Cfa Fra R23-24

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READING 23: INCOME TAXES

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Learning outcomes
23.a. Describe the differences between accounting profit and taxable

income and define key terms
23.b. Identify and contrast temporary versus permanent differences in
pre-tax accounting income and taxable income
23.c. Explain how deferred tax liabilities and assets are created and the
factors that determine how a company’s deferred tax liabilities and
assets should be treated for the purposes of financial analysis
23.d. Calculate the tax base of a company’s assets and liabilities

23.e. Calculate income tax expense, income taxes payable, deferred tax
assets and deferred tax liabilities and Calculate and interpret the
adjustment to the financial statements related to a change in the income
tax rate
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Learning outcomes
23.f. Evaluate the effect of tax rate changes on a company’s financial

statements and ratios
23.g. Describe the valuation allowance for deferred tax assets when it is
required and what effect it has on financial statements
23.h. Explain recognition and measurement of current and deferred tax
items
23.i. Analyze disclosures relating to deferred tax items and the effective
tax rate reconciliation and explain how information included in these
disclosures affects a company’s financial statements and financial ratios
23.j. Identify the key provisions of and differences between income tax
accounting under IFRS and US. GAAP
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[LOS 23.a] Describe the differences between accounting profit
and taxable income and define key terms
1. Describe the differences between accounting profit and

taxable income
Let’s begin with an illustrative example for income taxes
For accounting
For tax purposes
purposes
Revenue 100 100
Disposal of a car 20 20
Selling experimental products 0 10
Purchase without
0 (20)
supporting documents
Manufacturing cost (10) (10)
Profit 110 100
Profit for tax purpose is also (see the next slide) Profit for accounting purpose is
called taxable income also called accounting profit
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taxable income
Difference between the recognition of revenue and expense for tax and
accounting purposes may result in taxable income differing from accounting
profit. As a result, the amount of income tax expense recognized in the
income statement may differ from the tax payable to the taxing authorities.
Recognition of revenue & Recognition of revenue &

v
expense for tax expense for accounting
Taxable income Accounting profit
Income tax expense

Tax payable
recognize
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taxable income
Note: In actuality, to calculate taxable income for tax purposes, we start from
accounting profit with some adjustments for taxable (or non-taxable) and
deductible (or non-deductible) items (incomes or expenses), rather than start
from sales as mentioned in the previous slide.
Accounting profit 100
Other taxable income -
Non-taxable Income (10) (Selling experimental products)
(Purchase without supporting

Non-deductibale expense 20
documents)
Deductible expense -
Taxable income 110

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2. Define key terms
Tax return terminology
Taxable income Income subject to tax based on tax return
Current tax return liability resulting from the current period

Taxes payable
taxable income
Income tax Actual cash flows for income taxes, including

paid payments/refunds for other years
Tax loss carried

Taxable loss used to reduce future taxable income
forward
Net amount of an asset or liability used for tax reporting

Tax base
purposes
Pretax income Income before income tax expense
Expense recognized in the income statement that include

Income tax
taxes payables and changes in deferred tax assets and
expense
liabilities
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2. Define key terms
Financial reporting terminology
BS amounts that result from an excess of income tax

Deferred tax
expense over taxes payable that are expected to result in
liabilities
future cash outflows
BS amounts that result from an excess of taxes payable

Deferred tax
over income tax expense that are expected to be recovered
assets
from future operation
Valuation Reduction of deferred tax assets based on the likelihood

allowance the asset will not be realized
Carrying value Net balance sheet value of asset or liability
Permanent Difference between taxable income and pretax income that

difference will not reverse in future
Difference between the tax base and the carrying value of

Temporary
an asset of liability that will result in either taxable
difference
amounts or deductible amounts in the future
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3. How income tax expense works
Accounting profit
Difference between accounting

Other taxable income profit and taxable income
Non-taxable items
Temporary Permanent
difference difference
(refer to LOS 23b) (refer to LOS 23b)
Non-deductible expense
Deductible expense Deferred tax Deferred tax

asset liability
Change in Deferred tax asset/lia

Taxable income
(between accounting periods)
× Tax rate
Deferred tax Tax

Tax payable
expense expense
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[LOS 23.b] Identify and contrast temporary versus permanent
differences in pre-tax accounting income and taxable income
Identify and contrast temporary differences and

1. permanent differences
Difference between accounting

profit and taxable income
Temporary Permanent
different different
Temporary difference* Permanent difference
A temporary difference refers to a A permanent difference is a

difference between taxable difference between taxable
income and accounting profit, income and accounting profit
that is expected to reverse in the that will not reverse in the future.
future.
(*) Refer to LOS.23d to understand what is tax base.

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Identify and contrast temporary differences and permanent
1. differences
Example: Temporary difference

The company purchases a machine for $100 and it estimates the useful life of the machine
is five years. However, under the tax scheme for that machine, the tax authority only
accepts the useful life of four years. In this case, the temporary difference is incurred.
Depreciation Impact on pre-tax income

($) ($)
Year 1 (20)  20
Year 2 (20)  20
Accounting
Year 3 (20)  20  100
perspective
Year 4 (20)  20
Year 5 (20)  20
Year 1 (25)  2,500

Year 2 (25)  2,500
Tax perspective Year 3 (25)  2,500  100
Year 4 (25)  2,500
Year 5 0 0
For each year from year 1 to year 4, depreciation charge for tax purpose is higher than
accounting treatment. However, the total impacts on the pre-tax income is the same
between two perspective, on the other hand, that is expected to reverse in the future.
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Identify and contrast temporary differences and permanent
1. differences
Example: Permanent difference

The company purchases a machine for $10,000 and it estimates the useful life of the
machine is five years. However, under the tax scheme for that machine, the tax authority
only accepts for the cost of machine is capped at $6,000. In this case, the permanent
difference is incurred.
Depreciation Impact on pre-tax income
($) ($)
Year 1 (2,000)  2,000

Year 2 (2,000)  2,000
Accounting
Year 3 (2,000)  2,000  10,000
perspective
Year 4 (2,000)  2,000
Year 5 (2,000)  2,000
Year 1 (1,200)  1,200

Year 2 (1,200)  1,200
Tax perspective Year 3 (1,200)  1,200  6,000
Year 4 (1,200)  1,200
Year 5 (1,200)  1,200
For each year from year 1 to year 4, depreciation charge for tax purposes is higher than
accounting treatment. However, the total impacts on the pre-tax income under
accounting perspective is always higher than tax perspective, that leads to creating a
permanent difference for depreciation charge.
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2. Determine the temporary difference
Accounting Deductible
P&L approach
expenses expenses
Temporary
Accounting profit difference in Taxable income
pre-tax income
Recorded in Deferred tax Tax

Tax payable
P&L expense expense
Balance sheet ( B/S) approach
This approach
Change in Deferred tax asset, Deferred
is popularly
tax asset/liability is charged to P&L
used to
statement (∆DTA or ∆DTL)
calculate
Recorded
Deferred tax asset/liability
in BS
Temporary
Carrying amount
difference in Tax base
of asset/liability account balance
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Back to the example for temporary difference above:

• Accounting perspective
Year 1 2 3 4 5
CA opening 100 80 60 40 20
Depreciation 20 20 20 20 20
CA ending 80 60 40 20 0
Effects on accounting profit ↓ 20 ↓ 20 ↓ 20 ↓ 20 ↓ 20
• Tax perspective
Year 1 2 3 4 5
CA opening 100 75 50 25 0
Depreciation 25 25 25 25 0
CA ending (tax base) 75 50 25 0 0
Effects on Taxable income ↓ 25 ↓ 25 ↓ 25 ↓ 25 0

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• P&L approach
Year 1 2 3 4 5
Accounting profit ↓ 20 ↓ 20 ↓ 20 ↓ 20 ↓ 20
Taxable income ↓ 25 ↓ 25 ↓ 25 ↓ 25 ↓0
Temporary difference in 5 5 5 5 -20

pre-tax income
Deferred tax expense 1 1 1 1 -4
• In the first 4 years, the depreciation expense under tax is greater than
depreciation expense under accounting, the taxable income is then lower than
the accounting profit.
→ The company receives tax relief, which means that its tax payment is deferred
till the next years.
→ To be specific, the amount of tax that is deferred each year in the first 4 years
is: (Accounting profit – taxable income) x tax rate.
• However, in year 5, when the depreciation expense under accounting is greater
than depreciation expense under tax law, the taxable income is then higher
→ the company is charged additional tax, so the difference is only temporary.
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• Balance sheet approach
Year 0 1 2 3 4 5
CA ending 100 80 60 40 20 0
CA ending (tax base) 100 75 50 25 0 0
Temporary difference 0 5 10 15 20 0
in account balance (1)
DTL (2) 0 1 2 3 4 0
Change in DTL (∆DTL ) - 1 1 1 1 -4
Deferred tax expense - 1 1 1 1 -4
(1) The change in temporary difference in account balance is equal to temporary

difference in pre-tax income.
(2) By the end of year 1, temporary difference shows that:
• Under accounting, an amount of $80 expense will be allocated in the future
• Under tax law, an amount of $75 expense will be allocated in the future, lower
expense means higher profit and more tax payable.
 The temporary difference results in tax being payable in the future, a liability is
recorded = (carrying amount – tax base) x tax rate = $5 x 20% = $1.
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• Balance sheet approach

Year 0 1 2 3 4 5
CA ending 100 80 60 40 20 0
CA ending (tax base) 100 75 50 25 0 0
Temporary difference 0 5 10 15 20 0
in account balance
(1)
DTL (2) 0 1 2 3 4 0
Change in DTL (∆DTL ) - 1 1 1 1 -4
Deferred tax expense - 1 1 1 1 -4
(1) The change in temporary difference in account balance is equal to temporary

difference in pre-tax income.
(2) By the end of year 2, the company has a temporary difference of $10, which
includes the $5 brought forward from year 1, plus the additional difference of $5
arising in year 2.
• A liability is therefore recorded equal to (Carrying amount – tax base) x tax
rate = $10 x 20% = $2.
• Since there was a liability of $1 recorded at the end of year 1, $1 arising in DTL
(the change in DTL in comparison with year 1) that is recorded as an deferred
tax expense: ↑ deferred tax expense $1, and ↑ DTL $1
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• Relationship between PnL approach and B/S approach
Year 0 1 2 3 4 5
B/S approach DTL recognized (balance) 0 1 2 3 4 0
DTL ending - DTL opening = ∆DTL 2 - 1 = 1

