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  • A Case Study on Financial Reporting, Tax, and Business Decision Making EMBA ACC600 Group Project February 14, 2007 Adam Berk Louis Desouza Rachelle Ginsberg Marta Nobo Vince Rubiera Irene Tzouganakis
  • Beach Bums ACC60062 Group Project 2 Case Requirements for Part A: 1. Calculate the cost of tanning lotion sold and the cost of tanning lotion in ending inventory under a periodic system using (a) LIFO, (b) FIFO, and (c) weighted-average cost flow assumptions. [Refer to Horngren Chapter 6.] FIFO LIFO AVG Cost of Ending Inventory (560,000) (376,000) (448,000) Costs of Goods Sold 1,680,000$ 1,864,000$ 1,792,000$ See Exhibit A 2. Calculate bad-debt expense for the year using the percentage-of-sales method, assuming provisions of (a) 1 percent, and (b) 2 percent of sales. There are no cash sales; all sales are made on account. Assuming an ending balance in net receivables of $742,000 prior to the adjustment for current-year uncollectibles, what will be the end-of-year amount of net receivables on the balance sheet under each assumption? [Refer to Horngren Chapter 9 pages 460-462] To calculate these amounts, we multiplied each percent by the total amount of sales. This was done since all sales were made on account. 1% 2% Accounts receivable, net 672,000$ 602,000$ See Exhibit B 3. Assume that the production manager’s supposition about the existing equipment’s residual value is correct (that is, it will have a residual value of $500,000 regardless of whether it is disposed of at the end of Year 10 or the end of Year 6). Calculate the depreciation expense for the current year (that is, Year 5 of the asset’s life) using the straight-line method, assuming that the existing equipment has an estimated total useful life of (a) 10 years, or (b) 6 years. [Note: Depreciation expense has not been calculated for Year 5, so the remaining useful life at the beginning of the fifth year is assumed to be (a) 6 years, or (b) 2 years.] [Refer to Horngren Chapter 10 pages 520- 521.] (a) We took the purchase price minus the residual and divided it by the 10 year life to arrive at the expense for year 5. (b) This required calculating the book value at the end of year 4, subtracting the residual and dividing over the remainder of the years to arrive at a depreciation expense of $1,200,000 for year 5. 10 years Switch to 6 @ yr 5 Depreciation expense (year 5) 400,000$ 1,200,000$ See Exhibit C 4. Use your responses to questions 1 through 3 and the income statement in Exhibit 1 to calculate the highest net income that can be reported within the constraints of acceptable financial reporting. For this question, ignore the effects of income taxes. We arrived at this number by using the FIFO inventory, the 10 year depreciation and the 1% allowance method (percent-of-sales). Highest Pre-Tax Income 1,890,000$ See Exhibit D
  • Beach Bums ACC60062 Group Project 3 5. Use your response to questions 1 through 4 to complete the end-of-year balance sheet in Exhibit 2. For purposes of this requirement, assume a retained earnings balance at the beginning of the current year of $1,033,688. See Exhibit E for full balance sheet 6. Repeat questions 4 and 5 with the goal of calculating the lowest net income that can be reported within the constraints of acceptable financial reporting. What would be reported as the total assets under this low-income scenario? [Hint: prepare an income statement and balance sheet similar to those in Exhibits 1 and 2.] We arrived at this number by using the LIFO inventory, switching to a 6 year depreciation and using the 2% allowance method (percent-of-sales). Lowest Pre-Tax Income 836,000$ See Exhibit G for full income statement Total assets 3,819,688$ See Exhibit F for full balance sheet 7. Use your responses for questions 4 through 6 to calculate the return on net sales (using pre-tax income) for the company as a whole for the current year under both the high-income and low- income scenarios. Also, use your responses to questions 4 through 6 to calculate the current ratio and the debt ratio as of the current year-end under the high-income and low-income scenarios. [Refer to Horngren Chapter 17, page 869 for ratios.] Highest Lowest Return on Net Sales 27% 12% Current Ratio 9.49 8.48 Debt Ratio 16% 21% See Exhibit H for calculations
