is the tax rate that:
a. applies to the next dollar of income
b. has been set by law (statute)
c. is found by dividing the income tax provision by pretax income
d. is the legal maximum a firm can pay
(easy, L.O. 1, Section 1, b)

17. The tax rate that is found by dividing a firm’s income tax provision by pretax income is called the:
a. actual tax rate
b. statutory tax rate
c. effective tax rate
d. marginal tax rate
(easy, L.O. 1, Section 1, c)

18. The tax rate that is not the same for all types of income and applies to the next dollar of income is known
as the:
a. nominal tax rate
b. effective tax rate
c. statutory tax rate
d. marginal tax rate
(easy, L.O. 1, Section 1, d)

19. Financial reporting standards and income tax laws have different underlying purposes and different rules.
The underlying concept in accounting for income taxes is the:
a. effective tax rate
b. present value of the effective tax rate on core operations
c. historical cost principle
d. matching principle
(moderate, L.O. 2, Section 2, d)

20. The matching principle, when applied to income taxes, states that:
a. the matching principle does not apply to the calculation or payment of income taxes
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 b. federal income tax law recognizes the deduction for taxes in the same period as the income that
causes it
c. the income tax provision should be reported in the income statement in the period in which the
income taxes are paid
d. the income tax provision should be reported in the income statement in the same period as the
income that causes it
(moderate, L.O. 2, Section 2, d)

21. To apply the matching principle to income taxes, the analyst must distinguish between two types of
differences in financial reporting and income tax law. The type of difference that arises when a certain
financial statement item is never recognized for tax purposes is called a:
a. timing difference
b. pretax difference
c. permanent difference
d. marginal tax difference
(moderate, L.O. 2, Section 2, c)

22. Accelerated depreciation is an example of a _________ difference while the dividend exclusion is an
example of a __________ difference.
a. permanent; temporary
b. temporary; permanent
c. permanent; permanent
d. temporary; temporary
(easy, L.O. 2, Section 2, b)

23. Reconciling pretax income under GAAP with taxable income is done:
a. to help the analyst understand the computation of the income tax provision and its components
b. as a requirement under SFAS No. 106
c. as a requirement of the Internal Revenue Code of 1986 as amended
d. None of the above answers are correct.
(moderate, L.O. 2, Section 2, a)

24. What is the last step in the process of reconciling GAAP pretax income with taxable income?
a. the adjustment for any income or expense item considered a permanent difference
b. the adjustment for any item considered a temporary difference
c. obtaining the amount of GAAP pretax income that will ever be taxed
d. obtaining the amount of GAAP pretax income from all sources
(moderate, L.O. 2, Section 2, b)

25. The difference between the income tax provision found on the firm’s income statement and the amount
due to the IRS for the same period is called the:
a. deferred income tax provision
b. total income tax provision
c. current income tax provision
d. statutory tax provision
(moderate, L.O. 2, Section 2, a)

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26. A firm’s GAAP pretax income for 2003 is $2,750,000. Depreciation for the year is $750,000, and the
firm received interest from municipal bonds in the amount of $595,000 during the year. The firm has a
35% statutory tax rate. Ignoring any state taxation, the firm’s deferred income tax provision for 2003 is:
a. $262,500
b. $491,750
c. $750,000
d. $754,250
(moderate, L.O. 2, Section 2, a)

27. A firm’s GAAP pretax income for 2003 is $2,750,000. Depreciation for the year is $750,000, and the
firm received interest from municipal bonds in the amount of $595,000 during the year. The firm has a
federal statutory tax rate of 35%. Ignoring any state taxation, the firm’s current income tax provision for
2003 is:
a. $262,500
b. $750,000
c. $491,750
d. $754,250
(moderate, L.O. 2, Section 2, c)

28. A firm’s GAAP pretax income for 2003 is $3,250,000. Total depreciation for the year is $650,985. The
firm received interest from municipal bonds in the amount of $375,000, and received dividend income of
$100,000. The firm owns 16% of the stock of other companies in which it has invested. The firm has a
federal statutory tax rate of 35%. Ignoring any state taxation, how much did the firm save in federal taxes
from permanent differences?
a. $10,500
b. $131,250
c. $227,845
d. $141,750
(moderate, L.O. 2, Section 2, d)

29. A firm’s GAAP pretax income for 2003 is $3,250,000. Total depreciation for the year is $650,985. The
firm received interest from municipal bonds in the amount of $375,000, and received dividend income of
$100,000. The firm has a federal statutory tax rate of 35%. Ignoring any state taxation, how much did the
firm defer in federal taxes for the current period due to temporary differences?
a. $141,750
b. $227,845
c. $131,250
d. $24,500
(difficult, L.O. 2, Section 2, b)