∆DTL - 1 1 1 1 -4
P&L approach Expense recognized - 1 1 1 1 -4
• Under balance sheet approach, the difference is shown as a liability

account whose balance is accumulated as we recognize expense each year
(+/- ∆DTL).
• Under P&L approach, the difference in depreciation expense hit the taxable
income directly, so each year we recognize an expense.
 In short, under the P&L approach, the difference is represented as expenses
(∆DTL), and these expenses are accumulated over the years under a liability
account – known as DTL (deferred tax liability) – represented under the balance
sheet approach.
Note: The treatment for deferred tax asset (DTA) is the same as the
treatments for DTL mentioned above.
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Taxable temporary differences and Deductible temporary
3.
differences
Temporary differences can be divided into two categories:
Temporary differences
Taxable temporary differences Deductible temporary differences
Assets: Carrying amount > Tax base Assets: Carrying amount < Tax base
Liabilities: Carrying amount < Tax base Liabilities: Carrying amount > Tax base
Expected to result in future taxable Expected to provide tax deductions

income in the future
Deferred tax liability (DTL) Deferred tax asset (DTA)

Tax to pay in the future Tax saving in the future
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[LOS 23.c] Explain how deferred tax liabilities and assets are
created and how a company’s deferred tax liabilities and
assets should be treated for the purposes of financial analysis
Temporary differences
Deferred tax liability Deferred tax asset
The amounts of income taxes The amounts of income taxes

payable in future periods recoverable in future periods
• Revenue (or gains) are recognized • Revenue (or gains) are taxable
in the income statement before before they are recognized in the
they are included on the tax income statement
return due to temporary • Expenses (or losses) are
Occur if
difference recognized in the income

• Expense (or loss) are tax statement before they are tax-
deductible before they are deductible
recognized in the income • Tax loss carried forward are
statement available
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[LOS 23.d] Calculate the tax base of a company’s assets and
liabilities
1. Calculate the tax base of company’s assets
Tax base of assets

Tax base of assets is the amount that will be deducted (expensed) on the
tax return in the future as the economic benefits of the assets are
realized.
Example: Depreciable equipment

Equipment with historical cost of $100,000, useful life of 10 years. However,
under the tax authorities scheme, the useful life is only 5 years.
Accounting Tax perspective

perspective
Original cost $100,000 $100,000

Depreciation ($10,000) ($20,000)
Carrying amount/Tax base $90,000 $80,000
 Temporary difference = $90,000 - $80,000 = $10,000

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liabilities
Example: Determining the Tax Base of an asset
The following information pertains to Entiguan Sports, a hypothetical developer of
products used to treat sports-related injuries. (The treatment of items for
accounting and tax purposes is based on hypothetical accounting and tax standards
and is not specific to a particular jurisdiction.)
1. Dividends receivable: On its balance sheet, Entiguan Sports reports dividends of
€1 million receivable from a subsidiary. Dividends are not taxable.
2. Development costs: Entiguan Sports capitalized development costs of €3 million
during the year. Entiguan amortized €500,000 of this amount during the year. For
tax purposes amortization of 25 percent per year is allowed.
3. Research costs: Entiguan incurred €500,000 in research costs, which were all
expensed in the current fiscal year for financial reporting purposes. Assume that
applicable tax legislation requires research costs to be expensed over a four-year
period rather than all in one year.
4. Accounts receivable: Included on the income statement of Entiguan Sports is a
provision for doubtful debt of €125,000. The accounts receivable amount reflected
on the balance sheet, after taking the provision into account, amounts to
€1,500,000. The tax authorities allow a deduction of 25 percent of the gross
amount for doubtful debt.
Required: Calculate the tax base and carrying amount for each item.
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liabilities
Solution:
Carrying amount Temporary

Tax base (€)
(€) difference (€)
1. Dividends receivable 1,000,000 1,000,000 0
2. Development costs 2,500,000 2,250,000 250,000
3. Research costs 0 375,000 (375,000)
4. Accounts receivable 1,500,000 1,218,750 281,250
1. Dividends receivable: Although the dividends received are economic benefits from the
subsidiary, we are assuming that dividends are not taxable. Therefore, the carrying
amount equals the tax base for dividends receivable.
2. Development costs: We assume that development costs will generate economic
benefits for Entiguan Sports  it may be included as an asset on the balance sheet for the
purposes of this example. The amortization allowed by the tax authorities exceeds the
amortization accounted for based on accounting rules.
Accounting perspective Tax perspective
Original cost €3,000,000 €3,000,000

Depreciation (€500,000) (€750,000)
Carrying amount/Tax base €2,500,000 €2,250,000
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liabilities
3. Research costs:
Carrying amount/Tax base €0 €375,000

(€500,000 -€500,000/4)
The carrying amount is €0 because the full amount has been expensed for financial
reporting purposes in the year in which it was incurred. Therefore, there would not have
been a balance sheet item “Research costs” for tax purposes, and only a proportion may
be deducted in the current fiscal year. The tax base of the asset is (€500,000 - €500,000/4)
= €375,000.
4. Accounts receivable: The economic benefits that should have been received from
accounts receivable have already been included in revenues included in the calculation of
the taxable income when the sales occurred. Because the receipt of a portion of the
accounts receivable is doubtful, the provision is allowed. The provision, based on tax
legislation, results in a greater amount allowed in the current fiscal year than would be
the case under accounting principles.
Carrying amount/Tax base €1,500,000 €1,218,750
(€1,500,000 + €125,000) - [25% × (€1,500,000 + €125,000)]

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liabilities
2. Calculate the tax base of company’s liabilities
Tax base of liabilities

• Tax base of liabilities = the carrying value of the liabilities – amounts
that will be deductible on the tax return in the future.
• Tax base of revenue received in advance = the carrying value – amount
of revenue that will not be taxed in the future
Example: Warranty liability

Estimation of warranty expenses of $5,000 for goods sold.
Accounting Tax perspective
perspective
Carrying amount/Tax base $5,000 $0

On Tax point of view: Warranty is not deductible until warranty work is
performed, so Tax base = $0
 Temporary difference = $5,000
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liabilities
Example: Determining the Tax Base of a Liability
The following information pertains to the hypothetical company Entiguan
Sports for the fiscal year -end. The treatment of items for accounting and tax
purposes is based on fictitious accounting and tax standards and is not specific
to a particular jurisdiction.
1. Donations: Entiguan Sports made donations of €100,000 in the current fiscal
year. The donations were expensed for financial reporting purposes, but are
not tax deductible based on applicable tax legislation.
2. Interest received in advance: Entiguan Sports received in advance interest
of €300,000. The interest is taxed because tax authorities recognize the
interest to accrue to the company (part of taxable income) on the date of
receipt.
3. Rent received in advance: Entiguan recognized €10 million for rent received
in advance from a lessee for an unused warehouse building. Rent received in
advance is deferred for accounting purposes but taxed on a cash basis.
4. Loan: Entiguan Sports secured a long-term loan for €550,000 in the current
fiscal year. Interest is charged at 13.5 percent per annum and is payable at the
end of each fiscal year.
Required: Calculate the tax base and carrying amount for each item.
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liabilities
Solution:
Carrying amount Temporary

Tax base (€)
(€) difference (€)
1. Donations 0 0 0
2. Interest received in 300,000 0 300,000

advance
3. Rent received in advance 10,000,000 0 (10,000,000)
4. Loan 0 0 0
Interest paid 0 0 0
1. Donations: The amount of €100,000 was immediately expensed on Entiguan’s income

statement; therefore, the carrying amount is €0. Tax legislation does not allow donations
to be deducted for tax purposes,
 The tax base of the donations equals the carrying amount.
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liabilities
2. Interest received in advance:
Carrying amount/Tax base €300,000 €0

For accounting purposes, Interest received in advance is included in the financial period in
which it is deemed to have been earned. For this reason, the interest income received in
advance is a balance sheet liability. It was not included on the income statement because
the income relates to a future financial year.
For tax purposes, interest is deemed to accrue to the company on the date of receipt. For
tax purposes, it is thus irrelevant whether it is for the current or a future accounting
period; it must be included in taxable income in the financial year received. Because the
full €300,000 is included in taxable income in the current fiscal year, the tax base is
€300,000 - 300,000 = €0.
3. Rent received in advance: The result is similar to interest received in advance. The
carrying amount of rent received in advance would be €10,000,000 while the tax base is
€0.
4. Loan: Repayment of the loan has no tax implications. The repayment of the capital
amount does not constitute an income or expense. The interest paid is included as an
expense in the calculation of taxable income as well as accounting income. Therefore, the
tax base and carrying amount is €0.
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[LOS 23.e] Calculate income tax expense, income taxes
payable, deferred tax assets and deferred tax liabilities and
Calculate and interpret the adjustment to the financial
statements related to a change in the income tax rate
Calculate income tax expense, income taxes payable,
1.
deferred tax assets and deferred tax liability
Items Calculation
Income tax payable Taxable income x Tax rate
Income tax expense Taxes payable + ΔDTL − ΔDTA
Deferred tax liability/asset Temporary difference x Tax rate
Example: Deferred tax assets

Consider warranty guarantees and associated expenses. Pretax income (financial
reporting) includes an accrual for warranty expense, but warranty cost is not deductible
for taxable income until the firm has made actual expenditures to meet warranty claims.
Suppose:
• A firm has sales of $5,000 for each of two years.
• Warranty expense will be 2% of annual sales ($100).
• The actual expenditure of $200 to meet all warranty claims was not made until the
second year.
• Assume a tax rate of 40%.
Required: Calculate the firm’s income tax expense, taxes payable, and deferred tax assets
for year 1 and year 2
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Solution:
For tax reporting and financial reporting, taxable income and taxes payable for two years
are:
Financial Reporting-Warranty Tax Reporting- Warranty

Expense Expense
Year 1 Year2 Year 1 Year 2
Revenue $5,000 $5,000 $5,000 $5,000
Warranty expense $100 $100 0 $200
Taxable income $4,900 $4,900 $5,000 $4,800
Taxes payable $1,960 $1,960 $2,000 $1,920
Net income $2,940 $2,940 $3,000 $2,880

