Hi guys, I have two questions related to income tax from the Schewser notes and I am holping that someone could really help me out here. One is about the statutory tax rate. So on pg190 (FSA), it says that “income recognized on the F/S (e.g., tax-exempt interest income) that is not included in taxable income, will result in an effective tax rate lower than the statutory rate. Expenses recognized no the income satment that are not deductible for tax purpose will tend to increase the effective tax rate relative to the statutory tax rate”. I totally don’t get this and acutally i think things should be the other way around. And the other question is that do post-employment benifits and deferred compansation create DTA or DTL? The book says DTA OR DTL but I don’t see how they can result in a DTL since these payments are recognized as expense before paid out right? P.S How far do we have to go with income tax? Do we need to understand the underlying journal entries to do the exam questions? Thank you
First question: You earn $200 this year, half is tax free. 40% tax rate, no other income or expenses. Income statement is: Income 200 tax 40 (40% of the taxable $100) Net income 160 Effecrive tax rate on income statement is 20%, which is lower than the stautory rate. Expenses obviously go the other way. This is one of the TONS of areas on the exam that can be figured out with a quick calc using simple numbers.
Hi Super, Your illustration is really helpful. However, I still don’t quite understand why the tax expense here is calculated that way. Since this is an income statement, why didn’t you use 40% times 200 to get tax expense? Also, if the question says tax rate is 40%, is it the statutory rate or the effective rate? I think I am really confused about what relationship between these two rates is.
Warning - First time answering a thread. This may be wrong. Kitty, Note that super said: You earn $200 this year, ***half is tax free***. 40% tax rate, no other income or expenses. Thus taxes are .5(200)(.40)= 40 The effect of non-taxable income does lower you Effective tax rate. In this case your effective tax rate would be 40/200 which Super mentioned is 20%. Now let’s say that ALL of your income was taxable. Then you would find tax by using 40% times 200 as you said, and tax would be 80. The effective tax rate here would equal your statutory tax rate (both 40%). Hope this helps. Hope this is right. Best wishes
Hi guys, I think i finally figured out where this 20% came from. If there are only temporary differences then statutory rate will always be equal to effective rate. However, this case is different because the non-taxable income results in a permanent difference that will never be reversed. Since permanent differences don’t creat any DTL or DTA, here Income tax expense= Taxable Income=.5(200)(.40)=40. That’s why the book says permanent differences are reflected in the difference between statutory rate and effective rate.