Financial Reporting and Analysis Chapter 13 Solutions Income Tax Reporting Exercises

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Financial Reporting and Analysis Chapter 13 ^Solutions

Income Tax Reporting Exercises

Exercises

E13-1. Determining current taxes payable (AICPA adapted)

The amount of current income tax liability that would be reported on Allen Co.’s December 31, 2001, balance sheet is determined as follows:

Net income before depreciation expense and income taxes $100,000 Depreciation expense (for tax purposes) (20,000 )

Taxable income 80,000

Tax rate 30%

Current income tax liability $24,000 E13-2. Determining deferred tax liability

(AICPA adapted)

To determine the deferred income tax liability reported on the December 31, 2002, balance sheet requires a calculation of the cumulative temporary (timing) differences that give rise to future taxable amounts as of that date.

Gross margin temporary differences are as follows:

(Book purposes) (Tax purposes) Temporary Differences

Year Accrual Method Installment Method (Future Taxable Amount)

2001 $800,000 $300,000 $500,000

2002 1,300,000 700,000 600,000 Total temporary differences as of 12/31/02 $1,100,000 Tax rate in effect when differences will reverse 25%

Deferred tax liability on 12/31/02 $275,000

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E13-3. Determining deferred tax liability (AICPA adapted)

Tow’s deferred tax liability for December 31, 2001, is computed as follows:

Year

Reversal of Excess Tax

Deduction Enacted Tax Rate Deferred Tax Liability

2002 $50,000 35% $17,500

2003 40,000 35% 14,000

2004 20,000 25% 5,000

2005 10,000 25% 2,500

Deferred tax liability on 12/31/01 $39,000 E13-4. Deferred tax effects on balance sheet

(AICPA adapted)

If the asset’s financial reporting basis exceeds its tax basis, it means that the depreciation for tax purposes has been higher than depreciation for book purposes. A taxable temporary difference and a deferred tax liability are the result. Since the difference will reverse in future years when the enacted tax rate is 40%, Noor should record a deferred tax liability of

Temporary depreciation difference $250,000 Tax rate when difference will reverse 40%

Deferred tax liability on 12/31/01 $100,000 E13-5. Deferred tax effects on long-term contracts

(AICPA adapted)

Since income recognized for tax purposes exceeds the income recognized for book purposes, Mill has cumulative temporary differences that result in future deductible amounts giving rise to a deferred tax asset computed as follows:

(Tax purposes) (Book purposes) Temporary Difference Percentage-of- Completed Increase (Decrease) in

Year completion Contract Future Deductible Amounts

2001 $400,000 $0 $400,000

2002 625,000 375,000 250,000

2003 750,000 850,000 (100,000 )

Cumulative temporary difference on 12/31/2003 $550,000

Tax rate 40%

Deferred tax asset on December 31, 2003 $220,000

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E13-6. Determining current portion of tax expense (AICPA adapted)

Requirement 1:

The current portion of tax expense is the tax payable to the IRS for 2001.

Taxable income $650,000

Tax rate 30%

Current portion of tax expense $195,000 Requirement 2:

Deferred portion of tax expense is determined by the depreciation timing differences during the year.

Depreciation timing difference in 2001 ($750,000 - $650,000) $100,000

Tax rate 30%

Deferred portion of tax expense $30,000 Requirement 3:

Journal entry to record tax expense for 2001.

D R Tax expense–current ($650,000 ´ 30%) $195,000 D R Tax expense–deferred ($100,000 ´ 30%) 30,000

CR Deferred tax liability $30,000

CR Prepaid estimated tax payments* 90,000 CR Taxes payable ($195,000 - $90,000) 105,000

*This credit assumes the following entry was made when Tyre made its estimated tax payment during 2001:

DR Prepaid estimated tax payments $90,000

CR Cash $90,000

E13-7. Determining current taxes payable (AICPA adapted)

The calculation of the current income tax liability of Dunn Co. for the December 31, 2001, balance sheet is as follows:

Pre-tax income (per books) $90,000

Adjustments for permanent differences:

- Interest on municipal bonds (20,000)

Adjustments for temporary differences:

+ Rent received in advance 16,000

- Excess of tax depreciation over book depreciation (10,000 )

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E13-8. Determining deferred tax liability and current portion of tax expense (AICPA adapted)

Requirement 1:

Deferred tax liability on December 31, 2001

Cumulative temporary difference on 12/31/01 $20,000 Enacted tax rate when temporary differences will reverse 40%

Deferred tax liability on 12/31/01 $ 8,000 Requirement 2:

Current portion of 2001 tax expense

Taxable income for 2001 $129,000

Enacted tax rate 40%

Current portion of tax expense in 2001 $ 51,600 E13-9. Determining deferred tax asset amounts

(AICPA adapted)

Rent revenue for tax purposes (total received in 2001) $36,000 Rent revenue earned in 2001 (1/2 ´ $36,000) (18,000 ) Temporary difference (future deductible amount) $18,000 Enacted tax rate when temporary difference will reverse 40%

Deferred tax asset on December 31, 2001 $ 7,200 E13-10. Determining deferred tax asset amounts

(AICPA adapted)

The warranty temporary differences give rise to future deductible amounts and a deferred tax asset for Black Co. on December 31, 2001, computed as follows:

Reversal of Warranty Enacted Deferred

Year Temporary Difference Tax Rate Tax Asset

2002 $100,000 30% $30,000

2003 50,000 30% 15,000

2004 50,000 30% 15,000

2005 100,000 25% 25,000

Deferred tax asset on 12/31/01 $85,000 E13-11. Deferred portion of tax expense

(AICPA adapted)

To determine the deferred portion of Quinn’s 2002 income tax expense requires the amount of temporary differences created in 2002 ($100,000

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given) and the enacted (statutory) tax rate for 2002. Since the only difference between pre-tax (book) income and taxable income is the $100,000

temporary difference, this implies that the statutory (enacted) tax rate is the same as Quinn’s effective (book) tax rate (since there are no permanent differences). Thus, the deferred portion of the 2002 tax expense is calculated as follows:

Temporary differences in 2002 $100,000

Enacted (statutory) tax rate 30%

Deferred portion of 2002 tax expense $ 30,000 E13-12. Temporary and permanent differences

(AICPA adapted)

Tara’s equity in Flax’s 2001 earnings

40% ´ $750,000 = $300,000

- Tara’s share of Flax’s 2001 dividend distribution

40% ´ $250,000 = (100,000 )

Tara’s share of Flax’s undistributed earnings $200,000 Less: 80% that will never be taxed (160,000 ) Undistributed earnings that will be taxed in the

future when distributed as dividends (future

taxable amount) 40,000

Enacted tax rate in the future 25%

Increase in deferred tax liability for 2001 $ 10,000 E13-13. Loss carrybacks and carryforwards

(AICPA adapted) Requirement 1:

Tax benefit due to NOL carryback and carryforward is:

Amount of loss carryback $450,000

Amount of loss carryforward _ 150,000

$600,000

Tax rate 40%

Total tax benefit reported on 2002 income statement $240,000 Requirement 2:

Deferred tax asset on December 31, 2002 balance sheet:

Amount of loss carryforward $150,000

Tax rate 40%

Deferred tax asset $ 60,000

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E13-14. Tax effects of loss carryback and carry forward (AICPA adapted)

Requirement 1:

Tax benefit reported on 2001 income statement

Loss carried back to 2000 $100,000

Loss carried forward to 2002 100,000

Total $200,000

Tax rate 40%

Tax benefit recognized in 2001 income statement $ 80,000 Requirement 2:

Deferred tax asset reported on 12/31/01 balance sheet

Operating loss carryforward $100,000

Tax rate 40%

Deferred tax asset reported on 12/31/01

balance sheet $ 40,000

Requirement 3:

Amount reported as current taxes payable in 2002

Taxable income in 2002 $400,000

Less: Operating loss carryforward (100,000 )

Taxable income after adjustment $300,000

Tax rate 40%

Current taxes payable on 12/31/02 balance sheet $120,000 Entry to record taxes on 12/31/02: (not required)

D R Tax expense (40% ´ $400,000) $160,000

CR Deferred tax asset (40% ´ $100,000) $40,000

CR Current taxes payable 120,000

E13-15. Accounting for loss carryforwards (AICPA adapted)

Requirement 1:

If the loss occurred in 2001, then the tax benefit reported in the 2001 income statement would be $180,000 ´ 30% = $54,000. If the loss occurred prior to 2001, then no tax benefit would be reported in the 2001 income statement because that benefit would have been recorded as a credit to income in the year the loss occurred.

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Requirement 2:

The additional account that would be debited when the loss carryforward is recognized would be deferred tax assets for $54,000. The entry would be:

D R Deferred tax asset $54,000

CR Income tax expense (carryforward benefit) $54,000 E13-16. Accounting for loss carrybacks and carryforwards

Calculation of tax benefit and journal entry reported in 2001:

Loss carryback $300,000

Loss carryforward ($700,000 - $300,000) 400,000

Total 700,000

Tax rate 30%

Tax benefit reported on 2001 income statement $210,000 Journal entry in 2001 to record tax benefit:

D R Deferred tax asset

(30% ´ $400,000 loss carryforward) $120,000 D R Tax refund receivable

(30% ´ $300,000 loss carryback) 90,000 CR Income tax expense

(carryback and carryforward benefit) $210,000 Requirement 2:

Amount reported as current income tax liability in 2002:

2002 Taxable income before NOL carryforward $1,200,000 Less: Operating loss carryforward _ (400,000 )

Taxable income after adjustment $ 800,000

Tax rate 30%

Current income tax liability in 2002 $ 240,000 E13-17. Deferred tax asset and valuation allowance

(AICPA adapted)

Future deductible amount from warranty expense

temporary difference $300,000

Tax rate 30%

Deferred tax asset before adjustment $ 90,000

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E13-18. Deferred tax asset and valuation allowance (AICPA adapted)

Taft’s equity in Flame’s earnings $180,000

Less: Dividends received from Flame (30,000 ) Taft’s equity in Flames’ undistributed earnings 150,000 Less: 80% that will never be taxed under dividend

exclusion rule (80% ´ $150,000) (120,000 ) Undistributed earnings that will be taxed in future

period when distributed as dividends (future

taxable amount) 30,000

Tax rate 30%

Deferred tax liability reported on 12/31/01 $ 9,000 E13-19. Determining tax expense, taxes payable, and deferred taxes

(CMA adapted)

Requirements 1 and 2:

Calculation of taxable income and taxes payable for 2001:

Pre-tax book income $4,000,000

Adjustment for permanent difference:

Interest income (100,000)

Adjustment for temporary difference:

Rent revenue (80,000 )

Taxable income $3,820,000

Tax rate x 40%

Taxes payable $1,528,000

Requirement 3:

Change in deferred taxes for 2001:

Temporary difference

Rent revenue–future taxable amount $80,000

Tax rate x 40%

Increase in deferred tax liability $32,000 Requirement 4:

Calculation of income tax expense for 2001:

Income tax expense = Taxes payable+ Increase in deferred tax liability

= $1,528,000 + $32,000 Income tax expense = $1,560,000

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Requirement 5:

Repeat requirements (1)–(4) for 2002

Calculation of taxable income and taxes payable for 2002:

Pre-tax book income $5,000,000

Adjustment for permanent difference:

Interest income (100,000)

Adjustment for temporary difference:

Rent revenue 80,000

Taxable income $4,980,000

Tax rate x 40%

Taxes payable $1,992,000

Change in deferred taxes for 2002:

Reversal of temporary difference originating in 2001

Rent revenue ($80,000)

Tax rate x 40%

Decrease in deferred tax liability ($32,000 ) Calculation of income tax expense for 2002:

Income tax expense = Taxes payable - Decrease in deferred tax liability

= $1,992,000 - $32,000 Income tax expense = $1,960,000

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Financial Reporting and Analysis Chapter 13 ^Solutions

Income Tax Reporting Problems

Problems

P13-1. Deferred tax amounts with different tax rates (AICPA adapted)

Future Taxable Amounts

Enacted Tax Rate

Deferred Tax Liability

2001 $50,000 30% $15,000

2002 75,000 30% 22,500

2003 100,000 25% 25,000

Deferred tax liability reported in 12/31/00 balance sheet

$62,500

P13-2. Temporary and permanent differences and tax entry Requirement 1:

Calculation of temporary difference:

Income tax expense $52,000

- Income taxes payable (32,000 ) Deferred taxes payable $20,000

Amount of temporary difference = Deferred taxes Tax rate

Temporary difference due to depreciation = $20,000

.40 = $50,000

Since tax expense per books is greater than taxes payable per tax return, taxable income is lower than book income.

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Requirement 2:

Calculation of permanent difference:

Tax expense = Pre-tax book income (excluding permanent difference)

´ tax rate

Let X = Pre-tax book income (excluding permanent difference)

$52,000 = .40X

$52,000/.40 = $130,000 = Pre-tax book income (excluding permanent

difference)

Book income (excluding permanent difference) $130,000 Book income before taxes (given) (106,000 ) Permanent difference $ 24,000

Book income will be lower than taxable income because of this permanent difference.

Requirement 3:

Journal entry to record tax expense for year:

D R Tax expense (given) $52,000

CR Taxes payable (given) $32,000

CR Deferred taxes payable (see Req. 1) 20,000 Requirement 4:

Effective tax rate = Tax expense/Pre-tax book income

= $52,000/$106,000 Effective tax rate = 49.1%

The effective tax rate is higher than the statutory tax rate of 40% because the goodwill deduction reported on Ramesh’s books is not deductible for tax

purposes.

