Question

Income Tax Implication of Capital Investment Decisions

Read the following case study:

The Whitley Corporation's year-end is December 31, 2013. It is now October 1, 2013. The Whitley management team is taking a look at the prior nine months and attempting to make some short-term strategy decisions.

Whitley has experienced steady growth over the five preceding years. The result has been a steadily increasing EPS. Last year, Whitley reported an EPS of 1.95.

This year, owing to a mild recession, Whitley's sales have fallen off. Management is looking for strategies that can improve the appearance of the financial statements. At the same time, there is a need for new equipment in the plant. Despite the recession, Whitley has enough cash to make the purchase.

Based on the year's performance to date and extrapolation of the results to year-end, management feels that the pretax financial accounting income for the year will be $200,000. Transactions from prior years have resulted in a deferred tax asset of $15,000 and a deferred tax liability of $70,000 at the beginning of 2013. The temporary difference of $37,500 that resulted in the deferred tax asset is expected to completely reverse by the end of 2013. The deferred tax liability resulted totally from temporary depreciation differences. There will be a pretax reversal of $42,500 in this temporary difference during 2013.

Based on currently enacted tax law, the purchase of the equipment will result in a future taxable amount of $50,000. Whitley management feels that it can wait four to six months to purchase the machine. Whitley's tax rate is 40 percent.

Write a response of 700 to 1,050 words to the following:

Determine the projected amount of income tax expense that would be reported if Whitley waits until next year to purchase the equipment.

Determine the projected amount of income tax expense that would be reported if Whitley purchases the equipment in 2013.

Explain why Whitley should/shouldn't wait to purchase the equipment. Your answer should take into consideration the expected financial statement effects, as well as the effect on EPS. Support your conclusions with pro forma data. The number of shares that Whitley will use to calculate EPS is 55,500.

Determine the ethical considerations of this case.

Answer 1

1. The projected amount of income tax expense that would be recognized if Whitley waits until next year to purchase the equipment is calculated as follows:

	Amounts in dollars $
Pretax accounting income	200,000
Reversal of deductible amount	(37,500)
Reversal of taxable amount	42,500
Taxable Income	205,000
Taxes payable ( $205,000* 40%)	82,000
Decrease in deferred tax asset	15,000
Decrease in deferred tax liability (42,500*40%)	(17,000)
Income Tax Expense	80,000

2. The projected amount of income tax expense that would be reported if Whitley purchases the equipement in 2013 is calculated as follows:

Income tax expense ( as calculated above)	$80,000
Increase in deferred tax liability ($50,000* 40%)	$20,000
Income Tax Expense	$100,000

If Whitley decided to purchase equipment in current year 2013, they would have to pay higher income tax expense of $100,000. Hence, have to pay an additional tax of $20,000

3. The following difference in EPS will be occur, ignoring depreciation on purchase asset:

EPS - Postpone equipment purchase = ($200,000 - $80,000)/55,500 = $2.16

EPS - Equipment Purchase in 2013 = ($200,000 - $100,00)/55,500 = $1.80

Decline in EPS = $0.36

By taking the given data, it would better Whitley should postponed the equipment purchase as if purchase were made in 2013 the following effects would occur in the financial statement are:

• Current asset ( that is cash) would decrease by the amount of the purchase price.
• Long term assets would be increase by the same amount less depreciation.
• It would result in decrease in liquidity such as current ratio and working capital.
• Increase in deferred tax asset will increase the long term liabilities and Net income will decrease by the amount of depreciation expense and deferred tax liability increase. Therefore, it will result in increase in debt to equity ratio.
• The decrease in Net income will result in a decline in EPS.

4. If the purchase were postponed, the company would continue to project a steadily increasing EPS. Although the EPS will be historically correct, that is faithful, the projection implied by it may mislead by potential investors, if next year is no better or even worse than 2013. The ethical diemma is that company should not base economic decision on financial statement effects rather, the financial statement should describe economic reality.