Question 3 Accounting for Income Taxes                                                   

Reed Ltd is a manufacturer of surfboards which commenced operations on 1 July 2019. The Statement of Comprehensive Income and the Statement of Financial Position were compiled on 30 June 2020. The following information was available:

Statement of Comprehensive Income for the year ended 30 June 2020

  $                      $

Following information was extracted from the Statement of Financial Position at 30 June 2020:

Other information was available for the year ended 30 June 2020:

1. Sales are recorded for income tax purpose at the time the sales are made.
2. Cost of Goods Sold and administrative expense incurred have been paid. They are allowed as a tax deduction at the year end.
3. Warranty expense was accrued. Deduction for income tax purpose is available only when the amount is paid.
4. The machine was purchased two years ago at a value of $400,000. It is depreciated evenly over its useful life and it has no residual value. The useful life is ten years based on accounting policy, but it is depreciated over eight years according to the taxation rule.
5. Insurance is allowed as a tax deduction when it is paid.
6. Income tax rate is 30%.

Required: (Narrations are not required in this question)

1. Determine the amount of taxable income for the year ended 30 June 2020.
2. Determine the amount of income tax expense for the year ended 30 June 2020.
3. Prepare a journal entry to record current tax liability on 30 June 2020.
4. Determine the amount of tax base for machine.
5. Determine the amount of temporary difference for machine.
6. The temporary difference for machine is deductible in this question, is this correct? Explain.
7. Provide journal entry to record DTA or DTL for machine.

Part C Question 3 Accounting for Income Taxes                                                   

Reed Ltd is a manufacturer of surfboards which commenced operations on 1 July 2019. The Statement of Comprehensive Income and the Statement of Financial Position were compiled on 30 June 2020. The following information was available:

Statement of Comprehensive Income for the year ended 30 June 2020

  $                      $

Following information was extracted from the Statement of Financial Position at 30 June 2020:

Other information was available for the year ended 30 June 2020:

1. Sales are recorded for income tax purpose at the time the sales are made.
2. Cost of Goods Sold and administrative expense incurred have been paid. They are allowed as a tax deduction at the year end.
3. Warranty expense was accrued. Deduction for income tax purpose is available only when the amount is paid.
4. The machine was purchased two years ago at a value of $400,000. It is depreciated evenly over its useful life and it has no residual value. The useful life is ten years based on accounting policy, but it is depreciated over eight years according to the taxation rule.
5. Insurance is allowed as a tax deduction when it is paid.
6. Income tax rate is 30%.

Required: (Narrations are not required in this question)

1. Determine the amount of taxable income for the year ended 30 June 2020.
2. Determine the amount of income tax expense for the year ended 30 June 2020.
3. Prepare a journal entry to record current tax liability on 30 June 2020.
4. Determine the amount of tax base for machine.
5. Determine the amount of temporary difference for machine.
6. The temporary difference for machine is deductible in this question, is this correct? Explain.
7. Provide journal entry to record DTA or DTL for machine.

As we know that generally economic exposure can be managed by balancing sensitivity of revenue and expenses to exchange rate fluctuations. To accomplish this, however, the firm must first recognize how its revenue and expenses are affected by exchange rate fluctuations which in turn will affect the firm’s future cash flow. For some firms, revenue is more susceptible. These firms are most concerned that their home currency will appreciate against foreign currencies since the unfavourable effects on revenue will more than offset the favourable effects on expenses. Conversely, firms whose expenses are more sensitive to exchange rates than their revenue are most concerned that their home currency will depreciate against foreign currencies. When firms reduce their economic exposure, they reduce not only these unfavourable effects but also the favourable effects if the home currency value moves in the opposite direction. After comprehending the economic exposure assessment from the various perspectives, you are required to answer all the questions.

Smith Co. operates business in the United States and New Zealand. In attempting to assess its economic exposure, it compiled the following information.

i.    Smith’s U.S. sales are slightly influenced by the New Zealand dollar (NZ$) value, due to confronts rivalry from New Zealand exporters. It estimates the U.S. sales based on the following three exchange rate scenarios:

                                                                               Revenue from U.S. Business

                        Exchange Rate of NZ$                             (in millions)

                                   NZ$ = $.48                                              $100

                                   NZ$ =   .50                                                105

                                   NZ$ =   .54                                                110

      ii.    Revenues for Smith Co. in New Zealand dollars are projected to be NZ$600 million.

      iii.   Cost of goods sold is projected at $60 million from the U.S. materials purchase and NZ$100 million from the New Zealand materials purchase.

      iv. Fixed operating expenses are valued at $30 million.

v.   Variable operating expenses are projected at 20 percent of total sales (after including New Zealand sales, translated to a dollar amount).

vi. Interest expense is projected at $20 million on prevailing U.S. loans, and the company has no existing New Zealand loans.

Questions:

1. Generate a forecasted income statement for Smith Co. under each of the three exchange rate scenarios.                                                              

Also answer the following questions based on the rubric.                    