P13-3. Deferred tax amount on income statement (AICPA adapted)

Beginning balance, unearned royalties, 1/1/01 $400,000

Additional royalties received in 2001 600,000

Less: Unearned royalties on 12/31/01 (350,000 ) Royalty income recognized for book purposes $650,000 Amount recognized for tax purposes:

Royalty collections in 2001 ( 600,000 )

Temporary differences 50,000

Tax rate 50%

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Journal entry to record taxes for 2001 (not required):

D R Income tax expense (50% ´ $650,000) $325,000

CR Income taxes payable (50% ´ $600,000) $300,000 CR Deferred tax asset (50% ´ $50,000) 25,000 P13-4. Current and deferred portion of tax expense

Current provision for 2001 income tax expense is the taxes payable to the IRS on 2001 income computed as:

Taxable income $450,000

Tax rate 35%

Current provision for income taxes $157,500 Requirement 2:

Determination of deferred income taxes on 2001 income statement:

Construction revenue recorded on tax returns

but not on books—future deductible amount $100,000 Excess of accelerated depreciation for tax

over straight-line for books—future taxable amount (400,000 )

Net future taxable amount (300,000)

35%

Deferred portion of tax expense (DR) $105,000 Entry to record 2001 tax provision:

D R Tax expense $262,500

CR Taxes payable (current) $157,500

CR Deferred taxes payable 105,000

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P13-5. Tax expense and deferred tax calculations Requirement 1:

Computation of taxable income and financial reporting income:

2001 2002

Taxable Financial Taxable Financial Revenue (less other expenses) $500,000 $500,000 $500,000 $500,000 Less:

- Depreciation expense -60,000¹ -45,000² - 30,000¹ - 45,000² - Amortization of goodwill _ ______ _-50,000 _______ _-50,000 Net income $440,000 $405,000 $470,000 $405,000

1SYD method depreciation ²Straight-line depreciation 2001 = 2/3 ´ $90,000 = $60,000 $90,000/2 years = $45,000 2002 = 1/3 ´ $90,000 = $30,000

Requirement 2:

A permanent difference item is a revenue or expense that is recognized for book purposes but never for tax purposes or recognized for tax purposes but never for book purposes. That is, GAAP and tax rules permanently differ in how they recognize the revenue or expense item in question.

Goodwill amortization is an example of a permanent difference item for Nelson.

(Beginning in 1993, goodwill arising from certain acquisitions can be

amortized for tax purposes also.) Other common permanent difference items include Interest on municipal bonds and premiums paid on officers’ life

insurance.

Temporary differences are revenue or expense items that are recognized in a different period for book purposes than for tax purposes. GAAP and tax rules agree that temporary differences are included in income determination, but differ as to the timing of the recognition.

An example of a temporary difference for Nelson is the excess of sum-of- years’-digits depreciation for tax purposes over straight-line depreciation for book purposes.

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Requirement 3:

Ending Balance in Ending Balance in

Year Tax Liability Tax Expense Deferred Income Taxes 2001 $440,000 ´ 0.20 $455,000 ´ 0.20

= $88,000 = $91,000 $3,000 CR¹

2002 $470,000 ´ 0.20 $455,000 ´ 0.20

= $94,000 = $91,000 0

Note: Ignore amortization of goodwill when computing tax expense:

1 Temporary depreciation difference = $60,000 - $45,000 = $15,000 ´ 20% = $3,000

Requirement 4:

Increase/decrease in deferred income taxes:

Change in tax rate ´ Future taxable amount due to depreciation timing difference

(.30 - .20) ´ ($60,000 - $45,000)

= $1,500 increase in deferred tax liability Journal entry required to accomplish this:

D R Income tax expense $1,500

Income Tax Liability for 2002:

Taxable income ´ tax rate =

$470,000 ´ 0.30 = $141,000 Income Tax Expense for 2002:

Pre-tax book income (excluding permanent differences ´ tax rate =

$455,000 ´ .30 = $136,500 + $1,500 from change in the tax rate applied to future taxable amount

= $138,000

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P13-6. Determining current and deferred portion of tax expense and reconciling statutory and effective tax rates

Requirement 1:

Determining taxes payable:

( in $000 )

Taxable income (given) $1,400

Tax rate 35%

Taxes payable $490

Requirement 2:

Change in deferred tax assets (liabilities):

Temporary differences giving rise to future taxable amounts:

Depreciation $800

Enacted tax rate 40%

Increase in deferred tax liability $320

Temporary differences giving rise to future deductible amounts:

Warranty costs $ 400

Rent received in advance 600

$1,000 Enacted tax rate 40%

Increase in deferred tax asset $ 400 Requirement 3:

Tax expense for 2001:

Tax expense = Taxes payable + Increase in deferred tax liability - Increase in deferred tax asset

$410 = $490 + $320 - $400

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Requirement 4:

Reconciliation of statutory and effective tax rates (amounts):

Effective (book) tax rate = Tax expense (Req. 3) Pre - tax income (given)

$410

$1,000 41%

= =

Percentage of Pre-Tax

Amount Income Expected tax expense at statutory rate

(35% ´ $1,000) $350 35%

Effect of permanent differences

Amortization of goodwill (35% ´ $400) 140 + 14 Interest on municipal bonds (35% ´ $200) (70) - 7 Effect of higher tax rates on temporary differences

Depreciation (5% ´ $800) 40 + 4

Warranty costs (5% ´ $400) (20) - 2

Rent received in advance (5% ´ $600) (30 ) - 3 Effective tax rate ($410/$1,000) $410 41 % P13-7. Entries for loss carrybacks and carryforwards

Requirement 1:

Smith Corporation will offset the 2004 loss against the 2002 income and a portion of the income of year 2003 until the entire loss of $350,000 is fully offset. Note that the income prior to 2002 is beyond the allowable 2-year period.

Using the 2-year carryback rule, Smith Corporation will calculate its income tax refund as follows:

Taxable Tax Tax Income

Year Income Rate Refund Remaining

2002 $250,000 35% $87,500 -

2003 _100,000 32% __32,000 $300,000

$350,000 $119,500

The tax refund is calculated using the tax rates prevailing in the respective carryback years. Since the entire 2004 net loss is offset against past income using the carryback provision, the income tax benefit will be identical to

income tax refund receivable. Consequently, the following journal entry will be recorded in 2004:

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Entry for 12/31/04:

D R Income tax refund receivable $119,500

CR Income tax expense or benefit $119,500 Note that the effective tax “benefit” rate during 2004 is 34.14%

($119,500/$350,000), which is more than the 2004 statutory tax rate of 30%.

This is because the carryback provision allows companies to obtain the tax benefit based on the tax rates prevailing in the carryback years (i.e., 2002 and 2003).

Smith Corporation will offset the entire loss for the year 2005 against the remaining income from 2003. Using the 2-year carryback rule, Smith Corporation will calculate its income tax refund as follows:

2003 $275,000 32% $88,000 $25,000

$275,000 $88,000

The tax refund is calculated using the tax rate prevailing in the carryback year. Since the entire 2005 net loss is offset against past income using the carryback provision, the income tax benefit will be identical to income tax refund receivable. Consequently, the following journal entry will be recorded in 2005:

Entry for 12/31/05:

CR Income tax expense or benefit $88,000 The effective tax “benefit” rate during 2005 is 32% ($88,000/$275,000), which is more than the 2005 statutory tax rate of 30%. This is because the

carryback provision allows companies to obtain the tax benefit based on the tax rates prevailing in the carryback years (i.e., 2003).

Smith Corporation will offset the 2010 net loss of $800,000 against the past two years income beginning from 2008. Based on this carryback, Smith Corporation will be eligible for an income-tax refund, calculated as follows:

2008 $275,000 30% $82,500 -

2009 300,000 35% 105,000 -

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The following journal entry will be recorded in 2010 to show the income tax refund:

Entry for 12/31/10:

CR Income tax expense or benefit $187,500 Note, however, Smith Corporation had earned only $575,000 during the

previous two years. Consequently, the company needs to examine whether a deferred tax asset should be created for the remaining 2010 loss of $225,000 ($800,000 - $575,000). Based on the information in the problem, we create a deferred tax asset assuming the tax benefits of this loss will be fully realized at a rate of 35% ($225,000 ´ 0.35).

Entry for 12/31/10:

CR Income tax expense or benefit $78,750 Recall that by 2011, Smith Corporation has completely exhausted the benefits from the loss carryback provision. However, once again based on the

information in the problem, we create a deferred tax asset assuming the tax benefits of this loss will be fully realized at a rate of 35% ($250,000 ´ 0.35).

Entry for 12/31/11:

CR Income tax expense or benefit $87,500 At the end of 2011, the company has loss carryforwards of $475,000 -

$225,000 from 2010 and $250,000 from 2011. Consequently, when Smith Corporation earned $150,000 net income during 2012, it was able to offset this income against $150,000 of the 2010 loss carried forward. Without any tax liability during 2012, the journal entry for the expense reflects the realized tax benefit from the deferred tax assets ($150,000 ´ 0.35):

Entry for 12/31/12:

CR Deferred tax asset $52,500

Requirement 2:

In Requirement 2, it is more likely than not that only 40% of the tax benefits will be realized through loss carryforward. Consequently, we need to create a valuation allowance for 60% of the tax benefits not expected to be realized.

We do this in two steps. First, we record the journal entry assuming that all the tax benefits will be realized (as in Requirement 1).

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Entry for 12/31/10:

CR Income tax expense or benefit $78,750 Next, we create a valuation account to reduce the carrying value of the deferred tax asset account by 60% ($78,750 ´ 0.60). The purpose of the

“Allowance” account is to reduce the carrying value of the deferred tax asset to net realizable value.

D R Income tax expense or benefit $47,250

CR Valuation allowance $47,250

At the end of 2010, the deferred tax asset will be reported in the balance sheet as follows:

Deferred Tax Asset as of the end of 2010 Tax benefit of loss carryforward $78,750 Less: Valuation allowance (47,250 )

$31,500 The journal entries for 2011 follow the same two steps:

Entry for 12/31/11:

CR Income tax expense or benefit $87,500 Similar to 2010, we use the valuation account to reduce the carrying value of the deferred tax asset account by 60% ($87,500 ´ 0.60).

D R Income tax expense or benefit $52,500

CR Valuation allowance $52,500

At the end of 2011, the deferred tax asset will be reported in the balance sheet as follows:

Deferred Tax Asset as of the end of 2011 Tax benefit of loss carryforward $166,250 Less: Valuation allowance (99,750 )

$66,500

At the end of 2012, the valuation allowance is eliminated since it is more likely than not that the entire tax benefits will be realized.

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Entry for 12/31/12:

D R Valuation allowance $99,750

CR Income tax expense or benefit $99,750 As in Requirement 1, the following journal entry is recorded to show the tax expense on the income of $150,000.

Deferred Tax Asset as of the end of 2012 Tax benefit of loss carryforward $113,750

One interesting result is that, although the company reports a positive pre-tax income for 2012, it reports no income tax expense. In fact, the reversal of the valuation allowance results in an income tax benefit in the income statement.

Income Statement for the Year 2012

Pre-tax income $150,000

+ Income tax benefit ($99,750 - $52,500) 47,250

Net income $197,250

P13-8. Entries for loss carrybacks and carryforwards

Barron Corporation will offset the 2005 loss against the 2003 and 2004 taxable incomes. Note that income prior to 2003 is beyond the allowable 2- year period.

Using the 2-year carryback rule, Barron Corporation will calculate its income tax refund as follows:

2003 $ 90,000 40% $36,000 -

2004 60,000 40% 24,000 $140,000

$150,000 $60,000

Since the entire 2005 net loss is offset against past income using the carryback provision, the income tax benefit will be identical to income tax refund receivable. Consequently, the following journal entry will be recorded in 2005:

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Entry on 12/31/05:

D R Income tax refund receivable $60,000 CR Income tax expense

(benefit from loss carryback) $60,000

Barron Corporation will offset the 2006 loss against the remaining income from 2004. Using the carryback rule, Barron Corporation will calculate its income tax refund as follows:

2004 $140,000 40% $56,000 -

$140,000 $56,000

The following journal entry will be recorded in 2006 to show the income tax refund:

Entry on 12/31/06:

D R Income tax refund receivable $56,000 CR Income tax expense

(benefit from loss carryback) $56,000

Note, however, Barron Corporation had only $140,000 of income available during the carryback period. Consequently, the company needs to examine whether a deferred tax asset should be created for the remaining 2006 loss of

$40,000 ($180,000 - $140,000). Based on the information in the problem, we create a deferred tax asset assuming the tax benefits of this loss will be fully realized at a rate of 40% ($40,000 ´ 0.40).

Entry on 12/31/06:

CR Income tax expense

(benefit from loss carryforward) $16,000 At the end of 2006, the company has a loss carryforward of $40,000 from 2006. Consequently, when Barron Corporation earned $125,000 net income during 2007, it was able to offset this income against $40,000 of the 2006 loss carried forward. The income tax liability for 2007 is calculated as follows:

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Calculation of Tax Liability for 2007 2007 Taxable income $125,000 - 2006 Loss carryforward (40,000 )

Income subject to tax $ 85,000

Tax rate 40%

Tax liability at 40% $ 34,000

The journal entry to record the 2007 income tax expense reflects the realization of the deferred tax asset from the 2006 loss carryforward:

Entry on 12/31/07:

CR Income tax payable $34,000

CR Deferred tax asset 16,000

In 2008, the company incurred a net loss of $120,000. Only $85,000 of the loss can be offset against the 2007 income under the carryback provision.

Recall that $40,000 of the 2007 net income was offset against the 2006 loss under the carryforward provision.

The loss carryforward for 2008 is calculated as follows:

Calculation of Loss Carryforward for 2008

2008 Net loss ($120,000)

+ 2007 Income subject to tax 85,000 2008 Loss carryforward ($ 35,000 )

Therefore, the company is entitled to claim a refund of the all the taxes paid for the 2007 income. For the remainder of the loss, we record a deferred tax asset to represent the future benefits from the carryforward provision

($35,000 ´ 0.40 = $14,000):

Entry on 12/31/08:

D R Deferred tax asset 14,000

CR Income tax expense or benefit $48,000

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P13-9. Reconciling statutory and effective tax rates Requirement 1:

Determination of taxable income and taxes payable—

Pre-tax accounting income (loss) per books ($1,500,000) Less: Permanent difference items:

+ Charge for in-process technology 2,000,000

+ Amortization of goodwill ($1,000,000/20 years) 50,000

- Income from municipal bonds (80,000)

+ Management fee for municipal bond investments 10,000

+ Insurance premium on executives 15,000

- Insurance proceeds (250,000 )

Pre-tax income adjusted for permanent differences 245,000 Adjustments for temporary differences:

- Excess of bad debts written off over provision

for uncollectibles (75,000)

- Excess of accelerated depreciation for tax over S/L

depreciation for books ($210,000 - $140,000) (70,000 )

Taxable income 100,000

Statutory tax rate 35%

Taxes payable $ 35,000

Requirement 2:

Determination of change in deferred tax assets (liabilities):

Reversal of timing difference on bad debts

(Decrease in deferred tax asset)–$75,000 ´ .35 = $26,250 CR Originating temporary difference for depreciation

(Increase in deferred tax liability)–$70,000 ´ .35 = $24,500 CR Requirement 3:

Calculation of income tax expense:

Tax expense = Taxes payable + Decrease in deferred tax asset + Increase in deferred tax liability

= $35,000 + $26,250 + $24,500

= $85,750

Alternative calculation, since no change in tax rates:

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Requirement 4:

Effective tax book rate = $85,750/($1,500,000) = 5.72%

Reconciliation of effective and statutory tax rate:

Companies typically provide a table similar to the one shown below to explain the difference between the statutory tax rate and the effective tax rate.

Tax Expense (Credit)

Tax Rate Expected tax credit at the statutory rate

($1,500,000 loss ´ 35%) ($525,000) -35.00%

Effect of permanent differences:

+ Charge for in-process R&D (35% ´ $2 million) 700,000 46.67%

+ Amortization of goodwill (35% ´ $50,000) 17,500 1.17%

- Income from municipal bonds (35% ´ $80,000) (28,000) -1.87%

+ Management fee for municipal bonds

(35% ´ $10,000) 3,500 0.23%

+ Insurance premium on executives

(35% ´ $15,000) 5,250 0.35%

- Insurance proceeds ($250,000 ´ 35%) (87,500 ) -5.83%

Effective tax rate [$85,750/($1,500,000)] $ 85,750 5.72%

The expected tax credit at the statutory rate is calculated by multiplying the loss before income taxes by 35%. Each item below is calculated by

multiplying the corresponding permanent difference by 35%. The tax rate column is obtained by dividing each item in the tax expense column by the loss before income taxes.

Note: The problem is loosely based on the 1996 financial statements of World Com, Inc. The company’s effective tax rate was substantially different from its statutory tax rate due to the GAAP write-off of in-process technology.

Requirement 5:

The journal entry to record the tax expense is:

CR Income tax payable $35,000

CR Deferred tax asset 26,250

CR Deferred tax liability 24,500

Note that the higher bad debts written off indicates a reversing difference. The company would have recorded a deferred tax asset initially when recording the bad debt expense, which is being reversed when the bad debts are written off.

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In contrast, given the depreciation methods used by the company, the higher depreciation expense indicates an originating difference. The company is creating a deferred tax liability today when the tax depreciation is higher. This will reverse ultimately when the financial accounting depreciation becomes larger than the tax depreciation.

P13-10. Analytical insights from deferred tax account Requirement 1:

The following tables provide the balances in the deferred tax liability over the equipment life:

Annual Cumulative Balance in Depreciation Expense Difference in Difference in Deferred Tax Year St. Line SOYD Depreciation Depreciation Liability

(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35

Year 1 $20,000 $30,000 $10,000 $10,000 $3,500

Year 2 20,000 20,000 - 10,000 3,500

Year 3 20,000 _ 10,000 (10,000 ) - -

$60,000 $60,000 $ - $ - $ - The following table summarizes the balance in the deferred tax liability of Weber, assuming it buys new equipment for $60,000 every year through the year 2006:

Asset Balance in Deferred Tax Liability Account

Acquired in 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06

2001 $3,500 $3,500 -

2002 3,500 $3,500 -

2003 3,500 $3,500 -

2004 3,500 $3,500 -

2005 3,500 $3,500

2006 3,500

$3,500 $7,000 $7,000 $7,000 $7,000 $7,000

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Requirement 2:

The following tables provide the balances in the deferred tax liability over the equipment life for each of the assets acquired during 2002 through 2006 [See (1) for the equipment acquired in 2001]:

Equipment acquired in 2002:

(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35 Year 1 $22,000 $33,000 $11,000 $11,000 $3,850

Year 2 22,000 22,000 - 11,000 3,850

Year 3 22,000 11,000 (11,000 ) - -

$66,000 $66,000 $ - $ - $ - Equipment acquired in 2003:

(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35 Year 1 $24,000 $36,000 $12,000 $12,000 $4,200

Year 2 24,000 24,000 - 12,000 4,200

Year 3 24,000 12,000 (12,000 ) - -

(a) (b) (c) = (b) – (a) (d) (e) = (d) x .35 Year 1 $26,000 $39,000 $13,000 $13,000 $4,550

Year 2 26,000 26,000 - 13,000 4,550

Year 3 26,000 13,000 (13,000 ) - -

$78,000 $78,000 $ - $ - $ -

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Equipment acquired in 2005:

(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35

Year 1 $28,000 $42,000 $14,000 $14,000 $4,900

Year 2 28,000 28,000 - 14,000 4,900

Year 3 28,000 14,000 (14,000 ) - -

(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35 Year 1 $30,000 $45,000 $15,000 $15,000 $5,250

Year 2 30,000 30,000 - 15,000 5,250

Year 3 30,000 15,000 (15,000) - -

$90,000 $90,000 $ - $ - $ -

The following table summarizes the temporary differences and the balance in the deferred tax liability of Weber assuming it buys new equipment every year through the year 2006 (the cost of the equipment increases linearly from

$60,000 in 2001 to $90,000 in 2006):

Year

Book Depreciation

Tax Depreciation

Yearly Difference

Cumulative Difference

Balance in Deferred Tax Liability Account

(a) (b) (c) (d) = b - a (e) = (d) x .35

2001 $20,000 $30,000 $10,000 $10,000 $3,500

2002 42,000 53,000 11,000 21,000 7,350

2003 66,000 68,000 2,000 23,000 8,050

2004 72,000 74,000 2,000 25,000 8,750

2005 78,000 80,000 2,000 27,000 9,450

2006 84,000 86,000 2,000 29,000 10,150

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Requirement 3:

The answer to this requirement involves extending the last table for two more years without considering any new equipment purchases:

Year

Book Depreciation

Tax Depreciation

Yearly Difference

Cumulative Difference

Balance in Deferred Tax Liability Account

(a) (b) (c) (d) = b - a (e) = (d) x .35

2006 $84,000 $86,000 $2,000 $29,000 $10,150

2007 58,000 44,000 (14,000) 15,000 5,250

2008 30,000 15,000 (15,000) - -

Requirement 4:

Several generalizations can be made by examining the answers to the above three requirements. One controversy pertains to whether a deferred tax

liability is really an economic liability. As discussed in the chapter, if a

company sells its equipment at its accounting book value, then it will end up paying tax equal to the deferred tax liability for that equipment. In that sense, one might consider a deferred tax liability as a “true” liability. For instance, consider the equipment purchased for $60,000 on January 1, 2001. The

following table summarizes the change in the deferred tax liability with respect to this asset:

(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35 Year 1 $20,000 $30,000 $10,000 $10,000 $3,500

Year 2 20,000 20,000 - 10,000 3,500

Year 3 20,000 10,000 (10,000) - -

$60,000 $60,000 $ - $ - $ -

Assume that this equipment is sold for its accounting book value on January 1, 2002. At the time of sale, the accounting book value of the asset is $40,000 ($60,000 - $20,000), whereas its tax book value (referred to as tax basis) is only $30,000 ($60,000 - $30,000). The company will report no gain or loss in its financial reporting statements; however, it will report an income of $10,000 in its tax statement. Consequently, it will end up paying tax equal to $3,500 (35% of $10,000) in 2002. This $3,500 is exactly equal to the deferred tax liability reported at the end of 2001.

