19
Accounting CHAPTER for Income Taxes
ANSWERS TO QUESTIONS
1.
Pretax financial income is reported on the income statement and is often referred to as income
before income taxes. Taxable income is reported on the tax return and is the amount upon which a
companys income tax payable is computed.
2.
One objective of accounting for income taxes is to recognize the amount of taxes payable or
refundable for the current year. A second is to recognize deferred tax liabilities and assets for the
future tax consequences of events that have already been recognized in the financial statements or
tax returns.
3.
A permanent difference is a difference between taxable income and pretax financial income that,
under existing applicable tax laws and regulations, will not be offset by corresponding differences or
turn around in other periods. Therefore, a permanent difference is caused by an item that:
(1) is included in pretax financial income but never in taxable income, or (2) is included in taxable
income but never in pretax financial income.
Examples of permanent differences are: (1) interest received on municipal obligations (such interest
is included in pretax financial income but is not included in taxable income), (2) premiums paid on
officers life insurance policies in which the company is the beneficiary (such premiums are not
allowable expenses for determining taxable income but are expenses for determining pretax financial
income), and (3) fines and expenses resulting from a violation of law. Item (3), like item (2), is an
expense which is not deductible for tax purposes.
4.
A temporary difference is a difference between the tax basis of an asset or liability and its reported
(carrying or book) amount in the financial statements that will result in taxable amounts or deductible
amounts in future years when the reported amount of the asset is recovered or when the reported
amount of the liability is settled. The temporary differences discussed in this chapter all result from
differences between taxable income and pretax financial income which will reverse and result in
taxable or deductible amounts in future periods.
Examples of temporary differences are: (1) Gross profit or gain on installment sales reported for
financial reporting purposes at the date of sale and reported in tax returns when later collected. (2)
Depreciation for financial reporting purposes is less than that deducted in tax returns in early years of
assets lives because of using an accelerated method of depreciation for tax purposes. (3) Rent and
royalties taxed when collected, but deferred for financial reporting purposes and recognized as
revenue when earned in later periods.
5.
An originating temporary difference is the initial difference between the book basis and the tax basis
of an asset or liability. A reversing difference occurs when a temporary difference that originated in
prior periods is eliminated and the related tax effect is removed from the tax account.
6.
Book basis of assets
Tax basis of assets
Future taxable amounts
Tax rate
Deferred tax liability (end of 2007)
$900,000
700,000
200,000
34%
$ 68,000
19-1
Questions Chapter 19 (Continued)
7.
Book basis of asset
Tax basis of asset
Future taxable amounts
Tax rate
Deferred tax liability (end of 2007)
8.
A future taxable amount will increase taxable income relative to pretax financial income in future
periods due to temporary differences existing at the balance sheet date. A future deductible amount
will decrease taxable income relative to pretax financial income in future periods due to existing
temporary differences.
$80,000
0
80,000
34%
$27,200
Deferred tax liability (end of 2007)
Deferred tax liability (beginning of 2007)
Deferred tax benefit for 2007
Income tax payable for 2007
Total income tax expense for 2007
$ 27,200
68,000
(40,800)
230,000
$189,200
A deferred tax asset is recognized for all deductible temporary differences. However, a deferred tax
asset should be reduced by a valuation account if, based on all available evidence, it is more likely
than not that some portion or all of the deferred tax asset will not be realized. More likely than not
means a level of likelihood that is slightly more than 50%.
9.
Taxable income
Tax rate
Income tax payable
Deferred tax liability (end of 2007)
Deferred tax liability (beginning of 2007)
$100,000
Deferred tax expense for 2007
40%
$ 40,000
$ 36,000
0
Future taxable amounts
Tax rate
Deferred tax liability (end of 2007)
Current tax expense
Deferred tax expense
$90,000
40%
$36,000
$40,000
36,000
$ 36,000
Income tax expense for 2007
$76,000
10.
