ACCT 5327

Exam 1

Spring 2010

Hoskins Agricultural Manufacturing produces and sells farm equipment. It has manufacturing facilities in Canada and the U.S. The company manufactures components at both plants, assembles those components into final products, and sells those products to distributors around the world. In 2009, forty percent of its total sales were to distributors located outside the United States. Final assembly is completed in the U.S. All products manufactured by the company come with a five-year warranty. Customers do not pay extra for the warranty and no products are sold without the warranty.

Results for the year ended December 31, 2009 were as follows:

Accounts: / Dr. / Cr.
Cash and equivalents / $1,650,000
Accounts receivable / 3,000,000
Allowance for uncollectible accounts / 25,000
Reserve for warranties / 17,000
Inventories / 4,800,000
Land – Canada / 1,000,000
Land – U.S.
Depreciable realty – Canada / 15,000,000
Accumulated depreciation – Can. R/E / 1,000,000
Depreciable realty – U.S. / 35,000,000
Accumulated depreciation – U.S. R/E / 3,500,000
Depreciable equipment – Canada / 14,000,000
Accumulated depreciation – Can. Equip / 4,000,000
Depreciable equipment – U.S. / 42,000,000
Accumulated depreciation– U.S. Equip / 18,000,000
Goodwill / 3,000,000
Accounts payable / 2,000,000
Long-term debt / 60,000,000
Common stock / 3,300,000
Retained earnings (January 1, 2009) / 15,058,000
Sales / 42,000,000
Dividend income (from <20% owned firms) / 2,000,000
Net gains (losses) from sale of investment securities / 175,000
Cost of goods sold – Canada / 5,400,000
Cost of goods sold – U.S. / 4,600,000
Selling expenses—salaries & commissions / 1,350,000
Selling expenses—advertising / 2,125,000
Selling expenses—other / 1,500,000
Administrative expense—salaries and options / 9,050,000
Administrative expense—rent / 3,250,000
Administrative expense—property taxes / 750,000
Administrative expense—interest expense / 3,600,000 / _____
Totals / $151,075,000 / $151,075,000

The audit staff has provided us with the following additional information:

Planned adjustments to trial balance –

  • The beginning balance in the allowance for uncollectible accounts was $250,000. The auditors believe the ending balance should be $325,000.
  • The firm depreciates its buildings over 30 years for GAAP, using the straight-line method. There were no new acquisitions for 2009.
  • The firm depreciates its equipment over seven years, using the straight-line method. For tax, the equipment is 5 year property and the firm did not elect the straight-line method. There were no new acquisitions for 2009. All property was acquired when the firm opened its offices in the U.S. three years ago, and in Canada two years ago.
  • The beginning balance in the reserve for warranties was $300,000. The auditors believe the ending balance should be $240,000.
  • In addition to the amounts listed in the unadjusted trial balance, the firm issued nonqualified stock options to these four officers. Our audit department has determined that compensation expense should be recorded under FAS 123R in the amount of $2,850,000, to reflect the estimated market value of these options. None of the options had been exercised as of December 31.

Other information relevant to tax accrual –

  • “Selling expenses—other” includes meal & entertainment expenses incurred in customer development of $125,000. It also includes $1 million contributed to Texas Tech University to endow a research chair in the College of Agriculture.
  • “Administrative expenses—salaries and options” includes the following amounts:

Officer / Base Salary / Stock Options (unexercised)
Chief Executive Officer / $1,300,000 / $1,250,000
President / 1,250,000 / 1,000,000
Vice-president, Sales / 1,150,000 / 750,000
Vice-president, operations / 750,000 / 500,000
Vice-president, Finance / 600,000 / 500,000
  • The firm invests most of its idle cash in short-term investments. Seventy-five percent of its dividend income was received from domestic corporations. The remaining twenty-five percent was received from investments in the Canadian stock market.
  • The company has a net operating loss carryforward from prior years of $2,300,000

REQUIRED:

  1. Calculate Hoskins’ taxable income before the Sec. 199 deduction. (Ignore Canadian income taxes).
  2. Prepare a reconciliation of the company’s book income to its taxable income before the 199 deduction, explaining each adjustment. (Your explanations should be presented as notations to the adjustments themselves).
  3. Now, let’s turn to Sec. 199. We have an issue with the calculation of the company’s domestic production gross receipts (DPGR). The problem is determining how to allocate the selling price between the components of the final product produced in Canada and the production and assembly efforts occurring in the U.S. The company’s VP-finance wants us to treat the Canadian components as if they were purchased from the Canadian plant at cost.
  4. What effect would this assumption have on the calculation of the 199 deduction?
  5. Is this a reasonable assumption? If not, what would be more appropriate in your opinion?
  6. Explain how each category of expenses, including cost of goods sold, should be allocated between DPGR and non-DPGR for purposes of Section 199. Do not make the actual allocations at this point, just explain the approach that should be used to make the allocations (and provide citations to the Treasury Regulations where appropriate).
  7. Allocate the company’s sales between DPGR and non-DPGR using the approach you deemed to be reasonable in 3(b) above.Calculate the company’s allowable Sec. 199 deduction. For this purpose, assume that the company’s W-2 wages, included in cost of goods sold, selling expenses and administrative expenses, are sufficient to prevent the wage limitation from affecting your calculation.
  8. How would the company’s Sec. 199 deduction be affected if it shifted some of its sales from European distributors to U.S. distributors? Explain.
  9. Compute the company’s effective tax rate (defined as GAAP income tax expense divided by GAAP pre-tax income). Show how each of the permanent differences between GAAP and taxable income affect the ETR. (i.e., the 199 deduction reduces the ETR this year by x%; permanent differences 2-5 reduce or increase the ETR by a, b, c, d and e percent; the net reduction/increase in the ETR attributable to these items is y%).