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In year 1,
• The firm reports $1,960 of tax expense in the income statement, but $2,000 of taxes
payable are reported on the tax return  taxes payable are initially higher than tax
expense and the $40 difference is reported on the balance sheet by creating a DTA.
• The carrying value of the warranty liability is $100 (the warranty expense has been
recognized in the income statement but it has not been paid), and the tax base of the
liability is 0 (the warranty expense has not been recognized on the tax return)  we
get the balance of the DTA of $40 [($100 carrying value - zero tax base) × 40%].
We can reconcile income tax expense and taxes payable with the change in the DTA. In
this example, the DTA increased $40 (from zero to $40) during year 1. Thus, income tax
expense in year 1 is $1,960 ($2,000 taxes payable – $40 increase in the DTA).
In year 2,
The firm recognizes $1,960 of tax expense in the income statement but only $1,920 is
reported on the tax return (taxes payable). The $40 deferred tax asset recognized at the
end of year 1 has reversed as a result of the warranty expense recognition on the tax
return. So, in year 2, income tax expense is $1,960 ($1,920 taxes payable + $40 decrease
in DTA).
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2.
statements related to change in the income tax rate
Back to some formula about deferred asset and deferred tax liability
Deferred tax asset/liability = Temporary difference x Tax rate
From above formulas we know that when tax rate change, deferred tax
asset/liability will be adjusted. If tax rates decrease:
• Deferred tax asset will decrease  Decrease in value toward the offset
of future tax payments to the tax authorities.
• Deferred tax liability will decrease  Decrease in value off future tax
payments to the tax authorities.
Income tax expense = Taxes payable + ΔDTL − ΔDTA
Due to the relationship between income tax expense and deferred tax
asset/ liability (above formula), the decrease in the DTL would result in
lower income tax expense and the decrease in the DTA would result in
higher income tax expense
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[LOS 23.f] Evaluate the effect of tax rate changes on a
company’s financial statements and ratios
Evaluate the effect of tax rate change on a company’s financial
1.
statements
When tax rate decrease, the following items will be effected. We use the same
logic for the case in which tax rate increases.
Tax rate decrease
Change in deferred tax Change in deferred tax

assets decrease Or liabilities decrease
Change in deferred tax Change in deferred tax

assets decrease liabilities decrease
Income tax expense = Tax payable + Income tax expense

increase ΔDTL − ΔDTA decrease
Net income decrease Net income increase
Retained earnings
Retained earnings increase
decrease
Shareholder’s equity Shareholder’s equity

decrease increase
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Evaluate the effect of tax rate change on a company’s
1.
financial statements
Example:
A firm owns equipment and bad debt that will be shown below. (The tax
rate is 40%)
Items Carrying Tax base Deferred tax asset/

value (‘000) liability (‘000)
(‘000)
Equipment $200 $160 DTL = $16 [=($200 - $160) ×

40%]
Bad debt 0 $10 DTA = $4 [(=$10 – 0) x 40%]

expense
Calculate the effect on the firm’s income tax expense if the tax rate
decreases to 30%.
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1.
financial statements
Solution:
Items Carrying Tax Deferred tax Deferred tax

value base asset/ liability asset/ liability
(‘000) (‘000) (tax rate = 40%) (tax rate = 30%)
(‘000) (‘000)
Equipment $200 $160 DTL = $16 DTL = $12

[=($200 - $160) × [=($200 - $160) ×
40%] 30%]
Bad debt 0 $10 DTA = $4 DTA = $3

expense [($10 – 0) x 40%] [($10 – 0) x 30%]
• Deferred tax liability decreases by $4,000 ($16,000 reported DTL - $12,000

adjusted DTL).
• Deferred tax asset decreases by $1,000 ($4,000 reported DTA - $3,000 adjusted
DTA).
Using the income tax equation, we can see that income tax expense decreases by
$3,000 (income tax expense = taxes payable + ∆DTL - ∆DTA).
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2.
ratios
Again we assume that the tax rate is decrease, the following ratios will be effected
Ratios Effect
Long term Debt to • Decrease in deferred tax asset  Decrease in equity

Equity ratio  Increase in long term debt to equity
Long−term debt • Decrease in deferred tax liability  Increase in equity
( Total equity )
 Decrease in long term debt to equity
• Decrease in equity  Increase in long term debt to

Debt to equity ratio equity
Total debt
(Total equity) • Increase in equity and decrease in deferred tax
liability  Decrease in long term debt to equity
Total debt ratio • Decrease in total assets (deferred tax asset) 

Total debt Increase in total debt
( )
Total asset • Decrease in total liabilities (deferred tax liability) 
Decrease in total debt
Financial leverage • Decrease in equity and decrease in deferred tax asset

Average total asset
(Average total equity  Increase in financial leverage
• Increase in equity  Decrease in financial leverage
)
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[LOS 23.g] Describe the valuation allowance for deferred tax
assets when it is required and what effect it has on financial
statements
1. Describe the valuation allowance for deferred tax assets
• Deferred tax assets are assessed at each balance sheet date to determine the
likelihood of sufficient future taxable income to recover the tax assets. (Without
future taxable income, a Deferred tax assets is worthless)
• Under U.S. GAAP, DTA are reduced by creating a contra-asset account known as the
valuation allowance.
More likely to recover Not require valuation allowance

Sufficient future taxable income is more
likely to recover the tax assets or not ?
(>50%) account
Example: If a company has order backlogs or existing contracts which are

expected to generate future taxable income, a valuation allowance might not
be necessary.
More likely to not recover Require Valuation allowance

account
Example: If a company has cumulative losses over the past few years or a
history of inability to use tax loss carry forwards, then the company would
need to use a valuation allowance
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[LOS 23.g] Describe the valuation allowance for deferred tax
assets when it is required and what effect it has on financial
statements
2. Effect of valuation allowance on financial statements
Valuation allowance increases Valuation allowance decrease
Deferred tax asset decreases Deferred tax asset increase
Change in deferred tax asset Change in deferred tax asset

increases decreases
Income tax expense increases Income tax expense decreases
Net income decreases Net income increases
Retained earnings decreases Retained earnings increases
Shareholder’s equity decreases Shareholder’s equity increases

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[LOS 23.h] Explain recognition and measurement of current
and deferred tax items
1. Recognition of unused tax losses and tax credits
Tax losses: A tax loss (tax loss carryforward) is a provision that allows
a taxpayer to move a tax loss to future years to offset a profit.
Tax credit: A tax credit is an amount of money that taxpayers can
subtract directly from taxes owed to their government.
These two reduce the amount of

taxable income in the future
IFRS and US GAAP allow the creation of a deferred tax asset in the
case of tax losses and tax credits. The recognition is specified below:
IFRS US GAAP
IFRS allows the recognition of A deferred tax asset
unused tax losses and tax is recognized in full but is then
credits only to the extent reduced by a valuation
that it is probable that in the allowance if it is more likely
future there will be taxable than not that some or all of the
income against which the deferred tax asset will not be
unused tax losses and credits realized.
can be applied
40

1. Recognition of unused tax losses and tax credits
The existence of tax losses may indicate that the entity cannot reasonably be
expected to generate sufficient future taxable income
→ there are concerns about the uncertainty of future taxable profits
→ in this case, we follow these criteria:
• Taxable temporary differences are available to offset deferred tax
payable
• Assess the probability that the entity will in fact generate future taxable
profits before the unused tax losses and/or credits expire (*)
• Verify that the above is with the same tax authority and based on the
same taxable entity
• Determine whether the past tax losses were a result of specific
circumstances that are unlikely to be repeated
• Discover if tax planning opportunities are available to the entity that will
result in future profits. (**)
(*) Taxable profit → DTA (**)
opportunity
+
Unused tax loss profit
Loss loss loss loss loss

Before adding the effect of unused tax loss, Illustration for tax planning
we assess the probability of taxable profit
to decide whether to recognize a DTA.
41

2. Recognition of deferred tax charged directly to equity
Recognition of deferred tax items
Recognition of deferred tax items in Recognition of deferred tax items in

profit or loss other comprehensive income and
 Deferred Tax effect on equity not effect on net income
through effect on net income (see  Deferred Tax Charged Directly to
more in previous LOS) Equity
The following are example of deferred tax charged directly to equity:

• Revaluation of property, plant, and equipment (revaluations are not permissible
under US GAAP);
• Long- term investments at fair value;
• Changes in accounting policies;
• Errors corrected against the opening balance of retained earnings;
• Initial recognition of an equity component related to complex financial
instruments; and
• Exchange rate differences arising from the currency translation procedures for
foreign operations.
42

[LOS 23.i] Analyze disclosures relating to deferred tax items
and the effective tax rate reconciliation and explain how
information included in these disclosures affects a company’s
financial statements and financial ratios
Analyzing disclosures relating deferred tax items and the
1.
effective tax rate reconciliation
a. Analyzing disclosures relating deferred tax items
Details on the source of the temporary differences that cause the deferred
tax assets and liabilities reported.
Typically, the following deferred tax information is disclosed:
• Deferred tax liabilities, deferred tax assets, any valuation allowance, and
the net change in the valuation allowance over the period.
• Any unrecognized deferred tax liability for undistributed earnings of
subsidiaries and joint ventures.
• Current-year tax effect of each type of temporary difference.
• Components of income tax expense.
• Reconciliation of reported income tax expense and the tax expense
based on the statutory rate.
• Tax loss carry forwards and credits.
43

Analyzing disclosures relating deferred tax items and the
1.
effective tax rate reconciliation
b. The effective tax rate reconciliation
Some firms’ reported income tax expense differs from the amount based
on the statutory income tax rate. Thus, firm need explain the differences
between:
• The statutory rate tax (the tax rate of the jurisdiction where the firm
operates)
Income tax expense
• The effective tax rate (= )
Pretax income
The differences are generally the result of:
• Different tax rates in different tax jurisdictions (countries).
• Permanent tax differences: tax credits, tax-exempt income, nondeductible
expenses, and tax differences between capital gains and operating income.
• Changes in tax rates and legislation.
• Deferred taxes provided on the reinvested earnings of foreign and unconsolidated
domestic affiliates.
• Tax holidays in some countries (watch for special conditions such as termination
dates for the holiday or a requirement to pay the accumulated taxes at some point
in the future)
44

Explain how information included in these disclosures
2.
affects a company’s FS and financial ratios
Example: Analyzing deferred tax item disclosures