Deferred tax accounts are reported on the balance sheet as assets and liabilities. They should be
classified in a net current and a net noncurrent amount. An individual deferred tax liability or asset is
classified as current or noncurrent based on the classification of the related asset or liability for
financial reporting purposes. A deferred tax asset or liability is considered to be related to an asset or
liability if reduction of the asset or liability will cause the temporary difference to reverse or turn
around. A deferred tax liability or asset that is not related to an asset or liability for financial reporting
purposes, including deferred tax assets related to loss carryforwards, shall be classified according to
the expected reversal date of the temporary difference.
11.
The balances in the deferred tax accounts should be analyzed and classified on the balance sheet in
two categories: one for the net current amount, and one for the net noncurrent amount. This
procedure is summarized as indicated below.
1.
2.
3.
12.
Classify the amounts as current or noncurrent. If an amount is related to a specific asset or
liability, it should be classified in the same manner as the related asset or liability. If not so
related, it should be classified on the basis of the expected reversal date.
Determine the net current amount by summing the various deferred tax assets and liabilities
classified as current. If the net result is an asset, report on the balance sheet as a current asset;
if it is a liability, report as a current liability.
Determine the net noncurrent amount by summing the various deferred tax assets and liabilities
classified as noncurrent. If the net result is an asset, report on the balance sheet as a
noncurrent asset (other assets section); if it is a liability, report as a long-term liability.
A deferred tax asset or liability is considered to be related to an asset or liability if reduction of the
asset or liability will cause the temporary difference to reverse or turn around.
19-2
Questions Chapter 19 (Continued)
13.
Pretax financial income
Interest income on municipal bonds
Hazardous waste fine
Depreciation ($60,000 $45,000)
Taxable income
Tax rate
Income tax payable
$550,000
(70,000)
30,000
15,000
525,000
30%
$157,500
14.
$200,000 (2010 taxable (30% amount)
5% 25%)
$ 10,000 Decrease in deferred tax liability at the end of 2007
Deferred Tax Liability.................................................................................
Income Tax Expense..........................................................................
10,000
10,000
15.
Some of the reasons for requiring these disclosures are:
(a) Assessment of the quality of earnings. Many investors seeking to assess the quality of a
companys earnings are interested in the reconciliation of pretax financial income to taxable
income. Earnings that are enhanced by a favorable tax effect should be examined carefully,
particularly if the tax effect is nonrecurring.
(b) Better prediction of future cash flows. Examination of the deferred portion of income tax
expense provides information as to whether taxes payable are likely to be higher or lower in the
future.
16.
The carryback provision permits a company to carry a net operating loss back two years and receive
refunds for income taxes paid in those years. The loss must be applied to the second preceding year
first and then to the preceding year.
The carryforward provision permits a company to carry forward a net operating loss twenty years,
offsetting future taxable income. The loss carryback can be accounted for with more certainty
because the company knows whether it had taxable income in the past; such is not the case with
income in the future.
17.
The company may choose to carry the net operating loss forward, or carry it back and then forward
for tax purposes. To forego the two-year carryback might be advantageous where a taxpayer had tax
credit carryovers that might be wiped out and lost because of the carryback of the net operating loss.
In addition, tax rates in the future might be higher, and therefore on a present value basis, it is
advantageous to carry forward rather than carry back.
For financial reporting purposes, the benefits of a net operating loss carryback are recognized in the
loss year. The benefits of an operating loss carryforward are recognized as a deferred tax asset in
the loss year. If it is more likely than not that the asset will be realized, the tax benefit of the loss is
also recognized by a credit to Income Tax Expense on the income statement. Conversely, if it is
more likely than not that the loss carryforward will not be realized in future years, then an allowance
account is established in the loss year and no tax benefit is recognized on the income statement of
the loss year.
18.
Many believe that future deductible amounts arising from net operating loss carryforwards are
different from future deductible amounts arising from normal operations. One rationale provided is
that a deferred tax asset arising from normal operations results in a tax prepaymenta prepaid tax
asset. In the case of loss carryforwards, no tax prepayment has been made.