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30. A firm incurs a loss of $1,500,000 in 2000. It has a marginal federal tax rate of 35%. What is the
carryback and carryforward period for the firm’s year 2000 loss?
a. carryback of 2 years; carryforward of 20 years
b. carryback of 20 years; carryforward of 2 years
c. carryback of 2 years; carryforward of 2 years
d. carryback of 2 years; no carryforward is allowed since the loss is prior to 2001
(easy, L.O. 3, Section 3, a)

31. Loss carryforwards are temporary differences because the tax benefit is reported in the income statement
in the year the carryforward arises (the loss year), even though the benefit is not realized until some
future period. According to SFAS No. 109, when is a valuation allowance used in conjunction with a
deferred tax asset?
a. SFAS No. 109 does not address this issue.
b. when it is “more likely than not” that a deferred tax will not be realized in the future
c. when it is likely the loss carryforward will be entirely used within the next 2 years
d. when the loss was first carried back and a portion used in the last 2 years, and an amount still exists
that can be carried forward into the future
(difficult, L.O. 3, Section 3, b)

32. Loss carryforwards are valuable to most firms for several reasons, among which is the fact that they can
reduce the amount of future income taxes a firm would otherwise have to pay. The value of a
carryforward to a firm is dependent upon:
a. the size or magnitude of the carryforward
b. the certainty of using the carryforward before it expires
c. how quickly the carryforward can be used
d. All of the above answers are correct.
(easy, L.O. 4, Section 4, d)

33. The income tax footnote found in a firm’s annual report provides information an analyst can use in
making adjustments in a free cash flow analysis. Generally, an income tax footnote has three tables. The
table that in part explains why the firm’s effective and statutory tax rates differ is called the:
a. tax provision summary
b. deferred tax asset and liability summary
c. reconciliation of the statutory rate to the firm’s effective rate
d. reconciliation of income taxes and free cash flows
(easy, L.O. 5, Section 5, c)

34. The effective tax rate on core operations is a key assumption in a valuation. The analyst will need to
know or estimate the effects of each of the adjustments affecting pretax income. When an analyst is
removing a gain or loss in a free cash flow analysis, the most precise way to calculate such an amount is
to:
a. estimate the tax effect using an estimated marginal tax rate for the item
b. estimate the tax effect using an estimated statutory tax rate for the item
c. see if the firm has disclosed this transaction in the financial statements or footnotes in the firm’s
annual report
d. None of the answers above are correct.
(moderate, L.O. 6, Section 4, c)

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35. A firm has received $25,000 in dividend income for a period. The statutory federal tax rate for the firm is
35%. The state tax rate for the firm is 3%. If the firm owns less than 20% of the firm from which it
receives dividend income, the marginal tax rate on the dividend income is:
a. 11.085%
b. 36.950%
c. 7.390%
d. 33.95%
(difficult, L.O. 6, Section 4, a)

36. A firm has received $25,000 in dividend income during the year. The statutory federal tax rate for the
firm is 35%. The state tax rate for the firm is 3%. If the firm owns less than 20% of the company from
which it receives dividend income, the amount of tax paid on the dividend income for the year is:
a. $1,848
b. $2,771
c. $9,238
d. Zero, since dividend income is not taxed.
(difficult, L.O. 6, Section 4, b)

37. A firm has received $37,500 in dividend income for a period. The statutory federal tax rate for the firm is
35%. The state tax rate for the firm is 3%. If the firm owns 39% of the firm from which it receives
dividend income, the marginal tax rate on the dividend income is:
a. 11.085%
b. 36.950%
c. 7.390%
d. 33.95%
(difficult, L.O. 6, Section 4, c)

38. A firm has received $38,692 in dividend income during the year. The statutory federal tax rate for the
firm is 35%. The state tax rate for the firm is 3%. The firm owns 35% of the company from which it
received dividends. What percent of dividend income can the firm exclude from the taxable portion of its
dividend income?
a. 20%
b. 30%
c. 80%
d. 70%
(moderate, L.O. 6, Section 4, d)

39. An analyst examining the income tax footnote for a firm notes that the federal statutory tax rate has
remained unchanged for the last three years. However, the firm’s effective tax rate varied from 38.0% to
41.2% during the same time period. One reason for such a variance in the firm’s effective tax rate is:
a. state taxes, net of the federal benefit and other items, would cause the effective tax rate to differ
b. during the period, the firm increased its valuation allowance for its income tax provision
c. the firm reported nondeductible losses and merger costs in one year during the period
d. All of the answers above are correct.
(moderate, L.O. 5, Section 4, d)