  • Beach Bums ACC60062 Group Project 4 8. Determine the tax implications of each of the matters in questions 1 through 3. Will taxable income and financial income differ? Calculate the current-year tax cost that would result from using FIFO rather than LIFO for the inventory of tanning lotion. Also, calculate the income taxes payable that TWC would report in the current year (Year 5 of the equipment’s life) under the high-income and low-income scenarios. For purposes of these calculations, assume that TWC has a marginal income tax rate of 34 percent, that it has no accounts receivables in the current year considered worthless for tax purposes, that its equipment has a 7-year life for tax purposes, and that it adopts the half-year convention in the year of acquisition and disposal. [Hint: TWC uses regular half-year MACRS depreciation. It did not qualify to use Section 179 expensing.] How does the income tax expense shown on the financial statements differ from the income tax payable under the high-income and low-income scenarios? [Refer to tax readings that will be posted on Blackboard.] (a) When calculating the cost of tanning lotion, either LIFO or FIFO may be used when accounting for COGS and ending inventory. However, if LIFO is used for tax purposes, LIFO needs to be used for financial accounting purposes, as well. This is referred to as the LIFO conformity rule. In a period of rising prices, LIFO will give you the highest COGS and therefore, the lowest income tax payable. Refer to calculations below. (b) When calculating bad debt expense, there will definitely be a difference between financial and taxable income. According to GAAP, the allowance method is acceptable for recording bad debt expense. However, for tax purposes, the specific charge-off method or direct write-off method is the acceptable method. In this method, bad debts are actually expensed when written off as uncollectible during the year. Differences of these type lead to temporary differences between book income tax expense and actual income tax payable. Refer to calculations below. (c) When calculating depreciation expense, there are several methods that can be used for GAAP purposes (ie. SL, DDB). However, for tax purposes, the MACRS system is used. Under MACRS, cost recovery deductions begin the year an asset is placed in service, which is, when it is set up and ready to be used for its intended business purpose. This may not be the same as the year an asset is purchased. There are two depreciation methods used for these MACRS properties: the 200 percent declining-balance method with a switch to straight line to maximize deductions and the straight-line method. The 200 percent declining-balance method applies to MACRS property in the 5 year and 7 year classes. The straight-line method must be used for all property in the 27 1/2 year and 39 year classes. Differences of these type lead to temporary differences between book income tax expense and actual income tax payable. When using SL method for financial accounting purposes and MACRS DDB for tax purposes on 5 to 7 year property, this usually leads to a deferred income tax liability as income taxes are being saved in the current period as your book expense is lower than your expense for tax purposes. This situation reverses in future periods. Refer to calculations below.
  • Beach Bums ACC60062 Group Project 5 Answers for #8: COGS Tax Margin LIFO 1,864,000$ 34% 633,760$ FIFO 1,680,000$ 34% 571,200 Tax Cost Differential 62,560$ Highest Lowest Sales: Water Sports Equipment 4,500,000$ 4,500,000$ Lotion 2,500,000 2,500,000 Net Sales 7,000,000 7,000,000 COGS: Water Sports Equipment 2,500,000 2,500,000 Lotion 1,680,000 1,864,000 Total COGS 4,180,000 4,364,000 Gross Margin 2,820,000 2,636,000 Operating Expenses: Bad Debts 70,000 140,000 Depreciation 400,000 1,200,000 GS&A 275,000 275,000 Interest 120,000 120,000 Supplies 65,000 65,000 Total Expenses 930,000 1,800,000 Pre-Tax Income 1,890,000 836,000 Provision for Income Tax* 642,600 284,240 Net Income 1,247,400$ 551,760$ * Income Tax Expense with no adj. for permanent or temporary differences Tropical Wave Corporation Partial Income Statement Year Ended December 31, 2006 Exhibit I: Question 8 (Tax effect on Inventory)* Exhibit L: Question 8 (Taxes based on financial statements only) *Using FIFO rather than LIFO would result in a higher tax payable of $62,560, but a higher net income per the books of the same amount.
