Question & Answer

Stephanie Delaney, CPA, is the newly hired director of corporate taxation for Acme Incorporated, which is a publicly traded corporation. Ms. Delaney’s first job with Acme was the review of the company’s accounting practices on deferred income taxes. In doing her review, she noted differences between tax and book depreciation methods that permitted Acme to realize a sizable deferred tax liability on its balance sheet. As a result, Acme paid very little in income taxes at that time. Delaney also discovered that Acme has an explicit policy of selling off plant assets before they reversed in the deferred tax liability account. This policy, coupled with the rapid expansion of its plant asset base, allowed Acme to “defer” all income taxes payable for several years, even though it always has reported positive earnings and an increasing EPS. Delaney checked with the legal department and found the policy to be legal, but she’s uncomfortable with the ethics of it.

Instructions

Answer the following questions.

(a) Why would Acme have an explicit policy of selling plant assets before the temporary differences reversed in the deferred tax liability account?

(b) What are the ethical implications of Acme’s “deferral” of income taxes?

(c) Who could be harmed by Acme’s ability to “defer” income taxes payable for several years, despite positive earnings?

(d) In a situation such as this, what are Ms. Delaney’s professional responsibilities as a CPA?

Maria Rodriquez and Lynette Kingston are discussing accounting for income taxes. They are currently studying a schedule of taxable and deductible amounts that will arise in the future as a result of existing temporary differences. The schedule is as follows.

Future Years

2014 2015 2016 2017 2018

Taxable income $850,000

Taxable amounts $375,000 $375,000 $375,000 $375,000

Deductible amounts (2,400,000)

Enacted tax rate 50% 45% 40% 35% 30%

Instructions

(a) Explain the concept of future taxable amounts and future deductible amounts as illustrated in the schedule.

(b) How do the carryback and carryforward provisions affect the reporting of deferred tax assets and deferred tax liabilities?

At December 31, 2014, Higley Corporation has one temporary difference which will reverse and cause taxable amounts in 2015. In 2014, a new tax act set taxes equal to 45% for 2014, 40% for 2015, and 34% for 2016 and years thereafter.

Instructions

Explain what circumstances would call for Higley to compute its deferred tax liability at the end of 2014 by multiplying the cumulative temporary difference by:

(a) 45%.

(b) 40%.

(c) 34%.

Part A: This year, Gumowski Company has each of the following items in its income statement.

1. Gross profits on installment sales.

2. Revenues on long-term construction contracts.

3. Estimated costs of product warranty contracts.

4. Premiums on officers’ life insurance policies with Gumowski as beneficiary.

Instructions

(a) Under what conditions would deferred income taxes need to be reported in the financial statements?

(b) Specify when deferred income taxes would need to be recognized for each of the items above, and indicate the rationale for such recognition.

Part B: Gumowski Company’s president has heard that deferred income taxes can be classified in different ways in the balance sheet.

Instructions

Identify the conditions under which deferred income taxes would be classified as a noncurrent item in the balance sheet. What justification exists for such classification?

The asset-liability approach for recording deferred income taxes is an integral part of generally accepted accounting principles.

Instructions

(a) Indicate whether each of the following independent situations should be treated as a temporary difference or as a permanent difference, and explain why.

(1) Estimated warranty costs (covering a 3-year warranty) are expensed for financial reporting purposes at the time of sale but deducted for income tax purposes when paid.

(2) Depreciation for book and income tax purposes differs because of different bases of carrying the related property, which was acquired in a trade-in. The different bases are a result of different rules used for book and tax purposes to compute the basis of property acquired in a trade-in.

(3) A company properly uses the equity method to account for its 30% investment in another company.

The investee pays dividends that are about 10% of its annual earnings.

(4) A company reports a gain on an involuntary conversion of a nonmonetary asset to a monetary asset. The company elects to replace the property within the statutory period using the total proceeds so the gain is not reported on the current year’s tax return.