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40. The income tax footnote for a firm notes that the federal statutory tax rate has remained unchanged for
the last three years of its operations. However, the firm’s effective tax rate varied from 38.3% to 41.4%
during the same time period. What would not be a reason that contributed to the effective tax rate
variance during this time period?
a. the firm’s percentage of investment in another company from which it receives dividends increased
from 14% to 27% during the time period
b. depreciation for the firm increased during the time period
c. the firm reported nondeductible losses and merger costs in one year during the period
d. municipal bond interest was reported by the firm in its financial statements during the time period
(moderate, L.O. 5, Section 4, d)

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ESSAYS

41. What are the differences among statutory, marginal, and effective tax rates?

Suggested solution:

A tax rate can mean different things in different contexts. It is important to understand the differences in
these three types of tax rates. A statutory tax rate is simply the tax rate that has been established by law.
The marginal tax rate is the rate of tax assessed on the last dollar of income earned. There are different
marginal tax rates for different types of income. The effective tax rate is a firm’s income tax provision
divided by pretax income.

For states that tax corporate income, a firm may deduct the state tax from its federal return. Given this
fact, the net effect of a state income tax rate (which varies by state) is computed by taking the state
statutory income tax rate multiplied by (1 – federal income tax rate). When a firm operates in more than
one state, the reported state tax expense will be an average of state rates (net of the federal tax benefit).

For valuation purposes, a special effective tax rate is used known as the effective tax rate on core
operations. This is defined as the income tax provision that is related to core operations, divided by
pretax income related to core operations. To find this tax rate, information from the cash flow worksheet
is used for computational purposes.
(easy, L.O. 1, Section 1)

42. Explain temporary and permanent differences when computing a firm’s income tax provision.

Suggested solution:

Financial reporting standards and income tax laws have different underlying purposes, rules, and goals.
The audiences for financial reporting are investors who make financial decisions about a firm. The
purpose behind income tax laws is to determine how much a firm must pay in income taxes. Because of
these different purposes and goals, there will be differences in financial and income tax reporting for a
firm.

Under financial reporting rules (GAAP), the matching principle requires that the firm’s income tax
provision should be reported in the income statement in the same period as the income that causes it.
Income tax law, however, may or may not recognize the firm’s income or deductions in the same period.
This leads to two types of differences between financial reporting and income tax reporting: permanent
and temporary.

A permanent difference comes about when an item is reportable for financial purposes, but not income
tax purposes. It is a matter of whether an item is ever recognized. Examples of permanent differences are
municipal bond interest (which is not reported as income on federal tax returns) and the dividend
exclusion, a portion of which is never taxed.

A temporary difference comes about when both financial reporting and income tax rules treat an item the
same way, but at different times. It is a matter of when the item is recognized. An example of a
temporary difference would be using accelerated deprecation for income tax purposes while using
straight-line deprecation for financial reporting purposes.

The analyst should prepare a reconciliation of GAAP pretax income with taxable income to help in
understanding the computation of the income tax provision and its components. Within such
reconciliation, temporary and permanent items will be identified to reconcile the pretax income with
taxable income for a firm.
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 (moderate, L.O. 2, Section 2)

43. How does the analyst use the income tax footnote of a firm in the valuation process?

Suggested solution:

The income tax footnote provides the analyst with important information that can be used to determine
the amounts of certain adjustments in the free cash flow analysis. It also gives the analyst insight into any
loss carryforwards and valuation allowances the firm may have.

The typical income tax footnote is divided into three tables. The tax provision summary, the first table,
shows the current and deferred portions of the income tax provision. The deferred tax asset and liability
summary is the second table and summarizes the temporary differences that have not yet reversed as of
the balance sheet date, and the amounts each contributed to the firm’s deferred tax asset or liability. The
last table is the reconciliation of the statutory rate to the firm’s effective tax rate, which explains the
differences between the statutory tax rate and the firm’s tax rate, either in terms of dollars or tax rates.
The table highlights the reconciling items by showing each component of pretax income that is not taxed
at the statutory rate and the effect that this had on the effective rate.

The analyst will decide whether to make adjustments to the free cash flow analysis for items that may
have received an unusual tax treatment (such as a nondeductible item) when projecting the firm’s
effective tax rate for future periods. The analyst will look at the items disclosed and analyze their
potential impact on any future effective tax rate, and will also note items that are not found in the
footnote (such as the absence of any municipal bond interest). The presence or absence of an item in the
income tax footnote may have an effect on future projections of tax rates for the firm.
(moderate, L.O. 6, Section 4)

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