However, companies typically invest in property, plant, and equipment not with an objective of selling them, but with a view to using them in their operations to generate revenues. Companies in growth or mature stages are likely to

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continuing customer demands. For these firms, the deferred tax liability might represent the present value of obligation that could be postponed almost indefinitely through growth and expansion; consequently, the present value of the obligation is likely to be substantially smaller than the reported value of the deferred tax liability.

Note that in Requirement 1, when Weber is continuing to buy new equipment at the rate of $60,000, the deferred tax liability remains stable at $7,000 from 2002 to 2006. However, when the cost of the equipment increases over time, the balance in deferred tax liability in fact keeps increasing from $7,000 in 2001 to $10,150 in the year 2006. Many growth companies invest

increasingly larger amounts in property and equipment to build capacity.

Even mature companies that expect to maintain capacity invest increasingly larger dollar amounts due to inflation in equipment prices. In essence,

Requirements 2 and 3 indicate that the economic value of the deferred tax liability may be substantially lower than its reported value.

Requirement 4 shows that a continuing decline in deferred tax liability might indicate that a company is shrinking or declining since it is reducing its Investment in new property and equipment.

P13-11. Comprehensive tax allocation problem Requirement 1:

First, let us calculate the depreciation expense for the computer equipment.

Under both the straight-line and SOYD methods, original cost minus the estimated salvage value ($330,000 - $30,000) is depreciated over the useful life. The SOYD depreciation figures will be used for calculating the income tax liability.

Annual Depreciation Expense

Method 2001 2002 2003 2004 2005 Total

St. Line $60,000 $60,000 $60,000 $60,000 $60,000 $300,000 SOYD 100,000 80,000 60,000 40,000 20,000 300,000

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Based on the straight-line method of depreciation, the financial reporting income statements are provided below:

Financial Reporting Income Statements for the Years Ended

2001 2002

Sales revenue $1,000,000 $1,200,000

Income from municipal bonds 60,000 75,000

- Cost of goods sold (400,000) (504,000)

- Depreciation expense (60,000) (60,000)

- Warranty expense (100,000) (110,000)

- Provision for uncollectibles (8% of sales) (80,000) (96,000) - Life insurance premium for executives (30,000) (30,000) - Other operating expenses (300,000) (350,000)

Income before income taxes 90,000 125,000

- Income tax expense (see below) (21,000) (28,000)

Net income $ 69,000 $ 97,000

Effective tax rate (tax expense/pre-tax income) 23.33% 22.40%

After excluding the permanent differences, the income tax expense is calculated as follows:

Calculation of Income Tax Expense

2001 2002

Income before income taxes $90,000 $125,000

- Income from municipal bonds (60,000) (75,000) + Life insurance premium for executives 30,000 30,000 Income before permanent differences $60,000 $80,000

Tax rate 35% 35%

Income tax expense at 35% $21,000 $28,000

Requirement 2:

To calculate the income tax liability, we need to prepare the income statement for tax purposes. This requires two adjustments to the financial reporting

income statement. First, the permanent differences are excluded. Second, the expenses that are subject to timing or temporary differences are recalculated using the tax rules. The depreciation is calculated using the SOYD method (see answer to Requirement 1). The actual warranty expenditures made to correct defective products are shown as an expense. Similarly, the actual bad debts written off are allowed as a deduction for tax purposes.

The actual warranty expenditures are calculated by reconstructing the T-account for warranty liability.

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C R Warranty Liability

Balance as of 1/1/01 -

Warranty expense for 2001 (per income statement) $100,000 Cash paid for warranty services '01 (plug) ( 85,000 )

Balance as of 12/31/01 (given) 15,000

Warranty expense for 2002 (per income statement) 110,000 Cash paid for warranty services '02 (plug) ( 100,000 )

Balance as of 12/31/02 $25,000

The bad debts written off are calculated by reconstructing the T-account for allowance for uncollectibles.

C R Allowance for Uncollectibles

Balance as of 1/1/01 -

Provision for uncollectibles for 2001 (per Req. 1) $80,000 Bad debts written off (plug number) (30,000 )

Balance as of 12/31/01 (given) 50,000

Provision for uncollectibles for 2002 (per Req. 1) 96,000 Bad debts written off (plug number) (125,000 )

Balance as of 12/31/02 (given) $21,000

Based on the above calculations, the taxable income for tax purposes is computed as follows:

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Tax Income Statements for the Years Ended

2001 2002

Book income before tax $90,000 $125,000

Adjustments for permanent differences:

Tax-exempt municipal bond interest (60,000) (75,000) Nondeductible life insurance premiums 30,000 30,000 Book income adjusted for permanent differences 60,000 80,000 Adjustments for temporary differences:

Additional tax depreciation (40,000)¹ (20,000)² Warranty expense (accrual to cash basis) 15,000 ³ 10,000 ⁴ Bad debts (accrual to cash basis) 50,000 ⁵ (29,000 )⁶

Taxable income $85,000 $41,000

Times tax rate _´ .35 _´ .35 Income tax liability $ 29,750 $ 14,350

1 $100,000 (tax) - $60,000 (book) = $40,000

2 $80,000 (tax) - $60,000 (book) = $20,000

3 $100,000 (book) - $85,000 (tax) = $15,000

4 $110,000 (book) - $100,000 (tax) = $10,000

5 $80,000 (book) - $30,000 (tax) = $50,000

6 $96,000 (book) - $125,000 (tax) = ($29,000)

Requirement 3:

Reconciliation of Effective Tax Rate and Statutory Tax Rate

2001 2002

Income tax expense at statutory rate

$31,500 35.00% $43,750 35.00%

- Effect of non-taxable Income (21,000) -23.33% (26,250) -21.00%

+Effect of nondeductible expense 10,500 11.67% 10,500 _8.40%

Income tax expense $21,000 22.33% $28,000 22.40%

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Requirement 4:

Deferred Tax Accounts as of 12/31/2001

DR Asset

CR Liability Depreciation expense ($100,000 - $60,000) x 0.35 $14,000 Warranty expense ($100,000 - $85,000) x 0.35 $ 5,250

