chapter 12
TRANSCRIPT
EXAMPLE TEST QUESTIONS
Chapter 12
Multiple Choice
1. With respect to the difference between taxable income and pretax accounting income, the tax effect of the undistributed earnings of a subsidiary included in consolidated income should normally bea. Accounted for as a timing differenceb. Accounted for as a permanent differencec. Ignored because it must be based on estimates and assumptionsd. Ignored because it cannot be presumed that all undistributed earnings of a subsidiary will be
transferred to the parent company
Answer a
2. Income tax allocation procedures are not appropriate when a. An extraordinary loss will cause the amount of income tax expense to be less than the tax on
ordinary net incomeb. An extraordinary gain will cause the amount of income tax expense to be greater than the tax
on ordinary net incomec. Differences between net income for tax purposes and financial reporting occur because tax
laws and financial accounting principles do not concur on the items to be recognized as revenue and expense
d. Differences between net income for tax purposes and financial reporting occur that will not reverse.
Answer d
3. Which of the following would cause a deferred tax expense?a. Writedown of goodwill due to impairmentb. Use of equity method where undistributed earnings of a 30 percent owned investee are
related to probable future dividendsc. Premiums paid on insurance carried by company (beneficiary) on its officers or employeesd. Income is taxed at capital gains rates
Answer b
4. Differences between taxable income and pretax accounting income arising from transactions that, under applicable tax laws and regulations, will not be offset by corresponding differences or “turn around” in future periods is a definition of a. Permanent differencesb. Timing differencesc. Intraperiod tax allocationd. Interperiod tax allocation
Answer a
5. The tax effect of a difference between taxable income and pretax accounting income attributable to losses of a subsidiary is normally recognized for a. Neither carrybacks nor carryforwardsb. Both carrybacks and carryforwardsc. Carrybacks but not carryforwardsd. Carryforwards but not carrybacks
Answer b
6. Which of the following is not affected by tax allocation within a period?a. Income before extraordinary itemsb. Extraordinary eventsc. Adjustments of prior periodsd. Operating revenues
Answer d
7. Under the comprehensive deferred interperiod method of tax allocation, deferred taxes are determined on the basis of a. Tax rates in effect when the timing differences originate without adjustment for subsequent
changes in tax ratesb. Tax rates expected to be in effect when the items giving rise to the timing differences reverse
themselvesc. Net valuations of assets or liabilitiesd. Averages determined on an industry-by-industry basis
Answer b
8. The accounting recognition of the benefit from a tax loss carryforward in most situations should be reported asa. A reduction of the loss in the year of the loss with an appropriate valuation allowance b. A prior period adjustment in whichever year the benefit is realizedc. An extraordinary item in the year in which the benefit is realizedd. An item on the retained earnings statement, not the income statement
Answer a
9. Intraperiod tax allocation arises becausea. Items included in the determination of taxable income may be presented in different sections
of the financial statementsb. Income taxes must be allocated between current and future periodsc. Certain revenues and expenses appear in the financial statements either before or after they
are included in taxable incomed. Certain revenues and expenses appear in the financial statements but are excluded from
taxable income
Answer c
10. Assuming no prior period adjustments, would the following affect net income? Interperiod Intraperiod Income tax Income tax Allocation Allocation
a. Yes Yesb. Yes Noc. No Yesd. No No
Answer b
11. A machine with a 10-year useful life is being depreciated on a straight-line basis for financial statement purposes, and over 5 years for income tax purposes under the accelerated recovery cost system. Assuming that the company is profitable and that there are and have been no other timing differences, the related deferred income taxes would be reported in the balance sheet at the end of the first year of the estimated useful life as aa. Current liabilityb. Current assetc. Noncurrent liabilityd. Noncurrent asset
Answer c
12. Smith Corporation owns only 25 percent of the voting stock of Jones Corporation, but exercises significant influence over its operating and financial policies. The tax effect of differences between taxable income and pretax accounting income attributable to undistributed earnings of Jones Corporation should bea. Accounted for as a timing differenceb. Accounted for as a permanent difference c. Ignored because it must be based on estimates and assumptions
d. Ignored because Smith holds less than 51 percent of the voting stock of Jones
Answer a
13. A company has four “deferred income tax” accounts arising from timing differences involving (1) current assets, (2) noncurrent assets, (3) current liabilities, and (4) noncurrent liabilities. The presentation of these four “deferred income tax “ accounts in the statement of financial position should be shown as a. A single net amountb. A net current and a net noncurrent amountc. Four accounts with no netting permittedd. Valuation adjustments of the related assets and liabilities that gave rise to the deferred tax
Answer b
14. A company’s only temporary difference results from using double declining balance depreciation for tax purposes and straight-line depreciation for financial reporting. The company purchases new plant assets each year. If currently enacted tax law will result in a higher tax rate for all future tax years, which accounting approach for deferred taxes will result in the lowest net income for this current year?a. Nonallocation of deferred taxes.b. Partial allocation of deferred taxes under the asset/liability method.c. Comprehensive allocation of deferred taxes under the asset/liability method.d. Comprehensive allocation of deferred taxes under the deferred method.