Others argue that realization of a loss carryforward is less likelyand thus should require a more
severe testthan for a net deductible amount arising from normal operations. Some have suggested
that the test be changed from more likely than not to probable realization. Others have indicated
that because of the nature of net operating losses, deferred tax assets should never be established
for these items.
19-3
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 19-1
2007 taxable income
Tax rate
12/31/07 income taxes payable
$110,000
X 40%
$ 44,000
BRIEF EXERCISE 19-2
Excess depreciation on tax return
Tax rate
Deferred tax liability
$30,000
30%
$ 9,000
BRIEF EXERCISE 19-3
Income Tax Expense...................................................
Deferred Tax Liability...........................................
Income Tax Payable.............................................
$67,500***
9,000**
58,500*
*$195,000 x 30% = $58,500
**$30,000 x 30% = $9,000
***$58,500 + $9,000 = $67,500
The $9,000 deferred tax liability should be classified as a noncurrent liability.
The balances in the deferred tax accounts should be classified in the same
manner as the related asset. Since property, plant, and equipment is a
noncurrent asset, noncurrent liability is the proper classification for the
deferred tax liability.
BRIEF EXERCISE 19-4
Deferred tax liability, 12/31/07
Deferred tax liability, 12/31/06
Deferred tax expense for 2007
Current tax expense for 2007
Total tax expense for 2007
$42,000
25,000
17,000
43,000
$60,000
19-4
BRIEF EXERCISE 19-5
Book value of warranty liability
Tax basis of warranty liability
Cumulative temporary difference at 12/31/07
Tax rate
12/31/07 deferred tax asset
$125,000
0
125,000
X 40%
$ 50,000
BRIEF EXERCISE 19-6
Deferred tax asset, 12/31/07
Deferred tax asset, 12/31/06
Deferred tax benefit for 2007
Current tax expense for 2007
Total tax expense for 2007
$59,000
35,000
(24,000)
61,000
$37,000
BRIEF EXERCISE 19-7
Income Tax Expense.........................................................
Allowance to Reduce Deferred Tax Asset
to Expected Realizable Value...............................
80,000
80,000
BRIEF EXERCISE 19-8
Income before income taxes
Income tax expense
Current
Deferred
Net income
$175,000
$40,000
30,000
70,000
$105,000
BRIEF EXERCISE 19-9
Income Tax Expense.........................................................
Income Tax Payable ($144,000* X 45%)...................
Deferred Tax Liability ($14,000 X 45%)....................
*$154,000 + $4,000 $14,000 = $144,000
19-5
71,100
64,800
6,300
BRIEF EXERCISE 19-10
Year
2008
2009
2010
Future taxable amount
$ 42,000
294,000
294,000
X
Tax Rate
34%
34%
40%
=
Deferred tax liability
$ 14,280
99,960
117,600
$231,840
BRIEF EXERCISE 19-11
Income Tax Expense.......................................................
Deferred Tax Liability ($2,000,000 X 4%)...............
80,000
80,000
BRIEF EXERCISE 19-12
Income Tax Refund Receivable......................................
Benefit Due to Loss Carryback...............................
$97,500 + [($450,000$325,000) X 30%]
135,000
135,000
BRIEF EXERCISE 19-13
Income Tax Refund Receivable ($400,000 X .40)..........
Benefit Due to Loss Carryback...............................
160,000
Deferred Tax Asset ($500,000 $400,000) X .40...........
Benefit Due to Loss Carryforward..........................
40,000
19-6
160,000
40,000
BRIEF EXERCISE 19-14
Income Tax Refund Receivable ($400,000 X. 40)..........
Benefit Due to Loss Carryback...............................
160,000
Deferred Tax Asset ($500,000 $400,000) X .40...........
Benefit Due to Loss Carryforward..........................
40,000
Benefit Due to Loss Carryforward.................................
Allowance to Reduce Deferred Tax Asset
to Expected Realizable Value..............................
40,000
160,000
40,000
40,000
BRIEF EXERCISE 19-15
Current assets
Deferred tax asset ($52,000 $38,000)
$14,000
Long-term liabilities
Deferred tax liability ($96,000 $27,000)
$69,000
19-7