10.1 Flashcards
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 the current year exceeded its tax basis by $250,000 at December 31. This difference will reverse in future years. The enacted tax rate is 30% for the current year and 40% for future years. Noor has no other temporary differences. In its December 31 balance sheet, how should Noor report the deferred tax effect of this difference?
As a liability of $100,000.
The temporary difference arises because the excess of the reported amount of the depreciable asset over its tax basis will result in taxable amounts in future years when the reported amount is recovered. A taxable temporary difference results in a deferred tax liability. Because the enacted tax rate for future years is 40%, the deferred income tax liability is $100,000 ($250,000 × 40%).
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:
Uncollectible accounts expense
Tax return: $220,000
Accounting records: $250,000
Depreciation expense
Tax return: 860,000
Accounting records: 570,000
Tax-exempt interest revenue
Tax return: $0
Accounting records: $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?
$104,000
Deferred tax expense or benefit is the net change during the year in the entity’s deferred tax liabilities and assets. In the first year of operations, no previous deferred tax liability or asset exists. Furthermore, the tax-exempt interest revenue is a permanent difference and does not result in a deferred tax liability or asset. However, the following deferred tax amounts must be recognized: (1) a taxable temporary difference for an excess of tax depreciation over accounting depreciation ($860,000 – $570,000 = $290,000) and (2) a deductible temporary difference for the excess of uncollectible accounts expense over the corresponding tax deduction ($250,000 – $220,000 = $30,000). These differences result in the recognition of a deferred tax liability of $116,000 ($290,000 taxable temporary difference × 40% future rate) and a deferred tax asset of $12,000 ($30,000 deductible temporary difference × 40% future tax rate). Thus, the deferred tax expense is $104,000 [($116,000 deferred tax liability – $0) – ($12,000 deferred tax asset – $0)].
West Corp. leased a building and received the $36,000 annual rental payment on June 15, Year 4. The lease was classified as an operating lease. The beginning of the lease was July 1, Year 4. Rental income is taxable when received. West’s tax rates are 30% for Year 4 and 40% thereafter. 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, Year 4, balance sheet?
$7,200.
The $36,000 rental payment is taxable in full when received in Year 4, but only $18,000 [$36,000 × (6 ÷ 12)] should be recognized in financial accounting income for the year. The result is a deductible temporary difference (deferred tax asset) arising from the difference between the tax basis ($0) of the liability for unearned rent and its reported amount in the year-end balance sheet ($36,000 – $18,000 = $18,000). The income tax payable for Year 4 based on the rental payment is $10,800 ($36,000 × 30% tax rate for Year 4), the deferred tax asset is $7,200 ($18,000 future deductible amount × 40% enacted tax rate applicable after Year 4 when the asset will be realized), and the income tax expense is $3,600 ($10,800 current tax expense – $7,200 deferred tax benefit). The deferred tax benefit equals the net change during the year in the entity’s deferred tax liabilities and assets ($7,200 deferred tax asset recognized in Year 4 – $0).
A deferred tax asset must be reduced by a valuation allowance if it is
More likely than not that some portion will not be realized.
A deferred tax asset shall be reduced by a valuation allowance if the weight of the available evidence, both positive and negative, indicates that it is more likely than not (that is, the probability is greater than 50%) that some portion will not be realized. The allowance should suffice to reduce the deferred tax asset to the amount that is more likely than not to be realized. The effect of a change in the beginning balance resulting from a new judgment about realizability is an item of income from continuing operations.
Hemple Co. maintains escrow accounts for various mortgage companies. Hemple collects the receipts and pays the bills on behalf of the customers. Hemple holds the escrow monies in interest-bearing accounts. They charge a 10% maintenance fee to the customers based on interest earned. Hemple reported the following account data:
Escrow liability beginning of year: $500,000
Escrow receipts during the year: 1,200,000
Real estate taxes paid during the year: 1,450,000
Interest earned during the year: 40,000
What amount represents the escrow liability balance on Hemple’s books?
$286,000.
All escrow receipts collected by Hemple on behalf of its customers represent liabilities. As such, escrow receipts during the year ($1,200,000) must be added to the beginning escrow liability account ($500,000) to arrive at a balance of $1,700,000. Hemple decreases this liability by the amount of taxes paid during the year on behalf of its customers ($1,700,000 – $1,450,000 = $250,000). Hemple must then increase this liability by the amount of interest earned by the escrow monies, less the 10% maintenance fee. This is a net increase of $36,000 [$40,000 interest earned – ($40,000 × 10% fee)]. Thus, the ending escrow liability balance on Hemple’s books is $286,000 ($250,000 + $36,000).
At the end of its first year in business, Pebbles Corporation reported pretax financial statement income of $50,000. Included in pretax income were $10,000 of revenue from installment sales and depreciation expense of $12,000. On the tax return, $5,000 of installment sales revenue was reported, and depreciation expense of $16,000 was deducted. The income tax rate was 40%. Pebbles reports installment sales receivables as current assets. On its year-end statement of financial position, how should Pebbles report deferred tax amounts?
$3,600 as a noncurrent liability.
Temporary differences arise when the GAAP basis and the tax basis of an item of income or expense differ. Of the installment sales, all $10,000 was recognized for financial reporting, but only $5,000 was recognized for tax purposes, producing a temporary difference of $5,000. Because this amount will be recognized later for tax purposes than for financial reporting, it is a deferred tax liability in the amount of $2,000 ($5,000 × 40%). The depreciation expense also will result in a deferred tax liability. More expense was recognized for tax purposes than for GAAP reporting ($16,000 – $12,000 = $4,000). Thus, a deferred tax liability of $1,600 ($4,000 × 40%) results. In the statement of financial position, deferred tax liabilities and assets are classified as noncurrent amounts. Thus, a noncurrent deferred tax liability of $3,600 is recognized by Pebbles.
An automobile dealer sells service contracts. The contracts stipulate that the dealer will perform specific repairs on covered vehicles. The contracts vary in length from 12 to 36 months. Do the following increase when service contracts are sold?
Deferred revenue:
Service revenue:
Yes
No
Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. Thus, revenue is not recognized until the agreed services have been provided or the contracts expire. Consequently, deferred revenue (as contract liability) is credited (increased) at the date of sale of a service contract, but revenue is not.
On a statement of financial position, all of the following should be classified as current liabilities except
Deferred income taxes for differences based on depreciation methods.
On the statement of financial position, deferred tax liabilities and assets are classified as noncurrent amounts.
Salvador Co. sold 800,000 electronic can openers in Year 1. Based on past experience, the company estimated that 10,000 of the 800,000 would prove to be defective and that 60% of these would be returned for replacement under the company’s standard warranty against manufacturing defects. The cost to replace an electronic can opener is $6.00.
On January 1, Year 1, the balance in the company’s estimated liability for warranties account was $3,000. During Year 1, 5,000 electronic can openers were replaced under the warranty. The estimated liability for warranties reported on December 31, Year 1, should be
$9,000.
A standard warranty against manufacturing defects is an assurance-type warranty. This warranty creates a loss contingency. A liability for warranty costs is recognized on the date the product is sold. At the time of the sale of each electronic can opener, it is probable that a warranty liability has been incurred and its amount can be reasonably estimated. Consequently, a warranty expense should be recognized with a corresponding credit to an estimated liability for warranties account. As indicated below, the 1/1/Year 1 balance in this account is $3,000. It was increased during Year 1 by $36,000 (10,000 estimated defective can openers × $6 replacement fee × 60% estimated replacement rate). The account should be decreased by $30,000 (5,000 openers replaced × $6). Thus, the ending balance is $9,000.
Dunne Co. sells equipment service contracts that cover a 2-year period. The sales price of each contract is $600. Dunne’s past experience is that, of the total dollars spent for repairs on service contracts, 40% is incurred evenly during the first contract year and 60% evenly during the second contract year. Dunne sold 1,000 contracts evenly throughout the year. In its December 31 balance sheet, what amount should Dunne report as deferred service contract revenue?
$480,000.
Revenue should be recognized when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. The good or service is transferred when the customer obtains control of that good or service. Service contract revenue should be recognized over time as the services are provided. An appropriate measure of the entity’s progress to complete satisfaction of the performance obligation also must be selected. Assuming that services are provided in proportion to the incurrence of expenses, 40% of revenue should be recognized in the first year of a service contract. Given that expenses are incurred evenly throughout the year, revenue also will be recognized evenly. Moreover, given that Dunne sold 1,000 contracts evenly throughout the year, total revenue will be $600,000 (1,000 contracts × $600), and the average contract must have been sold at mid-year. Thus, the elapsed time of the average contract must be half a year, and revenue recognized for the year must equal $120,000 ($600,000 total revenue × 40% × .5 year). Deferred revenue (a contract liability) at year end will equal $480,000 ($600,000 – $120,000).