2. Discuss how Smith’s projected earnings before taxes are influenced by the vital of exchange rate forecasting. Justify your viewpoints.                                                   
3. Describe how Smith Co. can restruc­ture its operations to minimize the earnings sensitivity to the degree of exchange rate movements without reducing its business volume in New Zealand.                                                                                                   

As we know that generally economic exposure can be managed by balancing sensitivity of revenue and expenses to exchange rate fluctuations. To accomplish this, however, the firm must first recognize how its revenue and expenses are affected by exchange rate fluctuations which in turn will affect the firm’s future cash flow. For some firms, revenue is more susceptible. These firms are most concerned that their home currency will appreciate against foreign currencies since the unfavourable effects on revenue will more than offset the favourable effects on expenses. Conversely, firms whose expenses are more sensitive to exchange rates than their revenue are most concerned that their home currency will depreciate against foreign currencies. When firms reduce their economic exposure, they reduce not only these unfavourable effects but also the favourable effects if the home currency value moves in the opposite direction. After comprehending the economic exposure assessment from the various perspectives, you are required to answer all the questions.

Smith Co. operates business in the United States and New Zealand. In attempting to assess its economic exposure, it compiled the following information.

      i.    Smith’s U.S. sales are slightly influenced by the New Zealand dollar (NZ$) value, due to confronts rivalry from New Zealand exporters. It estimates the U.S. sales based on the following three exchange rate scenarios:

                                                                               Revenue from U.S. Business

                        Exchange Rate of NZ$                             (in millions)

                                   NZ$ = $.48                                              $100

                                   NZ$ =   .50                                                105

                                   NZ$ =   .54                                                110

      ii.   Revenues for Smith Co. in New Zealand dollars are projected to be NZ$600 million.

      iii.   Cost of goods sold is projected at $60 million from the U.S. materials purchase and NZ$100 million from the New Zealand materials purchase.

      iv. Fixed operating expenses are valued at $30 million.

v.   Variable operating expenses are projected at 20 percent of total sales (after including New Zealand sales, translated to a dollar amount).

vi. Interest expense is projected at $20 million on prevailing U.S. loans, and the company has no existing New Zealand loans.

Questions:

1. Generate a forecasted income statement for Smith Co. under each of the three exchange rate scenarios.   

Also answer the following questions based on the rubric.

2. Discuss how Smith’s projected earnings before taxes are influenced by the vital of exchange rate forecasting. Justify your viewpoints.                                                          

C.Describe how Smith Co. can restruc­ture its operations to minimize the earnings sensitivity to the degree of exchange rate movements without reducing its business volume in New Zealand.      

1. Project Evaluation.
   1. Describe the weighted average method of evaluation. How do you use it? How are the weights determined?
   2. A university is evaluating whether to continue using their current CRM (Customer Relationship Management) software:
      1. PowerCRM - The current system is slow, had two weeks worth of outages last year and frustrates the marketing department because it isn’t flexible.
      2. The competitor is SailsForce, a CRM platform developed by a company whose founder also loves ships. It is known for being reliable and flexible. Schools using it report average recruitment of 5 additional students per year.
      3. Using the above facts, choose 5 evaluation criteria, weigh the criteria and score the companies. The evaluation criteria should be pertinent to the question; use your imagination to score the companies (Hint: you can use the template) Explain your choices for criteria selection and weighting.

   3. Total Cost of Ownership

      1. What is meant by Total Cost of Ownership? How is it calculated? What is included? How is it used in project evaluation?

      2. Consider the options from Question 1 Project Evaluation:

      3. SailsForce has an upfront cost to implement $25,000. The annual licensing fee is $600 per user, and there are 75 employees in admissions who need a license.

      4. PowerCRM is already implemented and has a licensing cost of $40,000 per year. The average full-time student, after discount, pays $20,000 per year.

      5. Compare the 5-year total cost of ownership.  

      6. Based on the TCO and Weighted average, which would you recommend and why?

Frosty Co. is a publicly traded, medium-sized manufacturing firm that produces refrigerators, freezers, ice makers, and snow cone machines. During the past three years, the company has struggled against increasing competition, sluggish sales, and a public relations scandal surrounding the departure of the former Chief Executive Officer (CEO) and Chief Financial Officer (CFO). The new CEO, Jane Mileton, and CFO, Doug Steindart, have worked hard to improve the company's image and financial position. After several difficult years, the company now seems to be resolving its difficulties, and the management team is considering new investment opportunities. The team hopes that diversification into a line of professional ice cream makers, and perhaps a line of consumer products, will help the company continue its recent growth and effectively compete with future competitors.

In order to raise the funds needed for these new investments, Frosty Co.'s Board of Directors has approved a seasoned equity offering (SEO). The discussions regarding the new investment opportunities and the equity offering have been kept quiet until a positive set of financial statements can provide strong evidence that the company has turned around, leading to an increase in the company's stock price.

