Chapter 19: Income Taxes

Question 1

———————– Background ————————–
Garland Company had:

• Revenue of $102,000 this year, including $2,000 of
  municipal bond interest
• Purchased an asset for $20,000 which it expensed and
  deducted for tax purposes but capitalized for book
  purposes.
• Book depreciation was $5,000. Depreciation is the
  only expense incurred by Garland.
• Garland’s tax rate is 21%.

———————– Question —————————-
Compute Garland’s book income

Answer 1

Book income:

$102,000 – 5,000 depreciation = $97,000 book income

Question 2

———————– Background ————————–
Garland Company had:

• Revenue of $102,000 this year, including $2,000 of
  municipal bond interest
• Purchased an asset for $20,000 which it expensed and
  deducted for tax purposes but capitalized for book
  purposes.
• Book depreciation was $5,000. Depreciation is the
  only expense incurred by Garland.
• Garland’s tax rate is 21%.

———————– Question —————————-
Compute Garland’s taxable income

Answer 2

Taxable income:
= 102,000 – 2,000 municipal bond income – 20,000 depreciation
= $80,000 taxable income

Question 3

———————– Background ————————–
Garland Company had:

• Revenue of $102,000 this year, including $2,000 of
  municipal bond interest
• Purchased an asset for $20,000 which it expensed and
  deducted for tax purposes but capitalized for book
  purposes.
• Book depreciation was $5,000. Depreciation is the
  only expense incurred by Garland.
• Garland’s tax rate is 21%.

———————– Question —————————-
Compute Garland’s income tax expense?

Answer 3

Income tax expense:
= 97,000 book income – 2,000 favorable permanent difference

= 95,000 book expense on which tax is calculated
Income tax expense: 95,000 x 21% = $19,950

Question 4

———————– Background ————————–
Garland Company had:

• Revenue of $102,000 this year, including $2,000 of
  municipal bond interest
• Purchased an asset for $20,000 which it expensed and
  deducted for tax purposes but capitalized for book
  purposes.
• Book depreciation was $5,000. Depreciation is the
  only expense incurred by Garland.
• Garland’s tax rate is 21%.

———————– Question —————————-
Compute Garland’s Tax payable?

Answer 4

Tax payable:

21% x 80,000 = $16,800

Question 5

———————– Background ————————–
Garland Company had:

• Revenue of $102,000 this year, including $2,000 of
  municipal bond interest
• Purchased an asset for $20,000 which it expensed and
  deducted for tax purposes but capitalized for book
  purposes.
• Book depreciation was $5,000. Depreciation is the
  only expense incurred by Garland.
• Garland’s tax rate is 21%.

———————– Question —————————-
Compute Garland’s change to deferred tax accounts.

Answer 5

Change in deferred tax account:
19,950 – 16,800 = 3,150 increase in deferred tax liability
Tax expense in excess of tax liability – accelerated depreciation allows us to defer paying taxes to a later period

Question 6

What are temporary book-tax differences?

Answer 6

Temporary differences: occur when income/ expenses are accounted for in a different year for book purposes than for tax purposes.

Question 7

What are examples of items that create temporary book-tax differences?

Answer 7

Examples (this list is not comprehensive):
• Depreciation and amortization
• Receipt of prepaid income
• Accrued expenses
• Bad debts
• Start-up costs
• Goodwill
• Net operating losses
• Interest expense in excess of limitations

Question 8

What are permanent book-tax differences?

Answer 8

Permanent differences: revenue and expenses recognized on the financial statements but never recognized on the tax return (or vice versa).

Question 9

What are examples of items that create permanent book-tax differences?

Answer 9

Examples (this list is not comprehensive):
• Tax-exempt interest on state and local bonds
• Key-person life insurance premiums and proceeds
• Nondeductible meals and entertainment
• Political contributions
• Fines and penalties
• Dividend received deduction

Question 10

——————— Background Information ——————-
On 12/2/2021:
Heard Company, an accrual basis, calendar year taxpayer, receives a $12,000 prepayment of four months’ rent from a tenant.

Rent was for December of 2021 and January
through March of 2022.

—————————-Question—————————————–
Considering only this prepayment, what does Heard Company report as income on its financial statements for 2021? For 2022?

Answer 10

2021: $3,000 rental income (December rent)
$9,000 is a liability (advance from tenants)
2022: $9,000 rental income (January through March rent)

Question 11

——————— Background Information ——————-
On 12/2/2021:
Heard Company, an accrual basis, calendar year taxpayer, receives a $12,000 prepayment of four months’ rent from a tenant.

Rent was for December of 2021 and January
through March of 2022.

—————————-Question—————————————–
Considering only this prepayment, what does Heard Company report as taxable income for 2021? For 2022?

Answer 11

2021: $12,000 taxable income

2022: $0 taxable income

Question 12

——————— Background Information ——————-
On 12/2/2021:
Heard Company, an accrual basis, calendar year taxpayer, receives a $12,000 prepayment of four months’ rent from a tenant.

Rent was for December of 2021 and January
through March of 2022.

—————————-Question—————————————–
Considering only this prepayment, what does Heard Company report in 2021 with respect to taxes, considering a 20% tax rate?

Answer 12

Dr. Income tax expense 600 = 20% x 3,000

Dr. Deferred tax asset 1,800 = 20% x 9,000 deferred book inc

Cr. Income tax payable 2,400 = 20% x 12,000

Question 13

——————— Background Information ——————-
On 12/2/2021:
Heard Company, an accrual basis, calendar year taxpayer, receives a $12,000 prepayment of four months’ rent from a tenant.

Rent was for December of 2021 and January
through March of 2022.

—————————-Question—————————————–
Considering only this prepayment, what does Heard Company report in 2022 with respect to taxes, considering a 20% tax rate?

Answer 13

Dr. Income tax expense 1,800 = 20% x 9,000

Cr. Deferred tax asset 1,800 = 20% x 9,000

Question 14

——————— Background Information ——————-
Wyatt Enterprises sells a high-tech football that will never be dropped or turned over.

The company offers a three-year warranty on the product and estimates warranty costs using the percentage of sales method, estimating that 8% of sales revenue will be spent to satisfy warranty claims.

This year, sales totaled $640,000 and total expenditures for warranty claims totaled $62,000.

Wyatt reported pretax book income of $132,000.

—————————-Question—————————————–
What is taxable income?

Answer 14

What is taxable income?
 Pretax book income 132,000
 Add back warranty expense 51,200
 Subtract tax deduction (62,000)
 Taxable income 121,200

Question 15

——————— Background Information ——————-
Wyatt Enterprises sells a high-tech football that will never be dropped or turned over.

The company offers a three-year warranty on the product and estimates warranty costs using the percentage of sales method, estimating that 8% of sales revenue will be spent to satisfy warranty claims.

This year, sales totaled $640,000 and total expenditures for warranty claims totaled $62,000.

Wyatt reported pretax book income of $132,000.

—————————-Question—————————————–
First, what is the warranty expense for book purposes?

Answer 15

8% x 640,000 = 51,200

Question 16

——————— Background Information ——————-
Wyatt Enterprises sells a high-tech football that will never be dropped or turned over.

The company offers a three-year warranty on the product and estimates warranty costs using the percentage of sales method, estimating that 8% of sales revenue will be spent to satisfy warranty claims.

This year, sales totaled $640,000 and total expenditures for warranty claims totaled $62,000.

Wyatt reported pretax book income of $132,000.

—————————-Question—————————————–

Assuming a 20% tax rate, how would we record income tax expense?

Answer 16

Dr Income tax expense 26,400 = 20% of 132,000
Cr. Deferred tax asset 2,160 EWL account shrunk
Cr. Income tax payable 24,240 = 20% of 121,200

Question 17

——————— Background Information ——————-
Gee Designs uses an aging of accounts method to estimate uncollectibles for financial reporting
purposes.

At the start of 2021, the aging of accounts estimates an Allowance for Uncollectibles balance of $120,000.

At the end of 2021, the aging analysis reveals a balance of $130,000.

During the year, Gee Designs received bankruptcy notices for several clients whose balances totaled $60,000.

Reported pretax net income for the period was $420,000. The only book-tax difference is related to bad debt.

—————————-Question—————————————
What is the taxable income for the period, assuming this
information represents the only book-tax difference?

Answer 17

First, what is the amount of the bad debt expense?
Hint: Draw a T-account
= 130,000 – 120,000 + 60,000 = $70,000
T-account for allowance. BB – credit of $120,000 and EB – credit of $130,000. Write-off would
be a debit of $60,000 (we debit allowance and credit gross A/R).

What is taxable income?
 Pretax book income $420,000
 Add back bad debt expense 70,000
 Subtract bad debt deduction (60,000)
 Taxable income $430,000

Question 18

——————— Background Information ——————-
Gee Designs uses an aging of accounts method to estimate uncollectibles for financial reporting
purposes.

At the start of 2021, the aging of accounts estimates an Allowance for Uncollectibles balance of $120,000.

At the end of 2021, the aging analysis reveals a balance of $130,000.

During the year, Gee Designs received bankruptcy notices for several clients whose balances totaled $60,000.

Reported pretax net income for the period was $420,000. The only book-tax difference is related to bad debt.

—————————-Question—————————————
Assuming a 20% tax rate, how would we record income tax expense?

Answer 18

Dr. Income tax expense 84,000 = 20% of 420k
Dr. DTA 2,000 = 20% of (70k-60k)
Cr. Income tax payable 86,000 = 20% of 430k

Question 19

——————— Background Information ——————-
A company should reduce its deferred tax asset account by a valuation allowance if, based on available evidence, it is more likely than not that it will not realize some portion of the deferred tax asset.

At the end of 2021, after updating the deferred tax accounts, Diermeier Corporation has a deferred tax asset balance of $300,000.

After a review of the account, the CFO determines that it
is more likely than not that Diermeier will not realize $72,000 of the deferred tax asset.

How does Diermeier record this reduction in asset value?

—————————-Question—————————————
[Q1] How does Diermeier record this reduction in asset value?

At the end of 2022, the CFO of Diermeier again analyzes the deferred tax asset account, which has remained unchanged during the period. After careful analysis, the CFO determines that it is more likely than not that Diermeier will not realize $58,000 of the deferred tax asset.

[Q2] How does Diermeier adjust the valuation allowance?

Answer 19

——————————— [Q1] ————————————-
Dr. Income tax expense 72,000
Cr. Valuation Allowance for DTA 72,000

On its financial statements, Diermeier would then report:

Deferred tax asset 300,000
Valuation allowance (72,000)
DTA, net 228,000

——————————— [Q2] ————————————-
Dr. Valuation Allowance for DTA 14,000
Cr. Income tax expense 14,000

Question 20

——————— Background Information ——————-
Carmichael Enterprises has depreciable assets, the depreciation of which has contributed to a
book-tax difference.

The net PPE for these assets reported on the balance sheet is $1,200,000.

The remaining tax basis for these assets is $675,000. The tax rate has been 20%, but newly enacted law changes the tax rate to 25% going forward.

—————————-Question—————————————
[Q1] How does Carmichael adjust the deferred tax account?

[Q2] What was the DTL balance before the tax rate change?

[Q3] What will the DTL balance be after the tax rate change?

Answer 20

——————————— [Q1] ————————————-
Book value of depreciable assets 1,200,000
Tax basis of depreciable assets (675,000)
Cumulative difference 525,000

Accelerated depreciation gives rise to a DTL on the financial statements because the depreciation is taken earlier on the tax return than it is on the income statement.

——————————— [Q2] ————————————-
What was the DTL balance before the tax rate change?
20% x 525,000 = 105,000

——————————— [Q3] ————————————-
What will the DTL balance be after the tax rate change?
25% of 525,000 = 131,250

We need to record an increase of 26,250 in the DTL account.

Dr. Income Tax Expense 26,250
Cr. DTL 26,250