Wall Street Prep: Advanced Accounting
Questions and answers
How would raising capital through share issuances affect earnings per share (EPS)? -
correct answer-The impact on EPS is that the share count increases, which decreases EPS.
But there can be an impact on net income, assuming the share issuances generate cash
because there would be higher interest income, which increases net income and EPS.
However, most companies' returns on excess cash are low, so this doesn't offset the
negative dilutive impact on EPS from the increased share count.
Alternatively, share issuances might affect EPS in an acquisition where stock is the form of
consideration. The amount of net income the acquired company generates will be added to
the acquirer's existing net income, which could have a net positive (accretive) or negative
(dilutive) impact on EPS.
How would a share repurchase impact earnings per share (EPS)? - correct answer-The
impact on EPS following a share repurchase is a reduced share count, which increases
EPS. However, there would be an impact on net income, assuming the share repurchase
was funded using excess cash. The interest income that would have otherwise been
generated on that cash is no longer available, causing net income and EPS to decrease.
But the impact would be minor since the returns on excess cash are low, and would not
offset the positive impact the repurchase had on EPS from the reduced share count.
What is the difference between the effective and marginal tax rates? - correct
answer-Effective tax rate: % corporations must by in taxes
Effective tax rate = Taxes paid / earnings before tax
Marginal tax rate: % on the last dollar of a company's taxable income.
Why is the effective and marginal tax rate often different? - correct answer-Effective and
marginal tax rates differ because the effective tax rate calculation uses pre-tax income from
the accrual-based income statement. Since there's a difference between the taxable income
on the income statement and taxable income shown on the tax filing, the tax rates will nearly
always be different. Thus, the "Tax Provision" line item on the income statement rarely
matches the actual cash taxes paid to the IRS.
Could you give specific examples of why the effective and marginal tax rates might differ? -
correct answer-Under GAAP, many companies follow different accounting standards and
rules for tax and financial reporting.
i. Most companies use straight-line depreciation (i.e., equal allocation of the expenditure
over the useful life) for reporting purposes, but the IRS requires accelerated depreciation for
tax purposes - meaning, book depreciation is lower than tax depreciation for earlier periods
until the DTLs reverse.
, ii. Companies that incurred substantial losses in earlier years could apply tax credits (i.e.,
NOL carryforwards) to reduce the amount of taxes due in later periods.
iii. When debt or accounts receivable is determined to be uncollectible (i.e., "Bad Debt" and
"Bad AR"), this can create DTAs and tax differences. The expense can be reflected on the
income statement as a write-off but not be deducted in the tax returns.
What are deferred tax liabilities (DTLs)? - correct answer-Deferred tax liabilities ("DTLs") are
created when a company recognizes a tax expense on its GAAP income statement that,
because of a temporary timing difference between GAAP and IRS accounting, is not actually
paid to the IRS that period but is expected to be paid in the future.
DTLs are often related to depreciation. Companies can use accelerated depreciation
methods for tax purposes but elect to use straight-line depreciation for GAAP reporting. This
means that for a given depreciable asset, the amount of depreciation recognized in the
earlier years for tax purposes will be greater than under GAAP.
Those temporary timing differences are recognized as DTLs. Since these differences are just
temporary - under both book and tax reporting, the same cumulative depreciation will be
recognized over the life of the asset - at a certain point into the asset 's useful life, an
inflection point will be reached where the depreciation expense for tax reporting will become
lower than for GAAP.
What are deferred tax assets (DTAs)? - correct answer-Deferred tax assets ("DTAs") are
created when a company recognizes a tax expense on its GAAP income statement that, due
to a temporary timing difference between GAAP and IRS accounting rules, is lower than
what must be paid to the IRS for that period. These net operating losses ("NOLs") that a
company can carry forward against future income create DTAs.
For example, a company that reported a pre-tax loss of $10 million will not get an immediate
tax refund. Instead, it'll carry forward these losses and apply them against future profits.
However, under GAAP, the tax benefit will be recognized from a presumed future tax refund
immediately on the income statement, and this difference gets captured in DTAs. As the
company generates future profits and uses those NOLs to reduce future tax liabilities, the
DTAs gradually reverse.
Another reason for DTAs is the differences between book and tax rules for revenue
recognition. Broadly, tax rules require recognition based on receiving cash, while GAAP
adheres rigidly to accrual concepts.
What impact did the COVID-19 Tax Relief have on NOLs? - correct answer-Under the
Coronavirus Aid, Relief, and Economic Security (CARES) Act, NOLs that arise beginning in
2018 and through 2020 could be carried back for up to a maximum of five years. The rules
for claiming tax losses were changed to assist individuals and corporations negatively
impacted by the pandemic. For tax years beginning after 2020, the CARES Act would allow
NOLs deduction equal to the sum of:
Questions and answers
How would raising capital through share issuances affect earnings per share (EPS)? -
correct answer-The impact on EPS is that the share count increases, which decreases EPS.
