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Flashcards in Deferred Taxes Deck (61):
1

Rein Inc. reported deferred tax assets and deferred tax liabilities at the end of 2003 and at the end of 2004.

According to FASB Statements No. 109 Accounting for Income Taxes, for the year ended 2004, Rein should report deferred income tax expense or benefit equal to the

  1. Decrease in the deferred tax assets.
  2. Increase in the deferred tax liabilities.
  3. Amount of the current tax liability, plus the sum of the net changes in deferred tax assets and deferred tax liabilities.
  4. Sum of the net changes in deferred tax assets and deferred tax liabilities.

Sum of the net changes in deferred tax assets and deferred tax liabilities.

The net amount of deferred tax expense or benefit is that amount that is not recognized in current period income.

A simple equation describes the total tax effects for a period: income tax expense or benefit + deferred income tax expense or benefit = current tax liability. The deferred income tax expense or benefit can further be described as the net change in both types of deferred tax accounts.

  • Total income tax expense is the sum of the current and deferred portions. 
  • The current portion is the income tax liability for the year. 
  • The deferred portion is the net sum of the changes in the deferred tax accounts.

Consider the tax-accrual entry for a year, assuming no estimated tax payments have been made:

  • Dr. income tax expense 20
  • Dr. Deferred tax asset3
    • Cr. Deferred tax liability 5
    • Cr. income tax payable 18

Total income tax expense = 20=current tax expense+deferred tax expense

Deferred tax asset=$18+$2

2

According to FASB Statement No. 109, Accounting for Income Taxes, justification for the method of determining periodic deferred tax expense is based on the concept of

  1. Matching of periodic expense to periodic revenue.
  2. Objectivity in the calculation of periodic expense.
  3. Recognition of assets and liabilities.
  4. Consistency of tax-expense measurements with actual tax-planning strategies.

Recognition of assets and liabilities.

FAS 109 adopted the asset/liability approach. The deferred tax expense is the net change in the deferred tax accounts for the year. Deferred tax accounts are measured at the enacted tax rate for the period in which the future temporary differences reverse.

Rather than base income tax expense on accounting income adjusted for permanent differences, as was the case before 109, income tax expense is now the sum of current income tax expense (the income tax liability for the year) and the net change in deferred tax accounts. The expense is a residual amount, based on the changes in assets and liabilities. Matching is no longer the conceptual basis for measurement.

3

On June 31, 2004, Ank Corp. pre-paid a $19,000 premium on an annual insurance policy. 
The premium payment was a tax-deductible expense in Ank's 2004 cash-basis tax return. The accrual-basis income statement will report a $9,500 insurance expense in 2004 and 2005.

Ank elected early application of FASB Statement No. 109, Accounting for Income Taxes.
Ank's income tax rate is 30% in 2004 and 25% thereafter. In Ank's December 31, 2004 balance sheet, what amount related to the insurance should be reported as a deferred income tax liability?

  1. $5,700
  2. $4,750
  3. $2,850
  4. $2,375

$2,375

The future temporary difference at December 31, 2004 is $9,500, the amount of insurance expense to be recognized for financial-reporting purposes.

The entire $19,000 deduction was taken for tax purposes in 2004. Therefore, no further deduction will be taken beyond 2004. The difference is taxable, because future taxable income exceeds future pre-tax accounting income from transactions through 2004.

The deferred tax liability uses the future tax rate, because that is the rate at which the deferred taxes will be paid. The ending deferred tax liability for 2004 = $2,375 = .25($9,500).

4

Lake Corp., a newly organized company, reported pre-tax financial income of $100,000 for 2005. 
Among the items reported in Lake's 2005 income statement are the following:

  • Premium on officer's life insurance with Lake as owner and beneficiary $15,000
  • Interest received on municipal bonds $20,000

Lake elected early application of FASB Statement No. 109, Accounting for Income Taxes. The enacted tax rate for 2005 is 30% and 25% thereafter. In its December 31, 2005 balance sheet, Lake should report a deferred income tax liability of

  1. $28,500
  2. $4,500
  3. $3,750
  4. $0

$0

Both listed items are permanent differences. These are differences that never reverse and are not used in the determination of deferred tax accounts. Both income tax expense and income tax liability are affected the same way by these items.
A deferred income tax liability is based on future taxable differences at the end of the reporting year. 

There are no such differences. Therefore, there is no deferred tax liability.

5

When accounting for income taxes, a temporary difference occurs in which of the following scenarios?

  1. An item is included in the calculation of net income, but is neither taxable nor deductible.
  2. An item is included in the calculation of net income in one year and in taxable income in a different year.
  3. An item is no longer taxable, owing to a change in the tax law.
  4. The accrual method of accounting is used.

An item is included in the calculation of net income in one year and in taxable income in a different year.

This answer describes one category of temporary difference. In general, a temporary difference is one for which the item's recognition takes place at a different rate or time for financial reporting and the tax return. However, the total impact of the item is the same over its life, for both systems of reporting.

6

Orleans Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Since 2002, Orleans has applied FASB Statement No. 109, Accounting for Income Taxes. In its 2005 balance sheet, Orleans' deferred income- tax liabilities increased compared to 2004.

Which of the following changes would cause this increase in deferred income tax liabilities?

  • I. An increase in pre-paid insurance.
  • II. An increase in rent receivable.
  • III. An increase in warranty obligations.

  • I. An increase in pre-paid insurance. - YES
  • II. An increase in rent receivable. - YES
  • III. An increase in warranty obligations. - NO

Deferred tax liabilities are the future tax effects of future taxable temporary differences. Such differences cause future taxable income to exceed future pre-tax accounting income.

  1. An increase in pre-paid insurance implies that future accounting insurance expense will exceed future tax insurance expense. Therefore, future taxable income will increase relative to future pre-tax accounting income. This increases the deferred tax liability.
  2. An increase in rent receivable implies that future tax-rent revenue will exceed future accounting-rent revenue. A rent receivable is recorded when accounting-rent revenue is recognized before cash is received. Cash will be received in the future, which will be recognized as rent revenue for tax, but no revenue will be recognized for accounting. Therefore, again, future taxable income will increase relative to future pre-tax accounting income.
  3. An increase in warranty obligations implies that future tax-warranty expense will exceed future accounting-warranty expense. Accounting has recognized the warranty expense in the year of sale, whereas tax-warranty expense is recognized in the year the repairs are made. This time, future taxable income will decrease relative to future pre-tax accounting income. This increases the deferred tax asset, rather than the deferred tax liability.

Therefore, only I and II increase the deferred tax liability.

7

For the year ended December 31, 2004, Mont Co.'s books showed income of $600,000 before provision for income tax expense. To compute taxable income for federal income tax purposes, the following items should be noted:

  • Income from exempt municipal bonds $60,000
  • Depreciation deducted for tax purposes in excess of depreciation recorded on the books $120,000
  • Proceeds received from life insurance on death of officer $100,000
  • Estimated tax payments 0
  • Enacted corporate tax rate 30%

Ignoring the alternative minimum tax provisions, what amount should Mont report at December 31, 2004 as its current federal income tax liability?

  1. $96,000
  2. $114,000
  3. $150,000
  4. $162,000

$96,000

The tax liability is the tax rate times taxable income = .30($600,000 - $60,000 - $120,000 - $100,000) = $96,000.

The municipal- bond interest is tax exempt, but included in pre-tax accounting income of $600,000 and therefore is subtracted when computing taxable income.

The excess depreciation is also subtracted, because pre-tax accounting income reflects only depreciation recorded for financial accounting purposes.

The proceeds on life insurance are included in pre-tax accounting income, but are not taxable and are therefore subtracted in computing taxable income.

8

At the end of year one, Cody Co. reported a profit on a partially completed construction contract by applying the percentage-of-completion method.

By the end of year two, the total estimated profit on the contract at completion in year three had been drastically reduced from the amount estimated at the end of year one. 

Consequently, in year two, a loss equal to one-half of the year-one profit was recognized. Cody used the completed-contract method for income tax purposes and had no other contracts.

According to FASB Statement No. 109, Accounting for Income Taxes, the year-two balance sheet should include a deferred tax

  • Asset
  • Liability

  • Asset - NO
  • Liability - YES

More profit will be recognized under completed contract in year three for tax purposes than will be recognized under percentage-of-completion in year three for accounting purposes. The entire profit will be recognized under completed contract (tax purposes) in year three. But a portion of income has already been recognized for accounting purposes before year three. Therefore, less income will be recognized in year three for accounting purposes.

Consequently, at the end of year two, there is a future taxable difference because future taxable income will exceed future pre-tax accounting income. Taxable differences give rise to deferred tax liabilities.

9

Dunn Co.'s 2005 income statement reported $90,000 income before provision for income taxes. 

To compute the provision for federal income taxes, the following 2005 data are provided:

Rent received in advance $16,000

Income from exempt municipal bonds $20,000

Depreciation deducted for income tax purposes in excess of depreciation reported for financial-statement purposes $10,000

Enacted corporate income tax rate 30%

If the alternative minimum tax provisions are ignored, what amount of current federal income tax liability should be reported in Dunn's December 31, 2005 balance sheet?

  1. $18,000
  2. $22,800
  3. $25,800
  4. $28,800

$22,800

The tax liability is 30% of taxable income.

  • Pre-tax accounting income $90,000
  • Plus advance rent (taxable, but not included in pre-tax accounting income) $16,000
  • Less municipal bond income (this is included in pre-tax accounting income, but is not taxable) ($20,000)
  • Less depreciation for tax in excess of depreciation for the books (10,000)
  • Equals taxable income $76,000
  • Times tax rate x .30
  • Equals income tax liability = $22,800

10

In its 2005 income statement, Cere Co. reported income before income taxes of $300,000.

Cere estimated that, because of permanent differences, taxable income for 2005 would be $280,000. During 2005, Cere made estimated tax payments of $50,000, which were debited to income tax expense. Cere is subject to a 30% tax rate.

What amount should Cere report as income tax expense?

  1. $34,000
  2. $50,000
  3. $84,000
  4. $90,000

$84,000

income tax expense reflects the tax effects of permanent differences as measured by the tax code.

Because there are no temporary differences, income tax expense equals the income tax liability for the period or: $.30($280,000) = $84,000.

This reflects the tax ultimately payable on 2005 transactions.

Therefore, income tax expense should also reflect that amount, in the absence of temporary differences.

11

Busy Corp. prepared the following reconciliation between pre-tax accounting income and taxable income for the year ended December 31, 2004:

  • Pre-tax accounting income $250,000
  • Taxable income $150,000
  • Difference $100,000

========

  • Analysis of difference:
  • Interest on municipal bonds $25,000
  • Excess of tax over book depreciation$75,000
  • $100,000

========

Busy uses FASB Statement No. 109, Accounting for Income Taxes. Busy's effective income tax rate for 2004 is 30%. The depreciation difference will reverse in equal amounts over the next three years at an enacted tax rate of 40%.

In Busy's effective income statement, what amount should be reported as the current portion of its provision for income taxes?

  1. $45,000
  2. $67,500
  3. $75,000
  4. $82,500

$45,000

The current portion of the provision for income taxes is the current income tax expense amount and also the income tax liability for the year. This amount is the current tax rate times taxable income or $45,000 ($150,000 x .30). The information on temporary differences is not relevant to the solution.

12

As a result of differences between depreciation for financial-reporting purposes and tax purposes, the financial-reporting basis of Noor Co.'s sole depreciable asset, acquired in 2005, exceeded its tax basis by $250,000 at December 31, 2005. This difference will reverse in future years. The enacted tax rate is 30% for 2005, and 40% for future years. Noor has no other temporary differences.

In its December 31, 2005 balance sheet, how should Noor report the deferred tax effect of this difference?

  1. As an asset of $75,000.
  2. As an asset of $100,000.
  3. As a liability of $75,000.
  4. As a liability of $100,000.

As a liability of $100,000.

Future tax rates are used to measure the future tax consequences (balances in deferred tax accounts) of transactions through the balance sheet date.

This firm faces a 40% tax rate in the future and therefore measures the deferred tax account as $250,000(.40) = $100,000. The future difference of $250,000 is taxable, because the financial-reporting basis exceeds the tax basis at the balance sheet date. This means that the firm has recognized more depreciation for tax purposes as of December 31, 2005, than it has for financial reporting.

Therefore, in the future, more depreciation will be recognized for financial reporting than for tax reporting, causing future taxable income to exceed pre-tax financial income. Hence, a deferred tax liability is recognized at December 31, 2005.

This liability is recognized now, at the end of 2005, because it resulted from transactions through this date. When the difference reverses in the future, the deferred tax liability will be reduced, causing taxes payable to increase.

13

Stone Co. begins operations in 2004 and reports $225,000 in income before income tax for the year. Stone's 2004 tax depreciation exceeds its book depreciation by $25,000. Stone also has non-deductible book expenses of $10,000 related to permanent differences.

Stone's tax rate for 2004 is 40%, and the enacted rate for years after 2004 is 35%. Stone elects early adoption of FASB Statement No. 109, Accounting for Income Taxes.

In its December 31, 2004 balance sheet, what amount of deferred income tax liability should Stone report?

  1. $8,750
  2. $10,000
  3. $12,250
  4. $14,000

$8,750

The deferred tax liability is based solely on the depreciation temporary difference.

Permanent differences do not enter into the determination of deferred tax accounts. This is the first year of operations. Therefore, the depreciation difference in this year must equal the net future temporary difference.

The deferred tax liability balance at the end of the year is therefore $8,750 ($25,000 x .35). Future enacted tax rates are used because they are the rates that will be in effect when the future tax consequences will be realized.

14

According to FASB Statement No. 109, Accounting for Income Taxes, which of the following items should affect current income tax expense for 2005?

  1. Interest on a 1989 tax deficiency paid in 2005.
  2. Penalty on a 1989 tax deficiency paid in 2005.
  3. Change in income tax rate for 2005.
  4. Change in income tax rate for 2006.

Change in income tax rate for 2005.

Current income tax expense is the income tax liability for the year. A change in 2005's tax rate changes the tax on taxable income and therefore current income tax expense. A change in the 2006 tax rate, even if enacted in 2005, would not change current income tax expense. It would change deferred income tax, however.

The other two answer alternatives are amounts that must be paid in 2005, but are not recognized as current income tax. These amounts are separately payable to the taxing authority and are not computed as part of taxable income for 2005. Therefore, current income tax for 2005, which is income tax liability for 2005, is unaffected by these items.

15

Lion Co.'s income statement for its first year of operations shows pretax income of $6,000,000. In addition, the following differences existed between Lion's tax return and records:

Tax return / Accounting records

  • Uncollectible accounts expense $220,000 \ $250,000
  • Depreciation expense $860,000 / $570,000
  • Tax-exempt interest revenue $50,000

Lion's current year tax rate is 30% and the enacted rate for future years is 40%. What amount should Lion report as deferred tax expense in its income statement for the year?

  1. $148,000
  2. $124,000
  3. $104,000
  4. $78,000

$104,000

Two of the three differences are temporary, and thus contribute to the deferral of tax. The uncollectible accounts expense gives rise to a future deductible difference of $30,000 ($250,000 - $220,000) causing the firm's deferred tax asset to increase $12,000 ($30,000 x .40). The future enacted tax rate is used to measure changes in deferred tax accounts. The depreciation difference gives rise to a future taxable difference of $290,000 ($860,000 - $570,000) causing the firm's deferred tax liability to increase $116,000 ($290,000 x .40). The net deferral is $104,000 ($116,000 - $12,000). The tax-exempt interest is a nontemporary difference. Therefore, it does not affect the deferral of tax.

16

In 2005, Lobo Corp. reported for financial-statement purposes the following revenue and expenses that were not included in taxable income:

  • Premiums on officers' life insurance under which the corporation is the beneficiary $5,000
  • Interest revenue on qualified-state or municipal bonds $10,000
  • Estimated future warranty costs to be paid in 2006 and 2007 $60,000

Lobo's enacted tax rate for the current and future years is 30%. Lobo has paid income taxes of $170,000 for the three-year period ended December 31, 2005. There were no temporary differences in prior years.

Lobo elected early application of FASB Statement No. 109, Accounting for Income Taxes. The deferred tax benefit to be applied against current income tax expense is

  1. $18,000
  2. $19,500
  3. $21,000
  4. $22,500

$18,000

The only difference between taxable income and accounting income that results in a future tax benefit is the estimated warranty costs. 
The future tax benefit is $18,000, which is computed as .30($60,000). In the future, $60,000 of warranty costs will be deductible, yet these costs have reduced accounting earnings as of December 31, 2005. Therefore, future taxable income will be reduced by $60,000 as a result of transactions through December 31, 2005. 
That benefit is recorded as a deferred tax asset. The $18,000 amount reduces 2005 income tax expense relative to income tax payable, because the payable does not reflect the warranty deduction in 2005. It is not deductible until later years. 
The insurance premiums and municipal-bond interest are permanent differences and do not result in future tax benefits.

17

Shear, Inc. began operations in 2005. Included in Shear's 2005 financial statements were bad debt expenses of $1,400 and profit from an installment sale of $2,600.

For tax purposes, the bad debts will be deducted and the profit from the installment sale will be recognized in 2007. The enacted tax rates are 30% in 2005 and 25% in 2007.

Shear elected early application of FASB Statement No. 109, Accounting for Income Taxes. In its 2005 income statement, what amount should Shear report as deferred income tax expense?

  1. $300
  2. $360
  3. $650
  4. $780

$300

Deferred income tax is the net change in the deferred tax accounts for the year. Given that this is the first year of operations, the change equals the ending deferred tax balance. Deferred tax accounts are measured using the future enacted tax rates applicable in the period of reversal.

The future 2007 tax deduction for bad debt expense will cause 2007 taxable income to decrease relative to pre-tax accounting income (a deductible difference). Therefore, a deferred tax asset is recorded for $350 ($1,400 x .25) in 2005.

The future 2007 installment revenue will be taxable then and cause taxable income to increase relative to pre-tax accounting income (a taxable difference). Therefore, a deferred tax liability is recorded for $650 ($2,600 x .25) in 2005.

The net of the deferred tax asset and liability at the end of 2005 is $300 ($650 - $350). This is the amount by which total income tax expense exceeds income tax liability (current income tax expense) and therefore equals the deferred income tax expense.

18

Black Co., organized on January 2, 2004, had pre-tax financial statement income of $500,000 and taxable income of $800,000 for the year ended December 31, 2004. 
The only temporary differences are accrued product-warranty costs, which Black expects to pay as follows:

  • 2005 $100,000
  • 2006 $50,000
  • 2007 $50,000
  • 2008 $100,000

The enacted income tax rates are 25% for 2004, 30% for 2005 through 2007, and 35% for 2008. Black believes that future years' operations will produce profits. In its December 31, 2004 balance sheet, what amount should Black report as deferred tax asset?

  1. $50,000
  2. $75,000
  3. $90,000
  4. $95,000

$95,000

Black will recognize a deferred tax asset, rather than a deferred liability, because its current taxable income is greater than its current pre-tax financial income. 
This occurs because Black cannot deduct product warranty cost for tax purposes until the costs are incurred (paid), but, for financial reporting, it must recognize those estimated costs as an expense in the period of the related sales. 
The result is an amount that will be deductible in the future for tax purposes: a deferred tax asset. Because it is deductible now for financial reporting and will be deductible in the future for tax purposes, it is a temporary difference.

The amount of deferred tax asset (or, in another case, deferred tax liability) on temporary differences is calculated by multiplying the amount of the temporary differences by the enacted tax rate for the period(s) during which the deferred asset (or liability) is expected to be realized. 
Therefore, Black's deferred tax asset would be calculated as:

2005$100,000 x .30 =

$30,000

2006$50,000 x .30 =

$15,000

2007$50,000 x .30 =

$15,000

2008$100,000 x .35 =

$35,000

Total deferred tax asset =

$95,000

Please note:

 

This was the first year of operation for Black. Therefore, there was no previously recorded tax asset or liability.

Since Black expects operating profits in future years, it implicitly expects to realize the benefit of the deferred tax asset and no valuation allowance is necessary.

A, B, and C are incorrect. The tax benefit (asset) is the amount to be recognized as deductible in each future year times (multiplied by) the enacted tax rate applicable to each future year.

19

Fern Co. has net income, before taxes, of $200,000, including $20,000 interest revenue from municipal bonds and $10,000 paid for officers' life insurance premiums where the company is the beneficiary. The tax rate for the current year is 30%. What is Fern's effective tax rate?

  1. 27.0%
  2. 28.5%
  3. 30.0%
  4. 31.5%

28.5%

The effective tax rate is the ratio of income tax expense to pre-tax accounting income. income tax expense equals income tax liability in this case, because there are no temporary differences. Both the interest revenue and life-insurance premiums are permanent differences. The income tax liability is the product of the income tax rate and taxable income. Taxable income is $190,000 ($200,000 - $20,000 non-taxable interest included in the $200,000 + $10,000 non-deductible insurance premiums subtracted from $200,000). The income tax liability (and income tax expense) equal $57,000 (.30 x $190,000). The effective tax rate is .285 ($57,000/$200,000).

20

Zeff Co. prepared the following reconciliation of its pre-tax financial statement income to taxable income for the year ended December 31, 2005, its first year of operations:

  • Pre-tax financial income $160,000
  • Non-taxable interest received on municipal securities ($5,000)
  • Long-term loss accrual in excess of deductible amount $10,000
  • Depreciation in excess of financial statement amount ($25,000)
  • Taxable income $140,000

Zeff's tax rate for 2005 is 40%.

  • In its 2005 income statement, what amount should Zeff report as income tax expense (current portion)?
  • In its December 31, 2005 balance sheet, what should Zeff report as deferred income tax liability?​

  • Current income tax expense = $56,000 (140,000 x .4)
  • Deferred Liability = $6,000 ((25) + 10) x .4)

The $5,000 difference (interest) is a permanent difference. Therefore, it is not considered in the computation of deferred tax account balances.

The $10,000 difference (loss accrual) is a deductible amount, because more loss is recognized in the current year for accounting purposes than for tax purposes. Therefore, in the future, a greater amount of loss will be deductible for tax purposes, when the difference reverses. This amount gives rise to a long-term deferred tax asset of $4,000 ($10,000 x .4).

The $25,000 difference (depreciation) is a taxable amount, because less depreciation will be recognized for tax purposes than for accounting purposes in the future. This amount gives rise to a long-term deferred tax liability of $10,000 ($25,000 x .4).

GAAP requires that one long-term deferred tax item be reported. Therefore, in the balance sheet, a net deferred tax liability of $6,000 ($10,000 - $4,000) will be reported.

21

On January 1, 2003, Warren Co. purchased a $600,000 machine, with a five-year useful life and no salvage value.

The machine was depreciated by an accelerated method for book and tax purposes. The machine's carrying amount was $240,000 on December 31, 2004. On January 1, 2005, Warren changed retroactively to the straight-line method for financial-statement purposes. Warren can justify the change. Warren's income tax rate is 30%.

On January 1, 2005, what amount should Warren report as deferred income tax liability as a result of the change?

  1. $120,000
  2. $72,000
  3. $36,000
  4. $0

$0

Changes in depreciation method are treated prospectively. Prior-year depreciation amounts are unchanged. Therefore, as of the beginning of the year of change, no future temporary difference is generated. But starting at the end of the year of change, a deferred tax liability will be recorded for the future difference between book and tax depreciation, now that the methods are different for those reporting systems.

22

On January 2, 2004, Ross Co. purchases a machine for $70,000. This machine has a five-year useful life, a residual value of $10,000, and is depreciated using the straight-line method for financial-statement purposes.

For tax purposes, depreciation expense was $25,000 for 2004 and $20,000 for 2005. Ross elected early application of FASB Statement No. 109, Accounting for Income Taxes. Ross' 2005 income, before income tax and depreciation expense, was $100,000 and its tax rate was 30%.

If Ross had made no estimated tax payments during 2005, what amount of current income tax liability would Ross report in its December 31, 2005 balance sheet?

  1. $26,400
  2. $25,800
  3. $24,000
  4. $22,500

$24,000

The $24,000 current tax liability is the current tax rate times taxable income: $24,000 = .30($100,000 - $20,000).

23

West Corp. leased a building and received the $36,000 annual rental payment on June 15, 2004.

The beginning of the lease is July 1, 2004. Rental income is taxable when received. West's tax rates are 30% for 2004 and 40% thereafter. West has elected early adoption of FASB Statement No. 109, Accounting for Income Taxes. West had no other permanent or temporary differences. West determined that no valuation allowance was needed.

What amount of deferred tax asset should West report in its December 31, 2004 balance sheet?

  1. $5,400
  2. $7,200
  3. $10,800
  4. $14,400

$7,200

  • 2004 rent revenue recognized for financial-accounting purposes is $18,000 (.50 x $36,000).
  • Rent revenue to be recognized for financial-accounting purposes after 2004 (remaining rent revenue) $18,000
  • Less rent revenue taxable after 2004 (the entire $36,000 is taxable in 2004) (0)
  • Equals future deductible difference (future taxable income will be less than future pre-tax accounting income by this amount) $18,000
  • Times future enacted tax rate x .40
  • Equals ending deferred tax asset balance $7,200

24

At December 31, 2005, Bren Co. has the following deferred income tax items:

  • A deferred income tax liability of $15,000 related to a non-current asset
  • A deferred income tax asset of $3,000 related to a non-current liability
  • A deferred income tax asset of $8,000 related to a current liability

Which of the following should Bren report in the non-current section of its December 31, 2005 balance sheet?

  1. A non-current asset of $3,000 and a non-current liability of $15,000.
  2. A non-current liability of $12,000.
  3. A non-current asset of $11,000 and a non-current liability of $15,000.
  4. A non-current liability of $4,000.

A non-current liability of $12,000.

The classification of deferred tax accounts is based on the underlying account to which they are related. The $15,000 income tax liability is related to a non-current asset. Therefore, that deferred tax liability is classified as non-current. Balance-sheet presentation of deferred tax accounts nets the non-current accounts and nets the current accounts, for a maximum of two net deferred accounts reported.

This firm would net the $15,000 non-current deferred tax liability with the $3,000 non-current deferred tax asset, to yield a net non-current deferred tax liability of $12,000.

25

Because Jab Co. uses different methods to depreciate equipment for financial statement and income tax purposes, Jab has temporary differences that will reverse during the next year and add to taxable income.

Deferred income taxes that are based on these temporary differences should be classified in Jab's balance sheet as a

  1. Contra account to current assets.
  2. Contra account to non-current assets.
  3. Current liability.
  4. Non-current liability.

Non-current liability.

The classification of deferred tax accounts is the same as the accounts giving rise to the deferred taxes.

The temporary differences referred to in the question are future taxable differences, which cause a deferred tax liability. The account giving rise to the difference is equipment, which is classified as long-term.

Therefore, the deferred tax liability is also classified as long-term (non-current).

26

In its first four years of operations ending December 31, 2002, Alder, Inc.'s depreciation for income tax purposes exceeds its depreciation for financial-statement purposes. This temporary difference is expected to reverse in 2003, 2004, and 2005. Alder had no other temporary difference and elected early adoption of FASB 109.

Alder's 2002 balance sheet should include

  1. A non-current contra asset for the effects of the difference between asset bases for financial-statement and income tax purposes.
  2. Both current and non-current deferred tax assets.
  3. A current deferred tax liability only.
  4. A non-current deferred tax liability only.

A non-current deferred tax liability only.

The classification of deferred tax accounts is based on the classification of the underlying account giving rise to the deferred tax effect.

In this case, depreciable assets are non-current assets, therefore the deferred tax account is also classified as non-current. Because the future temporary differences are taxable (future tax depreciation will be less than book depreciation, causing future taxable income to exceed pre-tax accounting income), the deferred tax account is a liability. Future taxable temporary differences give rise to deferred tax liabilities.

27

Hut Co. has temporary taxable differences that will reverse during the next year and add to taxable income. These differences relate to non-current assets. Deferred income taxes based on these temporary differences should be classified in Hut's balance sheet as a

  1. Current asset.
  2. Non-current asset.
  3. Current liability.
  4. Non-current liability.

Non-current liability.

Future taxable differences cause taxable income in the future to exceed pre-tax accounting income. Therefore, deferred tax liabilities are the result of taxable differences. Classification of deferred tax accounts is based on the item giving rise to the temporary differences. In this case, the underlying item is non-current. Therefore, the deferred tax liability is also classified as non-current.

28

On its December 31, 2005 balance sheet, Shin Co. has income tax payable of $13,000 and a current deferred tax asset of $20,000, before determining the need for a valuation account.

Shin had reported a current deferred tax asset of $15,000 at December 31, 2004. No estimated tax payments are made during 2005. At December 31, 2005, Shin determines that it is more likely than not that 10% of the deferred tax asset would not be realized.

In its 2005 income statement, what amount should Shin report as total income tax expense?

  1. $8,000
  2. $8,500
  3. $10,000
  4. $13,000

$10,000

income tax expense is the net sum of the income tax liability for the year, the changes in the deferred tax accounts, and the change in the valuation account for deferred tax assets.

  • Tax liability (current portion of income tax expense):$13,000
  • Less increase in deferred tax asset: $20,000 - $15,000 ($5,000)
  • Plus increase in valuation account: .10($20,000) $2,000
  • Equals income tax expense $10,000

The increase in the deferred tax asset causes income tax expense to decrease relative to the tax liability, because, as a result of transactions through the end of the current year, future taxable income will be reduced. This reduction is not realized in the current year as a reduction in the tax liability. Therefore, the anticipated future reduction is treated as an asset at the end of the current period. When realized, the asset is reduced in a future year.

The increase in the valuation allowance, which is contra to the deferred tax asset, reduces the deferred-tax-asset effect, because it is an amount of the deferred tax asset not likely to be realized.

29

At the end of the current year, Swen Inc. prepares its tax return, which reflects an uncertain amount, reducing the firm's tax liability by $40,000. Swen estimates that, upon audit by the IRS, there is a 20% chance that the full $40,000 benefit will be upheld, and a 40% chance that the benefit will be only $25,000. As a result of the required recognition and measurement principles for uncertain tax positions, current-year income tax expense is reduced by what amount?

  1. $18,000
  2. $25,000
  3. $40,000
  4. $15,000

$25,000

This is the largest amount, which has at least a 50% probability of occurring. The cumulative probability through this amount is 60%. A liability is recognized for the $15,000 of the total $40,000, which has less than a 50% chance of occurring.

30

Two years ago, Aggre Inc. recognized the tax benefit of an uncertain tax position. income tax expense in that year was reduced by $20,000 as a result. In addition, Aggre recorded a $5,000 tax liability for unrecognized benefits for the same tax position. During the current year, the uncertainty is resolved and a benefit of $22,000 is upheld. By what amount is current-year income tax expense affected by the resolution of the prior uncertainty?

  1. $2,000 decrease.
  2. $22,000 decrease.
  3. $5,000 decrease.
  4. There is no effect.

$2,000 decrease.

Income tax expense was reduced two years ago by $20,000, but the final benefit upon resolution is $22,000. The $2,000 increase in benefit is recognized in the year of resolution.

31

rass Co. reported income before income tax expense of $60,000 for 2000. Brass had no permanent or temporary timing differences for tax purposes. Brass has an effective tax rate of 30% and a $40,000 net operating loss carry-forward from 1999. What is the maximum income tax benefit that Brass can realize from the loss carry-forward for 2000?

  1. $12,000
  2. $18,000
  3. $20,000
  4. $40,000

$12,000

The net operating loss (NOL) carry-forward of $40,000 is negative taxable income from the past that can be used to absorb future taxable income. With no temporary or permanent differences, we can assume taxable income and pre-tax accounting income are the same. The full amount of the NOL can be used to absorb $40,000 of 2000 income, saving $12,000 of tax ($40,000 x .30). The firm will pay only $6,000 in tax for the 2000 tax year ($60,000 - $40,000) x .30. The savings of $12,000 are the realization of the tax benefit recognized in previous years, when the firm recorded a deferred tax asset for the future tax benefit of the NOL.

32

Which of the following should be disclosed in a company's financial statements related to deferred taxes?

  • I. The types and amounts of existing temporary differences.
  • II. The types and amounts of existing permanent differences.
  • III. The nature and amount of each type of operating loss and tax credit carry-forward.

  • The types and amounts of existing temporary differences. - YES
  • The types and amounts of existing permanent differences. - NO
  • The nature and amount of each type of operating loss and tax credit carry-forward. - YES

Deferred income tax accounts are not affected by permanent differences, because their effect on income tax is the same as their effect on income tax liability.

But temporary differences and operating loss and tax-credit carry-forwards produce deferred tax accounts. Temporary differences cause both deferred tax liabilities and assets to be recognized. Operating loss and tax credit carry-forwards generate only deferred tax assets.

To fully understand the nature of deferred tax accounts, the types and amounts of I and III are reported in a detailed footnote. For example, depreciation differences are major causes of deferred tax liabilities.

33

Lance, Inc., a calendar year corporation, reported the following operating income (loss) before income tax and the enacted tax rates for the last three years of operations:

  • Income / Tax rate
  • Year 2$ 100,000 40%
  • Year 3 $(300,000) 30%
  • Year 4 $ 400,000 30%

There are no permanent or temporary differences between operating income (loss) for financial and income tax reporting purposes.  When filing its year 3 tax return, Lance elected to use only the carryforward provision.  What amount should Lance report as income tax refund receivable in year 3?

  1. $0
  2. $40,000
  3. $90,000
  4. $60,000

$0

Lance opted to only use the carryforward provision, not the carryback provision.

Loss carrybacks occur when losses in the current period are carried back to periods in which there was income.  Loss carrybacks result in tax refunds in the loss period and thus should be recognized in the year of the loss.  The entry to record the benefit is

  • Dr. Tax refund receivable(based on tax credit due to loss) 
    • Cr.  Tax loss benefit (income tax expense) (same)

34

According to ASC 740, Income Taxes, justification for the method of determining periodic tax expense is based on the concept of

  1. Matching of periodic expense to periodic revenue.
  2. Objectivity in the calculation of periodic expense.
  3. Recognition of assets and liabilities.
  4. Consistency of tax expense measurements with actual tax planning strategies.

Recognition of assets and liabilities.

ASC Topic 740 states that the objective of accounting for income taxes is to recognize current taxes payable or refundable and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns. Matching is also a rationale, but a less important one.

35

Which of the following should be disclosed in a company’s financial statements related to deferred taxes?

  • I.    The types and amounts of existing temporary differences.
  • II.    The types and amounts of existing permanent differences.
  • III.    The nature and amount of each type of operating loss and tax credit carryforward.
  1. I and II only.
  2. I and III only.
  3. II and III only.
  4. I, II, and III.

I and III ONLY.

According to ASC Topic 740, the types and amounts of existing temporary differences, and the nature and amount of each type of operating loss and tax credit carryforward must be disclosed in the notes to the financial statements. Permanent differences do not need to be disclosed.

36

Ajax Corp. has an effective tax rate of 30%. On January 1, year 2, Ajax purchased equipment for $100,000. The equipment has a useful life of 10 years. What amount of current tax benefit will Ajax realize during year 2 by using the 150% declining balance method of depreciation for tax purposes instead of the straight-line method?

  1. $1,500
  2. $3,000
  3. $4,500
  4. $5,000

$1,500

the additional $5,000 in depreciation on the tax return by using the 150% declining balance method would result in a tax savings or current tax benefit of $1,500 ($5,000 × 30%). If Ajax used the straight-line method of depreciation for tax purposes, depreciation for year 2 would have been $10,000 ($100,000/ 10 years). If Ajax uses the 150% declining balance method for tax purposes, depreciation would be $15,000 ($100,000 × 1/10 × 1.5 = $15,000).

37

HG, Inc., a calendar year corporation, reported the following operating income (loss) before income tax and the enacted tax rates for the last three years of operations:

  •  Income @ Tax rate
  • Year 2 $100,000 @ 40%
  • Year 3 $(300,000) @ 30%
  • Year 4 $400,000 @ 30%

There are no permanent or temporary differences between operating income (loss) for financial and income tax reporting purposes. When filing its Year 3 tax return, HG did not forgo to carryback the Year 3 loss. What amount should HG record in year 3 to account for the income tax refund receivable?

  1. $0
  2. $40,000
  3. $30,000
  4. $120,000

$40,000

HG elected to carryback the loss. Loss carrybacks can be carried back to the two immediate past periods’ income. Because HG only has one year of income before the loss, the refund is calculated based on that income. HG can only recover taxes already paid (taxable income multiplied by the tax rate in effect). Therefore, the refund receivable would be calculated as $100,000 × 40% = $40,000. The remainder of the loss ($300,000 − $100,000 = $200,000) would be carried forward as a deferred tax asset of $60,000 using the future enacted tax rate ($200,000 × 30% = $60,000).

38

Which of the following should be disclosed in a company’s financial statements related to deferred taxes?

  • I.    The types and amounts of existing temporary differences.
  • II.    The types and amounts of existing permanent differences.
  • III.    The nature and amount of each type of operating loss and tax credit carryforward.

I and II only.

I and III only.

II and III only.

I, II, and III.

I and III only. - ASC Topic 740 does not use the term permanent differences.

According to ASC Topic 740, the types and amounts of existing temporary differences, and the nature and amount of each type of operating loss and tax credit carryforward must be disclosed in the notes to the financial statements. Permanent differences do not need to be disclosed.

39

Among the items reported on Neal Corporation’s income statement for the year ended December 31, year 3, are the following:

  • Interest received on municipal bonds $10,000
  • Penalties and related interest $18,000

Temporary differences for measuring deferred taxes (interperiod tax allocation) amount to

  1. $28,000
  2. $18,000
  3. $10,000
  4. $0

$0

Temporary differences are differences between taxable income and accounting income which originate in one period and reverse in one or more subsequent periods. Interest received on municipal bonds ($10,000) and penalties and related interest ($18,000) are examples of permanent differences. Permanent differences are items that either enter into pretax accounting income but never into taxable income (such as these two items) or enter into taxable income but never into pretax accounting income.

40

According to ASC Topic 740, Income Taxes, which of the following items should affect current income tax expense for year 3?

  1. Interest on a 2006 tax deficiency paid in year 3.
  2. Penalty on a 2006 tax deficiency paid in year 3.
  3. Change in income tax rate for year 3.
  4. Change in income tax rate for year 4.

Change in income tax rate for year 3.

Per ASC Topic 740, income tax expense includes the following components:

  1. Current tax expense or benefit
  2. Deferred tax expense or benefit, exclusive of (5) below
  3. Investment tax credits and grants
  4. The benefits of operating loss carryforwards
  5. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or a change in the tax status of an enterprise.

Since current tax expense/benefit depends on the tax rate, a change in the income tax rate for year 3 will affect the amount of income tax assessed in year 3.

41

As a result of differences between depreciation for financial reporting purposes and tax purposes, the financial reporting basis of a company’s plant assets exceeded the tax basis. Assuming the company had no other temporary differences, the company should report a

  1. Current tax receivable.
  2. Current tax payable.
  3. Deferred tax asset.
  4. Deferred tax liability.

Deferred tax liability.

A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. Because the book value of the assets exceeds their tax basis, the accumulated tax depreciation must now exceed accumulated depreciation. In future years, this temporary difference will reverse as periodic book depreciation amounts exceed the corresponding tax amounts. Therefore, taxable amounts will result in future years as the assets become fully depreciated for tax purposes or (on a sale) when the tax gain exceeds the book gain (due to lower carrying value). Thus, a deferred tax liability currently exists.

42

For the year ended December 31, year 3, Colt Corp. has a loss carryforward of $180,000 available to offset future taxable income. At December 31, year 3, all available evidence concerning future profitability is positive. Assume an income tax rate of 30%. What amount of the tax benefit should be reported in Colt’s year 3 income statement?

  1. $180,000
  2. $126,000
  3. $54,000
  4. $0

$54,000

Per ASC Topic 740, a deferred tax liability or asset is recognized for all temporary differences and operating loss and tax credit carryforwards. When a deferred tax asset is recorded, the entity must consider the need for a valuation allowance. In assessing the need for a valuation allowance, provisions in the tax law that may limit utilization of an operating loss or tax credit carryforward are applied in determining whether it is more likely than not that some portion of the deferred tax asset will not be realized by reduction of taxable income or taxes payable during the carryforward period. For Colt Corp., it is not more likely than not that a part or all of the benefit will not be realized in future years. Therefore, the tax benefit of the loss carryforward to be recorded in Colt’s income statement is $54,000 ($180,000 × 30%).

43

Lance, Inc., a calendar year corporation, reported the following operating income (loss) before income tax and the enacted tax rates for the last three years of operations:

  • Income @ Tax rate
  • Year 2 $100,000 @ 40%
  • Year 3 $(300,000) @ 30%
  • Year 4 $400,000 @ 30%

There are no permanent or temporary differences between operating income (loss) for financial and income tax reporting purposes.  When filing its year 3 tax return, Lance elected to use only the carryforward provision.  What amount should Lance report as income tax refund receivable in year 3?

  1. $0
  2. $40,000
  3. $90,000
  4. $60,000

$0

Lance opted to only use the carryforward provision, not the carryback provision.

Operating losses of a particular period can be carried back to the two immediate past periods’ income resulting in a refund.  Losses still remaining after carrybacks may also be carried forward for twenty years to offset income if income arises in any of those twenty years.  Companies may at the time of the loss elect to use only the carryforward provision.

  • Loss carrybacks occur when losses in the current period are carried back to periods in which there was income.  Loss carrybacks result in tax refunds in the loss period and thus should be recognized in the year of the loss.  The entry to record the benefit is
    • Tax refund receivable(based on tax credit due to loss) 
      • Tax loss benefit (income tax expense) (same)
  1. The tax loss benefit account would be closed to revenue and expense summary in the year of the loss.
  • Tax loss carryforwards are recognized in the year the loss occurs.  Under ASC Topic 740 (SFAS 109), the benefit of a loss carryforward isalways recognized as a deferred tax asset which may be reduced by a valuation allowance if necessary.

44

Sandy Inc. prepares financial statements under IFRS. At December 31, Year 4, Sandy’s income for financial (book) purposes equaled $100,000 and Sandy’s only temporary difference related to depreciation. For financial (book) purposes, depreciation equaled $10,000 and for tax purposes, depreciation equaled $15,000. The difference is expected to reverse evenly over the next two years. The enacted tax rate for Year 4 is 30% and the substantially enacted tax rate for year 4 and thereafter is 40%. In its year-end balance sheet, what amount should Sandy report as a deferred tax asset (liability)?

  1. $1,500 deferred tax asset.
  2. $1,500 deferred tax liability.
  3. $2,000 deferred tax asset.
  4. $2,000 deferred tax liability.

$2,000 deferred tax liability.

A timing difference where, in the future, taxable income will be greater than financial (book) income is reported as a deferred tax liability. The amount to be recorded as the deferred tax liability is the temporary difference multiplied by the substantially enacted tax rate ($5,000 × 40% = $2,000).

45

Nala Inc. reported deferred tax assets and deferred tax liabilities at the end of year 3 and at the end of year 4. For the year ended year 4 Nala should report deferred income tax expense or benefit equal to the

  1. Sum of the net changes in deferred tax assets and deferred tax liabilities.
  2. Decrease in the deferred tax assets.
  3. Increase in the deferred tax liabilities.
  4. Amount of the income tax liability plus the sum of the net changes in deferred tax assets and deferred tax liabilities.

Sum of the net changes in deferred tax assets and deferred tax liabilities.

Deferred income tax expense or benefit is the net change during the year in an enterprise’s deferred tax liabilities or assets.