Answer c
15. Which of the following is not an argument that an advocate of nonallocation of deferred taxes might use to support his/her position?a. Income taxes result only from taxable income.b. Income taxes are an expense of doing business and should be treated the same as other
expenses of doing business under accrual accounting.c. Income taxes are not levied on individual items of income or expense.d. The current provision for income taxes is a better predictor of future cash flows than is
income tax expense that includes deferred taxes.
Answer b
16. Which of the following is an argument that an advocate of interperiod income tax allocation might use to support his/her position?a. Income taxes result from taxable income.b. Income taxes are an expense of doing business and should be treated the same as other
expenses of doing business under accrual accounting.
c. Nonallocation of income taxes hides an economic difference between a company that employs tax strategies that reduce current tax payments than one that does not.
d. Income taxes are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues.
Answer b
17. A net operating loss carryover that occurs in a company’s second year of operationsa. May cause a company to report a tax benefit in the current period income statement.b. Has no effect on income tax expense of the current period because no taxes are paid.c. Causes a company to report a deferred income tax liability for taxes that are not paid
currently.d. Results in future taxable amounts.
Answer a
18. Which of the following will result in a deferred tax asset?a. Using the installment sales method for tax purposes, while using point of sale for financial
reporting.b. Reporting an unrealized gain for a trading security.c. Using accelerated depreciation for tax purposes and straight-line depreciation for financial
reporting.d. Reporting an expected loss on from a lawsuit in the income statement, when it cannot be
reported on the tax return until it is actually incurred.
Answer d
19. Which of the following will result in a deferred tax liability?a. A net operating loss carryover.b. Reporting an unrealized gain for a trading security.c. Reporting an unrealized gain for an available-for-sale security.d. Reporting an expected loss on from a lawsuit in the income statement, when it cannot be
reported on the tax return until it is actually incurred.
Answer b
20. Which of the following causes a permanent difference between taxable income and financial accounting income?a. The useful life of an asset is 10 years. The asset is depreciated over 7 years for tax purposes.b. Rent received in advance is taxable upon receipt.c. A life insurance premium paid by the corporation on a policy that names the corporation as
the beneficiary.d. A penalty paid to a bank when a CD is cashed before its maturity date.
Answer c
21. Which of the following approaches to interperiod tax allocation best represents an example of the matching principle?a. The deferred method of interperiod income tax allocationb. Discounting deferred income taxesc. Nonallocation of income taxesd. The asset/liability method of income tax allocation.
Answer a
22. A company that has both short-term deferred tax assets of $22,000, long-term deferred tax liabilities of $36,000, short-term deferred tax liabilities of $51,000 and short-term deferred tax assets of $60,000 should reporta. A current asset for $22,000, a current liability for $36,000, a long-term asset for $60,000, and
a long-term liability for $51,000.b. A current liability for $14,000 and a long-term asset for $9,000.c. A current asset for $5,000.d. A current liability for $14,000, a long-term asset for $60,000, and a long-term liability for
$51,000.
Answer b
23. An increase in the deferred income tax asset valuation allowance a. Occurs when there is an operating loss carryforward.b. Has no effect on income tax expense.c. Occurs when there is an expected increase in future taxable icnome.d. Increases income tax expense.
Answer d
Essay
1. What are the objectives of accounting for income taxes?
The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and to recognize the future tax consequences of temporary differences as well as net operating losses (NOLs) and unused tax credits. To facilitate discussion of the issues raised by the concept of interperiod tax allocation, we first examine the nature of differences among pretax financial income, taxable income, and net operating losses (NOLs).