But there can be an impact on net income, assuming the share issuances generate cash
because there would be higher interest income, which increases net income and EPS.
However, most companies' returns on excess cash are low, so this doesn't offset the
negative dilutive impact on EPS from the increased share count.
Alternatively, share issuances might affect EPS in an acquisition where stock is the form of
consideration. The amount of net income the acquired company generates will be added to
the acquirer's existing net income, which could have a net positive (accretive) or negative
(dilutive) impact on EPS.
How would a share repurchase impact earnings per share (EPS)? - correct answer-The
impact on EPS following a share repurchase is a reduced share count, which increases
EPS. However, there would be an impact on net income, assuming the share repurchase
was funded using excess cash. The interest income that would have otherwise been
generated on that cash is no longer available, causing net income and EPS to decrease.
But the impact would be minor since the returns on excess cash are low, and would not
offset the positive impact the repurchase had on EPS from the reduced share count.
What is the difference between the effective and marginal tax rates? - correct
answer-Effective tax rate: % corporations must by in taxes
Effective tax rate = Taxes paid / earnings before tax
Marginal tax rate: % on the last dollar of a company's taxable income.
Why is the effective and marginal tax rate often different? - correct answer-Effective and
marginal tax rates differ because the effective tax rate calculation uses pre-tax income from
the accrual-based income statement. Since there's a difference between the taxable income
on the income statement and taxable income shown on the tax filing, the tax rates will nearly
always be different. Thus, the "Tax Provision" line item on the income statement rarely
matches the actual cash taxes paid to the IRS.
Could you give specific examples of why the effective and marginal tax rates might differ? -
correct answer-Under GAAP, many companies follow different accounting standards and
rules for tax and financial reporting.
i. Most companies use straight-line depreciation (i.e., equal allocation of the expenditure
over the useful life) for reporting purposes, but the IRS requires accelerated depreciation for
tax purposes - meaning, book depreciation is lower than tax depreciation for earlier periods
until the DTLs reverse.
, ii. Companies that incurred substantial losses in earlier years could apply tax credits (i.e.,
NOL carryforwards) to reduce the amount of taxes due in later periods.
iii. When debt or accounts receivable is determined to be uncollectible (i.e., "Bad Debt" and
"Bad AR"), this can create DTAs and tax differences. The expense can be reflected on the
income statement as a write-off but not be deducted in the tax returns.
What are deferred tax liabilities (DTLs)? - correct answer-Deferred tax liabilities ("DTLs") are
created when a company recognizes a tax expense on its GAAP income statement that,
because of a temporary timing difference between GAAP and IRS accounting, is not actually
paid to the IRS that period but is expected to be paid in the future.
DTLs are often related to depreciation. Companies can use accelerated depreciation
methods for tax purposes but elect to use straight-line depreciation for GAAP reporting. This
means that for a given depreciable asset, the amount of depreciation recognized in the
earlier years for tax purposes will be greater than under GAAP.
Those temporary timing differences are recognized as DTLs. Since these differences are just
temporary - under both book and tax reporting, the same cumulative depreciation will be
recognized over the life of the asset - at a certain point into the asset 's useful life, an
inflection point will be reached where the depreciation expense for tax reporting will become
lower than for GAAP.
What are deferred tax assets (DTAs)? - correct answer-Deferred tax assets ("DTAs") are
created when a company recognizes a tax expense on its GAAP income statement that, due
to a temporary timing difference between GAAP and IRS accounting rules, is lower than
what must be paid to the IRS for that period. These net operating losses ("NOLs") that a
company can carry forward against future income create DTAs.
For example, a company that reported a pre-tax loss of $10 million will not get an immediate
tax refund. Instead, it'll carry forward these losses and apply them against future profits.
However, under GAAP, the tax benefit will be recognized from a presumed future tax refund
immediately on the income statement, and this difference gets captured in DTAs. As the
company generates future profits and uses those NOLs to reduce future tax liabilities, the
DTAs gradually reverse.
Another reason for DTAs is the differences between book and tax rules for revenue
recognition. Broadly, tax rules require recognition based on receiving cash, while GAAP
adheres rigidly to accrual concepts.
What impact did the COVID-19 Tax Relief have on NOLs? - correct answer-Under the
Coronavirus Aid, Relief, and Economic Security (CARES) Act, NOLs that arise beginning in
2018 and through 2020 could be carried back for up to a maximum of five years. The rules
for claiming tax losses were changed to assist individuals and corporations negatively
impacted by the pandemic. For tax years beginning after 2020, the CARES Act would allow
NOLs deduction equal to the sum of:
