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Accounting for income taxes – Financial Statement presentation
Accounting for income taxes – Financial Statement presentation
Introduction:
Income tax is one of the major aspects for the corporations, firms as well as individuals. It is compulsory for the corporations to file the income tax return as per the guidelines of Internal Revenue Service. In the financial reports, the corporates mentions pretax financial income which is referred as income before taxes and it is computed as per GAAP, whereas taxable income is the income on which tax is calculated.
Income tax accounting focuses on recognizing the amount of taxes payable or refundable for the current year. It also helps in recognizing deferred tax liability and assets for future tax consequences.
Deferred Tax and its accountability:
Deferred Taxes represents company’s tax liability that is postponed to future period. Deferred tax is the result of tax laws that allow companies to write off the expenses before they are recognized and thus creates deferred tax liability. (Cheung, joseph k. 1989)
Deferred tax arises due to timing difference. Timing difference is the difference between the carrying value of an asset or liability recognized in the books of account and actual amount attributed to that asset or liability for tax laws.
Deferred Taxes Example
For federal tax purpose, assets are depreciated at a higher rate than they are depreciated in the books of accounts and thus create a deferred tax.
Deferred Tax Liability
Deferred tax liability generally arises where company receives tax relief in advance for an accounting expense or income is not taxed until its received.
Example of Deferred Tax Liability
A company claims acceleration rate of depreciation in tax returns while in books charges depreciation at different rate
A company makes pension contribution and is allowed deduction on paid basis while for accounting purpose, deduction is determined on actuarial valuation.
Deferred Tax Assets
Deferred Tax asset arises where a tax relief is received after an expense is deducted for accounting purpose in earlier years.
Example of Deferred Tax Asset
A company may accrue expenses in relation to provision for bad debt but for tax purposes deduction will be allowed when provision is utilized.
A company is able to carry forward the tax losses to reduce future taxable income.
Example of Deferred Tax Asset and Deferred Tax Liability
A company purchases an asset for $10,000 which is depreciated on a straight-line basis of five years for accounting purposes. While for tax purpose, company claims depreciation at 25% per year. The applicable rate of corporate income tax is assumed to be 35%
How to calculate deferred tax ?Calculating Deferred Taxes
Purchase Year 1 Year 2 Year 3 Year 4
Accounting value $10,000 $8,000 $6,000 $4,000 $2,000
Tax value $10,000 $7,500 $5,625 $4,219 $3,164
Taxable/(deductible) temporary difference $0 $500 $375 ($219) ($1,164)
Deferred tax liability/(asset) at 35% $0 $175 $131 ($77) ($407)
How deferred taxes are presented on the balance sheet?
Deferred Taxes on Balance sheet
Deferred Tax Asset are found on the balance sheet under Current Assets and is dealt as per US GAAP, IFRS and UK GAAP
Deferred Tax Liability are found on the balance sheet under Current Liabilities and is dealt as per US GAAP, IFRS and UK GAAP
Deferred income tax
Deferred income tax referred to the income tax liability recorded on the balance sheet that results from the income already earned or expenses not booked for tax purposes. The difference that arises between tax on accounting income and tax as per financial income is termed as deferred income tax (Cheung, joseph k. 1989)
Financial statement presentation:
When presenting the income taxes in the financial statements then the company first needs to classify that is the particular amount related to asset or liability and is current or not current in nature.
There are several aspects in income tax accounting that needs to be presented in the income statement of the corporation like:
Current tax expense or benefit.
Deferred tax expense or benefit
Investment tax credits.
Government grants
The benefits of operating loss carryforwardsTax expense that results from allocating tax benefits either directly to paid-in capital or to reduce goodwill or other noncurrent intangible assets of an acquired entity.
Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of a company.
Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years.