2. Define the following types of differences between financial accounting income and taxable income:a. Temporary
Most temporary differences between pretax financial accounting income and taxable income arise because the timing of revenues, gains, expenses, or losses in financial accounting income occurs in a different period from taxable income. These timing differences result in assets and liabilities having different bases for financial accounting purposes than for income tax purposes at the end of a given accounting period. Additional temporary differences occur because specific provisions of the IRC create different bases for depreciation or for gain or loss recognition for income tax purposes than are used for financial accounting purposes.b. Permanent
Certain events and transactions cause differences between pretax accounting income and taxable income to be permanent. Most permanent differences between pretax financial accounting income and taxable income occur when specific provisions of the IRC exempt certain types of revenue from taxation or prohibit the deduction of certain types of expenses. Others occur when the IRC allows tax deductions that are not expenses under GAAP. Permanent differences arise because of federal economic policy or because Congress may wish to alleviate a provision of the IRC that falls too heavily on one segment of the economy.
3. Describe the three types of permanent differences.`
There are three types of permanent differences:
1. Revenue recognized for financial accounting reporting purposes that is never taxable. Examples include interest on municipal bonds and life insurance proceeds payable to a corporation upon the death of an insured employee.
2. Expenses recognized for financial accounting reporting purposes that are never deductible for income tax purposes. An example is life insurance premiums on employees where the corporation is the beneficiary.
3. Income tax deductions that do not qualify as expenses under GAAP. Examples include percentage depletion in excess of cost depletion and the special dividend exclusion.
4. List and give examples of the f our types of differences that cause financial accounting income to be either greater than or less than taxable income.
These four types of differences are:
Current Financial Accounting Income Exceeds Current Taxable Income
1. Revenues or gains are included in financial accounting income prior to the time they are included in taxable income. For example, gross profit on installment sales is included in financial accounting income at the point of sale but may be reported for tax purposes as the cash is collected.
2. Expenses or losses are deducted to compute taxable income prior to the time they are deducted to compute financial accounting income. For example, a fixed asset may be
depreciated by MACRS depreciation for income tax purposes and by the straight-line method for financial accounting purposes.
Current Financial Accounting Income Is Less Than Current Taxable Income
1. Revenues or gains are included in taxable income prior to the time they are included in financial accounting income. For example, rent received in advance is taxable when it is received, but it is reported in financial accounting income under as it is earned.
2. Expenses or losses are deducted to compute financial accounting income prior to the time they are deducted to determine taxable income. For example, product warranty costs are estimated and reported as expenses when the product is sold for financial accounting purposes, but they are deducted as actually incurred in later years to determine taxable income.
5. Describe the accounting treatment for net operating losses.
A net operating loss (NOL) occurs when the amount of total tax deductions and tax-deductible losses is greater than the amount of total taxable revenues and gains during an accounting period. The IRC allows corporations reporting NOLs to carry these losses back and forward to offset other reported taxable income (currently back two years and forward twenty years).
A NOL carryback is applied to the taxable income of the two preceding years in the order in which they occurred, beginning with the older year first. If unused NOLs are still available, they are carried forward for up to twenty years to offset future taxable income. NOL carrybacks result in the refund of prior taxes paid. Thus, the tax benefits of NOL carrybacks are currently realizable and for financial accounting purposes are reported as reductions in the current period loss. A receivable is recognized on the balance sheet, and the associated benefit is shown on the current year’s income statement.
6. Discuss the arguments for and against interperiod tax allocation.
The primary income tax allocation issue involves whether and how to account for the tax effects of temporary differences between taxable income, as determined by the IRC, and pretax financial accounting income as determined under GAAP. Some accountants believe that it is inappropriate to give any accounting recognition to the tax effects of these differences. Others believe that recognition is appropriate but disagree on the method to use. There is also disagreement on the appropriate tax rate to use and whether reported future tax effects should be discounted to their present values. Finally, there is a lack of consensus over whether interperiod tax allocation should be applied comprehensively to all differences or only to those expected to reverse in the future.
Advocates of nonallocation argue as follows:
1. Income taxes result only from taxable income. Whether or not the company has accounting income is irrelevant. Hence, attempts to match income taxes with accounting income provide no relevant information for users of published financial statements.
