Magnolia Inc. is a profitable new company that has good prospects for growth. It is nearing the end of its first year in business and the president Mr. James must make some decisions regarding accounting policies for financial reporting to stockholders.
Magnolia's controller and certified public accountant have gathered the following information (see attachment #1, background).
***ACRS accelerated depreciation and flow-through of the investment credit will be used for TAX CALCULATION and payment purposes REGARDLESS of the method chosen for reporting to stockholders. For all other items, assume that the same method used for financial accounting is used for tax purposes.***
Use the format provided herein for the following requirements:
Step 1) Prepare a columnar income statement. Each column is a distinct option for displaying the financials of Magnolia. In column 1, show the results using LIFO, accelerated depreciation (assumed equal to ACRS depreciation), immediate expensing of store-opening costs, and amortization of the investment credit. Show earnings per share as well as net income. In successive columns, show the income statement and earnings per share of substituting the alternative methods: column 2, FIFO inventory; column 3, straight-line depreciation; column 4, amortization of store-opening costs; column 5, flow-through of investment credit. In column 6, show the total results of choosing all the alternative methods (columns 2 through 5). Note that in columns 2 through 5, only single changes from column 1 should be shown; that is column 3 does not show the effects of columns 2 and 3 together, nor does column 4 show the effects of columns 2, 3, and 4 together.
2.Prepare an end-of-period columnar balance sheet consistent with requirements of Step #1 above.
3.Prepare a columnar statement of cash flows consistent with requirements of Step #1 above.
4.Express all numerical data in thousands (omit 000), and comment on the results.
5.Which option would you recommend (select one only)? Why (relative advantages)?
This is how I interpret this question...The first column in the financial sheets represents the baseline handling of the statements. That is to say, Magnolia reports inventory using LIFO, accelerated depreciation (assumed equal to ACRS depreciation), immediate expensing of store-opening costs, and amortization of the investment credit. Each subsequent column changes the handling of one (and only one) reporting method. The last column changes the handling of all 4 reporting methods (inventory, appreciation, expensing of store opening costs and the handling of the tax credit).
Whew...that's a lot of info, I know.
As for question 5 above: Which option would you recommend and why (relative advantages)? The teacher suggested the following: "Comment on whatever you think suitable. Among others, you might address the implications of the substantially different net incomes produced; the value of the cash flow statement; the usefulness of ratios; the measurement of performance; recommendations for management or others.
I have included the background in attachment #1.
And in attachment #2, I have provided my first attempt at this, but I'm not sure its even close...but it at least gives you an idea of the format.
The tricky part is that to calculate the TAXES, you use ACCELERATED depreciation and FLOW THRU of the investment tax credit. But then in the actual statements, you use whatever treatment is prescribed by question 1 above (example: for column two, or "option 2), you use FIFO, accelerated depreciation, immediate expensing if store opening costs, and amortized tax credit. Its confusing!!!
FYI...since ITC is handled differently by different folks, in class, this is how ITC was defined:
THE FLOW THRU method for the ITC reduces reported income tax expense by the entire amount of the credit IN THAT YEAR the credit is taken. The tax liability decreases and reported income tax expense decreases by the same amount.
And the DEFERRAL method spreads the tax credit over the assets useful life by REDUCING REPORTED TAX EXPENSE in each of the years. The ITC is initially recorded as a deferred credit (liability) ..then the income tax expense would decrease each year
.... Example, $200,000 machine qualifying for a $20,000 investment tax credit....
Flow through: Reduces reported income tax expense by the whole amount in that year.. So here, tax liability will be decreased by $20,000. Record like this:
Income tax Liability.............20,000
Income tax Expense...................20,000.
So it decreases tax expense and increase net income by $20k.
Deferred: ITC is treated as a reduction in the cost of the asset (a true rebate). Spreads the tax credit over assets useful life. Reduces reported income tax expense in each year.
With deferred method, the ITC would initially be recorded as a deferred tax credit (a liability), analogous to unearned revenue.
Income tax liability..........20,000
Income Tax expense.................20,000
Entry has no effect on the income statement. In future years, income tax expense would decrease by $2k a year. The entry would be:
Deferred tax Credit.........2,000
Income Tax expense........2,000
So what does this mean for the balance sheet in my problem? Do I need to show the ITC as an income item on the balance sheet? If so, how?
Please see the attached spreadsheet for financial statements.
<br>For income tax purposes, you should always use ACRS (in this case $120k) for depreciation expenses AND flow-through for ITC which should be $5k, to get the correct tax payable amount. (You should make adjustment to BS reflecting the changes on ITC - I've done that in the file, namely the line for Tax Payables and the line for Deferred Tax).
<br>The main purpose of this question is to test your grasp of the impact on the ...