Chapter 16, Problem 16.6P

1.

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.

Multiple Temporary Difference

It is very unlikely to have a single temporary difference in any company. In that case, the same concept of temporary difference will be applicable for multiple temporary difference. In case of multiple temporary difference, we have to categorize all temporary difference into future taxable amount and future deductible amounts. The total amount of future taxable amounts multiplied by future tax rate will generate deferred tax liability and total amount of future deductible amount multiplied by future tax rate will generate deferred tax asset.

To prepare: The appropriate journal entry to record the income taxes.

Explanation of Solution

The journal entry to record the income taxes in the books is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2016
		Income Tax Expense (4)		16.4
		Deferred Tax Asset (2)		2.4
		Deferred Tax Liability (1)			15.6
		Income Tax Payable (3)			3.2
		(To record income taxes)

Table (1)

Working Notes:

Calculate the value of deferred tax liability

$\begin{array}{c}\text{Deferred}\text{Tax}\text{Liability}\text{=}\text{Future}\text{taxable}\text{amount}\text{×}\text{Tax}\text{Rate}\\ \text{=}\left(\text{Depreciation}\text{+}\text{Prepaid}\text{Insurance}\right)\text{×}\text{Tax}\text{Rate}\\ \text{=}\left(\text{\$30}\text{+}\text{\$9}\right)\text{×}\text{40\%}\\ \text{=\$15}\text{.6}\text{million}\end{array}$ (1)

Calculate the value of deferred tax asset

$\begin{array}{c}\text{Deferred}\text{Tax}\text{Asset}\text{=}\text{Future}\text{taxable}\text{amount}\text{×}\text{Tax}\text{Rate}\\ \text{=}\left(\text{Loss}\text{Contingency}\right)\text{×}\text{Tax}\text{Rate}\\ \text{=}\text{\$6}\text{×}\text{40\%}\\ \text{=\$2}\text{.4}\text{million}\end{array}$ (2)

Calculate the value of income tax payable

$\begin{array}{c}\text{Income}\text{tax}\text{payable}\text{=}\text{Taxable}\text{income}\text{×}\text{Tax}\text{Rate}\\ \text{=}\text{\$8 ×}\text{40\%}\\ \text{=\$3}\text{.2}\text{million}\end{array}$ (3)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax liability}\right)\text{-}\text{Deferred}\text{tax}\text{asset}\\ \text{= }\left(\text{\$3}\text{.2 million + 15}\text{.6 million}\right)\text{-}\text{2}\text{.4}\text{million}\\ \text{=\$16}\text{.4}\text{million}\end{array}$ (4)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $16.4 million.
• Deferred tax asset is an asset and is increased by $2.4 million. Therefore, debit deferred tax asset account with $2.4 million.
• Deferred tax liability is a liability and is increased by $15.6 million. Therefore, credit deferred tax liability account with $15.6 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $3.2 million.

2.

To determine

To show:  how the deferred tax amounts classified in the classified balance sheet

Explanation of Solution

In the balance sheet all deferred tax liabilities, deferred tax assets and valuation allowances are treated as non-current items. If the deferred tax accounts belong to the same tax jurisdictions then, they are netted against each other and shown as a single number (after the adjustments) in the balance sheet. If deferred tax liability amount is more than deferred tax asset, then it will report as a liability. Similarly, it will report as an asset when deferred tax asset is more than deferred tax liability. 

The following table shows the deferred tax liability to be reported in a classified balance sheet.

Related balance sheet account	Classification	Future tax deductible amount	Tax rate	Deferred tax (asset) / Liability
				Current	Non-current
Loss contingency	Non-current	($6)	× 40%		($2.4)
Depreciable assets		30	× 40%		12
Prepaid insurance		9	× 40%	3.6
Net current liability				3.6
Net non-current liability					9.6

Table (2)

3.

To determine

The amount necessary to record income taxes for 2016 and prepare appropriate journal entry to record the income taxes.

Explanation of Solution

Determine the amounts necessary to record income taxes for 2016

	Current Year	Future Taxable (Deductible) Amounts			Deferred Tax
	2016	2017	2018	2019	Liability	Asset
Pretax accounting income	41
Temporary Differences:
Depreciation	(30)		30
Prepaid Insurance	(9)	9
Future Tax rate		40%	35%
Deferred tax liability		3.6	10.5		14.1
Loss Contingency	6		(6)
Future Tax rate			35%
Deferred tax asset			2.1			(2.1)
Taxable Income	8
Tax rate	40%
Income Tax payable	3.2 (5)

Table (3)

Compute deferred tax asset and deferred tax liability amount

	Deferred tax liability (in million)	Deferred tax assets (in million)
Ending balance (current balance needed)	$14.1	$2.1
Less: Beginning balance	$0	$0
Change needed to achieve desired balance	$14.1 (6)	$2.1 (7)

Table (4)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax liability}\right)\text{-}\text{Deferred}\text{tax}\text{asset}\\ \text{= }\left(\text{\$3}\text{.2 million + 14}\text{.1 million}\right)\text{-}\text{2}\text{.1}\text{million}\\ \text{=\$15}\text{.2}\text{million}\end{array}$ (8)

The journal entry to record the income taxes at the end of 2016 is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2016
		Income Tax Expense (8)		15.2
		Deferred Tax Asset (7)		2.1
		Deferred Tax Liability (6)			14.1
		Income Tax Payable (5)			3.2
		(To record income taxes)

Table (5)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $15.2 million.
• Deferred tax asset is an asset and is increased by $2.1 million. Therefore, debit deferred tax asset account with $2.1 million.
• Deferred tax liability is a liability and is increased by $14.1 million. Therefore, credit deferred tax liability account with $14.1 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $3.2 million.

Note:

When a portion of temporary difference is yet to generate in future period, we have to consider only the reversals of temporary difference at balance sheet date e.g., $ 30 for depreciation. Future temporary difference of depreciation has not taken into consideration. We assume that existing difference reverses in the first year after the difference no longer is originating (in this case year 2020). If we consider future originations of temporary difference then the deferred tax liability would be $7.5 million instead of $10.5 million.

	Current Year	Future Taxable (Deductible) Amounts			Total
	2016	2017	2018	2019
Depreciation	(30)	(60)	50	40
Future Tax rate		40%	35%	35%
Deferred tax liability		(24)	17.5	14	7.5

Table (6)