(b) Discuss the nature of the deferred income tax accounts and possible classifications in a company’s balance sheet. Indicate the manner in which these accounts are to be reported.

Dexter Company appropriately uses the assetliability method to record deferred income taxes. Dexter reports depreciation expense for certain machinery purchased this year using the modified accelerated cost recovery system (MACRS) for income tax purposes and the straight-line basis for financial reporting purposes. The tax deduction is the larger amount this year. Dexter received rent revenues in advance this year. These revenues are included in this year’s taxable income. However, for financial reporting purposes, these revenues are reported as unearned revenues, a current liability.

Instructions

(a) What are the principles of the asset-liability approach?

(b) How would Dexter account for the temporary differences?

(c) How should Dexter classify the deferred tax consequences of the temporary differences on its balance sheet?

The amount of income taxes due to the government for a period of time is rarely the amount reported on the income statement for that period as income tax expense.

Instructions

(a) Explain the objectives of accounting for income taxes in general-purpose financial statements.

(b) Explain the basic principles that are applied in accounting for income taxes at the date of the financial statements to meet the objectives discussed in (a).

(c) List the steps in the annual computation of deferred tax liabilities and assets.

Wise Company began operations at the beginning of 2015. The following information pertains to this company.

1. Pretax financial income for 2015 is $100,000.

2. The tax rate enacted for 2015 and future years is 40%.

3. Differences between the 2015 income statement and tax return are listed below:

(a) Warranty expense accrued for financial reporting purposes amounts to $7,000. Warranty deductions per the tax return amount to $2,000.

(b) Gross profit on construction contracts using the percentage-of-completion method per books amounts to $92,000. Gross profit on construction contracts for tax purposes amounts to $67,000.

(c) Depreciation of property, plant, and equipment for financial reporting purposes amounts to $60,000. Depreciation of these assets amounts to $80,000 for the tax return.

(d) A $3,500 fine paid for violation of pollution laws was deducted in computing pretax financial income.

(e) Interest revenue recognized on an investment in tax-exempt municipal bonds amounts to $1,500.

4. Taxable income is expected for the next few years. (Assume (a) is short-term in nature; assume (b) and (c) are long-term in nature.)

Instructions

(a) Compute taxable income for 2015.

(b) Compute the deferred taxes at December 31, 2015, that relate to the temporary differences described above. Clearly label them as deferred tax asset or liability.

(c) Prepare the journal entry to record income tax expense, deferred taxes, and income taxes payable for 2015.

(d) Draft the income tax expense section of the income statement, beginning with “Income before income taxes.”

The information shown below and on page 1170 was disclosed during the audit of Elbert Inc.

1. Amount Due

Year per Tax Return

2014 $130,000

2015 104,000

2. On January 1, 2014, equipment costing $600,000 is purchased. For financial reporting purposes, the company uses straight-line depreciation over a 5-year life. For tax purposes, the company uses the elective straight-line method over a 5-year life. (Hint: For tax purposes, the half-year convention as discussed in Appendix 11A must be used.)

3. In January 2015, $225,000 is collected in advance rental of a building for a 3-year period. The entire

$225,000 is reported as taxable income in 2015, but $150,000 of the $225,000 is reported as unearned revenue in 2015 for financial reporting purposes. The remaining amount of unearned revenue is to be recognized equally in 2016 and 2017.

4. The tax rate is 40% in 2014 and all subsequent periods. (Hint: To find taxable income in 2014 and

2015, the related income taxes payable amounts will have to be “grossed up.”)

5. No temporary differences existed at the end of 2013. Elbert expects to report taxable income in each of the next 5 years.

Instructions

(a) Determine the amount to report for deferred income taxes at the end of 2014, and indicate how it should be classified on the balance sheet.

(b) Prepare the journal entry to record income taxes for 2014.

(c) Draft the income tax section of the income statement for 2014, beginning with “Income before income taxes.” (Hint: You must compute taxable income and then combine that with changes in cumulative temporary differences to arrive at pretax financial income.)

