Financial accounting

Retained earnings, pretax financial income, tax rates. Clarence’s retained earnings on January
1, 2008 was $4,000,000 and its tax rate for all past fiscal years, including 2008, is 30%. The tax
laws have changed and Clarence’s tax rate for all years after 2008 will be 40%. Clarence’s pretax
financial income (i.e., accounting income before tax) is $2.2 million for fiscal 2008.

Prior to 2008, Clarence never had any temporary or permanent differences between pretax
financial income and taxable income (in other words, pretax financial income and taxable
income always were the same prior to 2008).

Tax Information. In 2008, Clarence realized that, for the first time, there were items that are
treated differently for financial reporting and income tax purposes. First, it did not allow one of
its employees to take time off when she had a baby, contrary to federal law. The federal
government imposed a fine on Clarence of $200,000 on October 1, 2008, properly expensing it
for accounting purposes although it is not deductible for tax purposes. Clarence intends to pay
the fine early in 2009.

Also, Clarence acquired a significant amount of new construction equipment in 2008. Tax
depreciation exceeded accounting depreciation by $500,000 in 2008.

Finally, in 2008, Clarence began a new practice of providing its customers with warranties on its
completed buildings. Clarence accrued estimated warranty expense (and the related current
liability) of $400,000 in 2008 for accounting purposes, and actually spent $100,000 in 2008 to
service these warranties. Warranty expenses are not deductible until paid for tax purposes.

Clarence properly accounted for all of these items for financial accouting purposes.
Consequently, they are properly reflected in the pretax financial income figure of $2.2 million.

4. HW4 - 3 points
Ignore the effects of the accounting errors when completing this problem.
a. What is Clarence’s taxable income for 2008?

b. What is the effect of deferred taxes on net income for 2008? You must
indicate increase, decrease, or no effect and, if increase or decrease,
indicate a dollar amount.

c. What is the effect of deferred taxes on cash flows for 2008? You must
indicate increase, decrease, or no effect and, if increase or decrease,
indicate a dollar amount and state whether it is an operating, financing or
investing activity.