FAR: ALL: 4/20/2018

Question 1

Orleans Co., a cash-basis taxpayer, prepares accrual-basis financial statements. Since Year 1, Orleans has applied FASB ASC 740 - Income Taxes. In its Year 3 balance sheet, Orleans’ deferred income- tax liabilities increased compared to Year 2.

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.

1) I only.
2) I and II.
3) II and III.
4) III only.

Answer 1

1 & 11

I. and II. increase the deferred tax liability, but III. does not.

I. 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.

II. 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.

III. 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.

Question 2

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
Yes      Yes
No       Yes
Yes      No
No       No

Answer 2

No, 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.

Question 3

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.

Answer 3

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

Question 4

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.

Answer 4

Unearned service contract revenue.

This answer is incorrect (% of depletion in excess of cost depletion) as percentage depletion in excess of cost depletion will never be recognized on the books and thus represents a permanent difference. Allocation is not required for such differences.