Chapter 18 Questions

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Chapter 18 Questions 1. Explain the difference between pretax financial income and taxable income. Pretax financial income is reported on the income statement and is often referred to as income before income taxes. Taxable income is reported on the tax return and is the amount upon which a company’s income tax payable is computed. 2. What are the two objectives of accounting for income taxes? One objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. A second is to recognize deferred tax liabilities and assets for the future tax consequences of events that have already been recognized in the financial statements or tax returns. 3. Explain the meaning of a temporary difference as it relates to deferred tax computations, and give three examples. A temporary difference is a difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years when the reported amount of the asset is recovered or when the reported amount of the liability is settled. The temporary differences discussed in this chapter all result from differences between taxable income and pretax financial income which will reverse and result in taxable or deductible amounts in future periods. Examples of temporary differences are: (1) Gross profit or gain on installment sales reported for financial reporting purposes at the date of sale and reported in tax returns when later collected. (2) Depreciation for financial reporting purposes is less than that deducted in tax returns in early years of assets’ lives because of using an accelerated depreciation method for tax purposes. (3) Rent and royalties taxed when collected, but deferred for financial reporting purposes and recognized as when the performance obligation is satisfied in later periods. (4) Unrealized gains or losses recognized in income for financial reporting purposes but deferred for tax purposes. 4. Differentiate between an originating temporary difference and a reversing difference. An originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. A reversing difference occurs when a temporary difference that originated in prior periods is eliminated and the related tax effect is removed from the tax account. 5. The book basis of depreciable assets for Erwin Co. is $900,000, and the tax basis is $700,000 at the end of 2026. The enacted tax rate is 17% for all periods. Determine the amount of deferred taxes to be reported on the balance sheet at the end of 2026. Book basis of assets $900,000 Tax basis of assets 700,000 Future taxable amounts 200,000 Tax rate 34% Deferred tax liability (end of 2018) $68,00

6. Roth Inc. has a deferred tax liability of $68,000 at the beginning of 2026. At the end of 2026, it reports accounts receivable on the books at $90,000 and the tax basis at zero (its only temporary difference). If the enacted tax rate is 17% for all periods, and income taxes payable for the period is $230,000, determine the amount of total income tax expense to report for 2026. Book basis of asset $90,000 Deferred tax liability (end of 2018) $ 30,600 Tax basis of asset –0– Deferred tax liability (beginning of 2018) 68,000 Future taxable amounts 90,000 Deferred tax benefit for 2018 (37,400) Tax rate X 34% Income taxes payable for 2018 230,000 Deferred tax liability $30,600 Income tax expense for 2018 $192,600 (end of 2018) 7. What is the difference between a future taxable amount and a future deductible amount? When is it appropriate to record a valuation account for a deferred tax asset? A future taxable amount will increase taxable income relative to pretax financial income in future periods due to temporary differences existing at the balance sheet date. A future deductible amount will decrease taxable income relative to pretax financial income in future periods due to existing temporary differences. A deferred tax asset is recognized for all deductible temporary differences. However, a deferred tax asset should be reduced by a valuation account if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. More likely than not means a level of likelihood that is slightly more than 50%. 8. Pretax financial income for Lake Inc. is $300,000, and its taxable income is $100,000 for 2026. Its only temporary difference at the end of the period relates to a $70,000 difference due to excess depreciation for tax purposes. If the tax rate is 20% for all periods, compute the amount of income tax expense to report in 2026. No deferred income taxes existed at the beginning of the year. Taxable income $100,000 Future taxable amounts $70,000 Tax rate X 40% Tax rate X 40% Income taxes payable $ 40,000 Deferred tax liability (end of 2018) $28,000 Deferred tax liability (end of 2018) $28,000 Current tax expense $40,000 Deferred tax liability (beg of 2018) (–0–) Deferred tax expense 28,000 Deferred tax expense for 2018 $28,000 Income tax expense for 2018 $68,000 9. Feagler Company’s current income taxes payable related to its taxable income for 2025 is $460,000. In addition, Feagler’s deferred tax asset decreased $20,000 during 2025. What is Feagler’s income tax expense for 2025? In this case, the decrease in the deferred tax asset of $20,000 is added to income taxes payable of $460,000 to compute income tax expense of $480,000 for the year.