(d) Determine the deferred income taxes at the end of 2015, and indicate how they should be classified on the balance sheet.

(e) Prepare the journal entry to record income taxes for 2015.

(f) Draft the income tax section of the income statement for 2015, beginning with “Income before income taxes.”

Crosley Corp. sold an investment on an installment basis. The total gain of $60,000 was reported for financial reporting purposes in the period of sale. The company qualifies to use the installment-sales method for tax purposes. The installment period is 3 years; one-third of the sale price is collected in the period of sale. The tax rate was 40% in 2014, and 35% in 2015 and 2016. The 35% tax rate was not enacted in law until 2015. The accounting and tax data for the 3 years is shown below.

2015 2016 2017 2018 2019

Taxable amounts $300 $300 $300 $ 300 $300

Deductible amount — — — (1,600) —

2015 2016 2017 2018

Taxable amounts $300 $300 $ 300 $300

Deductible amount — — (2,300) —

Financial Tax

Accounting Return

2014 (40% tax rate)

Income before temporary difference $ 70,000 $70,000

Temporary difference 60,000 20,000

Income $130,000 $90,000

2015 (35% tax rate)

Income before temporary difference $ 70,000 $70,000

Temporary difference –0– 20,000

Income $ 70,000 $90,000

2016 (35% tax rate)

Income before temporary difference $ 70,000 $70,000

Temporary difference –0– 20,000

Income $ 70,000 $90,000

Instructions

(a) Prepare the journal entries to record the income tax expense, deferred income taxes, and the income taxes payable at the end of each year. No deferred income taxes existed at the beginning of 2014.

(b) Explain how the deferred taxes will appear on the balance sheet at the end of each year. (Assume

Installment Accounts Receivable is classified as a current asset.)

(c) Draft the income tax expense section of the income statement for each year, beginning with “Income before income taxes.”

Presented below are two independent situations related to future taxable and deductible amounts resulting from temporary differences existing at December 31, 2014.

1. Mooney Co. has developed the following schedule of future taxable and deductible amounts.

2015 2016 2017 2018 2019

Taxable amounts $300 $300 $300 $ 300 $300

Deductible amount — — — (1,600) —

2. Roesch Co. has the following schedule of future taxable and deductible amounts.

2015 2016 2017 2018

Taxable amounts $300 $300 $ 300 $300

Deductible amount — — (2,300) —

Both Mooney Co. and Roesch Co. have taxable income of $4,000 in 2014 and expect to have taxable income in all future years. The tax rates enacted as of the beginning of 2014 are 30% for 2014–2017 and 35% for years thereafter. All of the underlying temporary differences relate to noncurrent assets and liabilities.

Instructions

For each of these two situations, compute the net amount of deferred income taxes to be reported at the end of 2014, and indicate how it should be classified on the balance sheet.

Jennings Inc. reported the following pretax income (loss) and related tax rates during the years 2010 2016.

Pretax Income (loss) Tax Rate

2010 $ 40,000 30%

2011 25,000 30%

2012 50,000 30%

2013 80,000 40%

2014 (180,000) 45%

2015 70,000 40%

2016 100,000 35%

Pretax financial income (loss) and taxable income (loss) were the same for all years since Jennings began business. The tax rates from 2013–2016 were enacted in 2013.

Instructions

(a) Prepare the journal entries for the years 2014–2016 to record income taxes payable (refundable), income tax expense (benefit), and the tax effects of the loss carryback and carryforward. Assume that Jennings elects the carryback provision where possible and expects to realize the benefits of any loss carryforward in the year that immediately follows the loss year.

(b) Indicate the effect the 2014 entry(ies) has on the December 31, 2014, balance sheet.

(c) Prepare the portion of the income statement, starting with “Operating loss before income taxes,” for 2014.

(d) Prepare the portion of the income statement, starting with “Income before income taxes,” for 2015.

The accounting records of Shinault Inc. show the following data for 2014 (its first year of operations).

1. Life insurance expense on officers was $9,000.

2. Equipment was acquired in early January for $300,000. Straight-line depreciation over a 5-year life is used, with no salvage value. For tax purposes, Shinault used a 30% rate to calculate depreciation.

3. Interest revenue on State of New York bonds totaled $4,000.

4. Product warranties were estimated to be $50,000 in 2014. Actual repair and labor costs related to the warranties in 2014 were $10,000. The remainder is estimated to be paid evenly in 2015 and 2016.

5. Gross profit on an accrual basis was $100,000. For tax purposes, $75,000 was recorded on the installment- sales method.

6. Fines incurred for pollution violations were $4,200.

7. Pretax financial income was $750,000. The tax rate is 30%.

Instructions

(a) Prepare a schedule starting with pretax financial income in 2014 and ending with taxable income in

2014.

(b) Prepare the journal entry for 2014 to record income taxes payable, income tax expense, and deferred  income taxes.

The following information has been obtained for the Gocker Corporation.

1. Prior to 2014, taxable income and pretax financial income were identical.

2. Pretax financial income is $1,700,000 in 2014 and $1,400,000 in 2015.

3. On January 1, 2014, equipment costing $1,200,000 is purchased. It is to be depreciated on a straightline basis over 5 years for tax purposes and over 8 years for financial reporting purposes. (Hint: Use the half-year convention for tax purposes, as discussed in Appendix 11A.)

4. Interest of $60,000 was earned on tax-exempt municipal obligations in 2015.

5. Included in 2015 pretax financial income is an extraordinary gain of $200,000, which is fully taxable.

6. The tax rate is 35% for all periods.

7. Taxable income is expected in all future years.

Instructions

(a) Compute taxable income and income taxes payable for 2015.

(b) Prepare the journal entry to record 2015 income tax expense, income taxes payable, and deferred taxes.

(c) Prepare the bottom portion of Gocker’s 2015 income statement, beginning with “Income before income taxes and extraordinary item.”

(d) Indicate how deferred income taxes should be presented on the December 31, 2015, balance sheet.

The pretax financial income of Truttman Company differs from its taxable income throughout each of 4 years as follows.

Pretax Taxable

Year Financial Income Income Tax Rate

2014 $290,000 $180,000 35%

2015 320,000 225,000 40%

2016 350,000 260,000 40%

2017 420,000 560,000 40%

Pretax financial income for each year includes a nondeductible expense of $30,000 (never deductible for tax purposes). The remainder of the difference between pretax financial income and taxable income in each period is due to one depreciation temporary difference. No deferred income taxes existed at the beginning of 2014.

Instructions

(a) Prepare journal entries to record income taxes in all 4 years. Assume that the change in the tax rate to 40% was not enacted until the beginning of 2015.

(b) Prepare the income statement for 2015, beginning with Income before income taxes.

The following information is available for Remmers Corporation for 2014.

1. Depreciation reported on the tax return exceeded depreciation reported on the income statement by $120,000. This difference will reverse in equal amounts of $30,000 over the years 2015–2018.

2. Interest received on municipal bonds was $10,000.

3. Rent collected in advance on January 1, 2014, totaled $60,000 for a 3-year period. Of this amount,

$40,000 was reported as unearned at December 31, 2014, for book purposes.

4. The tax rates are 40% for 2014 and 35% for 2015 and subsequent years.

5. Income taxes of $320,000 are due per the tax return for 2014.

6. No deferred taxes existed at the beginning of 2014.

Instructions

(a) Compute taxable income for 2014.

(b) Compute pretax financial income for 2014.

(c) Prepare the journal entries to record income tax expense, deferred income taxes, and income taxes   for 2014 and 2015. Assume taxable income was $980,000 in 2015.

(d) Prepare the income tax expense section of the income statement for 2014, beginning with “Income before income taxes.

Meyer reported the following pretax financial income (loss) for the years 2012–2016.