Bad debts ($80,000 - $30,000) x 0.35 17,500

Total $22,750 $14,000

Net deferred tax asset $ 8,750

Deferred Tax Liability for Depreciation Expense C R

Balance as of 12/31/01 $14,000

Additional timing difference($80,000 - $60,000) ´ 0.35 7,000

Balance as of 12/31/02 $21,000

Deferred Tax Asset for Warranty Expense D R

Balance as of 12/31/01 $5,250

Additional timing difference ($110,000 - $100,000) ´ 0.35 3,500

Balance as of 12/31/02 $8,750

Deferred Tax Asset for Bad Debt Expense D R

Balance as of 12/31/01 $17,500

Reversal of timing difference ($125,000 - $96,000) ´ 0.35 (10,150)

Balance as of 12/31/02 $ 7,350

D R C R

Deferred Tax Accounts as of 12/31/2002 Asset Liability

Depreciation expense $21,000

Warranty expense $ 8,750

Bad debts 7,350

Total $16,100 $21,000

Net deferred tax liability $ 4,900

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Requirement 5:

Reconciliation of Income Tax Expense and Income Tax Liability

2001 2002

Income tax expense $21,000 $28,000

Changes in deferred tax arising from:

Depreciation expense (14,000) (7,000)

Warranty expense 5,250 3,500

Bad debt expense 17,500 (10,150 )

Income tax liability $29,750 $14,350

The tables in the answers to Requirements 3 through 5 are commonly provided in company annual reports.

Requirement 6:

Entry on 12/31/01:

D R Deferred tax asset 22,750

CR Income tax payable 29,750

The debit to deferred tax asset is due to warranty expense ($5,250) plus bad debts ($17,500). The credit to deferred tax liability is due to accelerated

depreciation for tax purposes.

Entry on 12/31/02:

CR Deferred tax liability 7,000

The net credit to deferred tax asset is due to the tax effect of $10,150 from the reversal of the timing difference for bad debts offset by the debit from the tax effect of $3,500 from the additional originating timing difference in warranty expense. The credit to deferred tax liability is due to the additional originating difference in depreciation expense.

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P13-12. Determination of taxes payable, deferred taxes and tax expense Requirement 1:

Reality Corp.

Calculation of Taxable Income and Taxes Payable Computation of Taxable Income:

Pre-tax accounting income (given) $200,000

Adjustments for permanent differences:

- Interest on municipal bonds (5,000)

+Premium on executive life insurance 3,000

+Amortization of implicit goodwill 10,000

- 80% equity in investee’s earnings (72,000 ) Adjustments for permanent differences (64,000 ) Income before adjustment for temporary differences $136,000 Adjustments for Temporary Differences:

Excess of tax depreciation over book depreciation (125,000) Excess of equity in investee earnings over dividends

Received, less portion considered permanent due to

80% dividend exclusion rule [(20%) ($90,000 - $30,000)] (12,000) Rent income included in book income in 2001, taxed in 2000 (4,000) Rent received in advance, taxable in 2001 10,000 Temporary difference on sale of land:

Amount recognized per book (30,000)

Amount recognized for tax 10,000 (20,000) Warranty timing difference:

Amount recognized per book 50,000

Amount recognized for tax (15,000 ) 35,000 Bad debt timing difference:

Amount recognized per book 15,000

Amount recognized for tax (6,000 ) 9,000 Operating loss carryforward (10,000 )

Taxable income $ 19,000

Tax rate x 40 %

Taxes payable $ 7,600

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Requirement 2:

Computation of change in deferred tax asset and deferred tax liability accounts:

Temporary Difference

Deferred Tax Asset

Deferred Tax Liability (org) Depreciation

($225,000 - $100,000) ´ 40% $50,000 CR

(org) Equity in investee earnings

40% [20% ´ ($90,000 - $30,000)] 4,800 CR

(rev) Rental income earned in 2001, taxed in 2000

40% ($4,000) ($1,600) CR

(org) Rent received in advance

40% ($10,000) 4,000 DR

(org) Deferred profit on sale of land

40% ($20,000) 8,000 CR

(org/rev) Warranty cost timing difference

40% ($35,000) 14,000 DR

(org/rev) Bad debt timing difference

40% ($15,000 - $6,000) 3,600 DR

(org/rev) Tax benefit of loss carryforward

40% ($10,000) (4,000) CR Change in deferred tax asset (liability) $16,000 DR $62,800 CR

Requirement 3:

Determination of tax expense for 2001

Tax expense = Taxes payable + Increase in deferred tax liability - Increase in deferred tax asset (less allowance)

Before allowance:

$54,400 = $7,600 + $62,800 - $16,000

+11,200 Allowance (see below)

$65,600

Deferred tax asset beginning balance $40,000 Increase in 2001 (see Requirement 2) 16,000

$56,000

x 20%

Estimated allowance $11,200

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P13-13. Leasing and deferred taxes Requirement 1:

2001 2002 2003 Income before lease transaction $100,000 $100,000 $100,000 Lease expense (10,000 ) (10,000 ) (10,000 )

Taxable income 90,000 90,000 90,000

Income tax liability at 40% $ 36,000 $ 36,000 $ 36,000 Requirement 2:

Note: Since the company leased the equipment for its entire useful life, it must use capital lease accounting for financial reporting purposes. A schedule showing the interest component (using the implicit interest rate) and

reduction of principal for each lease payment is shown below.

Year

Interest Expense

Repayment of Lease Obligation

Balance of Lease Obligation

$24,869

2001 $2,487 $7,513 17,356

2002 1,736 8,264 9,092

2003 908 9,092 0

2001 2002 2003

Income before lease transaction $100,000 $100,000 $100,000

Interest on capital lease (2,487) (1,736) (908)

Depreciation expense (8,290 ) (8,290 ) (8,289 )

Income before income tax 89,223 89,974 90,803

Income tax expense at 40% (35,689 ) (35,990 ) (36,321 )

Net income $ 53,534 $ 53,984 $ 54,482

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Requirement 3:

2001

D R Deferred income tax asset 311

CR Income taxes payable $36,000

2002

D R Deferred income tax asset 10

CR Income taxes payable $36,000

2003

CR Deferred income tax asset $321

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Financial Reporting and Analysis Chapter 13 ^Solutions

Income Tax Reporting Cases

Cases

C13-1. Baldwin Piano and Organ Company (KR) (Analysis of tax footnote) Requirement 1:

Entry for 12/31/97:

DR Income tax expense $852,000

DR Income tax refund receivable 536,000

CR Net deferred tax asset/liability $1,388,000 Entry for 12/31/98:

DR Net deferred tax asset/liability $2,020,000

CR Income tax payable $ 181,000

CR Income tax expense (benefit) 1,839,000

Entry for 12/31/99:

DR Net deferred tax asset/liability $7,276,000

CR Income tax payable $ 55,000

CR Income tax expense (benefit) 7,221,000

Requirement 2:

Baldwin Piano specifically identifies four accounting items that cause the

income tax expense to be different from the taxes currently payable or income tax liability. These items are the allowance for doubtful accounts, non-

deductible accruals, inventory reserves and LIFO differences, and net operating loss carryforwards. Note that all these items are reflected in the

“Deferred tax assets”. Recall that when expenses are recorded first in the financial statements, and subsequently for tax purposes, then they give rise to deferred tax assets (e.g., warranty expense). In contrast, when expenses are recorded initially for tax purposes and subsequently in the financial statements, then they give rise to deferred tax liabilities (e.g., accelerated depreciation for tax purposes and straight-line for book purposes).