46

In year 3, Lobo Corp. reported for financial statement purposes the following revenue and expenses which were not included in taxable income:

  • Premiums on officer’s life insurance under which the corporation is the beneficiary $5,000
  • Interest revenue on qualified state or municipal bonds $10,000
  • Estimated future warranty costs to be paid in year 4 and year $560,000

Lobo’s enacted tax rate for the current and future years is 30%. Lobo has never had any net operating losses (book or tax) and does not expect any in the future. There were no temporary differences in prior years.  The deferred tax benefit to be applied against current income tax expense is

  1. $18,000
  2. $19,500
  3. $21,000
  4. $22,500

$18,000

The premiums on officers’ life insurance ($5,000) and the municipal interest revenue ($10,000) are both permanent differences, so they do not affect deferred taxes. The estimated future warranty cost ($60,000) is a temporary difference which results in future deductible amounts in year 4 and year 5. The deferred tax benefit is $18,000 (30% × $60,000). A reduction of the deferred tax benefit and establishment of a related allowance account are not needed in this case because the evidence about past and future profitability does not indicate that it is more likely than not that part or all of the asset may not be realized.

47

For calendar year 3 Steiner Corporation reported depreciation of $300,000 in its income statement. On its year 3 income tax return Steiner reported depreciation of $500,000. Additionally, Steiner’s income statement included interest revenue of $50,000 on municipal obligations. Assuming an enacted income tax rate of 30%, the amount of deferred tax expense reported on Steiner’s year 3 income statement should be

  1. $45,000
  2. $60,000
  3. $75,000
  4. $90,000

$60,000

Deferred taxes are only created by temporary differences or, in other words, differences that will reverse.  The depreciation expense is a temporary difference because, although differing amounts may be reported each year, total depreciation over the life of any asset will be the same for both financial reporting and tax purposes.  The interest income on municipal obligations is a permanent difference because this income is never taxable.  Since depreciation expense is $200,000 ($500,000 − $300,000) greater for tax purposes than for accounting purposes, payment of $60,000 ($200,000 × 30%) of taxes is deferred to future periods. The entry is

  • Income tax expense (deferred portion) $60,000 
  • Deferred tax liability $60,000

The $60,000 must be reported as the deferred taxes component of income tax expense on the current period’s income statement.

48

At the most recent year-end, a company’s appropriately recognized noncurrent deferred income tax asset exceeded a current deferred income tax liability. Which of the following should be reported in the company’s most recent year-end balance sheet?

  1. The deferred income tax asset as a current asset.
  2. The excess of the deferred income tax asset over the deferred income tax liability as a current asset.
  3. The deferred income tax asset as a noncurrent asset.
  4. The excess of the deferred income tax asset over the deferred income tax liability as a noncurrent asset.

The deferred income tax asset as a noncurrent asset.

Deferred taxes shall be classified into two categories: the net current amount and the net noncurrent amount. Therefore, the company’s balance sheet should report the deferred tax asset as a noncurrent asset and the deferred income tax liability as a current liability.

49

No net deferred tax asset (i.e., deferred tax asset net of related valuation allowance) was recognized in the year 2 financial statements by the Chaise Company when a loss from discontinued segments was carried forward for tax purposes because it was more likely than not that none of this deferred tax asset would be realized. Chaise had no temporary differences. The tax benefit of the loss carried forward reduced current taxes payable on year 3 continuing operations. The year 3 income statement would include the tax benefit from the loss brought forward in

  1. Income from continuing operations.
  2. Gain or loss from discontinued segments.
  3. Extraordinary gains.
  4. Cumulative effect of accounting changes.

Income from continuing operations.

Per ASC Topic 740, the tax benefit of an operating loss carryforward or carryback shall be reported in the same manner as the source of income (loss) in the current year. The problem states that the tax benefit of the loss reduced taxes on continuing operations. Thus, in year 3, the tax benefit shall be reported under income from continuing operations.

50

For its first year of operations, Cable Corp. recorded a $100,000 expense in its tax return that will not be recorded in its accounting records until next year. There were no other differences between its taxable and financial statement income.  Cable’s effective tax rate for the current year is 45%, but a 40% rate has already been passed into law for next year.  In its year-end balance sheet, what amount should Cable report as a deferred tax asset (liability)?

  1. $40,000 asset.
  2. $40,000 liability.
  3. $45,000 asset.
  4. $45,000 liability.

$40,000 liability.

a tax expense that will be expensed for book purposes results in a deferred tax liability and it should be calculated using the expected tax rate when the deferred tax item reverses.

51

As a result of differences between depreciation for financial reporting purposes and tax purposes, the financial reporting basis of Noor Co.’s sole depreciable asset, acquired in year 3, exceeded its tax basis by $250,000 at December 31, year 3. This difference will reverse in future years. The enacted tax rate is 30% for year 3, and 40% for future years. Noor has no other temporary differences. In its December 31, year 3 balance sheet, how should Noor report the deferred tax effect of this difference?

  1. As an asset of $75,000.
  2. As an asset of $100,000.
  3. As a liability of $75,000.
  4. As a liability of $100,000.

As a liability of $100,000.

At 12/31/Y3, the financial reporting basis of the depreciable asset exceeds its tax basis by $250,000. This means that in future years tax depreciation will be less than book depreciation, resulting in future taxable amounts. The existence of future taxable amounts requires recognition of a deferred tax liability at 12/31/Y3 based on future enacted tax rates. Therefore, Noor should report a 12/31/Y3 deferred tax liability of $100,000 ($250,000 × 40%). Note that the deferred tax liability should reflect the future tax consequences of events which have been recognized in the financial statements, so its computation is based on current tax rates, unless future tax rates have been enacted and are different from the current rate.

52

On December 20, year 3, Sussex Corporation received a condemnation award of $300,000 as compensation for the forced sale of a company plant with a book value of $200,000.  In its income tax return for the year ended December 31, year 3, Sussex elected to replace the condemned plant within the allowed replacement period.  Accordingly, the $100,000 gain was not reported as taxable income for year 3. Sussex has an enacted income tax rate of 30% for year 3.  In its December 31, year 3 balance sheet, what amount should Sussex report as a deferred tax liability on the above gain?

  1. $70,000
  2. $30,000
  3. $20,000
  4. $0

$30,000

Per ASC Topic 740, such gains on involuntary conversions are to be recognized in the financial statements in the year they occur. Furthermore, the interpretation specifies that such a gain, which is not recognized for tax purposes in the same year as for financial accounting purposes, is a temporary difference. Therefore, a deferred tax liability of $30,000 (30% × $100,000) is necessary, since pretax accounting income exceeds taxable income by $100,000.

53

North, Inc. uses the equity method of accounting for its 50% investment in Mill Corp.’s common stock. During year 3, Mill reported earnings of $600,000 and paid dividends of $200,000. Assume that: (1) all undistributed earnings of Mill will be distributed as dividends in future periods, (2) the dividends received from Mill are eligible for the 80% dividends received deduction, and (3) North’s income tax rate is 30%. The change in the amount of deferred income tax to be reported by North for year 3 is

  1. $0
  2. $12,000
  3. $24,000
  4. $60,000

$12,000

Under the equity method, North included revenue of $300,000 ($600,000 × 50%) in its book income. The dividends received of $100,000 ($200,000 × 50%) were reported as a reduction of the investment in Mill Corp. account. Taxable income, however, included the dividends but excluded the undistributed earnings. The total difference between book and taxable income is, therefore, $200,000. This entire amount will eventually be included in taxable income when distributed as dividends. Then, however, there would be an 80% DRD (permanent difference) of $160,000 ($200,000 × 80%). The remaining $40,000 is a temporary difference which should be reflected as a $12,000 increase in the deferred tax liability account ($40,000 × 30%).