2012 $240,000

2013 350,000

2014 120,000

2015 (570,000)

2016 180,000

Pretax financial income (loss) and taxable income (loss) were the same for all years involved. The enacted tax rate was 34% for 2012 and 2013, and 40% for 2014–2016. Assume the carryback provision is used first for net operating losses.

Instructions

(a) Prepare the journal entries for the years 2014–2016 to record income tax expense, income taxes payable (refundable), and the tax effects of the loss carryback and loss carryforward, assuming that based on the weight of available evidence, it is more likely than not that one-fifth of the benefits of the loss carryforward will not be realized.

(b) Prepare the income tax section of the 2015 income statement beginning with the line “Income (loss) before income taxes.”

Beilman Inc. reports the following pretax income (loss) for both book and tax purposes. (Assume the carryback provision is used where possible for a net operating loss.)

Year Pretax Income (Loss) Tax Rate

2012 $120,000 40%

2013 90,000 40%

2014 (280,000) 45%

2015 120,000 45%

The tax rates listed were all enacted by the beginning of 2012.

Instructions

(a) Prepare the journal entries for years 2012–2015 to record income tax expense (benefit) and income taxes payable (refundable), and the tax effects of the loss carryback and loss carryforward, assuming that based on the weight of available evidence, it is more likely than not that one-half of the benefits of the loss carryforward will not be realized.

(b) Prepare the income tax section of the 2014 income statement beginning with the line “Operating loss before income taxes.”

(c) Prepare the income tax section of the 2015 income statement beginning with the line “Income before income taxes.”

Hamderson Inc. reports the following pretax income (loss) for both financial reporting purposes and tax purposes. (Assume the carryback provision is used for a net operating loss.)

Year Pretax Income (Loss) Tax Rate

2012 $120,000 34%

2013 90,000 34%

2014 (280,000) 38%

2015 220,000 38%

The tax rates listed were all enacted by the beginning of 2012.

Instructions

(a) Prepare the journal entries for the years 2012–2015 to record income tax expense (benefit) and income taxes payable (refundable) and the tax effects of the loss carryback and carryforward, assuming that at the end of 2014 the benefits of the loss carryforward are judged more likely than not to be realized in the future.

(b) Using the assumption in (a), prepare the income tax section of the 2014 income statement beginning with the line “Operating loss before income taxes.”

(c) Prepare the journal entries for 2014 and 2015, assuming that based on the weight of available evidence, it is more likely than not that one-fourth of the benefits of the loss carryforward will not be realized.

(d) Using the assumption in (c), prepare the income tax section of the 2014 income statement beginning with the line “Operating loss before income taxes.”

The differences between the book basis and tax basis of the assets and liabilities of Castle Corporation at the end of 2013 are presented below.

Book Basis Tax Basis

Accounts receivable $50,000 $–0–

Litigation liability 30,000 –0–

It is estimated that the litigation liability will be settled in 2014. The difference in accounts receivable will result in taxable amounts of $30,000 in 2014 and $20,000 in 2015. The company has taxable income of

$350,000 in 2013 and is expected to have taxable income in each of the following 2 years. Its enacted tax rate is 34% for all years. This is the company’s first year of operations. The operating cycle of the business is 2 years.

Instructions

(a) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013.

(b) Indicate how deferred income taxes will be reported on the balance sheet at the end of 2013.

Nadal Inc. has two temporary differences at the end of 2013. The first difference stems from installment sales, and the second one results from the accrual of a loss contingency. Nadal’s accounting department has developed a schedule of future taxable and deductible amounts related to these temporary differences as follows.

2014 2015 2016 2017

Taxable amounts $40,000 $50,000 $60,000 $80,000

Deductible amounts (15,000) (19,000)

$40,000 $35,000 $41,000 $80,000

As of the beginning of 2013, the enacted tax rate is 34% for 2013 and 2014, and 38% for 2015–2018. At the beginning of 2013, the company had no deferred income taxes on its balance sheet. Taxable income for 2013 is $500,000. Taxable income is expected in all future years.

Instructions

(a) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013.

(b) Indicate how deferred income taxes would be classified on the balance sheet at the end of 2013.