Use the table below to explain why income tax expense has exceeded taxes payable over
the last three years. Also explain the effect of the change in the valuation allowance on
WCCO’s earnings for 20X5
20X5 ($) 20X4 ($) 20X3 ($)
Employee benefits 278 310 290
Internal tax loss carry forwards 101 93 115
Valuation allowance (24) (57) (64)
Deferred tax asset 355 346 341
Property, plant and equipment 452 361 320
Unrealized gain on available for sale securities 67 44 23
Deferred tax liability 519 405 343
Deferred income taxes 164 59 2

45

Example: Analyzing deferred tax item disclosures

Solution:
Explain why income tax expense has exceeded taxes payable over the last three years
• The company’s deferred tax asset balance = international tax loss carry forwards +
employee benefits (most likely pension and other post-retirement benefits) – valuation
allowance.
• The company’s deferred tax liability balance = property, plant, and equipment (most
likely from using accelerated depreciation methods for tax purposes and straight-line
on the financial statements) + unrealized gains on securities classified as available-for-
sale (because the unrealized gain is not taxable until realized).
• Income tax expense = taxes payable + deferred income tax expense
= taxes payable + ∆deferred tax liabilities – ∆deferred tax assets
Because deferred tax liabilities have been growing faster than deferred tax assets,
deferred income tax expense has been positive, resulting in income tax expense being
higher than taxes payable.
Explain the effect of the change in the valuation allowance on WCCO’s earnings for 20X5
• Management decreased the valuation allowance by $33 million in 20X5  a reduction
in deferred income tax expense and an increase in reported earnings for 20X5
46

Example: Analyzing the tax rate reconciliation

Analyze the trend in effective tax rates over the three years shown in NDC Co by using
following information:
20X3 20X4 20X5
Statutory U.S. federal income tax rate 35% 35% 35%
State income taxes, net of related federal 2.1% 2.2% 2.3%

income tax benefit
Benefits and taxes related to foreign (6.5%) (6.3%) (2.7%)

operations
Tax rate changes 0% 0% (2%)
Property, plant and equipment 0% (3%) 0%
Special items (1.6%) 8.7% 2.5%
Other, net 0.8% 0.7% (1.4%)
Effective income tax rates 29.8% 37.3% 33.7%

47

Example: Analyzing the tax rate reconciliation (cont)

Solution:
• The effective tax rate is upward trending over the 3-year period.
Contributing to the upward trend is
o An increase in the state income tax rate and
o A decrease in benefits related to taxes on foreign income.
• In 20X4, taxes created by special items are increased significant and partially
offset the decrease in taxes created by sale of PPE.
• In 20X3 and 20X5, the special items and the other items also offset each
other. The fact that the special items and other items are so volatile over the
3-year period suggests that it will be difficult for an analyst to forecast the
effective tax rate for NDC for the foreseeable future without additional
information. This volatility also reduces comparability with other firms.
48

[LOS 23.j] Identify the key provisions of and differences
between income tax accounting under IFRS and US. GAAP
Accounting for income taxes under U.S. GAAP and IFRS is similar in most respects.
However, there are some differences. The following table is a summary of a few of the
more important differences.
IFRS GAAP
Revaluation of fixed Deferred taxes are recognized No applicable, no

assets and in equity revaluation allowed
intangible asset
Undistributed profit Deferred taxes are recognized • No deferred taxes for

from an investment unless the parent is able to foreign subsidiary that
in a subsidiary control the distribution of meet the indefinite
profit and it is probable the reversal criterion
temporary difference will • No deferred taxes for
reverse in the future domestic subsidiary if the
amounts are tax free
Undistributed profit Deferred taxes are recognized No deferred taxes for joint
from an investment unless the parent is able to venture that meet the
in a joint venture control the distribution of indefinite reversal criterion
profit and it is probable the
temporary difference will
reverse in the future
49

[LOS 23.j] Identify the key provisions of and differences
between income tax accounting under IFRS and US. GAAP
IFRS GAAP
Undistributed profit Deferred taxes are recognized Deferred taxes are

from an investment unless the investor is able to recognized from
in an associate firm control the sharing of profit temporary differences
and it is probable the
temporary difference will not
reverse in the future
Deferred tax asset Recognized in full and then Recognized if probable

recognition reduced if “more likely than that sufficient taxable
not” that some or all of the tax profit will be available to
asset will not be realized recover the tax asset
Tax rate used to Enacted tax rate only Enacted or substantively

measure deferred enacted tax rate
taxes
50

Practice questions
Learning outcome statements Exercises
23.a. Describe the differences between accounting profit and N/A

taxable income and define key terms
23.b. Explain how deferred tax liabilities and assets are created Question 1, 2
and the factors that determine how a company’s deferred tax
liabilities and assets should be treated for the purposes of
financial analysis
23.c. Calculate the tax base of a company’s assets and liabilities Question 3
23.d. Calculate income tax expense, income taxes payable, Question 4, 5

deferred tax assets and deferred tax liabilities and Calculate and
interpret the adjustment to the financial statements related to a
change in the income tax rate
23.e. Evaluate the effect of tax rate changes on a company’s N/A

financial statements and ratios
23.f. Identify and contrast temporary versus permanent N/A

51

Practice questions
23.g. Describe the valuation allowance for deferred tax assets Question 6
when it is required and what effect it has on financial statements
23.h. Explain recognition and measurement of current and N/A

deferred tax items
23.i. Analyze disclosures relating to deferred tax items and the N/A
effective tax rate reconciliation and explain how information
included in these disclosures affects a company’s financial
statements and financial ratios
23.j. Identify the key provisions of and differences between N/A

income tax accounting under IFRS and US. GAAP
52

Practice questions
1 Using the straight-line method of depreciation for reporting purposes

and accelerated depreciation for tax purposes would most likely result
in a:
A valuation allowance.
B deferred tax asset.
C temporary difference.
2 Income tax expense reported on a company’s income statement equals

taxes payable, plus the net increase in:
A deferred tax assets and deferred tax liabilities.
B deferred tax assets, less the net increase in deferred tax liabilities.
C deferred tax liabilities, less the net increase in deferred tax assets
3 The author of a new textbook received a $100,000 advance from the

publisher this year. $40,000 of income taxes were paid on the advance
when received. The textbook will not be finished until next year.
Determine the tax basis of the advance at the end of this year.
A $0.
B $40,000.
C $100,000
53

Practice questions
4 A firm acquires an asset for $120,000 with a 4-year useful life and no
salvage value. The asset will generate $50,000 of cash flow for all four
years. The tax rate is 40% each year
The firm will depreciate the asset over three years on a straight-line
(SL) basis for tax purposes and over four years on a SL basis for financial
reporting purposes. Taxable income in year 1 is:
A $6,000.
B $10,000.
C $20,000
5 A firm acquires an asset for $120,000 with a 4-year useful life and no
salvage value. The asset will generate $50,000 of cash flow for all four
years. The tax rate is 40% each year
The firm will depreciate the asset over three years on a straight-line
(SL) basis for tax purposes and over four years on a SL basis for
financial reporting purposes. Pretax income in year 4 is:
A $4,000.
B $6,000.
C $8,000
54

Practice questions
6 A company has following information:

Year ended 30 June Year 1 Year 2 Year 3
Expected federal income ($112,000) $768,000 $685,000

tax expense
Expenses not deductible $357,000 $32,000 $51,000

for income tax purposes
State income taxes, net $132,000 $22,000 $100,000

of federal benefit
Change in valuation ($150,000) ($766,000) ($754,000)

allowance for deferred
tax assets
Income tax expense $227,000 $56,000 $82,000
Over the three years presented, changes in the valuation allowance

for deferred tax assets were most likely indicative of:
A decreased prospect for future profitability.
B increased prospects for future profitability.
C assets being carried at a higher value than their tax base
55

Practice answers
1. C is correct. Because the differences between tax and financial accounting

will correct over time, the resulting deferred tax liability, for which the
expense was charged to the income statement but the tax authority has
not yet been paid, will be a temporary difference. A valuation allowance
would only arise if there was doubt over the company’s ability to earn
sufficient income in the future to require paying the tax.
2. C is correct. Higher reported tax expense relative to taxes paid will

increase the deferred tax liability, whereas lower reported tax expense
relative to taxes paid increases the deferred tax asset.
3. A For revenue received in advance, the tax base is equal to the carrying
value minus any amounts that will not be taxed in the future. Since the
advance has already been taxed, $100,000 will not be taxed in the future.
Thus, the textbook advance liability has a tax base of $0 ($100,000
carrying value – $100,000 revenue not taxed in the future)
4. B Annual depreciation expense for tax purposes is ($120,000 cost – $0

salvage value) / 3 years = $40,000. Taxable income is $50,000 – $40,000 =
$10,000.
56

Practice answers
5. C Annual depreciation expense for financial purposes is ($120,000 cost –

$0 salvage value) / 4 years = $30,000. Pretax income is $50,000 – $30,000
= $20,000
6. B is correct. Over the three-year period, changes in the valuation

allowance reduced cumulative income taxes by $1,670,000 (= 766,000 +
754,000 + 150,000). The reductions to the valuation allowance were a
result of the company being “more likely than not” to earn sufficient
taxable income to offset the deferred tax assets.
57
READING 24: NON-CURRENT

(LONG-TERM) LIABILITIES
58
READING 24: NON-CURRENT (LONG-TERM)

LIABILITIES
Learning outcomes
Bonds
19.a. Determine the initial recognition and initial measurement

of bonds
19.b. Determine the subsequent recognition of bonds using the

effective interest method and calculate interest expense,
amortization of bond discounts/premiums, and interest
payments
19.c. Explain the derecognition of debt
19.d. Describe the role of debt covenants in protecting creditors
19.e. Describe the financial statement presentation of and

disclosures relating to debt
59

LIABILITIES
Learning outcomes
Leases
19.f. Explain motivations for leasing assets instead of purchasing

them
19.g. Explain the financial reporting of leases from a lessee’s

perspective
19.h. Explain the financial reporting of leases from a lessor’s

perspective
Pensions and evaluating solvency
19.i. Compare the presentation and disclosure of defined

contribution and defined benefit pension plans
19.j. Calculate and interpret leverage and coverage ratios