Dunne Co. sells equipment service contracts that cover a 2-year period. The sales price of each contract is $600. Dunne’s past experience is that, of the total dollars spent for repairs on service contracts, 40% is incurred evenly during the first contract year and 60% evenly during the second contract year. Dunne sold 1,000 contracts evenly throughout the year. In its December 31 balance sheet, what amount should Dunne report as deferred service contract revenue?
$480,000.
Revenue should be recognized when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. The good or service is transferred when the customer obtains control of that good or service. Service contract revenue should be recognized over time as the services are provided. An appropriate measure of the entity’s progress to complete satisfaction of the performance obligation also must be selected. Assuming that services are provided in proportion to the incurrence of expenses, 40% of revenue should be recognized in the first year of a service contract. Given that expenses are incurred evenly throughout the year, revenue also will be recognized evenly. Moreover, given that Dunne sold 1,000 contracts evenly throughout the year, total revenue will be $600,000 (1,000 contracts × $600), and the average contract must have been sold at mid-year. Thus, the elapsed time of the average contract must be half a year, and revenue recognized for the year must equal $120,000 ($600,000 total revenue × 40% × .5 year). Deferred revenue (a contract liability) at year end will equal $480,000 ($600,000 – $120,000).
Oak Co. offers a standard 3-year warranty against manufacturing defects on its products. Oak previously estimated warranty costs to be 2% of sales. Due to a technological advance in production at the beginning of Year 4, Oak now believes 1% of sales to be a better estimate of warranty costs. Warranty costs of $80,000 and $96,000 were reported in Year 2 and Year 3, respectively. Sales for Year 4 were $5 million. What amount should be disclosed in Oak’s Year 4 financial statements as warranty expense?
$50,000.
An assurance-type warranty creates a loss contingency. The change affects only Year 4 sales. No change in the previously recorded estimates is necessary. Thus, the debit to warranty expense is $50,000 ($5,000,000 sales × 1%). Estimated liability under warranties is credited for $50,000.
For the year ended December 31, Tyre Co. reported pretax financial statement income of $750,000. Its taxable income was $650,000. The difference is due to accelerated depreciation for income tax purposes. Tyre’s effective income tax rate is 30%, and Tyre made estimated tax payments during the year of $90,000. What amount should Tyre report as current income tax expense for the year?
$195,000.
Current income tax expense equals taxable income for the year times the applicable enacted rate, or $195,000 ($650,000 × 30%).
Orlean Co., a cash-basis taxpayer, prepares accrual-basis financial statements. In its current-year balance sheet, Orlean’s deferred income tax liabilities increased compared with those reported for the prior year. Which of the following changes would cause this increase in deferred income tax liabilities?
I. An increase in prepaid insurance
II. An increase in rent receivable
III. An increase in warranty obligations
I & II only.
An increase in prepaid insurance signifies the recognition of a deduction on the tax return of a cash-basis taxpayer but not in the accrual-basis financial statements. The result is a temporary difference giving rise to taxable amounts in future years when the reported amount of the asset is recovered. An increase in rent receivable involves recognition of revenue in the accrual-basis financial statements but not in the tax return of a cash-basis taxpayer. This temporary difference also will result in future taxable amounts when the asset is recovered. A deferred tax liability records the tax consequences of taxable temporary differences. Hence, these transactions increase deferred tax liabilities. An increase in warranty obligations is a noncash expense recognized in accrual-basis financial statements but not on a modified-cash-basis tax return. The result is a deductible temporary difference and an increase in a deferred tax asset.
Ajax Corp. has an effective tax rate of 30%. On January 1, Year 1, 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 1 by using the 150% declining balance method of depreciation for tax purposes instead of the straight-line method?
$1,500.
The straight-line rate is 10% ($100,000 ÷ 10 years). Assuming no salvage value, straight-line depreciation is $10,000 ($100,000 × 10%). Declining-balance depreciation at 150% of the straight-line rate is $15,000 [$100,000 × (10% × 150%)]. Consequently, depreciation expense is $10,000, the tax deduction is $15,000, and the realized current tax benefit of using the 150% declining balance method of depreciation for tax purposes instead of the straight-line method is $1,500 [($15,000 – $10,000) × 30% tax rate].