With the income tax presentation in the income statement one is able to assess the quality of earnings, predicting the future cash flows, predicting the loss caryyforwards, (Kieso, weygandt & warfield, 2012),
When presenting the income taxes in balance sheet a strong focus on given in the classification of deferred taxes and their classification as non current and current and asset and liability.
Income taxes in Apple Inc:
Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. (Apple, 10-K report, 2012)
Conclusion:
The tax expense income related to profit from ordinary activities shall be presented on the face of the income statement. International Accounting Standards requires certain exchange differences to be recognised as income or expense but does not specify where such differences should be presented in the income statement. Accordingly, where exchange differences on deferred foreign tax liabilities or assets are recognised in the income statement, such differences may be classified as deferred tax expense (income) if that presentation is considered to be the most useful to financial statement users. (Fleming, Damon M. 2011)
The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods
References:
Apple 10-K report, 2012 from: http://files.shareholder.com/downloads/AAPL/2383281926x0xS1193125-12-444068/320193/filing.pdfNurnberg, Hugo, (2010), a note of financial reporting of depreciation and income tax, Journal of Accounting Research. Autumn, Vol. 7 Issue 2, p257-261.Cheung, joseph k. (1989), In nature of Deferred income tax, Contemporary Accounting Research. Spring1989, Vol. 5 Issue 2, p625-641. 17p.
Fleming, Damon M. (2011), Accounting for Income taxes: A misfit on converge of standards, Strategic Finance. May2011, Vol. 92 Issue 11, p49-53. 5p.
Kieso, weygandt & warfield, (2012), Intermediate Accounting, 14th edition
CAPITAL STRUCTURE OF A COMPANY (2)
CAPITAL STRUCTURE OF A COMPANY
Student Name
Institutional Affiliation
Introduction
Before making an investment, investors assess different companies to determine the ones that are financially stable, and performing optimally to invest in. A majority of the investors will make their decision based on the overall financial position and performance which is determined by different financial ratios such as the working- and capital-structure of the company. Assessing such financial ratios will help the investor to be in a better position to know how, and the capability of a company from an investment perspective (Dimitrov, 2011). Organizations in which people are highly likely to invest in, or the ones that will be considered to be doing financially well are the ones that will have a high level of equity, while having low issues with its debt. Such metrics are an indication of the investment quality of a company. The capital structure of a company is considered as a permanent type of funding, which contributes to the overall company’s growth and its overall assets.
Over the years, there has been arguments in line, and against the relevance of the capital structure on the overall valuation of the company. There are theories such as the Modigliani and Miller’s theory of capital structure, which states that during the valuation of a company, there is no need to assess, or take into consideration the capital structure of the company (Habimana, 2015). In this study, the researcher is interested in determining whether, the capital structure of a company has a significant impact on its overall value. This will be determined by evaluating the prominent theories that are related to the capital structure (Tifow, & Sayilir, 2015). These are: the Modigliani and Miller’s theory of capital structure, the trade-off theory, and the pecking order theory.
The Modigliani and Miller’s Theory of Capital Structure
According to the Modigliani and Miller’s approach to the capital theory, it does not have any form of significant impact, or information that potential investors can rely on to determine the real market value of an establishment (Cheremushkin, 2011). To put it into perspective, according to the Modigliani-Miller theory, the overall market value of a firm is calculated based on the present value, and the future earnings of a firm, together with its underlying assets. It is an indication that when conducting the valuation of a firm, potential investors and businesses should not use the capital structure.
The logic of the Modigliani-Miller theory is based on the existing approaches that companies have in relation to financing their operations. Companies utilize only three strategies when they are raising the money to finance their operations, and to engage in the growth and expansion activities. These strategies are borrowing money by issuing bonds to the public, issue new stocks shares to their investors, and obtain loans from financial institutions (Cheremushkin, 2011). According to this theory, the option that a company selects to finance its operations and objectives will have no real effect on its overall market value.
Putting this notion into perspective indicates that the value of two companies that have used different financial options can be the same. For instance, company A is leveraged, and company B is unleveraged (Nugroho, 2013). This means that in the event that an investor will purchase the shares of a leveraged firm, the cost will be similar as purchasing shares of an unleveraged firm. When using the Modigliani and Miller approach, there are specific assumptions that are made such as: there are no taxes, the transaction costs for buying and selling securities is zero
An important point to note is that, when using the Modigliani and Miller approach, there are various assumptions that are made such as, in this situation, there are no taxes. Second, the overall transaction costs for purchasing, and selling the securities are nil. In addition to that, there is the need to have a symmetry of information. The investor in the two scenarios will have access to the same information as that of the corporation, which will ensure that the investor will behave in a rational manner (Welch, 2004). Other assumptions that will be made are: the overall cost of borrowing will be similar for both the investors and the companies, there are no flotation costs such as the underwriting of the commission, and no corporate dividend tax.
As has been stated, in the Modigliani and Miller approach, the assumption that is made is that there are no taxes. However, in reality, a majority of countries, tax companies. In this theory, there is the recognition that there are different tax benefits that are achieved, or accrued when by the overall interest payments. While the interest that is paid on the borrowed funds is considered to be tax deductible, this is not the case for the dividends that are paid on equity. The approach that is used in relation to the corporate taxes in this theory indicates that there are tax savings, and a change on the debt-equity ratio will have an overall effect on the Weighted Average Cost of Capital (WACC).
The Trade-Off Theory of Capital Structure
One of the primary assumptions that exists in the Modigliani and Miller theorem is that there are no taxes. To put it into perspective, the trade-off theory was built on the knowledge of the MM theoretical approach, but it takes into consideration, some of the cost effects of some of the assumptions such as the affects of the taxes, and the bankruptcy costs. An important point to note is that, while the M&M theorem can be used to indicate, or describe how a variety of the firms use their taxation to manipulate their overall profitability, and select their optimum debt level. However, it is important to point out that as the debt level of a company increases, there is the increased risk of a company being susceptible to bankruptcy.
In the trade-off theory, there is the recommendation that the optimal level of debt of a company is a situation in which its marginal benefits of the debt finance are equal to its marginal costs. This means that a company is in a better position of achieving its optimal capital structure by adjusting its debt and equity level, and balancing the overall tax shield and the financial distress cost. For the supporters of this theory such as, Myers (1977), there is the suggestion that the utilization of debt up to a specific level to offset the cost of the financial distress and interest tax shield. Fama and French (2002) pointed out that the ideal capital structure will be identified by the benefits of the debt tax deductibility of its overall interests, and the overall bankruptcy and agency costs.
Arnold (2008) provided an ideal explanation of how the increase in the debt capital in the relation to its capital structure has an impact on the overall valuation of a firm. In this case, as the debt capital of a company increases, the WACC of the firm will experience a decline until the point whereby a company will reach its optimal gearing level, and the overall cost of its financial distress increases in line with its overall debt level. This line of argument is supported by an earlier study that was conducted by Miller (1988) in relation to the optimal debt top the equity ratio of a company, which highlighted the highest possible tax shield that a company can be in a position to enjoy. An important point to note is that, according to Miller (1988), companies risk bankruptcy by because of an increased debt capital in its overall capital structure. The reason for this is that, in this theory, the cost of the debt of the company is associated with the direct and indirect costs of bankruptcy. The costs of bankruptcy include costs such as the legal and the administrative costs, as the direct costs, while the possibility of the company losing its valued customers, or clients is considered to be an indirect cost for the company.
Another important cost that is considered in this theory is the agency costs. There are direct and indirect costs that are associated with the agency costs that will mainly result from the principles and agents who are acting in their best interests. According to an earlier study that was conducted by Jenson (1986), the researcher argued that, the overall debt of a company can contribute to the reduction of its agency cost as the higher the debt capital, the greater the amount of money that will be used to service the debt. For the debt holders, they may instruct a company to engage in safe investments so that they can be able to recoup their debt. At this point, the debt holders are not concerned with the profitability of their investments in as much as they are considered with the ability of the company to pay its debts.