60

LIABILITIES
LOS 24.a: Determine the initial recognition and initial
measurement of bonds
1. Bond Terminology
A bond is a contractual promise between a borrower (the bond issuer)

and a lender (the bondholder) that obligates the bond issuer to make
payments to the bondholder over the term of the bond.
Two types of payments are involved:
• Periodic interest payments
• Repayment of principle at maturity
Face or Par The amount of principal that will be paid to the bondholder at
value maturity and is used to calculate the coupon payments.
Coupon The interest rate stated in the bond that is used to calculate
rate the coupon payments and is typically fixed for the term of
bonds.
Coupon The periodic interest payments to the bondholders and are

payments calculated by multiplying the face value by the coupon rate
61

LIABILITIES
1. Bond Terminology
Effective • The market rate of interest that is used to value the bond
rate of and depends on the bond’s risks as well as the structure of
interest interest rates and the timing of the bond’s cash flows.
• The market rate will likely change over the bond’s life,
which changes the bond’s market value as well.
The • Known as the book value or the carrying value of the bond,
balance equals to the present value (PV) of its remaining cash flows
sheet (coupon payments and par value), discounted at the market
liability rate of interest at issuance.
• At maturity, the liability will equal the face value of the
bond.
Interest Reported in the income statement and is calculated by

expense multiplying the book value of the bond liability at the
beginning of the period by the market rate of interest of the
bond at issuance.
62

LIABILITIES
1. Bond Terminology
At the date of issuance, the market rate can be the same as or

different than the coupon rate:
Market rate > Market rate = Market rate <

coupon rate coupon rate coupon rate
the bond is a the bond is a par the bond is a

discount bond bond (priced at face premium bond
(priced below par). value) (priced above par).
63

LIABILITIES
1. Bond Terminology
Example 1: Discount, Premium and Par bond

On December 31, 20X2, a company issued a 3-year, 10% annual coupon
bond with a face value of $100, assuming the bond was issued at a market
rate of interest (r) of:
a. 9%.
b. 10%
c. 11%
Answer:
Coupon payment each period = 10% × $100 = $10
Issuance date 31 Dec 20X3 31 Dec 20X4 31 Dec 20X5
a. PV = $102.531 $10 $10 $10 + $100 = $110

b. PV = $100
c. PV = $97.556
(Continue in the next slide)
64

LIABILITIES
1. Bond Terminology
Example 1: Discount, Premium and Par bond
Answer:
a. The market rate of 9% < the coupon rate of 10% → the bond is issued at
premium.
The bond proceeds = the book value at issuance = $102.531 > Par
(N = 3, PMT = 10, FV = 100, I/Y = 9, CPT → PV = - 102.531)
b. The market rate of 10% = the coupon rate of 10% → the bond is issued
at Par.
The bond proceeds = the book value at issuance = Par = $100
c. The market rate of 11% > the coupon rate of 10% the bond is issued at
discount.
The bond proceeds = the book value at issuance = $97.556 < Par
(N = 3, PMT = 10, FV = 100, I/Y = 11, CPT → PV = - 97.556)
65

LIABILITIES
2. Initial recognition of bond issued
(Continue with example 1)
Par bond Premium bond Discount bond
Assets and Liabilities increase by the bond proceeds

Balance
sheet Bond proceeds Bond proceeds Bond proceeds
= $100 = $102.531 = $97.556
Income
No effect
statement
The issued proceeds are reported as a cash inflow

Cash flow from financing (CFF)
statement
CFF = +$100 CFF = +$102.531 CFF = +$97.556
66

LIABILITIES
LOS 24.b: Determine the subsequent measurement of bonds
using the effective interest method: calculate interest
expense, amortization of bond discounts/premiums, and
interest payments
1. Effective interest method
Premium bond
PV ($102.531) – Total premium amortization in 3 years (2.531) = Par ($100)
Market rate < coupon rate → interest expense < the coupon payment
→ premium amortization each year = coupon payment – interest expense
Discount bond
PV ($97.556) + Total discount amortization in 3 years (2.444) = Par ($100)
Market rate > coupon rate → interest expense > the coupon payment
→ discount amortization each year = interest expense – coupon payment
67

LIABILITIES
interest payments
Zero-coupon bond
• Zero-coupon bonds, known as pure-discount bonds have no

periodic coupon payments.
• The effects of zero-coupon bonds on the financial statements
are the same as any discount bonds but with larger impact due
to larger discount.
68

LIABILITIES
interest payments
Example 2: Effective interest method

Consider discount and premium bonds in the Example 1
Answer:
(continue in the next slide)

69

LIABILITIES
interest payments
Premium bond ( r = 9%) Discount bond (r = 11%)
Bond Liability 20X3 20X4 20X5 20X3 20X4 20X5
Beginning
$102.531 $101.759 $100.917 $97.556 $98.287 $99.099
book value (1)
Interest
expense (2) = $9.228 $9.158 $9.083 $10.731 $10.812 $10.901
(1) × r decreases over time increases over time
Coupon
payments (3) $10 $10 $10 $10 $10 $10
= $10
Ending book
value
$101.759 $100.917 $100 $98.287 $99.099 $100
= (1) – (3) +
(2) decreases over time increases over time
70

LIABILITIES
interest payments
2. Periodic recognition of bond issued
Balance The book value of The premium is The discount is

sheet bond liability will not amortized → the book amortized → the
change over the term value of bond liability book value of bond
of the bond decreases until it liability increases
reaches the Par until it reaches the
Par
Income Interest expense = market rate at issuance × the book value of bond
statement liability at beginning of each period
• Interest expense = • Interest expense < • Interest expense >

coupon payment coupon payment coupon payment
• Interest expense is • Interest expense • Interest expense
constant decreases over time increases over time
Cash flow The coupon payments are reported as cash outflow from operating
statement (CFO) under U.S.GAAP and cash outflow from operating (CFO) or
financing (CFF) under IFRS
71

LIABILITIES
interest payments
3. Maturity recognition of bond issued
Balance sheet Remove the bond issued
Income statement –
Cash flow Principle repayment (face value) of the bond is

statement reported as a cash outflow from financing (CFF)
72

LIABILITIES
interest payments
4. Issuance cost
Issuance cost involves legal and accounting fees, printing costs,

sales commissions, and other fees incurred when bond is issued.
U.S. GAAP IFRS
• Issuance costs are expensed in the measurement of the liability

and decrease the initial bond liability on the balance sheet and
increase the bond’s effective interest rate.
• Issuance costs are reported as an outflow of CFF.
U.S.GAAP still permits to

capitalize these costs (deferred
charge) and allocated to the
income statement on a straight-
line basis.
73

LIABILITIES
interest payments
4. Issuance cost
Example 3: Expense the issuance cost (for IFRS and U.S.GAAP)

A premium bond issued is similar in the example 1, with the issuance cost
of $6.
Answer:
PV = $102.531 $10 $10 $10 + $100 = $110

Issuance cost = $6 is deducted from the bond liability at issuance.
The initial bond liability is reduced by $6 = $102.531 - $6 = $96.531
→ The bond’s effective interest rate = 11.43%
N = 3, PMT = 10, PV = -96.531, FV = 100, CPT → I/Y = 11.43% higher than
the market rate of 9% at issuance.
74

LIABILITIES
interest payments
4. Issuance cost
Example 3: Expense the issuance cost (for IFRS and U.S.GAAP)

Year 1 Year 2 Year 3
Asset Cash ↓ $6
Cash flow: CFF outflow $6
Beginning book value $102.531 - $6 =

$97.564 $98.716
(1) $96.531
Interest expense (2)

$11.033 $11.152 $11.283
Liability: = (1) × 11.43%
Bond
liability Coupon payment
$10 $10 $10
= $10
Ending book value (3)

$97.564 $98.716 $100
= (1) – (3) + (2)
Income statement No effect of issuance cost

75

LIABILITIES
interest payments
4. Issuance cost
Example 4: Capitalize the issuance cost (only for U.S.GAAP)

A premium bond issued is similar in the example 1, with the issuance cost
of $6.
Answer:
PV = $102.531 $10 $10 $10 + $100 = $110

Issuance cost = $6 is allocated equally in the income statement

76

LIABILITIES
interest payments
4. Issuance cost
Example 4: Capitalize the issuance cost (only for U.S.GAAP)

Income Liability &
Asset Cash flow statement Equity
Cash Prepaid CFF outflow Expense Owner

expense equity
Year 1 ↓ $6 ↑ $4 $6 ↑ $2 ↓ $2
Year 2 – ↓ $2 ↑ $2 ↓ $2
Year 3 – ↓ $2 ↑ $2 ↓ $2
Issuance cost is
allocated equally in
the income statement
77

LIABILITIES
interest payments
5. Fair value reporting option
Under effective interest rate method, the book value of the bond is based
on the market rate at issuance → If market interest rates fluctuate → the
actual value of the firm’s debt deviates from its reported book value:
Market rates rise Market rates fall
Book value > fair value of debt Book value < fair value of debt
Overstate the firm’s leverage Understate the firm’s leverage

level level
Companies have the option to report financial liabilities at fair value.
Gains and losses that result from changes in bonds’ market yields are
reported in the income statement.
78

LIABILITIES
LOS 24.c: Explain the derecognition of debt
A firm may redeem the bond before maturity due to some reasons:
When bonds are redeemed before maturity, a gain or loss is recognized
by subtracting the redemption price from the book value of the bond
liability at the reacquisition date:
Example 5: Redeem bond before maturity

A 3-year bond was redeemed in the end of the 2nd year at the price of
$1,042. The book value of the bond at the end of the 2nd year is $1,037.
The company will recognize a loss of $5 ($1,037 carrying value - $1,042
redemption price)
At the end of 2nd year
Assets Cash ↓ = $1,042
Liability & Equity Bond liability ↓ = $1,037

Owner equity ↓= $5
Income statement Loss ↑= $5
Cash flow statement CFF outflow = $1,042

79

LIABILITIES
LOS 24.d: Describe the role of debt covenants in protecting
creditors
Debt covenants are restrictions imposed by the lender on borrower to

protect the lender’s position.
Affirmative covenants Negative covenants
The borrower must: The borrower must not:

• Make timely payments of • Increasing dividends or
principal and interest. repurchasing shares.
• Maintain certain ratios (such as • Issuing more debt.
the current, debt-to-equity, • Engaging in mergers and
and interest coverage ratios) in acquisitions
accordance with specified
level.
• Maintain collateral, if any, in
working order.
If the borrower violates a covenant → technical default → the

bondholder can demand immediate repayment of principle
80

LIABILITIES
LOS 24.e: Describe the financial statement presentation of
and disclosures relating to debt
• Firm will often report all of their outstanding long-term debt

on a single line on the balance sheet.
• The portion of long - term debt that has due date < 1 year is
reported on a current liability
• More details about the long - term debt is disclosed in the
footnotes, including:
o The nature of the liabilities.
o Maturity dates.
o Stated and effective interest rates.
o Call provisions and conversion privileges.
o Restrictions imposed by creditors.
o Assets pledged as security.
o The amount of debt maturing in each of the next 5 years

81

LIABILITIES
LOS 24.f: Explain motivations for leasing assets instead of
purchasing them
A lease is a contract between the owner of the asset (lessor) and

another party that wants to use the asset (lessee). The lessee
gains the right to use the asset for a period of time in return for
periodic lease payments.
The right to use the asset

Lessor Lessee
Lease payments
Three requirements for a lease contract
• It must refer to a specific asset.