INTRODUCTION

After a full week of carefully examining financial statements, Simon was exhausted. He had become Frosty Co.'s corporate controller only a month ago, after several years as an auditor at a public accounting firm, and was excited about the move to corporate accounting. The first few weeks had gone well, as Simon met his accounting staff and settled into his new responsibilities. Then, he had started reviewing Frosty Co.'s financial statements for the prior year to make sure they correctly followed GAAP, and to familiarize himself more with the company and industry. Unfortunately, his relative inexperience with the industry and Frosty's accounting procedures had required him to spend more time on the review than he had anticipated.

He still had a few questions about the financial statements, but he needed to start preparing for the upcoming SEO. He decided that he would talk to his staff about his lingering questions tomorrow morning, just before his meeting with the CEO and CFO. The three of them were to discuss the upcoming audit and the earnings announcement and how they would impact the proposed SEO. He rubbed his tired eyes and headed home to get a little sleep.

MEETING OF THE ACCOUNTING STAFF: 10:30AM

Simon looked up as the divisional controllers, Elsa Pilebody and John Mortenson, came into his office. Elsa worked with Frosty Co.'s fridge and freezer division; John worked with the ice maker and snow cone machine division. So far, Simon had enjoyed working with them, especially since neither of them seemed to resent him stepping in as their new boss. They were both smiling as they came through the door, and their good-natured teasing started almost before they had finished shaking hands.

“Sorry we're a little late,” Elsa started, “but John had to stop for the last jelly donut.”

“I did not!” John said indignantly. He looked at Simon. “It was chocolate.”

Because of his busy schedule that day, Simon got down to business instead of joining the banter as he normally would have done. “Thanks for coming by, Elsa and John. We have several issues to discuss before I have to meet with Jane and Doug this afternoon.” He paused for a second. “I've spent the past week going over the financial statements. Overall, they look well done, but I need clarification on a few details. To start with, I want to discuss the construction project we began last year.”

“That's our big project at the moment. We're building a new factory that should be done next summer,” Elsa said. “Construction is going well, and we've been careful to capitalize all of the expenditures.”

Simon shook his head. “That's the problem. I think we capitalized more than we should have. More specifically, it looks like we capitalized all of the interest on our most recent bank loan.”

“We did,” Elsa replied. “Since we're using all of the loan proceeds to build the new factory, we felt it was appropriate to capitalize all of the interest.” John nodded in agreement.

“I disagree,” said Simon. “Here's a breakdown of the payments we made on our new building and a list of our outstanding long-term debt (see tables below). Did we take out any of these loans specifically for the new factory?”

Elsa shook her head. “No, we took out the new loan, Loan 2, for general expansion, then decided the most appropriate use of the funds would be for the new factory.”

Simon frowned. “Why are we capitalizing the interest on Loan 2 if it wasn't originated specifically for the new factory?”

“Well, if the capital from the loan is eventually used on a specific construction project, then I think we should be able to capitalize the interest on that loan as part of the historical cost of the

2

project. Of course,” Elsa frowned, “maybe we are capitalizing too much. Perhaps we need to calculate avoidable interest to determine the amount of interest that should be capitalized.”

“You are right that generally we would need to calculate avoidable interest before capitalizing any interest,” Simon answered. “But in this case, we don't need to do that. I believe GAAP allows interest to be capitalized only if a specific construction loan is used.”

“Well, I still think that we should be able to capitalize at least some of the interest. But I'll do some research to make sure.”

Date Expenditure Spent The Amount of Expenditure

February 15 $90,000

April 1 $125,000

June 30 $200,000

October 1 $300,000

November 15 $585,000

Liabilities Amount Annual Interest Rate

Bond A $678,000 7.1%

Loan 1 $650,000 6%

Loan 2 $1,000,000 7%

Answer the following questions based on the information above: Capitalizing interest on the new factory:

1) During the year, Frosty Co. paid all of the interest accrued on Bond A and Loan 1, but only $50,000 of the interest accrued on Loan 2. Using one journal entry, summarize how Frosty originally recorded the accrued interest on all three long-term debts.

2) Assuming John and Elsa are right that the new loan meets the standards for capitalizing interest, calculate avoidable interest.

3) What correcting entries would need to be made to properly record interest on Frosty Co.'s construction project if John and Elsa are right?

4) What would be the effect of interest adjustments on net income, assuming that Frosty Co.’s income tax rate is 30 percent?

In Kelo v. City of New London, 545 U.S. 469 (2005), the U.S. Supreme Court decided a case in which landowners challenged the power of a city in Connecticut to take their property for redevelopment. The redevelopment plan did not contemplate that all of the land would be open to the public. Parts would be privately developed. The plaintiffs alleged that the taking was unconstitutional because it was not for a public purpose. The Supreme Court rejected this claim. Use economic analysis to argue for or against the view that such a mixed development plan should be regarded as serving a public purpose.

Is the following statement true or false:  "The correlation between (U.S.) stock market returns and long-term U.S. treasury bond returns is generally negative during times when equity markets are crashing."

True

False

Is the following statement true or false: " Consider a strategy that buys 1-year US treasury bonds, holds them to maturity, and uses the proceeds from the maturing bonds to buy new 1-year bonds. In this case, the actual/realized returns is uncertain, but it is always positive."

True

False

What does the flight-to-safety feature of government bonds imply? Choose all that apply.