In the study by Brounen et al. (2005), it was argued that the presence of an optimal capital structure increases the overall shareholder wealth. In addition to that, the study findings by Brounen et al. (2005) provided an explanation that even with the maximization use of its debt capital to the full capacity, these companies face the risk of low probability of becoming bankrupt. In the study by Hovakimian et al. (2004), the study findings suggested that, the high profitability of the gearing indicated that when a firm’s tax shield is higher, then its possibility of becoming bankrupt decreases significantly.
The optimal capital structure selection of an organization should be designed in such a way that it would be easy to issue its debt capital, or its equity capital. The argument tat os provided in the trade-off theory suggests that all firms should have an optimal debt ratio, whereby the tax shield will be equal to the overall financial distress cost. The advantage of the use of this theory is that, it eliminates the impact of the overall information asymmetry.
The Pecking Order Theory
In a perfect capital market that was proposed in the M&M theorem, the management under the pecking order theorem prefer to utilize the internally generated funds, over the externally generated funds. In accordance with the pecking order theory, there is the belief that the management of a company will want to use the money that the company generates for investments that will promote its growth, as opposed to the use of finances, or funds that are obtained from loans, and other external funds. In line with this theory, in an ideal company, the management will first use its internal funds, and in case they are not enough, it will result in the issuance of debt, and as a final resort, it will issue equity capital for its business operations.
According to the Pecking order theory, a firm will most likely resort to borrowing funds, in the event that its internally generated funds are considered to be not sufficient to fulfil their current investment needs. This argument is supported by the study by Myers (2001) who noted that the debt ratio of a company normally reflects its cumulative figure in line with its external financing, and that companies that experience a higher profit and growth opportunities mainly use less, or significantly lower debt capital. In the event that a company does not have current investment opportunities, then its profits will be retained to avoid its future external financing.
In an earlier study that was conducted by Harris and Raviv (1991) they suggested that the capital structure decisions are meant to reduce, or eliminate the inefficiencies that are caused by the information asymmetry between the potential investors and the company. This was supported by Myers (2001) who suggested that the information asymmetry that exists between the insiders and the outsiders in a company setting, and its overall separation of the ownership of a company is one of the main reasons as to why a majority of the companies tend to avoid the capital markets. In another study that was conducted by Frydenberg (2004), the researcher provides the explanation that the debt issue of a company is an indication of its confidence in the market where it operates in such a manner that the management of the company is not afraid, or deterred in its ability to engage in debt financing. Frank and Goyal added that because of agency conflict between the management, the owners and the outside investors, the pecking order as proposed in this theory is highly likely to occur.
To put it into perspective, the overall studies in relation to the pecking order theory have failed to show the significance of the this theory in accurately determining a company’s overall capital structure. However, there are certain aspects of the study i.e. the capital structure that are best described by the use of the pecking order theory in comparison to the trade-off theory such as the preference of the company’s management to use internal funds for its investments and therefore reduce its likelihood to accumulate debts, that may increase the likelihood of the company stating that it is bankrupt. However, the short-comings of this theory have contributed to the formulation of other theories such as market timing theory.
Conclusion
All the three theories that have been discussed in this paper are meant to provide a better understanding of the capital structure decision of companies. In particular, the Modigliani and Miller theory indicates that the capital structure should be considered irrelevant when conducting the overall valuation of the company. It was developed to show the relationship between the debt and equity of a company. However, this theory was considered insufficient because of its assumptions, which cannot exist in the real world such as tax free companies. The trade off theory was developed to indicate the importance of the tax shield advantage and the value maximization through the engagement of the optimal debt to the equity mix. In addition to that, the pecking order theory shows the approach that the company uses to raise funds. The first approach is to use internal funds before proceeding to use external funds.