  • Beach Bums ACC60062 Group Project 6 Answers for #8 (cont’d): Income Tax Payable per Tax Return Type of Difference High Low Income per book before tax 1,890,000$ 836,000$ MACRS Depreciation P Non deductible portion of meals & entertainment 5,500 5,500 Year 1 643,050 P Non deductible premiums on officers' life insurance 6,000 6,000 Year 2 1,102,050 P Non deductible political contributions 10,000 10,000 Year 3 787,050 T Excess of tax accelerated depreciation over book SL (1,850) 798,150 Year 4 562,050 T Excess of bad debt allowance over direct write off 70,000 140,000 Year 5 401,850 Taxable Income 1,979,650 1,795,650 Marginal Tax Rate 34% 34% Income Tax Payable per Tax Return 673,081$ 610,521$ Exhibit M: Question 8 (Book to Tax Reconciliation) Type of Difference High Low Income per book before tax 1,890,000$ 836,000$ P Non deductible portion of meals & entertainment 5,500 5,500 P Non deductible premiums on officers' life insurance 6,000 6,000 P Non deductible political contributions 10,000 10,000 Modified Income after permanent differences 1,911,500 857,500 Book tax expense adjusted for perm. differences 649,910 291,550 Adj. for temp. differences (DTL) to book tax expense Depreciation (MACRS vs. SL) (1,850) DTL Temporary Difference - Tax Effect @ 34% 629 Modified Tax Expense after DTL temporary differences 650,539 291,550 Adj. for temp. differences (DTA) to book tax expense Depreciation (MACRS vs. SL) - 798,150 DTA Bad Debt Expense 70,000 DTA 140,000 DTA Modified Tax Expense after DTA temporary differences ** 626,739$ (27,421)$ Effective Tax Rates 34.42% 34.87% High Method Low Method Book Tax 650,539$ 291,550$ Taxes Paid 673,081$ 610,521$ In conclusion, the difference between your total book tax expense and actual taxes paid are as follows: **Book tax expense was adjusted for all permanent differences and those temporary differences resulting in a DTL (ie. MACRS vs. SL in High Income Scenario). The tax expense adjustments resulting in DTA temporary differences will not be made as it cannot be determined if the deferred tax asset will be realized in future periods. In conclusion, the effective tax rate becomes: Exhibit O: Question 8 (FAS 109 Calculation)
  • Beach Bums ACC60062 Group Project 7 9. Three financial-reporting decisions were alluded to during the executive meeting. They relate to the inventory policy, the uncollectibles provision, and the depreciation provision. How did these decisions influence the ratios you calculated in question 7? Assume that the high-income and low-income scenarios are the financial statements of two different companies. Which “company” appears more profitable? Which “company” appears more liquid? The financial-reporting decisions made by management definitely affected the ratios calculated in # 7. In the high-income scenario, the following calculations were made: 1% bad debt expense vs. 2 % bad debt expense, depreciation expense on the machinery over a 10 year useful life instead of a 6 year useful life, and FIFO instead of LIFO for ending inventory and COGS. Under the high- income scenario, these decisions resulted in a higher pre-tax income for Tropical Wave Corporation. In the low-income scenario, Tropical Wave Corporation results a lower pre-tax income, which results in overall lower taxes for the company. The high-income scenario is more favorable to companies wanting to show higher earnings at period end due to analyst and market pressures (i.e. public company). However, the low-income scenario is more favorable to companies wanting to report less income for tax purposes. In the high-income scenario, total assets were higher due to using FIFO (resulting in a higher ending inventory), 1% for bad debt expense (resulting in higher AR) and depreciation over 10 years (resulting in lower accumulated depreciation). All these calculations resulted in a higher current ratio. In this example, it appears the company has a better ability to pay its short term obligations vs. in the low-income scenario. For the same reason, the high-income scenario also provides the company with a lower debt ratio. The lower the debt ratio, the less total debt the corporation has as compared to its total assets and therefore, appears more solvent. Businesses with higher debt are in danger of becoming insolvent. Furthermore, under the high income scenario, it appears that the company has a much higher return on sales. For every dollar generated from sales, $0.27 is produced of net income vs. $0.12 in the low-income scenario. Based on the above, the high-income company appears to be more liquid, more solvent and more profitable.