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First, let us focus on the deduction for bad debt expense on Baldwin’s books versus tax return. While companies use the allowance method and matching principle to estimate bad debt expense for financial reporting purposes, they must wait until the bad debts are written off to claim a deduction for tax

purposes. Therefore, when a company records bad debt expense on its books, this gives rise to a deferred tax asset debit (originating difference) because the deduction for tax purposes will occur in a later period. However, when the bad debt is realized and written off, the corresponding deferred tax asset is eliminated or credited (reversing difference).

The fact that the deferred tax asset related to bad debt timing differences increased from 1998 to 1999 implies that the bad debt expense recorded on Baldwin’s books in 1999 exceeded the deduction taken on the tax return for accounts written off during the period. That is, book income was smaller than taxable income in 1999 due to this temporary difference.

Next, let’s turn our attention to the “Nondeductible accruals.” The term

“nondeductible” is somewhat of a misnomer. If accrued expenses are truly

“nondeductible”, then they would be considered as permanent differences, and therefore, will not affect deferred taxes. What Baldwin means by

“nondeductible” is that these financial reporting expenses are not deductible for tax purposes when initially recorded for book purposes. What are

examples of nondeductible expenses? Note that Baldwin has accrued for a number of expenses that have resulted in accrued liabilities (pension, other postretirement and postemployment benefits (healthcare), as well as

compensation). SFAS 87, 106 and 112 require companies to record pension, postretirement and postemployment expenses using accrual accounting.

However, deductions are allowed for tax purposes only when the liabilities are discharged by paying cash. Similarly, accrued liabilities for compensation might represent an incentive bonus accrued for employees and management that is deductible for tax purposes when paid.

An examination of the components of the deferred tax expense suggests that, collectively, these “nondeductible” items resulted in a reduction of the

deferred tax asset (reversing difference) for 1999. This indicates that for financial reporting, these expenses were lower than the deduction for tax purposes during 1999. Therefore, book income was higher than taxable income, resulting in a credit (reduction) to deferred tax assets related to these temporary “nondeductible” expenses. In essence, more cash payments were made for these items, and thus deducted on the current period tax return, than what was accrued and deducted for book purposes.

The third temporary difference relates to inventory accounting. It appears that certain inventory write-downs taken for book purposes are not deductible immediately for tax purposes until “realized” through sale of inventory (and consequent lower profits). For instance, the IRS does not allow companies

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using the LIFO method (like Baldwin Piano) to apply the lower of cost or market value rule for tax purposes. This explains the deferred tax asset that arose in the current period due to inventory temporary differences.

It appears that during 1999 Baldwin wrote down LIFO inventories in its

financial statements that were not deductible for tax purposes, resulting in the creation of a deferred tax asset (originating difference). This deferred tax asset will not be realized until the inventory is sold in some future period.

The final deferred tax item deals with net operating loss carryforwards. This is an originating difference. The operating loss reported in the current period will provide Baldwin with a deduction in the future when it is used to offset future taxable income. Thus, this item gives rise to a deferred tax asset (debit).

C13-2. Sara Lee Corp. (LR) (Analysis of tax footnotes)

Requirement 1: Book journal entry for tax expense in 1999

($ in millions)

DR Income tax expense $480

CR Deferred tax asset/liability $34

CR Income tax payable 446

Requirement 2: Sara Lee’s pre-tax book income for 1999 Let X = pre-tax book income ($ in millions):

$ 585 = .35 X

$1671.43 = X

Requirement 3: Overall effective tax rate for 1999 Income tax expense (per books) $480 _

Pre-tax book income =

$1671.43 = 28.72%

Requirement 4: Taxable income as per tax return in 1999 Let X = taxable income as per tax return ($ in millions)

Income Tax Payable = Effective Tax Rate * X

$446 = .2872X X = $1,552.92

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C13-3. Motorola vs. Intel: Adjusting for depreciation differences Requirement 1:

Begin by looking at the edited financial statement disclosures from the 1996 10K of Motorola, which shows the balances in the sub-components of the deferred tax account. The highlighted depreciation item reflects the $213 million cumulative deferred tax liability arising from book versus tax

depreciation expense at December 31, 1996. The liability rose by $16 million during 1996 ($213 million minus $197 million).

The change in the deferred income tax liability arising from depreciation is:

Change = (Tax depreciation - Book depreciation) x Effective tax rate Motorola’s effective tax rate is 35% and the depreciation deferred tax change was $16 million as shown in the edited 1996 10K of Motorola.

Substituting these values into the equation above, we get:

$16 = (Tax depreciation - Book depreciation) x .35 Dividing both sides by .35 yields:

$45.7 = (Tax depreciation - Book depreciation)

Since the edited financial statement disclosures show Motorola’s book depreciation was $2,308 million, tax depreciation must have been $2,308 million + $45.7 million = $2,353.7 million, which was 2% higher.

The highlighted portion of the financial statement disclosures show that

Intel’s depreciation-related deferred income tax liability was $573 million -- an increase of $98 million in one year. Repeating the analytical approach we used for Motorola:

Change = (Tax Depreciation - Book Depreciation) x Effective Tax Rate or:

$98 = (Tax Depreciation - Book Depreciation) x .35 or:

$280 = (Tax Depreciation - Book Depreciation)

Intel’s book depreciation was $1,888 million (from disclosures), so tax

depreciation must have been $1,888 million + $280 million = $2,168 million, an increase of 14.8%.

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Requirement 2:

Adjusting both firms’ financial reporting to the same rate and useful lives used for tax purposes lowers Motorola’s pre-tax income by 2.6% ($45.7 million ¸ $1,775 million). Intel’s pre-tax income is lowered by 3.5% ($280 million ¸ $7,934 million).

Requirement 3:

Since the adjusted figures are not affected by variations in depreciation reporting choices across firms, it becomes easier to compare the operating results of the two companies. The unadjusted numbers are difficult to

compare since they reflect differences in depreciation accounting methods as well as differences in underlying operating performance.

C13-4. Circuit City Stores Inc. (KR) (Analysis of tax footnotes) Requirement 1: ($ in thousands)

Entry on 2/28/98:

DR Provision for income taxes $ 76,581

CR Net deferred tax asset/liability $ 15,052

CR Income taxes payable 61,529

Entry on 2/28/99:

DR Provision for income taxes $129,611

Entry on 2/29/00:

DR Provision for income taxes $200,928

Consistent with the terminology used by Circuit City, we have used the term

“provision for income taxes” to indicate income tax expense.

Requirement 2: ($ in thousands)

The deferred portion of the tax provision in 2000 is $43,053 while the change in the net deferred tax liability is equal to $41,447. The difference of $1,606 could be attributable to multiple sources. First, Circuit City reports in its 2000 income statement that they have discontinued operations of $130,240 net of tax effects. The tax effects that arise from discontinued operations are not