2. Income taxes are different from other expenses; therefore, allocation in a manner similar to other expenses is irrelevant. Expenses are incurred to generate revenues; income taxes generate no revenues. They are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues.
3. Income taxes are levied on total taxable income, not on individual items of revenue and expense. Therefore, there can be no temporary differences related to these items.
4. Interperiod tax allocation hides an economic difference between a company that employs tax strategies that reduce current tax payments (and is therefore economically better off) and one that does not.
5. Reporting a company’s income tax expense at the amount paid or currently payable is a better predictor of the company’s future cash outflows because many of the deferred taxes will never be paid, or will be paid only in the distant future.
6. Income tax allocation entails an implicit forecasting of future profits. To incorporate such forecasting into the preparation of financial information is inconsistent with the long-standing principle of conservatism.
7. There is no present obligation for the potential or future tax consequences of present or prior transactions because there is no legal liability to pay taxes until an actual future tax return is prepared.
8. The accounting recordkeeping and procedures involving interperiod tax allocation are too costly for the purported benefits.
On the other hand, the advocates of interperiod tax allocation cite the following reasons to counter the preceding arguments or to criticize nonallocation:
1. Income taxes result from the incurrence of transactions and events. As a result, income tax expense should be based on the results of the transactions or events that are included in financial accounting income.
2. Income taxes are an expense of doing business and should involve the same accrual, deferral, and estimation concepts that are applied to other expenses.
3. Differences between the timing of revenues and expenses do result in temporary differences that will reverse in the future. Expanding, growing businesses experience increasing asset and liability balances. Old assets are collected, old liabilities are paid, and new ones take their place. Deferred tax balances grow in a similar manner.
4. Interperiod tax allocation makes a company’s net income a more useful measure of its long-term earning power and avoids periodic income distortions resulting from income tax regulations.
5. Nonallocation of a company’s income tax expense hinders the prediction of its future cash flows. For instance, a company’s future cash inflows from installment sales collection would usually be offset by related cash outflows for taxes.
6. A company is a going concern, and income taxes that are currently deferred will eventually be paid. The validity of other assets and liabilities reported in the balance sheet depends on the presumption of a viable company and hence the incurrence of future net income.
7. Temporary differences are associated with future tax consequences. For example, reversals of originating differences that provide present tax savings are associated with higher future taxable incomes and therefore higher future tax payments. In this sense, deferred tax liabilities are similar to other contingent liabilities that are currently reported under GAAP. However, one could argue that the recognition and measurement of other contingent liabilities hinges on the probability of their incurrence, whereas probability of future tax consequences is not a consideration.
7. Discuss the arguments for comprehensive vs. partial allocation of interperiod taxes.
Under comprehensive allocation, the income tax expense reported in an accounting period is affected by all transactions and events entering into the determination of pretax financial accounting income for that period. Comprehensive allocation results in including the tax consequences of all temporary differences as deferred tax assets and liabilities, regardless of how significant or recurrent they are. Proponents of comprehensive allocation view all transactions and events that create temporary differences as affecting cash flows in the accounting periods when the future tax consequences of temporary differences are realized. Under this view, the future tax consequence of a temporary difference is analogous to an unpaid accounts receivable or accounts payable invoice, which in the future is collected or paid.
In contrast, under partial allocation, the income tax expense reported in an accounting period would not be affected by those temporary differences that are not expected to reverse in the future. That is, proponents of partial allocation argue that, in certain cases, groups of similar transactions or events may continually create new temporary differences in the future that will offset the realization of any taxable or deductible amounts, resulting in an indefinite postponement of deferred tax consequences. In effect, partial allocationists argue that these types of temporary differences are more like permanent differences. Examples of these types of differences include depreciation for manufacturing companies with large amounts of depreciable assets and installment sales for merchandising companies.
Advocates of comprehensive allocation raise the following arguments:
1. Individual temporary differences do reverse. By definition, a temporary difference cannot be permanent; the offsetting effect of future events should not be assumed. It is inappropriate to look at the effect of a group of temporary differences on income taxes; the focus should be on the individual items comprising the group. Temporary differences should be viewed in the same manner as accounts payable. Although the total balance of accounts payable may not change, many individual credit and payment transactions affect the total.
