Ethics: Deferred Taxes, Income Effects

Ethics: 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 is uncomfortable with the ethics of it.

Answer the following questions in the Discussion Board:

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

Posted 1

Hello All,

Acme may be allowed to pay their income tax later in order to avoid things like bankruptcy and financial limitations for the company. Companies are allowed to do this legally so long as they promise to pay the tax owned at a future date. In this case Acme should document the actual value of the asset in the market in relation to the tax that has been deferred in that time period, because it would give a better idea of what is actually owed as they will still have to pay these liabilities. This is still something that is allowed legally by the tax authority. These type of companies may have to be watched closer to ensure they are paying their share and what is truly owned, but overall I do not think anything is being done unethically by Acme.

The government could be harmed by the ability to defer income tax payable, because they would receive less money from Acme than they normally would if the income tax was not deferred, and paid on time. Also the investors and creditors may be affected in minimum as well. As a CPA, Ms. Delaney, needs to be ensured that Acme is being ethical with their financial reporting, and presenting it with integrity. If she in fact believes something is unethical with their practice then she should escalate this issue to higher management, and members of Board of Directors for the company to be reassured that this type of practice is legal for the company before she signs her name off.

Posted 2

Hello Class and Professor,

When a company realized its income in one accounting period and the taxable portion was not due until the future periods, it deferred income tax payable. (Kieso, Weygant & Warfield, 2016, p. 1055). Besides, the IRS measures individual and business incomes on a cash basis. In other words, the taxable income is calculated based on the funds received, not on the date of making the sales.

a/ When reversing the temporary differences in the deferred tax liability, Acme’s taxable income might be higher than the financial reporting income. Also, since “Acme paid very little in income taxes at that time”, the company may have to pay more on the deferred income tax in the current year. By selling its plant asset, Acme could report the income as capital gain instead of earnings which could be paid at a lower tax rate. In addition, when Acme sells its asset at a profit, it is possible to spread the capital gain or loss for more than one period if the company deferred the collection of money.

b/ The ethic I’m seeing here is that Acme was selling off its asset before reversing the temporary differences. This helps Acme reducing the tax payable. Technically, there is nothing wrong with this strategy of minimizing tax payment. It was just a method of getting away from paying taxes that the IRS allows. The same difference situation as individuals giving donations but claiming back on their tax returns to reduce taxes or contribute to the pre-tax retirement plans and pay fewer taxes when they withdraw at their retirement.

c/ I believe the IRS would be affected directly by Acme’s ability to defer income tax payable. The IRS would receive less money than it supposed to collect. Also, in the long run, it may affect Acme itself due to the action of selling its plant asset. If it was worth selling plant assets, Acme could make profits and that would be fine. However, it would take time and cost more to have a replacement.

d/ Since it is ethical and legal to defer tax payable, I do not think Ms. Delaney, as a CPA, needs to do things differently. Her job is making sure all the numbers recorded correctly in Acme’s financial statements and made tax payment accordingly. If doing this affects the company’s profit, then she should report her concerns to upper management, otherwise, it is fine with the way the company was doing.

Posted 3

Acme was permitted to realize a sizable deferred tax liability on its balance sheet. This indicates that it has a large Accounts receivable account that allows a higher percentage of receivables to rollover to the next tax period. Overextending your Accounts receivable can hurt your Accounts receivable turnover ratio and for Acme being a publicly traded corporation it may look better in the short run to raise the deferred tax liability but the risk of outstanding receivables isn’t worth it.

Acme would like to at anytime that when deferred tax liability account had to be paid out in a that tax period then they would be able to sell off any plant asset ahead of time to show a capital gain thus lowering the tax rate. They would see how much deferred tax liability would have to be owed that tax period and then can see what plant assets could be sold off to help counter the liability for a lower tax rate and can reap the benefits of the sale that would overlook the tax liability.

Deferral of income taxes is used for company’s who haven’t yet received funds from their sales in the current period. Acme is operating within the legal part of the law but walking a fine line for themselves. Stockholders are only seeing positive earnings and an increasing EPS. Withholding taxes and when taxes are inevitable you sell off some plant assets to try and cover it up to keep the image strong. Even with construction in place assuming due to the rapid expansion of its plant asset base, you shouldn’t try to sugar coat your investors.

The federal government would be most affected by Acme’s ability to defer income taxes since they wouldn’t be able to use that money to reinvest in the country. Using the tax-deferred money to invest in plant assets could harm Acme, which is harder to liquidate when the need arises.

Ms. Delaney’s professional responsibilities as a CPA are to follow the code of conduct. In this case integrity and public interest would be two of the principles that Ms. Delaney would look extra closely at. What is “right” in this situation, do what is right, do what you think is right, do not do what you think is wrong. In this case Acme is taking advantage of the system to defer taxes and then selling off assets to lower future tax rates and also show a potential profit in doing so.

Though by law it is legal and if your company was under construction for a short period of time and needed to make a one-time exception, lifeline in essence it can make sense but cutting corners everywhere all the time is no way to keep up the appearance that the company is on the up and up. What happens if there isn’t an asset to sell and tax liability is up and the market went down this becomes panic mode quickly.

Ms. Delaney would have to take into account her own responsibility and integrity and let Acme know that this is border-line and could eventually hurt the company unless they start to change. If Acme decides not to change it’s ways then Ms. Delaney should look elsewhere for employment keeping her ethics intact.