Chapter 16, Problem 16.5P

Change in tax rate; record taxes for four years

• LO16–1, LO16–4, LO16–5

The DeVille Company reported pretax accounting income on its income statement as follows:

2018	$350,000
2019	270,000
2020	340,000
2021	380,000

Included in the income of 2018 was an installment sale of property in the amount of $50,000. However, for tax purposes, DeVille reported the income in the year cash was collected. Cash collected on the installment sale was $20,000 in 2019, $25,000 in 2020, and $5,000 in 2021.

Included in the 2020 income was $15,000 interest from investments in municipal bonds.

The enacted tax rate for 2018 and 2019 was 30%, but during 2019, new tax legislation was passed reducing the tax rate to 25% for the years 2020 and beyond.

Required:

Prepare the year-end journal entries to record income taxes for the years 2018–2021.

To determine

Temporary Difference

Temporary difference refers to the difference of one income recognized by the tax rules and accounting rules of a company in different periods. Consequently the difference between the amount of assets and liabilities reported in the financial reports and the amount of assets and liabilities as per the company’s tax records, is known as temporary difference.

Deferred Tax

Deferred tax is an amount i.e. computed on the basis of tax liability on the income as per income statement and the income as per tax return, that difference is known as deferred tax. Deferred tax amount is deferred to the next financial year.

Deferred tax asset

When the Income Tax Expense account is more than the Income Tax Payable account, this difference is known as Deferred Tax Asset.

Deferred tax liability

When the Income Tax Expense account is less than the Income Tax Payable account, this difference is known as Deferred Tax Liability.

To prepare: The journal entry to record the income taxes in 2018 assuming no difference between accounting and taxable income.

Explanation of Solution

The journal entry to record income taxes for 2018 is as follows:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2018	Income Tax Expense (9)		105,000
	Deferred Tax Liability (5)			15,000
	Income Tax Payable (1)			90,000
	(To record the income tax in 2018)

Table (1)

Compute income tax expense amount.

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax liability}\right)\\ \text{= \$90,000 + \$15,000}\\ \text{=\$105,000 }\end{array}$ (9)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $105,000.
• Deferred tax liability is a liability and is increased by $15,000. Therefore, credit deferred tax liability account with $15,000.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $90,000.

The journal entry to record income taxes for 2019 is as follows:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2019	Income Tax Expense (10)		79,500
	Deferred Tax Liability (6)		7,500
	Income Tax Payable (2)			87,000
	(To record the income tax in 2019)

Table (2)

Compute income tax expense amount.

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable -}\text{Deferred tax liability}\right)\\ \text{= \$87,000 - \$7,500}\\ \text{=\$79,500}\end{array}$ (10)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $79,500.
• Deferred tax liability is a liability and is decreased by $7,500 million. Therefore, debit deferred tax liability account with $7,500.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $87,000.

The journal entry to record income taxes for 2020 is as follows:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2020	Income Tax Expense (11)		81,250
	Deferred Tax Liability (7)		6,250
	Income Tax Payable (3)			87,500
	(To record the income tax in 2020)

Table (3)

Compute income tax expense amount.

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable -}\text{Deferred tax liability}\right)\\ \text{= \$87,500 - \$6,250}\\ \text{=\$81,250}\end{array}$ (11)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $81,250.
• Deferred tax liability is a liability and is decreased by $6,250. Therefore, debit deferred tax liability account with $6,250.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $87,500.

The journal entry to record income taxes for 2021 is as follows:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2021	Income Tax Expense (12)		95,000
	Deferred Tax Liability (8)		1,250
	Income Tax Payable (4)			96,250
	(To record the income tax in 2021)

Table (4)

Compute income tax expense amount.

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable -}\text{Deferred tax liability}\right)\\ \text{= \$96,250 - \$1,250}\\ \text{=\$95,000}\end{array}$ (12)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $95,000.
• Deferred tax liability is a liability and is decreased by $1,250. Therefore, debit deferred tax liability account with $1,250.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $96,250.

Working Notes:

The following table shows the taxable income and income tax payable for the year 2018 to 2021

Particulars	2018	2019	2020	2021
Pretax accounting income	$350,000	$270,00	$340,000	$380,000
Installment sale	(50,000)	20,000	25,000	5,000
Municipal bond interest	_______	_______	(15,000)	_______
Taxable income (tax return)	$300,000	$290,000	$350,000	$385,000
$\times$ Tax rate	30%	30%	25%	25%
Income tax payable	$90,000(1)	$87,000(2)	$87,500(3)	$96,250(4)

Table (5)

Calculate the amount of temporary difference of installment sale (Deferred tax liability) for the year 2018 to 2021.

Temporary difference:	2018	2019	2020	2021		Cumulative temporary difference
	(50,000)	20,000	25,000	5,000	=	0
2018		20,000	25,000	5,000		50,000
2019			25,000	5,000		30,000
2020				5,000		5,000
2021						0

Table (6)

Calculate the amount of deferred tax liability to be (debited)/credited in the journal entry.

	2016	2017	2018	2019
Cumulative  temporary difference	$50,000	$30,000	$5,000	$0
$\times$ Tax rate	30%	25%	25%	25%
Year- end balance	$15,000	$7,500	$1,250	0
Less: Previous year balance	0	(15,000)	(7,500)	(1,250)
Deferred tax liability - Credit / (Debit)	$15,000(5)	$ (7,500) (6)	$ (6,250)(7)	$ (1,250) (8)

Table (7)