• It must give the lessee effectively all the asset’s economic
benefits during the term of the lease.
• It must give the lessee the right to determine how to use the
asset during the term of the lease.
82

LIABILITIES
LOS 24.f: Explain motivations for leasing assets instead of
purchasing them
The advantages of leasing rather than purchasing an asset
• Less initial cash outflow: a lease only requires a small down

payments
• Less costly financing: a lease is effectively secured by the leased
asset if the lessee defaults → the interest rate implicit in a
lease contract < the interest rate would be on a loan to
purchase the asset.
• Less risk of obsolescence: At the end of a lease, the lessee often
returns the leased asset to the lessor and therefore does not
bear the risk of an unexpected decline in the asset’s end-of-
lease value.
83

LIABILITIES
LOS 24.g: Explain the financial reporting of leases from a
lessee’s perspective
1. Types of lease
Finance lease Operating lease
Transferred substancially all the Does not transferred

benefits and risks of ownership to substancially all the benefits and
the lessee. risks of ownership to the lessee.
Five conditions for a lease to be classified as a finance lease
• Ownership of the leased asset transfers to the lessee.

• The lessee has an option to buy the asset and is expected to exercise it.
• The lease is for most of the asset’s useful life.
• The present value of the lease payments is greater than or equal to the
asset’s fair value.
• The lessor has no other use for the asset.
84

LIABILITIES
2. Classifications for Lessee and Lessor
Lessee
Lease accounting IFRS U.S.GAAP

exemption:
< 12 months
leases (IFRS and
US GAAP) or
All leases Finance lease Operating lease
< $5,000 in sales
price (IFRS only)
→ the lessee can Lessor
simply expense
the lease
payments on a
straight-line basis. IFRS U.S.GAAP
Finance lease Operating lease Finance lease Operating lease

85

LIABILITIES
3. Accounting for lease under IFRS and U.S.GAAP
Example 6: Accounting lease for lessee

Affordable Company leases a machine for its own use for 2 years
with annual payments of $60,000. The interest rate implicit in
the lease is 6%. How will the lease be reported by the lessee if
it’s classified as a finance lease? As an operating lease under
U.S.GAAP?

86

LIABILITIES
Answer:
The present value of lease payments = $110,000:

N = 2; I/Y = 6%; PMT = - $60,000; FV = 0; CPT → PV = $110,000
At lease inception under IFRS and U.S.GAAP is the same
Assets: Liabilities: Income

Right-of-use asset Lease liability statement Cash flow
PV of all future PV of all future No effect No effect
lease payments lease payments
= $110,000 = $110,000

87

LIABILITIES
After the inception under IFRS and U.S.GAAP
IFRS U.S.GAAP
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Right- Beginning value 110 55 Same as IFRS 110 56.6

of-use (1)
asset
Amortization (2) 55 55 53.4 56.6
Ending value 55 0 56.6 0

= (1) – (2)
(2)
• Finance lease: the ROU asset is straight-line amortized.
• Operating lease: the ROU asset is not straight-line amortized:
Amortization = the reduction of lease liability each period
= lease payment – interest expense
88

LIABILITIES
IFRS U.S.GAAP
Lease Beginning value 110 56.6 110 56.6

liabilit- (3)
y
Interest expense 6.6 3.4 6.6 3.4
(4) = (3) × 6%
Same as IFRS
Lease payment (5) 60 60 60 60
Ending value 56.6 0 56.6 0

= (3) – (5) + (4)
89

LIABILITIES
IFRS U.S.GAAP
All lease Finance lease Operating lease
Income Interest 6.6 3.4 Same as IFRS

statement expense
–
Amortization 55 55
expense
Lease expense 61.6 58.4 60 60

(6)
(6)
• Finance lease: interest expense and amortization expense are reported
separately in the income statement.
• Operating lease: Lease expense = Lease payment
(the interest expense and amortization expense are reported as a single
line titled “lease expense”)
90

LIABILITIES
IFRS U.S.GAAP
All lease Finance lease Operating lease
Cash flow CFO outflow 6.6 3.4 60 60

statement (7)
Same as IFRS
CFF outflow 53.4 56.6 –
= reduction of
lease liability
(7)
• Finance lease: interest and principal (reduction of lease liability)
repayment are reported separately.
• Operating lease: the entire lease payment is reported as cash
outflow from operating.
91

LIABILITIES
2. Accounting for lease under IFRS and U.S.GAAP
All lease (IFRS) and Finance lease Operating lease

(US.GAAP) (U.S.GAAP)
(as borrowing and buy)
• Right-of-use asset = PV of future lease Record as finance

payments (at lease inception) lease. But the right-of-
ROU Assets
• Straight-line amortization of right-of-use use asset is not
asset - Cost model (after the inception) straight-line
amortized:
Lease • Lease liability = PV of future lease o Amortization =
liability payments (at lease inception) reduction of lease

• Reduction of lease liability from lease liability
payment each period - Amortized cost
(after the inception)
Income • Interest expense on lease liability Rental expense = Lease

statement • Amortization expense on leased asset payment
Interest expense = CFO/CFF outflow under Lease payments = CFO

Cash flow IFRS and CFO outflow under U.S.GAAP outflow
statement
Reduction of lease liability = CFF outflow
92

LIABILITIES
LOS 24.h: Explain the financial reporting of leases from a
lessor’s perspective
Example 7: Accounting lease for lessor

A lease contract as in Example 6. How the lessor report it?
Answer:
The present value of lease payments:
N = 2; I/Y = 6%; PMT = - $60,000; FV = 0; CPT → PV = $110,000
The accounting for lessors is substantially identical under IFRS and US
GAAP:
Operating lease: lease payments are simply reported as lease income in
the P&L and CFO inflow over the period.
Finance lease: Lessors under US GAAP recognize finance leases as either
“sales-type” or “direct financing” lease:
• Sale-type lease: PV of lease payments (sales) > the book value of
leased asset (COGS)
• Direct financing lease: PV of lease payments = the book value of
leased asset
93

LIABILITIES
At lease inception under IFRS and U.S.GAAP
Liabilities & Income
Assets Equity statement Cash flow
Leased
Lease
asset (de- Liability Equity
receivable
recognize)
Operatin
No effect No effect No effect No effect
g lease
Sale- PV of lease Book

No
type payments value ↑ $30 Gain = $30 No effect
effect
lease = $110,000 = $80
Direct PV of lease
fair value
financing payments No effect No effect No effect
= $110
lease = $110,000

94

LIABILITIES
Remove leased asset Finance lease
Direct financing
Sale-type lease
lease
Year 1 Year 2 Year 1 Year 2
Beginning value 110 56.6

(1)
Interest revenue 6.6 3.4

Assets (2) = (1) × 6%
Lease Same
receivable Lease payment 60 60
received (3)
Ending value 56.6 0

= (1) – (3) + (2)
Liability –
95

LIABILITIES
Remove leased asset Finance lease
Sale-type lease Direct financing

lease
Year 1 Year 2 Year 1 Year 2
Interest revenue 6.6 3.4 6.6 3.4
Income Sales 110 –

statement COGS 80 – –
Gain = Sales - COGS 30 –
Cash flow
CFO inflow 60 60 Same
statement
96

LIABILITIES
Retain leased asset Operating lease
Year 1 Year 2
Beginning value (1) 110 55

Assets
Right-of-use Depreciation (2) 55 55
asset
Ending value = (1) – (2) 55 0
Liabilities –
Lease income (3) 60 60

Income
Depreciation expense = (2) 55 55
statement
Net = (3) – (2) 5 5
Cash flow CFO inflow 60 60

97

LIABILITIES
Finance lease (as sell and lending) Operating lease
(no lending)
Sale-type lease Direct financing lease
(U.S.GAAP) (U.S.GAAP)
• Remove assets (at lease inception) • Retain assets(at

• Lease receivables = PV of future lease payments lease inception)
(at lease inception) • Depreciation on
Assets
• Reduction of lease receivable from lease lease leased assets
payment received each period - Amortized cost (after the
(after the inception). inception).
Liability – –
• Interest revenue on Interest revenue on • Lease revenue =

lease receivables lease receivables lease payment
Income • Gain = PV of future • Depreciation
statement lease payments (sales) expense on
– book value of leased leased assets
asset (COGS)
• Interest revenue = CFO/CFI inflow under IFRS Lease revenue =

Cash flow
and CFO inflow under U.S.GAAP CFO inflow
statement
• Receipt of lease principle = CFI inflow
98

LIABILITIES
LOS 24.i: Compare the presentation and disclosure of defined
Defined contribution Defined benefit plans

plans
Definition Pension plans in which Pension plans in which
the employee and the the company contributes
company is required to into the plan and
contribute and invest a promises to pay future
certain of funds into the benefits to the
plan. However, the employee during
company makes no retirement.
promise to the employee
regarding the future
value of the plan assets.
Contribution Amount is defined each Depends on current

from period. period estimate and
employer investment performance
of assets.
99

LIABILITIES
Defined contribution Defined benefit plans

plans
Amount of Depends on investment Based on plan’s formula:
future performance of plan’s the firm promises to
benefit to assets make periodic payments
employee to employees after
retirement
Investment The employees The employers
risk goes to
Example An employee periodically The firm contributes a

contributed 5% of basic plan and makes a
salary, this amount is commitment that the
matched by the employee might earn a
employer. But the retirement benefit of 2%
employee’s future of her final salary for
benefit is not specified. each year of service.
100

LIABILITIES
1. Accounting for Defined contribution plans
Balance sheet • Records a decrease in cash.