  • Beach Bums ACC60062 Group Project 8 Case Requirements for Part B: 1. Advise Maria of the advantages and disadvantages of each of the three forms of business. C Corporations Advantages Shareholders are only at risk for their capital investment (limited liability) Owners can be employees and receive tax-free employee fringe benefits There’s no mutual agency among the stockholders the transfer of corporate ownership is easy Corporation has continuous life Corporations can raise more money than a proprietorship or partnership Disadvantages Double taxation- Corporate tax paid on Form 1120 and Shareholders include dividends in income Net operating losses do not pass through to shareholders; they can only be used against corporate profits Capital losses can only offset capital gains Government regulation is expensive Ownership and management are separated Partnership Advantages Bring together the abilities of more than one person Can raise more Capital than a proprietorship Less expensive to organize than a corporation No double taxation Disadvantages Partnership agreements may be difficult to formulate Each time a new partner is admitted or a partner withdraws, the business needs a new partnership agreement Relations among partners may be fragile Mutual agency and unlimited liability create personal obligations for each partner S Corporation Advantages Corporate losses can be passed through to the shareholders, and as the owner (and shareholder), you may be able to take the loss against income that appears on your personal return. You can have the protection of limited personal liability without having to pay corporate taxes. You can minimize self-employment tax and FICA tax. Your profits, as a shareholder, are not taxed in this manner. Disadvantages Numerous regulations and requirements must be upheld by an S Corporation, including a limit on the number of shareholders (see list below). It can be costly to set up and follow corporate formalities. All shareholders must be U.S. citizens
  • Beach Bums ACC60062 Group Project 9 2. Compute Maria’s after-tax cash flow from each form of business (assume a 6% discount rate). PartnershipCash out-flow Cash in-flow 6% discount NPV of cash in-flow Year 1 -$ 3,168$ 0.94 2,987.42$ Year 2 - 1,320 0.89 1,174.80 Year 3 (6,600) - 0.84 (5,544.00) Year 4 - 53,600 0.792 42,451.20 Year 5 -$ 80,400$ 0.747 60,058.80 101,128.22$ See Exhibit P S-Corp Cash out-flow Cash in-flow 6% discount NPV of cash in-flow Year 1 -$ 2,640$ 0.943 2,489.52$ Year 2 - - 0.89 - Year 3 - 9,648 0.84 8,104.32 Year 4 - 53,600 0.792 42,451.20 Year 5 -$ 80,400$ 0.747 60,058.80 113,103.84$ See Exhibit Q C-Corp Income Tax Liability After tax income Maria's 40% 15% Taxes on Dividend Maria's after tax cash flow 6% discount NPV NPV of after tax cash in-flow Year 4 200,000$ (78,000)$ 122,000$ 48,800$ (7,320)$ 41,480$ 0.792 32,852.16$ Year 5 300,000.00$ (117,000)$ 183,000.00$ 73,200.00$ (10,980.00)$ 62,220.00$ 0.75$ 46,478.34$ 79,330.50$ See Exhibit R 3. Advise Maria as to which form of business you think she should choose and explain why you selected this form. Maria should use an S Corporation because she will not be taxed twice when she receives her dividends beyond the 4th year. She will also have the protection of limited personal liability without having to pay corporate taxes, and given the small loss in cash flow compared to a partnership, an S Corporation’s liability protection negates that small loss. Also, given that the S Corporation is a conduit entity, she can take the losses that occurred and use it to shelter against other income that appears on her personal return.
