Question

(Deferred Taxes, Income Effects) Stephanie Delaney, CPA, is the newly hired director of corporate taxation for Acme Incorporated, which is a publicly traded corporation. Ms. Delaney’s first job with Acme was the review of the company’s accounting practices on deferred income taxes. In doing her review, she noted differences between tax and book depreciation methods that permitted Acme to realize a sizable deferred tax liability on its balance sheet. As a result, Acme paid very little in income taxes at that time.

Delaney also discovered that Acme has an explicit policy of selling off plant assets before they reversed in the deferred tax liability account. This policy, coupled with the rapid expansion of its plant asset base, allowed Acme to “defer” all income taxes payable for several years, even though it always has reported positive earnings and an increasing EPS. Delaney checked with the legal department and found the policy to be legal, but she’s uncomfortable with the ethics of it.

Instructions

Answer the following questions.

1. Why would Acme have an explicit policy of selling plant assets before the temporary differences reversed in the deferred tax liability account?
2. What are the ethical implications of Acme’s “deferral” of income taxes?
3. Who could be harmed by Acme’s ability to “defer” income taxes payable for several years, despite positive earnings?
4. In a situation such as this, what are Ms. Delaney’s professional responsibilities as a CPA?

Short answer

1. Acme must have employed accelerated depreciation for tax purposes but straight-line depreciation for financial accounts.
2. Acme looks to be lowering its taxes using a totally lawful tax strategy plan.
3. Acme's income tax approach might affect the federal government.
4. Stephanie has a responsibility to maintain objectivity and honesty when it comes to financial reporting.

Step-by-step solution

Meaning of Income-tax payable

A business's tax responsibility to the government in which it operates is known as "income tax payable."

(a) Explaining why Acme has an explicit policy.

Acme adopted an accelerated depreciation technique for tax reasons while utilizing straight-line depreciation for its financial statements torealize a significant deferred tax liability.

Taxable income would surpass financial accounting income after the temporary discrepancy was corrected. Acme would have to pay the taxes it "delayed" in years where tax depreciation exceeded book depreciation.

Acme would have to sell these plant assets to prevent this from happening. It would be again on sale, but it would almost certainly be taxed at the lower capital gains rates. Acme will continue a "deferral" of income taxes if it purchases new plant assets and employs accelerated depreciation for tax reasons and straight-line for books.

(b) Explaining the ethical implications of Acme’s.

Deferring income taxes indicates that a corporation will be able to delay paying its income taxes (or reaping an income tax benefit) until future periods due to transitory variations created by changes in financial accounting rules and tax legislation. The practice of selling assets before the temporary difference disappears implies the corporation will pay less tax to the government.

While some may be worried that Acme is not paying its "fair share," the company appears to be lowering its taxes using a legal tax strategy plan. The taxation body has decided to grant these benefits, and there is nothing wrong with postponing the payment.

(c) Explaining the person harmed by Acme’s ability to “defer” income taxes payable for several years.

The federal government, which gets lower taxes due to Acme's income tax strategy, is the key stakeholder who might be damaged. Other taxpayers will have to pay more in the end. Furthermore, if acquiring new plant assets is prohibitively expensive, positive cash flow diminishes. Investors and creditors are harmed, even though the impact should be minimal.

(d) Explaining Ms. Delaney’s professional responsibilities as a CPA.

Stephanie is required to maintain objectivity and honesty in the conduct of financesas a public accountant. If she believes this practice is unethical, she should raise her concerns with Acme's senior management, including the Board of Directors and the Audit Committee members. However, Acme is only attempting to reduce its income taxes, which should not be regarded as immoral.