The differences in the capital structure theories is their approach on providing explanations on the significance of the taxes, information and agency costs on investments and overall valuation of the company. Although the three theories offers a unique insight of the capital structure and its impact on the valuation of the company, the theories are not perfect, or do not offer valid explanations that can be accepted by the economists and potential investors who want to assess the overall value of a company. This is an indication of the need to have a more comprehensive assessment on the impact of the capital;’s structure on the overall value of the firm.
References
Arnold, G. (2008). Corporate Financial Management. 4th ed. Harlow: Prentice-Hall.
Brounen, D., De Jong, A., & Koedijk, K. (2005). Capital structure policies in Europe: Survey evidence. Journal of Banking & Finance, 30(5), 1409-1442. https://doi.org/10.1016/j.jbankfin.2005.02.010Cheremushkin, S. V. (2011). undefined. Capital Structure and Corporate Financing Decisions, 151-169. https://doi.org/10.1002/9781118266250.ch9Dimitrov, V. (2011). Capital structure and firm risk. Capital Structure and Corporate Financing Decisions, 59-73. https://doi.org/10.1002/9781118266250.ch4Fama, E. F., & French, K. R. (1999). Testing tradeoff and pecking order predictions about dividends and debt. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.199431Frank, M. Z., & Goyal, V. K. (2007). Tradeoff and pecking order theories of debt. In: Eckbo, B.(Ed.). Handbook of Corporate Finance: Empirical Corporate Finance. Amsterdam: North-Holland, pp.135-202.
Frydenberg, S. (2004). Determinants of Corporate Capital Structure of Norwegian Manufacturing Firms, Trondheim Business School Working Paper No. 1999:6. https://doi.org/10.2139/ssrn.556634.
Habimana, O. (2015). Capital structure and financial performance: Evidence from firms operating in emerging markets. International Journal of Academic Research in Economics and Management Sciences, 3(6). https://doi.org/10.6007/ijarems/v3-i6/1383HARRIS, M., & RAVIV, A. (1991). The theory of capital structure. The Journal of Finance, 46(1), 297-355. https://doi.org/10.1111/j.1540-6261.1991.tb03753.xHovakimian, A. (2006). Are Observed Capital Structures Determined by Equity Market Timing?, The Journal of Financial and Quantitative Analysis, 41(1), (Mar., 2006), 221-243. https://doi.org/10.1017/S0022109000002489.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405x(76)90026-xMiller, M. H. (1988). The Modigliani-Miller propositions after thirty years. Journal of Economic Perspectives, 2(4), 99-120. https://doi.org/10.1257/jep.2.4.99Myers, S. C. (2001). Capital structure. Journal of Economic Perspectives, 15(2), 81-102. https://doi.org/10.1257/jep.15.2.81Nugroho, A. B. (2013). Proving modigliani and Miller theories of capital structure: The research on Indonesia’s cigarette companies. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3393045Tifow, A. A., & Sayilir, O. (2015). Capital structure and firm performance: An analysis of manufacturing firms in Turkey. Eurasian Journal of Business and Management, 3(4), 13-22. https://doi.org/10.15604/ejbm.2015.03.04.002Welch, I. (2004). Capital structure and stock returns. Journal of Political Economy, 112(1), 106-132. https://doi.org/10.1086/379933
Moral Conviction
Student’s Name:
Name of Tutor:
Course:
Date of Submission:
Moral Conviction
The predicaments faced by Lily in her quest to avoid moral depravity give a meaning ‘Moral Conviction’. Moral conviction is the utter belief in the wrongs or rights of a situation and the ability to substantially stand by the conviction (Brownlee 24).Lily is the one soul that ultimately stands for her beliefs and suffers punishment for them. The lady on more than one occasion loses her teaching job for her inability to be persuaded out of believes. The strength she exhibits and the courage to face the consequences of advocating right choices is an admirable factor worth emulating. Her character is a presentation of mental independence and valiance. Moral depravity to her is unacceptable but most importantly, moral conviction doesn’t serve to deflate her conscience and freedom of the mind (Brownlee 33).