2. Accounting is primarily historical. It is inappropriate to offset the income tax effects of possible future transactions against the tax effects of transactions that have already occurred.
3. The income tax effects of temporary differences should be reported in the same period as the related transactions and events are reported in pretax financial accounting income.
4. Accounting results should not be subject to manipulation by management. That is, a company’s management should not be able to alter the company’s results of operations and ending financial position by arbitrarily deciding what temporary differences will and will not reverse in the future.
In contrast, advocates of partial income tax allocation argue that
1. All groups of temporary differences are not similar to certain other groups of accounting items, such as accounts payable. Accounts payable “roll over” as a result of actual individual credit and payment transactions. Income taxes, however, are based on total taxable income and not on the individual items constituting that income. Therefore, consideration of the impact of the group of temporary differences on income taxes is the appropriate viewpoint.
2. Comprehensive income tax allocation distorts economic reality. The income tax regulations that cause the temporary differences will continue to exist. For instance, Congress is not likely to reduce investment incentives with respect to depreciation. Consequently, future investments are virtually certain to result in originating depreciation differences of an amount to at least offset reversing differences. Thus, consideration should be given to the impact of future, as well as historical, transactions.
3. Assessment of a company’s future cash flows is enhanced by using the partial allocation approach. Since the deferred income taxes (if any) reported on a company’s balance sheet under partial allocation should actually reverse rather than continue to grow, partial allocation would better reflect future cash flows.
4. Accounting results should not be distorted by the use of a rigid, mechanical approach, such as comprehensive tax allocation. Furthermore, an objective of the audit function is to identify and deter any management manipulation.
8. Discuss the arguments for and against discounting deferred taxes.
Proponents of reporting deferred taxes at their discounted amounts argue that the company that reduces or postpones tax payments is economically better off. It is their belief that by discounting deferred taxes, a company best reflects the operational advantages of its tax strategies in its financial statements. Proponents also feel that discounting deferred taxes is consistent with the accounting principles established for such items as notes receivable and notes payable, pension costs, and leases. They argue that discounted amounts are considered to be the most appropriate indicators of future cash flows.
Critics of discounting counter that discounting deferred taxes mismatches taxable transactions and the related tax effects. That is, the taxable transaction would be reported in one period and
the related tax effects over several periods. They also argue that discounting would conceal a company’s actual tax burden by reporting as interest expense the discount factor that would otherwise be reported as part of income tax expense. Furthermore, deferred taxes may be considered as interest-free loans from the government that do not require discounting because the effective interest rate is zero. Although this argument has conceptual merit, a plausible counterargument would be that the time value of money is important to the well-being of companies, and because of this aspect, GAAP requires interest to be imputed for non-interest-bearing financial instruments. It follows that the time value of money is enhanced by postponing tax payments, thus, consistency under GAAP would require imputing interest on deferred taxes.
9. Define the following:a. Deferred method of income tax allocation
The deferred method of income tax allocation is an income statement approach. It is based on the concept that income tax expense is related to the period in which income is recognized. The deferred method measures income tax expense as though the current period pretax financial accounting income is reported on the current year’s income tax return. The tax effect of a temporary difference is the difference between income taxes computed with and without inclusion of the temporary difference. The resulting difference between income tax expense and income taxes currently payable is a debit or credit to the deferred income tax account.
The deferred tax account balance is reported in the balance sheet as deferred tax credit or deferred tax charge. Under the deferred method, the deferred tax amount reported on the balance sheets is the effect of temporary differences that will reverse in the future and that are measured using the income tax rates and laws in effect when the differences originated. No adjustments are made to deferred taxes for changes in the income tax rates or tax laws that occur after the period of origination. When the deferrals reverse, the tax effects are recorded at the rates that were in existence when the temporary differences originated.
b. Asset-liability method of income tax allocation
The asset/liability method of income tax allocation is balance sheet oriented. The intent is to accrue and report the total tax benefit or taxes payable that will actually be realized or assessed on temporary differences when their respective future taxable or deductible amounts are expected to occur. A temporary difference is viewed as giving rise to either a tax benefit that will result in a decrease in future tax payments or a tax liability that will be paid in the future at tax rates that are then current. Theoretically, the future tax rates used should be estimated, based on expectations regarding future tax law changes. However, GAAP requires that the future tax rates used to determine current period deferred tax asset and liability balances be based on currently enacted tax law.
