Chapter 12 - Solution Manual

A representational faithfulness representational

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a. Representational faithfulness. Representational faithfulness implies that the financial information reported reflects what it is purported to represent. Because deferred tax liabilities measure future cash flows, the time value of money would imply that a part of the future cash flow is for interest and therefore, the present value of those cash flows provides a representationally faithful measure of the liability. b. Verifiability and Neutrality. It could be argued that the selection of an interest rate appropriate to discount deferred tax liabilities is subjective or even arbitrary. If so, there would be a much greater degree of consensus among independent measurers if the deferred taxes were not discounted. Also, because subjectivity inherent in the selection of an interest rate would be avoided, nondiscounted deferred taxes would be more neutral.
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257 iii. Understandability. Presuming that users understand the nature of deferred taxes and present value, neither method would provide financial statements that would be more understandable than the other. iv. Comparability. Because other, significant liabilities are measured at present value, financial statements containing discounted deferred tax liabilities should provide greater comparability across time and among companies. The amounts of the various reported liabilities would be more comparable as well as aggregated data across firms. c. Supporters of discounting deferred taxes argue that the present value of liabilities provides measures that are more representationally faithful. If deferred taxes portray future tax consequences (cash outflows) and those tax consequences are liabilities, then because of the time value of money they should be discounted. As a result, discounted deferred taxes provide better measures of future cash flows, and are thus more relevant. By deferring taxes, the company is economically better off, and discounting better reflects the resulting well-offness. Also, discounting deferred taxes is consistent with measurements of other liabilities such as notes and bonds. d. Opponents of discounting deferred taxes argue that the result is a mismatching of the deferred tax consequences with the temporary differences and reversals causing them to occur. Moreover, discounting conceals the actual tax burden by reporting part of the future tax consequences as interest expense. Finally, it can be argued that there is no interest expense because the government is in effect making an interest free loan to the company; hence, there is no interest rate with which to discount the deferred taxes. Case 12-3 a. Intraperiod income tax allocation is necessary to obtain an appropriate relationship between income tax expense and each element of earnings (continuing operations, discontinued operations and extraordinary items, or between income tax expense and prior-period adjustments. Income tax expense attributable to earnings before extraordinary items is computed
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