This explanation includes the methodology used to determine deferred taxes, procedures for reporting accounting changes and error corrections, and the rationale for establishing the subsidiary as a corporation. I am providing you with information about the professional responsibilities of a CPA. I am also providing an explanation of the difference between a review and an audit. Deferred Taxes Accounting for taxes and tax expense is extremely important to the company. Fundamental differences exist between accounting for taxes and the financial reporting of pretax income.
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Pretax financial income is calculated according to generally accepted accounting principles (GAAP). Taxable income is calculated using Internal Revenue Service (IRS) rules (Kieso, Weygandt, & Warfield, 2007). This difference in accounting principles creates a difference between taxable income and income tax payable. This difference results in a deferred tax amount. If the income tax expense is greater than the income tax payable, this results in a deferred tax liability. If the income tax payable is greater than the income tax expense, this results in a deferred tax asset.
Deferred tax liabilities and assets cause temporary differences. Temporary differences are carried over into future years and adjustments are made accordingly (Kieso, Weygandt, & Warfield, 2007). Reporting Accounting Changes and Error Reporting Accounting changes result from a change from one GAAP to another. Adoption of a new principle affects the current period’s financial statements. Three possible approaches are used to account for this change. If the company chooses to report the change currently, the cumulative effect of the change on prior years’ income is adjusted for the current period.
Previous financial statements are not changed using this approach. By not changing prior financial statements, the company avoids any contractual difficulties that may arise and complicated calculations that may be wrong. Another approach is to report the changes retrospectively. This involves going back and changing prior financial statements as if the principle were always in place. Those in favor of this method argue that comparability between periods is ensured. However, this approach requires a significant amount of recalculation for the prior years’ statements.
A third approach is to report the change prospectively. This means that the company generates future financial statements based on the new principle without any adjustment to the prior or current year. The Financial Accounting Standards Board (FASB) requires that companies use the retrospective approach. This is because the retrospective approach provides users of the financial information with more useful information than the other approaches. Because this approach results in greater consistency between reporting periods, user can make better comparisons (Kieso, Weygandt, & Warfield, 2007).
The retrospective approach considers the accounting principle change over the prior years and results in differences in net income. The changes in net income are reflected in the retained earnings balances for the years affected and carried forward until the current period. These changes are direct effects of the new principle. Indirect effects may also be experienced because of a change in accounting principle. Although these effects are not seen in prior years’ statements, the indirect effect may result in changes in the current cash flow and income statements (Kieso, Weygandt, & Warfield, 2007).
The establishment of the subsidiary as a corporation requires reporting a change in entity. This change requires a disclosure note in the current period financial statements. The nature of the change, and the reasoning behind the change must be part of the disclosure. The change in entity may result in changing prior years’ financial statements (Kieso, Weygandt, & Warfield, 2007). Because of the complexities involved in financial accounting, errors do occur.
Errors may result from a change in accounting principle, mathematical mistakes, changes in estimates not prepared in good faith, an oversight, a misuse of facts, or an incorrect classification. These errors can cause serious financial report misstatements. When errors are discovered, adjustments must be made to prior periods. These adjustments result in a change in the retained earnings balances for those periods. The company goes back to the earliest period affected by the error when calculating these adjustments (Kieso, Weygandt, & Warfield, 2007).
Rationale Behind Establishment of the Subsidiary The decision to establish the subsidiary as a corporation is based on several factors. Because a change in entity is required, the resulting adjustments to prior and current financial statements may have a positive effect on users of this information. Tax advantages may occur and the consolidated financial statements of the parent corporation may also experience a positive boost. The addition of accounting categories for capital stock, additional paid-in capital, and retained earnings are part of this change (Bline, Fischer, & Skekel, 2004).
Another valid reason for establishing the subsidiary as a corporation involves the legal advantages a corporations holds over other business entities. The liability of the owners is generally limited to the amount invested. If the company wishes to sell the subsidiary, establishing the entity as a corporation makes this an easier task. Stockholders hold a vote in creating the board of directors. GAAP is required when preparing financial statements. This helps add consistency and comparability to the company. The company becomes the taxable entity when it becomes a corporation.
This further limits the wners’ liability (Bline, Fischer, & Skekel, 2004). Another nice aspect of incorporating is that the entity is allowed to accept outside investments in return for stock in the company. This creates capital that may be necessary to expand operations and grow the business. Professional Responsibilities of a CPA Licensed CPAs are regulated by state boards of accountancy and thus follow strict rules governing the profession. These rules are designed to protect the public against fraud, incompetence, and conflicts of interest. CPAs must also adhere to the American Institute of Certified Public Accountants (AICPA) Code of Professional Conduct.
The AICPA Code of Conduct covers the areas of responsibilities, the public interest, integrity, objectivity and independence, and due care. Because of this code, CPAs are often seen as a client’s most trusted advisor. In addition to providing accounting services, a CPA may also provide valuable financial planning. This planning encompasses the areas of budgeting and cash flow planning, income tax planning, risk management and insurance planning, investment planning, and wealth transfer planning (AICPA, n. d. ). These services are available to companies and individuals. Difference between a Review and an Audit
The major difference between an audit and a review is that an audit is much more comprehensive in scope and results in an expressed opinion about the client’s business. An audit is conducted using generally accepted audit standards (GAAS) and includes an examination of the internal control systems of the client. This helps to form the opinion of not only what is happening within the company, but also why. An audit includes risk assessments and tests of controls that a review does not require. A review provides only a basic assurance that the financial statements are reported accurately.