Teri Hatcher Inc., in its first year of operations, has the following differences between the book basis and tax basis of its assets and liabilities at the end of 2013.

Book Basis Tax Basis

Equipment (net) $400,000 $340,000

Estimated warranty liability $200,000 $ –0–

It is estimated that the warranty liability will be settled in 2014. The difference in equipment (net) will result in taxable amounts of $20,000 in 2014, $30,000 in 2015, and $10,000 in 2016. The company has taxable income of $520,000 in 2013. As of the beginning of 2013, the enacted tax rate is 34% for 2013–2015, and 30% for 2016. Hatcher expects to report taxable income through 2016.

Instructions

(a) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013.

(b) Indicate how deferred income taxes will be reported on the balance sheet at the end of 2013.

Andy McDowell Co. establishes a $100 million liability at the end of 2014 for the estimated site-cleanup costs at two of its manufacturing facilities. All related closing costs will be paid and deducted on the tax return in 2015. Also, at the end of 2014, the company has $50 million of temporary differences due to excess depreciation for tax purposes, $7 million of which will reverse in 2015.

The enacted tax rate for all years is 40%, and the company pays taxes of $64 million on $160 million of taxable income in 2014. McDowell expects to have taxable income in 2015.

Instructions

(a) Determine the deferred taxes to be reported at the end of 2015.

(b) Indicate how the deferred taxes computed in (a) are to be reported on the balance sheet.

(c) Assuming that the only deferred tax account at the beginning of 2014 was a deferred tax liability of

$10,000,000, draft the income tax expense portion of the income statement for 2014, beginning with the line “Income before income taxes.” (Hint: You must first compute (1) the amount of temporary difference underlying the beginning $10,000,000 deferred tax liability, then (2) the amount of temporary differences originating or reversing during the year, and then (3) the amount of pretax financial income.)

During 2014, Kate Holmes Co.’s first year of operations, the company reports pretax financial income at $250,000. Holmes’s enacted tax rate is 45% for 2014 and 40% for all later years. Holmes expects to have taxable income in each of the next 5 years. The effects on future tax returns of temporary differences existing at December 31, 2014, are summarized as follows.

Future Years

2015 2016 2017 2018 2019 Total

Future taxable (deductible) amounts:

Installment sales $32,000 $32,000 $32,000 $ 96,000

Depreciation 6,000 6,000 6,000 $6,000 $6,000 30,000

Unearned rent (50,000) (50,000) (100,000)

Instructions

(a) Complete the schedule below to compute deferred taxes at December 31, 2014.

(b) Compute taxable income for 2014.

(c) Prepare the journal entry to record income taxes payable, deferred taxes, and income tax expense for 2014.

Future Taxable December 31, 2014

(Deductible) Tax Deferred Tax

Temporary Difference Amounts Rate (Asset) Liability

Installment sales $ 96,000

Depreciation 30,000

Unearned rent (100,000)

Totals $

Taxable income and pretax financial income would be identical for Huber Co. except for its treatments of gross profit on installment sales and estimated costs of warranties. The income computations shown on page 1164 have been prepared.

Taxable income 2013 2014 2015

Excess of revenues over expenses  excluding two temporary differences) $160,000 $210,000 $90,000

Installment gross profi t collected 8,000 8,000 8,000

Expenditures for warranties (5,000) (5,000) (5,000)

Taxable income $163,000 $213,000 $93,000

Pretax fi nancial income 2013 2014 2015

Excess of revenues over expenses (excluding two temporary differences) $160,000 $210,000 $90,000

Installment gross profi t earned 24,000 –0– –0–

Estimated cost of warranties (15,000) –0– –0–

Income before taxes $169,000 $210,000 $90,000

The tax rates in effect are 2013, 40%; 2014 and 2015, 45%. All tax rates were enacted into law on January 1, 2013. No deferred income taxes existed at the beginning of 2013. Taxable income is expected in all future years.

Instructions

Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013, 2014, and 2015.