Lily’s Stand by her Convictions
Having been plagued with financial shortfalls that drove her family into multitasking in desperate attempts to make something of themselves, Lily struck yet another job. Grady Gammage, who had been of help previously in Red Lake, helped her get a remote teaching role. In the small town of Main Street, Lily and her company get a kind reception that start to change upon the revelation of her husband’s real identity.The ‘Teacher Lady’, for yet another time, began with enthusiasm her role of administering knowledge, while at the time instilling in the crop of learners the elements of free will. The factor was not received with the same alacrity among the Mormon families who considered modernity as blasphemous. The village patriarch labels her attempt to impart knowledge and encouragement not as education, but as confusion.However, Lily stood by her mentality and rebuffed the attempts of correction and streamlining from the old man. Her reaction is so intense that she delivers an even stronger lesson to the learners the following day. The old man, Uncle Eli, lands in a life threatening situation when he attempts to advance his corrections to Lily. Events that develop henceforth deprive Lily of her job, as she was served with a letter from the County Superintendent of Mohave bearing the dismissal.The Lady Teacher believed that people intentionally block their ability to reason. Earlier in the novel, a conversation between her and her dad symbolizes this aspect. Her daddy says, “…horses are smarter than they let on. Kind of like the Indians who pretend they can’t speak English because no good ever came from talking with the Anglos.” (Walls 22)Lily’s case is just one among many. Experiences like such are a common phenomenon in different places and are catapulted by various reasons. Personally, I’ve been party to moral conviction and have experienced situations that threaten to hang my moral beliefs and statements.
Personal Struggle with Moral Conviction
I teamed up with High School peers during the 2009 summer in the creation of a community club that aimed at offering communal services to the disadvantaged in the community. The group set objectives to mete out cleaning and mowing services for the old and physically challenged. The project had been inspired by a drive from school that challenged all students to be a part of every social aspect in the communities. Communal service was the sure way of earning credibility and maximum points.The other groups members, Jese, Stephan, Rebeca, and Ciara, thrived on their ability to socialize freely and manipulate their ways around with the recipients of our services. On the other hand, I had a belief in a discreet relationship with our hosts. I did not encourage acceptance of rewards or invitation for meals as such would be payback that derail the essence of communal service.
One evening after a visit to a crippled man’s home in which we did mowing, trimming and training of hedges, I confronted the group over their acceptance of the reward money the host had offered.”You do not understand!” said Stephan. “Had we not accepted the offer, the man would have felt insulted.”I totally did not agree and did not hesitate to object. “You all fall short of knowledge about communal service, failing to take the money in humble ways, could have earned our credit, even before the man!” I shouted back at him.In my perception, the statement I made was a restatement of the obvious, but in got such a horrible reception from my peers. Their moods suddenly changed. It was liked I had stepped on a time bomb that had been waiting to explode, and explode it did.”You are mentally messed up, and we do not work with crooks, do we buddies?” Jese called out, and the response was unified to signify their acceptance. I was voted out of the group and for the rest of the summer, I stayed indoors with no friends but family.My ego and belief in upholding the truth dint give me a room for a second thought, or even an apology. In a sense, I dint see the relevance of participating in activities that had lost their course and value. All the while though, I dint feel like I was alone, I felt like Lily, I felt like I was with truth.Negation of principles degrades the aspects of mental freedom (Brownlee 47). There is little sense in having principles that cannot be followed and that is the belief that drive both Lily and I.
Works Cited
Brownlee, Kimberley. Conscience and Conviction: The Case for Civil Disobedience. Oxford: Oxford University Press, 2012. Print.
Half Broke Horses: A True-Life Novel. Perfection Learning Prebound, 2009. Print.