Under the asset/liability method, the deferred tax amount reported on the balance sheet measures the future tax consequences of existing temporary differences using the currently enacted tax rates and laws that will be in effect when those tax consequences are expected to occur. At the end of each accounting period, or when the temporary differences that caused the company to report a deferred tax asset or liability no longer exist, companies adjust their deferred tax asset and liability account balances to reflect any changes in the income tax rates. Stated differently, at year-end companies report deferred tax asset and liability balances that measure the future tax consequences of anticipated deductible and taxable amounts that were caused by current and prior period temporary differences. The reported amounts are measured using tax rates that under currently enacted tax law will be in effect in those years when the deductible and taxable amounts are expected to occur. This practice results in reporting deferred tax assets and liabilities at their expected realizable values.
c. Net-of-tax method
The net-of-tax method is more a method of disclosure than a different method of calculating deferred taxes. Under this method, the income tax effects of temporary differences are computed by applying either the deferred method or the asset/liability method. The resulting deferred taxes, however, are not separately disclosed on the balance sheet. Instead, under the net-of-tax method the deferred charges (tax assets) or deferred credits (tax liabilities) are treated as adjustments of the accounts to which the temporary differences relate. Generally, the accounts are adjusted through the use of a valuation allowance rather than directly. For instance, if a temporary difference results from additional tax depreciation, the related tax effect would be subtracted (by means of a valuation account) from the cost of the asset (along with accumulated depreciation) to determine the carrying value of the depreciable asset. Similarly, the carrying value of installment accounts receivable would be reduced for the expected increase in income taxes that will occur when the receivable is collected (and taxed). Reversals of temporary differences would reduce the valuation allowance accounts.
10. Discuss how SFAS No. 109, now FASB ASC 740, changed the accounting for deferred tax assets.
The FASB was convinced by the critics of SFAS No. 96 that deferred tax assets should be treated similarly to deferred tax liabilities and that the scheduling requirements of SFAS No. 96 were often too complex and costly. However, the Board did not want to return to the deferred method and remained committed to the asset/liability approach. SFAS No. 109 (See FASB ASC 740) responded to these concerns by allowing the separate recognition and measurement of deferred tax assets and liabilities without regard to future income considerations, using the average enacted tax rates for future years. The deferred tax asset is to be reduced by a tax valuation
allowance if available evidence indicates that it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax asset will not be realized.
11. Describe the use of the valuation allowance for deferred tax assets.
The deferred tax asset measures potential benefits to be received in future years arising from temporary differences, NOL carryovers, and unused tax credits. Because there may be insufficient future taxable income to actually derive a benefit from a recorded deferred tax asset, SFAS No. 109 requires a valuation allowance sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.
12. Describe accounting for uncertain tax positions under FIN No. 48, now FASB ASC 740-10-25.
The validity of a tax position is a matter of tax law, and it is not controversial to recognize the benefit of a tax position in a firm’s financial statements when there is a high degree of confidence that a particular tax position will be sustained after examination by the IRS. However, in some cases, tax law is subject to varied interpretations, and whether a tax position will ultimately be sustained may be uncertain.
The evaluation of a tax position under FIN No. 48 (See FASB ASC 740-10-25) is a two-step process:
1. Recognition. A firm determines whether it is more likely than not that a tax position will be sustained upon examination by the IRS based on the technical merits of the position. In evaluating whether a tax position has merit, a firm is to use a more-likely-than-not recognition threshold. This evaluation should presume that the IRS would have full knowledge of all relevant information.
2. Measurement. A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest cumulative amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.
13. Discuss the rationale behind the calculation of a company’s earnings conservatism ratio.
The rationale for the earnings conservatism ratio is that most companies will use the most conservative revenue and recognition criteria for income tax reporting purposes while attempting to maximize their deductible expenses in order to minimize income taxes. On the other hand, management is under constant pressure to report favorable financial accounting earnings. As a result, it may choose accounting methods and estimations that maximize financial accounting income. In interpreting the results of this calculation, amounts in excess of 1.0 will indicate that a company is being more aggressive in its use of accounting choices for financial reporting than it is in calculating its income taxes.