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Workshop 3
6 Nontax costs of tax planning 5, 6
7 The importance of marginal tax rates and dynamic planning considerations 1, 4
5. Suppose Sonics Inc. just started business this period. The firm purchased 400 units during the period at various prices as follows:
DateUnitsUnit Cost Total
January100$10$1,000
March100$12$1,200
June100$14$1,400
October100$15$1,500
Total400 $5,100
The firm sold 250 units at $30 each on the following dates:
Date Units Unit Price Total Sales
February75$30$2,250
May90$30$2,700
August75$30$2,250
December10$30$300
Total250$30$7,500
Required (assume the firm faces a marginal tax rate of 35%):
a. Calculate taxable income and taxes payable assuming the firm uses FIFO (first-in, first-out) for inventory costing purposes.
b. Calculate taxable income and taxes payable assuming the firm uses LIFO (last-in, first-out) for inventory costing purposes.
Discuss your results, including any nontax costs that might be associated with either inventory costing system.
a. Calculate taxable income and taxes payable assuming the firm uses FIFO (first-in, first-out) for inventory costing purposes.
Relate this problem to your Managerial accounting courses.
unitsprice
Sales $0formula created for you. Fill in yellow cells.
Less cost of goods sold
create formulas to left and enter result
Taxable income0formula created for you.
Tax @ 35%$0<-- answer formula created for you.
b. Calculate taxable income and taxes payable assuming the firm uses LIFO (last-in, first-out) for inventory costing purposes.
An additional assumption needs to be made. Is LIFO being applied at each sale (so only the latest cost figures at the sale date can be used, known as the continuous method) or applied at the end of the year (so the latest cost figures for the year are used regardless of when the sale occurred within the year, known as the periodic method)? We will assume the latter as this minimizes taxable income and hence taxes.
unitsprice
Sales $0formula created for you. Fill in yellow cells.
Less cost of goods sold
create formulas to left and enter result
Taxable income0formula created for you.
Tax @ 35%$0<-- answer formula created for you.
Now compare the difference and discuss. also are there financial accounting (reporting) issues using LIFO vs FIFO?
Exercise 6
6. Assume Sonics Inc., from the prior exercise, uses LIFO with the periodic inventory system. Thus the LIFO cost of ending inventory at year 1 of 150 units is $1,600 (100 @ $10 + 50 @ $12). Suppose in year 2, Sonics reports the following purchases and sales:
DateUnits Unit Cost/PriceTotal
Purchases
June100$17$1,700
Sales
July200$30$6,000
Required:
a. Calculate taxable income and taxes payable (again assuming Sonics faces a marginal tax rate of 35%) for year 2.
-How many more units did Sonics sell than purchase?
-What is the difference in the unit cost and latest purchase price for each of these units?
b. Instead of purchasing 100 units in June, Sonics purchased 110 units. Recalculate taxable income and taxes payable.
c. Instead of purchasing 100 units in June, Sonics purchased 90 units. Recalculate taxable income and taxes payable.
d. How many units should Sonics have purchased to avoid dipping into earlier layers of inventory?
e. Do you notice any opportunities for Sonics Inc. to smooth reported net income (by varying the amount purchased relative to sales)? Are there any costs associated with this strategy? Does FIFO offer the same opportunities?
f. Suppose the top managers of Sonics are compensated, in part, by a bonus linked to reported net income. What inventory costing method might you expect the managers to favor? What costs to the firm arise from this choice?
a. unitsprice
Sales $0formula created for you. Fill in yellow cells.
Less cost of goods sold
create formulas to left and enter result
Taxable income0formula created for you.
Tax @ 35%$0<-- answer formula created for you.
How many more units did Sonics sell than purchase?
-What is the difference in the unit cost and latest purchase price for each of these units?
b.unitsprice
Sales $0formula created for you. Fill in yellow cells.
Less cost of goods sold
create formulas to left and enter result
Taxable income0formula created for you.
Tax @ 35%$0<-- answer formula created for you.
Note the change in taxable income of $-70. Analyze this change and explain below.
......
Note the change in taxable income of $+70. Analyze this change and explain below.
d. How many units should Sonics have purchased to avoid dipping into earlier layers of inventory?
f. Suppose the top managers of Sonics are compensated, in part, by a bonus linked to reported net income. What inventory costing method might you expect the managers to favor? What costs to the firm arise from this choice?
By varying the number of units purchased at year-end, managers can increase or decrease taxable income AND reported earnings. illustrate this statement both mathematically and in writing below.
Increasing purchases at year-end (even if units purchased is greater than units sold) allows the latest unit prices to be used in calculating cost of goods sold and taxable income thus lowering taxable income and taxes. Note disadvantages of this practice below.
Why doesn't FIFO offer the same opportunity as LIFO. Consider rising prices due to inflation in your response below
f. Suppose the top managers of Sonics are compensated, in part, by a bonus linked to reported net income. What inventory costing method might you expect the managers to favor? What costs to the firm arise from this choice?
Managers face a trade-off. Discuss this tradeoff below. Consider which inventory method would report higher earnings when prices were increasing.
Exercise 1
1. Suppose a firm is equally likely to earn $2 million this year or lose $3 million. The firm faces a tax rate of 40% on each dollar of taxable income, and the firm pays no taxes on losses. In this simple one-period scenario, ignore the carryback and carryforward rules. The firm’s expected taxable income is thus a loss of $500,000 calculated as .50(−$3) + .50($2). What is the firm’s expected marginal tax rate?
Suppose a second firm is equally likely to earn $3 million this year or lose $2 million. This firm also faces a tax rate of 40% on each dollar of taxable income (and the firm pays no taxes on losses). Again in this simple one-period scenario, ignore the carryback and carryforward rules. The firm’s expected taxable income is thus a profit of $500,000 calculated as .50($3) + .50(−$2).
What is the firm’s expected marginal tax rate?
Explain and discuss your results.
What is the firm’s expected marginal tax rate?
E = expectedmtr = marginal tax rate
.5 x mrt of .4+.5 x mrt of 0=nn%
Firm 1: Expected marginal tax rate, E(mtr) = <-create formula
.5 x mrt of .4+.5 x mrt of 0=nn%
Firm 2: Expected marginal tax rate, E(mtr)= <-create formula
Note that each Firm has the same Expected marginal tax rate
Fill in the blank lines
For firm 1, while the expected taxable income is a loss of $500,000 there is a __% chance of its mtr being __% and a __% chance of its mtr being _ thus the correct answer is .50(.40%) + .50(0%) = __% rather than E(TI) = -$500,000, with an E(mtr) = 0.
If the firm were to earn another dollar of income, what effect would this have on its tax bill? This effect is the mtr. There is a __% chance the additional dollar will be taxed at __% and a __% chance that the dollar will not be taxed giving, in expectation, an mtr of __%. Similar reasoning applies to firm 2.
Exercise 4
4. Find the annual report for some publicly listed high-technology company that has losses. Refer to the tax footnote in the report to extract the NOL carryforward. Assume an after-tax discount rate of 10%.
Calculate the firm’s marginal explicit tax rate using the Manzon (1994) market-value approach. Discuss and explain your result.
Under the Manzon (1994) approach, first calculate expected annual taxable income : TI = MVE*r, where MVE is the market value of equity of the firm and r is the after-tax discount rate. [Show Less]