54

Agard Company’s enacted income tax rate is 30%. For the year ended December 31, year 3, Agard’s income statement reflected depletion expense of $1,000,000 based on the cost of assets being depleted. However, Agard properly deducted $4,000,000 for percentage depletion on its year 3 tax return. How much should be reported as provision (expense) for deferred income taxes in Agard’s year 3 financial statements?

  1. $1,200,000
  2. $900,000
  3. $300,000
  4. $0

$0

A common mistake when solving this problem would be to treat the depletion difference between book and tax income as a temporary difference, similar to using the MACRS for tax and the straight-line method for book purposes. But using percentage depletion for tax, which means taking depletion in excess of cost, creates a permanent difference which does not affect the deferred income tax provision. Therefore, the correct answer would be $0.

55

Which of the following could require interperiod tax allocation?

  1. Percentage depletion in excess of cost depletion.
  2. Unearned service contract revenue.
  3. Interest received on municipal obligations.
  4. Nondeductible officers life insurance premium.

Unearned service contract revenue.

Interperiod tax allocation is the adjustment process that reflects tax expense based on pretax accounting income where the tax expense is different from taxes paid. Unearned service contract revenue creates a temporary difference as it would be included in income for tax purposes but would not be recognized in pretax accounting income as revenue until it is earned.

56

At December 31, year 3, Bren Co. had the following deferred income tax items:

  • A deferred income tax liability of $15,000 related to a noncurrent asset.
  • A deferred income tax asset of $3,000 related to a noncurrent liability.
  • A deferred income tax asset of $8,000 related to a current liability.

Which of the following should Bren report in the noncurrent section of its December 31, year 3 balance sheet?

  1. A noncurrent asset of $3,000 and a noncurrent liability of $15,000.
  2. A noncurrent liability of $12,000.
  3. A noncurrent asset of $11,000 and a noncurrent liability of $15,000.
  4. A noncurrent liability of $4,000.

A noncurrent liability of $12,000.

Per ASC Topic 740, deferred tax liabilities and assets should be classified as current or noncurrent based on the classification of the related asset or liability for financial reporting.  ASC Topic 740 also requires the netting of current deferred tax liabilities and assets, and noncurrent deferred tax liabilities and assets.  Therefore, Bren should report a noncurrent deferred tax liability of $12,000 and a current deferred tax asset of $8,000

57

For calendar year 3, Clark Corp. had depreciation of $300,000 on its income statement. On its Year 3 tax return, Clark had depreciation of $500,000. Clark’s income statement also included $50,000 accrued warranty expense that will be deducted for tax purposes when paid. Clark’s enacted tax rates are 30% for Year 3 and 25% for future years. These were Clark’s only temporary differences. In Clark’s Year 3 income statement, the deferred portion of its provision for income taxes should be

  1. $60,000.
  2. $45,000.
  3. $37,500.
  4. $50,000.

$37,500.

The income tax provision (expense) must be reported in two components:  the amount currently payable (current) and the tax effects of temporary differences (deferred). The deferred portion should be based on future enacted tax rates.  The depreciation difference results in future taxable amounts totaling $200,000 in Years 3 to 12, while the warranty difference results in future deductible amounts totaling $50,000 in Years 3 to 12. Deferred tax expense is computed as follows:
Increase in deferred tax liability  

  •  $200,000 future taxable amount × 25% =$50,000
  • Increase in deferred tax asset ($50,000) future deductible amount × 25% = (12,500)
  • Deferred portion of income tax expense $37,500

58

On January 2, year 2, Ross Co. purchased a machine for $70,000. This machine has a 5-year useful life, a residual value of $10,000, and is depreciated using the straight-line method for financial statement purposes. For tax purposes, depreciation expense was $25,000 for year 2 and $20,000 for year 3. Ross’ year 3 income, before income taxes and depreciation expense, was $100,000 and its tax rate was 30%. If Ross had made no estimated tax payments during year 3, what amount of current income tax liability would Ross report in its December 31, year 3 balance sheet?

  1. $26,400
  2. $25,800
  3. $24,000
  4. $22,500

$24,000

The current income tax liability is computed by multiplying taxable income by the current tax rate (30%). Taxable income is computed as income before taxes and depreciation less tax depreciation ($100,000 − $20,000 = $80,000). Therefore, the current income tax liability is $24,000 ($80,000 × 30%). Note that the temporary depreciation difference of $8,000 ($20,000 − $12,000) affects deferred taxes, not current taxes.

59

Brass Co. reported income before income tax expense of $60,000 for year 2. Brass had no permanent or temporary timing differences for tax purposes. Brass has an effective tax rate of 30% and a $40,000 net operating loss carryforward from year 1. What is the maximum income tax benefit that Brass can realize from the loss carryforward for year 2?

  1. $12,000
  2. $18,000
  3. $20,000
  4. $40,000

$12,000

The $40,000 net operating loss carryforward is the amount of loss in year 1 which may be carried forward to future years to offset the tax due in those years. The value of the carryforward is the net operating loss multiplied by the tax rate for the year in which the carryforward is expected to be realized. Therefore, the maximum income tax benefit that Brass can realize from the carryforward in year 2 is $12,000 ($40,000 × 30%).

60

At the end of year 1, Cody Co. reported a profit on a partially completed construction contract by applying the percentage-of-completion method. By the end of year 2, the total estimated profit on the contract at completion in year 3 had been drastically reduced from the amount estimated at the end of year 1. Consequently, in year 2, a loss equal to one-half of the year 1 profit was recognized. Cody used the completed-contract method for income tax purposes and had no other contracts. The year 2 balance sheet should include a deferred tax

  • Asset
  • Liability

  • Asset - NO
  • Liability - YES

Per ASC Topic 740, a deferred tax liability is recognized for temporary differences that will result in net taxable amounts (taxable income exceeds book income) in future years. Although Cody Co. has recognized a loss (per books) in year 2 of the construction contract, the contract is still profitable over the 3 years. Therefore, in year 3 when the contract is completed, Cody will recognize the total profit on its tax return while only a portion of the profit will be recorded on its income statement. Thus, the contract will result in a taxable amount in year 3 and a deferred tax liability exists. Note that this liability was recorded at the end of year 1 and reduced by one-half at the end of year 2 due to a change in estimated profit.

61

At the most recent year-end, a company had a deferred tax liability related to an asset classified as current. The amount exceeded a deferred tax asset related to a current liability, and a deferred tax liability related to a noncurrent liability. Which of the following should be reported in the company’s most recent year-end balance sheet?

  1. The sum of the two deferred tax liabilities as a noncurrent liability.
  2. The excess of the two deferred tax liabilities over the deferred tax asset as a current liability.
  3. The excess of the deferred tax liability related to a current asset over the deferred tax asset related to a current liability as a current liability.
  4. The deferred tax asset as a current asset.

The excess of the deferred tax liability related to a current asset over the deferred tax asset related to a current liability as a current liability.

Proper classification of deferred assets and liabilities involves two steps. First, deferred tax assets or liabilities must be classified as current or noncurrent for presentation on the balance sheet. Second, the current assets and liabilities should be netted to give a single current asset or liability and the same would be done for the noncurrent items. Thus, the current deferred tax liability and the current deferred tax asset should be netted in this case, and the noncurrent deferred tax liability would be disclosed separately.