  • Beach Bums ACC60062 Group Project 10 FIFO LIFO AVG Costs of goods available Purchases 2,240,000$ 2,240,000$ 2,240,000$ FIFO 28,000 @ $20 (560,000) LIFO 4,000 @ $10 (40,000) 24,000 @ $14 (336,000) AVG ($2,240,000/140,000) 28,000 @ $16 (448,000) Costs of Goods Sold 1,680,000$ 1,864,000$ 1,792,000$ 1% 2% $7,000,000 x 0.01 $7,000,000 x 0.02 Accounts receivable 742,000 742,000 Allowance for uncollectible accounts (70,000) (140,000) Accounts receivable, net 672,000$ 602,000$ 10 years Accumulated 10 year then 6 @ yr 5 Accumulated Book Value Depreciation expense (year 1) 400,000$ 400,000$ 400,000$ 400,000$ 4,100,000$ Depreciation expense (year 2) 400,000 800,000 400,000 800,000 3,700,000 Depreciation expense (year 3) 400,000 1,200,000 400,000 1,200,000 3,300,000 Depreciation expense (year 4) 400,000 1,600,000 400,000 1,600,000 2,900,000 Depreciation expense (year 5) 400,000$ 2,000,000$ 1,200,000$ 2,800,000$ 1,700,000$ Exhibit A: Question 1 Exhibit C: Question 3 Exhibit B: Question 2
  • Beach Bums ACC60062 Group Project 11 Sales: Water Sports Equipment 4,500,000$ Lotion 2,500,000 Net sales 7,000,000$ Cost of goods sold: Water Sports Equipment (2,500,000) Lotion (FIFO) (1,680,000) Total cost of goods sold (4,180,000) Gross Margin 2,820,000$ Operating expenses: Bad debts (1%) (70,000) Depreciation (10 years) (400,000) General, Selling and Administration (275,000) Interest (120,000) Supplies (65,000) Total expenses (930,000) Pre-Tax Income 1,890,000$ Current Assets: Current Liabilities Cash 512,863$ Accts. payable 250,000$ Accounts receivable 672,000 Long-term Liabilities Lotion inventory 560,000 Bonds Payable 450,000 Water Sports Equipment inventory 620,000 Other 100,000 Other 8,825 Total liabilities 800,000$ Total Current Assets 2,373,688$ Plant Assets: Common stock 1,150,000 Production Equipment 4,500,000 Retained earnings 1,890,000 Less: Accumulated Depreciation (2,000,000) Total stockholders' equity 3,040,000$ Net Plant Assets 2,500,000$ Total liabilities and Total assets 4,873,688$ Stockholders' Equity & Liabilities 4,873,688$ Exhibit D: Question 4 (highest income) Tropical Wave Corporation Partial Income Statement Year Ended December 31, 2006 Stockholders' Equity Exhibit E: Question 5 (highest income) Assets Liabilities Tropical Wave Corporation Balance Sheet December 31, 2006
  • Beach Bums ACC60062 Group Project 12 Current Assets: Current Liabilities Cash 512,863$ Accts. payable 250,000$ Accounts receivable 602,000 Long-term Liabilities Lotion inventory 376,000 Bonds Payable 450,000 Water Sports Equipment inventory 620,000 Other 100,000 Other 8,825 Total liabilities 800,000$ Total Current Assets 2,119,688$ Plant Assets: Common stock 1,150,000 Production Equipment 4,500,000 Retained earnings 1,869,688 Less: Accumulated Depreciation (2,800,000) Total stockholders' equity 3,019,688$ Net Plant Assets 1,700,000$ Total liabilities and Total assets 3,819,688$ Stockholders' Equity & Liabilities 3,819,688$ Sales: Water Sports Equipment 4,500,000$ Lotion 2,500,000 Net sales 7,000,000$ Cost of goods sold: Water Sports Equipment (2,500,000) Lotion (FIFO) (1,864,000) Total cost of goods sold (4,364,000) Gross Margin 2,636,000$ Operating expenses: Bad debts (2%) (140,000) Depreciation (6 years) (1,200,000) General, Selling and Administration (275,000) Interest (120,000) Supplies (65,000) Total expenses (1,800,000) Pre-Tax Income 836,000$ Tropical Wave Corporation Partial Income Statement Year Ended December 31, 2006 Tropical Wave Corporation Balance Sheet December 31, 2006 Assets Liabilities Exhibit G: Question 6 (income statement - lowest income) Exhibit F: Question 6 (balance sheet - lowest income) Stockholders' Equity
  • Beach Bums ACC60062 Group Project 13 Highest Lowest Pre-tax Income 1,890,000$ 836,000$ Net Sales 7,000,000 7,000,000 Return on Net Sales 27% 12% Total Current Assets 2,373,688 2,119,688 Total Current Liabilities 250,000 250,000 Current Ratio 9.49 8.48 Total Liabilities 800,000 800,000 Total Assets 4,873,688 3,819,688 Debt Ratio 16% 21% Exhibit H: Question 7 Partnership Loss Income Basis Carry over Loss Gain Tax savings Tax Liability Cash out-flow Cash in-flow 6% discount NPV NPV of cash in-flow Year 1 9,600$ 32,000$ 22,400$ 9,600$ 3,168$ -$ 3,168$ 0.94 2,987.42$ Year 2 4,000 22,400 18,400 4,000 1,320 - 1,320 0.89 1,174.80 Year 3 20,000 6,600 (6,600) - 0.84 (5,544.00) Year 4 80,000 26,400 - 53,600 0.792 42,451.20 Year 5 120,000$ 39,600$ -$ 80,400$ 0.747 60,058.80 101,128.22$ Exhibit P: Question B 2
  • Beach Bums ACC60062 Group Project 14 S-Corp Loss Income Basis Carry over Loss Gain Tax savings Tax Liability Cash out-flow Cash in-flow 6% discount NPV NPV of cash in-flow Year 1 9,600$ 8,000$ (1,600)$ 8,000$ 2,640$ -$ 2,640$ 0.943 2,489.52$ Year 2 4,000 (1,600) (1,600) - - - - 0.89 - Year 3 20,000 (5,600) - 5,600 14,400 (4,752) (4,752) 0.84 (3,991.68) Year 4 80,000 80,000 26,400 - 53,600 0.792 42,451.20 Year 5 120,000$ 120,000$ 39,600$ -$ 80,400$ 0.747 60,058.80 101,007.84$ Exhibit Q: Question B 2 C-Corp Income Tax Liability After tax income Maria's 40% 15% Taxes on Dividend Maria's after tax cash flow 6% discount NPV NPV of after tax cash in-flow Year 4 200,000$ (78,000)$ 122,000$ 48,800$ (7,320)$ 41,480$ 0.792 32,852.16$ Year 5 300,000.00$ (117,000)$ 183,000.00$ 73,200.00$ (10,980.00)$ 62,220.00$ 0.75$ 46,478.34$ 79,330.50$ Exhibit R: Question B 2
  • Beach Bums ACC60062 Group Project 15 Affidavit Sheet I have not received assistance for this project from anyone other than my group members. I have actively participated in the preparation of this assignment and I now understand its solution. __________________________________ Adam Berk __________________________________ Louis Desouza __________________________________ Rachelle Ginsberg __________________________________ Marta Nobo __________________________________ Vince Rubiera __________________________________ Irene Tzouganakis