10. Lee Company’s current income taxes payable related to its taxable income for 2025 is $320,000. In addition, Lee’s deferred tax liability increased $40,000 and its deferred tax asset increased $10,000 during 2025. What is Lee’s income tax expense for 2025? In this case, the increase in the deferred tax liability increased income tax expense by $40,000 and the increase in the deferred tax asset decreased income tax expense by $10,000 Income tax expense for 2017 is therefore $350,000 ($320,000 + $40,000 − $10,000). 11. How are deferred tax assets and deferred tax liabilities reported on the balance sheet? Deferred tax accounts are reported on the balance sheet as assets and liabilities. Companies should classify these accounts as a net noncurrent amount on the balance sheet. That is, deferred tax assets and deferred tax liabilities are separately recognized and measured and are then offset in the balance sheet. The net deferred tax asset or net deferred tax liability is therefore reported in the noncurrent section of the statement of financial position 12. Interest on municipal bonds is referred to as a permanent difference when determining the proper amount to report for deferred taxes. Explain the meaning of permanent differences, and give two other examples. A permanent difference is a difference between taxable income and pretax financial income that, under existing applicable tax laws and regulations, will not be offset by corresponding differences or “turn around” in other periods. Therefore, a permanent difference is caused by an item that: (1) is included in pretax financial income but never in taxable income, or (2) is included in taxable income but never in pretax financial income. Examples of permanent differences are: (1) interest received on municipal obligations (such interest is included in pretax financial income but is not included in taxable income), (2) premiums paid on officers’ life insurance policies in which the company is the beneficiary (such premiums are not allowable expenses for determining taxable income but are expenses for determining pretax financial income), and (3) fines and expenses resulting from a violation of law. Item (3), like item (2), is an expense which is not deductible for tax purposes. 13. At the end of the year, Falabella Co. has pretax financial income of $550,000. Included in the $550,000 is $70,000 interest income on municipal bonds, $25,000 fine for dumping hazardous waste, and depreciation of $60,000. Depreciation for tax purposes is $45,000. Compute income taxes payable, assuming the tax rate is 30% for all periods. Pretax financial income $550,000 Interest income on municipal bonds (70,000) Hazardous waste fine 25,000 Depreciation ($60,000 – $45,000) 15,000 Taxable income 520,000 Tax rate X 30% Income taxes payable $156,000

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14. Addison Co. has one temporary difference at the beginning of 2025 of $500,000. The deferred tax liability established for this amount is $150,000, based on a tax rate of 30%. The temporary difference will provide the following taxable amounts: $100,000 in 2026, $200,000 in 2027, and $200,000 in 2028. If a new tax rate for 2028 of 20% is enacted into law at the end of 2025, what is the journal entry necessary in 2025 (if any) to adjust deferred taxes? $200,000 (2020 taxable amount) 10% (30% – 20%) $20,000 Decrease in deferred tax liability at the end of 2017 Deferred Tax Liability 20,000 Income Tax Expense 20,000 15. What are some of the reasons that the components of income tax expense should be disclosed and a reconciliation between the effective tax rate and the statutory tax rate be provided? Some of the reasons for requiring income tax component disclosures are: (a) Assessment of the quality of earnings. Many investors seeking to assess the quality of a company’s earnings are interested in the reconciliation of pretax financial income to taxable income. Earnings that are enhanced by a favorable tax effect should be examined carefully, particularly if the tax effect is nonrecurring. (b) Better prediction of future cash flows. Examination of the deferred portion of income tax expense provides information as to whether taxes payable are likely to be higher or lower in the future 16. Describe a “loss carryforward.” Discuss the uncertainty when it arises. The loss carryback provision permits a company to carry a net operating loss back two years and receive refunds for income taxes paid in those years. The loss must be applied to the second preceding year first and then to the preceding year. The loss carryforward provision permits a company to carry forward a net operating loss twenty years, offsetting future taxable income. The loss carryback can be accounted for with more certainty because the company knows whether it had taxable income in the past; such is not the case with income in the future. 17. What is the possible treatment for tax purposes of a net operating loss? What is the proper treatment of a net operating loss for financial reporting purposes? The company may choose to carry the net operating loss forward, or carry it back and then forward for tax purposes. To forego the two-year carryback might be advantageous where a taxpayer had tax credit carryovers that might be wiped out and lost because of the carryback of the net operating loss. In addition, tax rates in the future might be higher, and therefore on a present value basis, it is advantageous to carry forward rather than carry back. For financial reporting purposes, the benefits of a net operating loss carryback are recognized in the loss year. The benefits of an operating loss carryforward are recognized as a deferred tax asset in the loss year. If it is more likely than not that the asset will be realized, the tax benefit of the loss is also recognized by a credit to Income Tax Expense on the income statement. Conversely, if it is more likely than not that the loss carryforward will not be realized in future years, then an allowance account is established in the loss year and no tax benefit is recognized on the income statement of the loss year.

18. What controversy relates to the accounting for net operating loss carryforwards? Many believe that future deductible amounts arising from net operating loss carryforwards are different from future deductible amounts arising from normal operations. One rationale provided is that a deferred tax asset arising from normal operations results in a tax prepayment—a prepaid tax asset. In the case of loss carryforwards, no tax prepayment has been made. Others argue that realization of a loss carryforward is less likely—and thus should require a more severe test—than for a net deductible amount arising from normal operations. Some have suggested that the test be changed from “more likely than not” to “probable” realization. Others have indicated that because of the nature of net operating losses, deferred tax assets should never be established for these items. 19. What is an uncertain tax position, and what are the general guidelines for accounting for uncertain tax positions? Uncertain tax positions are tax positions for which the tax authorities may disallow a deduction in whole or in part. Uncertain tax positions often arise when a company takes an aggressive approach in its tax planning, such as instances in which the tax law is unclear or the company may believe that the risk of audit is low. Such positions give rise to tax benefits by either reducing income tax expense or related payables or by increasing an income tax refund receivable or deferred tax asset. In assessing whether an uncertain tax position should be recognized, companies must determine whether a tax position will be sustained upon audit. If the probability is more than 50 percent, the company may reduce its liability or increase its assets. If the probability is less that 50 percent, companies may not record the tax benefit. In determining “more likely than not,” companies must assume that they will be audited by the tax authorities. If the recognition threshold is passed, companies must then estimate the amount to record as an adjustment to its tax assets and liabilities.