Financial Reporting II Exam III (Accounting for Income Taxes

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					Financial Reporting II
Exam III (Accounting for Income Taxes and Derivatives)
Spring 2007


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.

Question 1:

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.

Question 2:

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
       1, 2006.

Question 3:

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?