• If the agreed-upon amount is not
deposited into the plan during a
particular period → the outstanding
amount is recognized as a liability.
Income statement Employer’s contribution is reported as

pension expense
Cash flow statement Employer’s contribution is reported as CFO

outflow
101

LIABILITIES
2. Accounting for Defined benefit plans
Pension benefit = a% × final salary at retirement × number of years of

services.
Example 8: Employee’s pension benefit (Firm’s pension payments)

Consider a company that determines annual pension benefit of each
employee during retirement as 2% × final salary at retirement × number
of years of services. A retiree who served the company for 20 years and
had a final salary at retirement of $200,000 . What is the amount of
pension benefit employee will receive each period after the retirement?
102

LIABILITIES
Example 8: Employee’s pension benefit (Firm’s pension payments)
Answer
A retiree who served the company for 20 years and had a final salary at
retirement of $200,000 would, under the terms of this defined-benefit
plan, be entitled to an annual pension payment of 0.02 x $200,000 x 20 =
$80,000 each year during her retirement until her death.
0 1 19 20 21 22
$200,000 $80,000 $80,000 $80,000
Final salary at
retirement
103

LIABILITIES
Pension obligation allocated over the Pension expense

= PV of annual Included in COGS/
pension payment years of services SG&A in the P&L
Assumption to determine the pension obligation:

• Expected salary at date of retirement.
• Number of years the employee is expected to live after
retirement.
• The discount rate (typically assumed to be the high-quality
corporate bond yield).
104

LIABILITIES
Example 9: Pension obligation

An employee is eligible to participate in the company’s defined-benefit
pension plan. Under the plan, he is promised an annual payment of 2% of
his final salary for each year of service. The pension benefit will be paid at
the end of each year. The final annual salary is 50,000. The fair value of
plan assets in the first year of employment is $2,140.
The discount rate is 8%.
The employee will work for 25 years.
The employee will live for 15 years after retirement and receive 15 annual
pension benefit payments.
105

LIABILITIES
Example 9: Pension obligation
Answer:
At the end of the 1st year of service, the employee’s annual pension
benefit = 2% × $50,000 × 1 = $1,000 per year from retirement until death.
Step 1: The PV of payments on the retirement date = $8,560
(I/Y = 8, PMT = 1,000, N = 15, FV = 0, CPT → PV = -8,560)
Step 2: At the end of the 1st year of employment, the PV of the annuity
that begins in 24 years = The pension obligation (PBO) of the first year =
$8,560/(1.08^24) = $1,350.
0 1 2 24 25 26 39 40
PBO $1,000 $1,000 $1,000

= 1,350 $8,560
Step 2 Step 1
106

LIABILITIES
The change in the pension obligation (Additional reading)
Beginning value of pension obligation
Under IFRS Under U.S.GAAP
+ Current service costs + Current service costs
+ Net interest expense + Interest costs
+ Actuarial losses + Actuarial losses change in net

pension
– Net interest income + Past service costs
liability/asset
– Actuarial gains – Actuarial gains
– Actual return on – Expected return on plan

plan asset asset
Ending value of pension obligation

107

LIABILITIES
Recognized as Under IFRS Under U.S.GAAP
Current service costs = present value of the increase in pension

benefit earned by the employee as a result of providing one more
year of service to the company
Net interest expense/income = Interest costs: the company

beginning net pension does not pay out service costs
Pension expense liability/asset × discount rate earned by the employee over
in profit and loss used to estimate the pension the year until retirement
obligation
Expected return on plan asset:

This is an explicit assumption
for the expected long-term
rate of return on plan assets
108

LIABILITIES
Recognized as Under IFRS Under U.S.GAAP
Actuarial losses/gains: arise when changes are made in any of

the assumptions used to estimate the company’s pension
obligation (e.g., mortality rates, life expectancy, rate of
Other compensation increase, and retirement age)
comprehensive
income in profit Actual return on plan asset: Past service costs: retroactive
and loss return which are gained from benefits awarded to employees
investing in a wide variety of when a plan is initiated or
asset classes including equity amended
instruments
109

LIABILITIES
Fair value of plan asset – Pension obligation

= Net pension asset/liability
Balance sheet • The fair value of plan assets > the pension
obligation → the plan has a surplus → reflect a
net pension asset.
• The fair value of plan assets < the pension
obligation → the plan has a deficit → reflect a
net pension liability.
Income The change in net pension liability/asset is

statement recognized either in profit and loss or in other
comprehensive income.
110

LIABILITIES
Example 10: Change in pension obligation and Net pension

asset/liability
Continue with the pension plan for an employee as in the Example 9.
Answer
At the end of the 2nd year of service, the employee’s annual pension
benefit = 2% × $50,000 × 2 = $2,000 per year from retirement until death.
Step 1: The PV of payments on the retirement date = $17,119
(I/Y = 8, PMT = 2,000, N = 15, FV = 0, CPT → PV = -17,119)
Step 2: At the end of the 2nd year of employment, the PV of the annuity
that begins in 23 years = The pension obligation (PBO) of the 2nd year
= $17,119/(1.08^23) = $2,916.
0 1 2 24 25 26 39 40
PBO PBO $2,000 $2,000 $2,000

= $1,350 = $2,916 $17,119
Step 2 Step 1
111

LIABILITIES
Example 10: Change in pension obligation and Net pension

asset/liability
Answer
During the 2nd year of service, the PBO increased $1,566. The increase is a
result of current service cost and interest cost as follows:
1st PBO = $1,350
+ Current service cost = $1,458 (PV of 15 payments of $1,000 ($2000 –
$1000) starting in 23 years)
+ Interest cost = $108 (= $1,350 × 8%)
2nd PBO = $2,916
If the fair value of the plan assets at the end of 2nd year = $2,000
→ report a net pension liability = $2,916 - $2,000 = $916
112

LIABILITIES
LOS 24.j: Calculate and interpret leverage and coverage ratios
• Solvency ratios to measure a firm’s ability to satisfy its long-

term obligation.
• 2 types of commonly used solvency ratios:
Leverage ratios Coverage ratios
• Focus on balance sheet • Focus on income

• Measure relative amount statement
of debt in the firm’s • Measure the sufficiency
capital of earnings to repay
interest and other fixed
charges when due.
113

LIABILITIES
Leverage ratios
• Debt-to-assets ratio = total debt / total assets
→ Measures the percentage of total assets financed with debt
o The higher the ratio, the higher the financial risk and → the weaker
the solvency
• Debt-to-capital ratio = total debt / (total debt + total equity)
→ Measures the percentage of total capital financed with debt. It is
different from debt-to-asset ratio by the non-interest-bearing liabilities.
o The higher the ratio → the weaker the solvency
• Debt-to-equity ratio = total debt / total equity.
→ Measures the amount of debt financing relative to the firm’s equity
base.
→ A debt-to-equity ratio of 1.0 indicates equal amounts of debt and equity
→ a debt-to-capital ratio of 50%.
o The higher the ratio → the weaker the solvency
• Financial leverage ratio = average total assets / average total equity.
→ Measure of leverage used in the DuPont formula
o The higher the financial leverage ratio, the more leveraged the
company in the sense of using debt and other liabilities to finance
assets.
114

LIABILITIES
Coverage ratios
• Interest coverage = EBIT / interest payments
→ Measures the number of times a company’s EBIT could cover its
interest payments.
o The higher interest coverage ratio, the stronger solvency → greater
assurance that the company can service its debt from operating
earnings
• Fixed charge coverage = (EBIT + lease payments) / (interest payments +
lease payments).
→ Measures the number of times a company’s earnings (before interest,
taxes, and lease payments) can cover the company’s interest and lease
payments.
→ Fixed charge coverage is more meaningful for firms that engage in
significant operating leases
115

LIABILITIES
Example 8: Leverage ratios and coverage ratios

BT Group data:
31-Mar-18 31-Mar-17
Short-term borrowings 2,281 2,632
Long-term debt 11,994 10,081
Total shareholders' equity 10,304 8,335
Total assets 42,759 42,372
EBIT 3,381 3,167
Interest expense 776 817
1. Comment on any changes in the calculated leverage ratios from

year-to-year.
2. Comment on any changes in the interest coverage ratio from
year to year
116

LIABILITIES
Answer:
31-Mar-18 31-Mar-17
Debt-to-assets (2,281 + 11,994)/42,759 (2,632 + 10,081)/42,372

= 33.4% = 30%
Debt-to-capital (2,281 + 11,994)/(2,281 + (2,632 + 10,081)/(2,632 +

11,994 + 10,304) 10,081 + 8,335)
= 58.1% = 60.4%
Debt-to-equity (2,281 + 11,994)/10,304 (2,632 + 10,081)/8,335

= 1.39 = 1.53
Interest coverage 3,381/776 = 4.36 3,167/817 = 3.88

ratio
117

LIABILITIES
Answer:
1. Debt-to-assets ratio increased, while its debt-to-capital and

debt-to-equity ratios both decrease: The decrease in debt-
to-capital and debt-to-equity ratios resulted primarily from
the company’s increase in total equity and indicate stronger
solvency.
2. Interest coverage ratios increased from 2017 to 2018 → an
improvement in solvency. The company has sufficient
operating earnings to cover interest payments.
118
Practice questions
119

LIABILITIES
Practice exercises
19a. Determine the initial recognition, initial Question 1

measurement and subsequent measurement of –2
bonds
19b. Describe the effective interest method and Question 3

calculate interest expense, amortization of bond –5
discounts/premiums, and interest payments
19c. Explain the derecognition of debt Question 6
19d. Describe the role of debt covenants in Question 7

protecting creditors
19e. Describe the financial statement presentation Question 8

of and disclosures relating to debt
120

LIABILITIES
Practice exercises
19f. Explain motivations for leasing assets instead of Question 9

purchasing them
19g. Explain the financial reporting of leases from a Question 10

lessee’s perspective - 11
19h. Explain the financial reporting of leases from a Question 12

lessor’s perspective – 13
19i. Compare the presentation and disclosure of Question 14

defined contribution and defined benefit pension
plans
19j. Calculate and interpret leverage and coverage Question 15

ratios
121

LIABILITIES
Practice exercises
1. A company issues €1 million of bonds at face value. When the bonds are
issued, the company will record a:
A. cash inflow from investing activities.
B. cash inflow from financing activities.
C. cash inflow from operating activities.
2. At the time of issue of 4.50% coupon bonds, the effective interest rate was
5.00%. The bonds were most likely issued at:
A. par.
B. a discount.
C. a premium.
3. Oil Exploration LLC paid $45,000 in printing, legal fees, commissions, and
other costs associated with its recent bond issue. It is most likely to record
these costs on its financial statements as:
A. an asset under US GAAP and reduction of the carrying value of the
debt under IFRS.
B. a liability under US GAAP and reduction of the carrying value of the
debt under IFRS.
C. a cash outflow from investing activities under both US GAAP and
IFRS.
122

