Financial Reporting II
Exam III (Accounting for Income Taxes and Derivatives)
This is a graded exam. You should follow the same rules that you follow when taking
an exam in class — you may not talk with anyone other than me about the exam. You
should use your book and notes and materials on the course website to help you with
the exam. If after consulting all of those resources, you remain confused or need help,
please feel free to contact me. It is due at the start of class on Monday, May 14. Please
do not put your name on your exam; just use your student ID number.
Scudder Computers, Inc. began operations in January 2003. Pretax accounting income
for 2003 was $810,000. Scudder reported the following differences between accounting
and taxable income:
1. When computers are sold on an installment basis, Scudder recognizes all of the
income for financial reporting purposes in the year of the sale. For tax purposes,
profits on installment sales are recognized under the installment method. 2003
installment sales (included in the pretax income reported above) were $600,000
and will be collected over the next three years. The cost of the computers sold
was $375,000. Scheduled collections for 2004-2006 are $150,000, $250,000, and
$200,000, respectively (none of the sales were collected in 2003).
2. Scudder’s pretax income included product warranty costs of $80,000 expensed for
financial reporting purposes in 2003. For tax purposes, only the $20,000 of
warranty costs actually paid in 2003 was deducted. Expected cash costs for
warranties in 2004-2006 are $20,000, $25,000, and $15,000, respectively.
3. Scudder reported interest revenue of $10,000 (included in pretax income) from
investments in municipal bonds that is not taxable.
The current income tax rate is 30%; however, Scudder expects the tax rate to increase to
40% on January 1, 2005.
1. Assuming that there are no temporary differences other than those described
above, prepare the journal entry(ies) to record Scudder Computer's 2003 income
2. Indicate the balances of each deferred tax asset and liability that would result
from analysis of the information above as of the end of 2003 and 2004 and
indicate where within a classified balance sheet they would appear.
3. Present an excerpt from the 2003 income statement for Scudder Computers,
beginning with income before income taxes for 2003.
4. Prepare a reconciliation of the statutory rate and the effective tax rate for 2003.
The tax footnote for Atlas Container for the year ended August 1, 2006 contained the
following (amounts in millions):
2004 2005 2006
Income before taxes $224 $284 $524
Taxes on Income
Current $82 $92 $190
Deferred (15) (4) (23)
Total $67 $88 $167
Effective Tax Rate
Federal tax rate 35% 35% 35%
State and local taxes 2 2 1
Nontaxable interest revenue (3) (2) (1)
Foreign tax rates (4) (5) (6)
Other - 1 3
Total 30% 31% 32%
Components of Deferred Taxes
Deferred Tax Assets
Pensions $ 73 $ 85 $101
Inventories 77 89 94
Total $150 $174 $195
Deferred Tax Liabilities
Depreciation $7 $27 $25
Total $7 $27 $25
No changes in tax rates are expected in the future years.
1. What was the amount of income tax expense reported on the income statement for
2. By how much did depreciation expense for book purposes differ from depreciation
claimed for tax purposes for the year ended August 1, 2006? Please indicate whether
tax or book depreciation was higher and by what amount.
3. Was book income before taxes larger or smaller than taxable income for the year ended
August 1, 2006? Explain.
4. Prepare the journal entry for the recording of income taxes for the year ended August
Newton Grains plans to sell 100,000 bushels of corn from its current inventory in March
2008. The company incurred production costs of $1 million for planting and harvesting
the corn during the fall 2007 harvest season. On October 1, 2007, Newton writes a
forward contract to sell 100,000 bushels of corn on March 15, 2008 for $1,100,000. The
forward contract has zero value at inception. On December 31, 2007, the March forward
price for corn is $1,050,000 and the forward contract has a fair value of $95,000. On
March 15, 2008 Newton sells the corn for $1,075,000 and settles the forward contract
(now valued at $25,000).
1. Why did Newton hedge its planned sale of corn? Was it a good idea to do so?
2. Newton designates the forward contract as a cash flow hedge of its exposure to
corn price fluctuations. What journal entries are made when the forward contract
is signed on October 1, 2007?
3. What journal entries are made on December 31, 2007?
4. What journal entries are made on March 15, 2008 when the forward contract is
settled and Newton sells the corn?
5. Suppose that Newton considers this to be a hedge of the fair value of its corn
inventory instead of a cash flow hedge. What journal entries are required at
October 1, 2007, December 31, 2007, and March 15, 2008?