LIABILITIES
Practice exercises
4. Midland Brands issues three-year bonds dated 1 January 2015 with a face
value of $5,000,000. The market interest rate on bonds of comparable risk
and term is 3%. If the bonds pay 2.5% annually on 31 December, bonds
payable when issued are most likely reported as closest to:
A. $4,929,285.
B. $5,000,000.
C. $5,071,401
5. On 1 January 2010, Elegant Fragrances Company issues £1,000,000 face

value, five-year bonds with annual interest payments of £55,000 to be paid
each 31 December. The market interest rate is 6.0 percent. Using the
effective interest rate method of amortization, Elegant Fragrances is most
likely to record:
A. an interest expense of £55,000 on its 2010 income statement.
B. a liability of £982,674 on the 31 December 2010 balance sheet.
C. a £58,736 cash outflow from operating activity on the 2010
statement of cash flows
123

LIABILITIES
Practice exercises
6. The management of Bank EZ repurchases its own bonds in the open

market. They pay €6.5 million for bonds with a face value of €10.0 million
and a carrying value of €9.8 million. The bank will most likely report:
A. other comprehensive income of €3.3 million.
B. other comprehensive income of €3.5 million.
C. a gain of €3.3 million on the income statement.
7. Which of the following is an example of an affirmative debt covenant? The

borrower is:
A. prohibited from entering into mergers.
B. prevented from issuing excessive additional debt.
C. required to perform regular maintenance on equipment pledged as
collateral
8. Regarding a company’s debt obligations, which of the following is most

likely presented on the balance sheet?
A. Effective interest rate
B. Maturity dates for debt obligations
C. The portion of long-term debt due in the next 12 months
124

LIABILITIES
Practice exercises
9. Compared to purchasing a long-lived asset using debt financing, leasing

the asset most likely:
A. is more costly to the lessee.
B. requires a greater initial cash outflow from the lessee.
C. allows the lessee to avoid the risk of obsolescence.
10. Beginning with fiscal year 2019, for leases with a term longer than one
year, lessees report a right-to-use asset and a lease liability on the balance
sheet:
A. only for finance leases.
B. only for operating leases.
C. for both finance and operating leases.
11. A company enters into a finance lease agreement to acquire the use of an
asset for three years with lease payments of €19,000,000 starting next
year. The leased asset has a fair market value of €49,000,000 and the
present value of the lease payments is €47,250,188. Based on this
information, the value of the lease liability reported on the company’s
balance sheet at lease inception is closest to:
A. €47,250,188.
B. €49,000,000.
C. €57,000,000.
125

LIABILITIES
Practice exercises
12. Under US GAAP, a lessor’s reported revenues at lease inception will be

highest if the lease is classified as:
A. a sales-type lease.
B. an operating lease.
C. a direct financing lease
13. For a lessor, the leased asset appears on the balance sheet and continues
to be depreciated when the lease is classified as:
A. a finance lease.
B. a sales-type lease.
C. an operating lease.
14. Penben Corporation has a defined benefit pension plan. At 31 December,

its pension obligation is €10 million and pension assets are €9 million.
Under either IFRS or US GAAP, the reporting on the balance sheet would
be closest to which of the following?
A. €10 million is shown as a liability, and €9 million appears as an asset.
B. €1 million is shown as a net pension obligation.
C. Pension assets and obligations are not required to be shown on the
balance sheet but only disclosed in footnotes.
126

LIABILITIES
Practice exercises
15. The following presents selected financial information for a company:
$ Millions
Short-term borrowing 4,231
Current portion of long-term interest-bearing debt 29
Long-term interest-bearing debt 925
Average shareholders’ equity 18,752
Average total assets 45,981
The financial leverage ratio is closest to:

A. 0.113
B. 0.277
C. 2.452
127

LIABILITIES
Practice exercises
Answer
1. B is correct. The company receives €1 million in cash from investors at the
time the bonds are issued, which is recorded as a financing activity
2. B is correct. The effective interest rate is greater than the coupon rate and
the bonds will be issued at a discount.
3. A is correct.
• Under US GAAP, expenses incurred when issuing bonds (issuance cost)
are generally recorded as an asset and amortized to the related expense
(legal, etc.) over the life of the bonds.
• Under IFRS, they are included in the measurement of the liability.
• The related cash flows are financing activities.
4. A is correct. The bonds payable reported at issue is equal to the sales

proceeds = $4,929,285
Coupon payments each period = 2.5% × $5,000,000 = $125,000
I/Y = 3; N = 3; PMT = 125,000; FV = 5,000,000; CPT→ PV = -4,929,285
1 Jan 2015 31 Dec 2015 31 Dec 2016 31 Dec 2017
PV = $4,929,285 $125,000 $125,000 $5,125,000

128

LIABILITIES
Practice exercises
5. B is correct. Book value of bond liability is equal to the present value of the
remaining future cash flow.
At the beginning of 2010, book value of bond = £978,938 and it is also a
cash inflow from financing in 2010
Interest expense in 2010 = £978,938 × 6% = £58,736
2010
Beginning book value (1) £978,938
Interest expense (2) = (1) × 6% £58,736

Bond liability
Coupon payments (3) = £55,000 £55,000
Ending book value = (1) – (3) + (2) £982,674
Income statement Interest expense £58,736
Cash flow CFF inflow £978,938

129

LIABILITIES
Practice exercises
6. C is correct. A gain of €3.3 million (carrying amount less amount paid) will
be reported on the income statement.
7. C is correct.
• Affirmative covenants require certain actions of the borrower. Requiring
the company to perform regular maintenance on equipment pledged as
collateral is an example of an affirmative covenant because it requires
the company to do something.
• Negative covenants require that the borrower not take certain actions.
Prohibiting the borrower from entering into mergers and preventing the
borrower from issuing excessive additional debt are examples of
negative covenants.
8. C is correct. The non-current liabilities section of the balance sheet usually

includes: a single line item of the total amount of a company’s long-term
debt due after 1 year → the current liabilities section shows the portion of
a company’s long-term debt due in the next 12 months.
• Notes to the financial statements generally present the stated and
effective interest rates and maturity dates for a company’s debt
obligations
130

LIABILITIES
Practice exercises
9. C is correct. At the end of a lease, the lessee often returns the leased asset
to the lessor → does not bear the risk of an unexpected decline in the
asset’s end-of-lease value → the interest rate implicit in a lease contract
may be less than the interest rate on a loan to purchase the asset.
• The terms of a lease may not require all the covenants typically included
in loan agreements or bond indenture.
10. C is correct. Beginning with fiscal year 2019, lessees report a right-of-use
asset and a lease liability for all leases longer than one year. An exception
under IFRS exists for leases when the underlying asset is of low value.
11. A is correct. Under the revised reporting standards under IFRS and U.S.
GAAP, a lessee must recognize an asset and a lease liability at inception of
each of its leases (with an exception for short-term leases):
→ The lessee reports a “right-of-use” (ROU) asset and a lease liability = the
present value of fixed lease payments on its balance sheet → the company
will record a lease liability on the balance sheet of €47,250,188.
131

LIABILITIES
Practice exercises
12. A is correct. A sales-type lease treats the lease as a sale of the asset, and
revenue is recorded at the time of sale equal to the value of the leased
asset. Under a direct financing lease, only interest income is reported as
earned. Under an operating lease, revenue from lease receipts is reported
when collected.
13. C is correct. When a lease is classified as an operating lease, the underlying

asset remains on the lessor’s balance sheet. The lessor will record a
depreciation expense that reduces the asset’s value over time
14. B is correct. The company will report a net pension obligation of €1 million
equal to the pension obligation (€10 million) less the plan assets
(€9 million).
15. C is correct. The financial leverage ratio is calculated as follows:

(Average total assets/average total shareholder’s equity)
= 45,981/18,752 = 2.452
132
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1

READING 23: INCOME TAXES

READING 23: INCOME TAXES

23.a. Describe the differences between accounting profit and taxable

23.d. Calculate the tax base of a company’s assets and liabilities

READING 23: INCOME TAXES

23.f. Evaluate the effect of tax rate changes on a company’s financial

READING 23: INCOME TAXES

1. Describe the differences between accounting profit and

Revenue 100 100

Selling experimental products 0 10

Manufacturing cost (10) (10)

Profit 110 100

READING 23: INCOME TAXES

1. Describe the differences between accounting profit and

Recognition of revenue & Recognition of revenue &

Taxable income Accounting profit

Income tax expense

READING 23: INCOME TAXES

1. Describe the differences between accounting profit and

Accounting profit 100

Other taxable income -

Non-taxable Income (10) (Selling experimental products)

(Purchase without supporting

Taxable income 110

READING 23: INCOME TAXES

2. Define key terms

Tax return terminology

Taxable income Income subject to tax based on tax return

Current tax return liability resulting from the current period

Income tax Actual cash flows for income taxes, including

Tax loss carried

Net amount of an asset or liability used for tax reporting

Pretax income Income before income tax expense

Expense recognized in the income statement that include

READING 23: INCOME TAXES

2. Define key terms

Financial reporting terminology

BS amounts that result from an excess of income tax

BS amounts that result from an excess of taxes payable

Valuation Reduction of deferred tax assets based on the likelihood

Carrying value Net balance sheet value of asset or liability

Permanent Difference between taxable income and pretax income that

Difference between the tax base and the carrying value of

READING 23: INCOME TAXES

3. How income tax expense works

Difference between accounting

Deductible expense Deferred tax Deferred tax

Change in Deferred tax asset/lia

Deferred tax Tax

READING 23: INCOME TAXES

Identify and contrast temporary differences and

Difference between accounting

Temporary difference* Permanent difference

A temporary difference refers to a A permanent difference is a

(*) Refer to LOS.23d to understand what is tax base.

READING 23: INCOME TAXES

Example: Temporary difference

Depreciation Impact on pre-tax income