Chapter 16, Problem 16.8P

Multiple differences; taxable income given; two years; balance sheet classification; change in tax rate

• LO16–4, LO16–6, LO16–8

Arndt, Inc., reported the following for 2018 and 2019 ($ in millions):

	2018	2019
Revenues	$888	$983
Expenses	760	800
Pretax accounting income (income statement)	$128	$183
Taxable income (tax return)	$120	$200
Tax rate: 40%

a. Expenses each year include $30 million from a two-year casualty insurance policy purchased in 2018 for $60 million. The cost is tax deductible in 2018.

b. Expenses include $2 million insurance premiums each year for life insurance on key executives.

c. Arndt sells one-year subscriptions to a weekly journal. Subscription sales collected and taxable in 2018 and 2019 were $33 million and $35 million, respectively. Subscriptions included in 2018 and 2019 financial reporting revenues were $25 million ($10 million collected in 2017 but not recognized as revenue until 2018) and $33 million, respectively. Hint: View this as two temporary differences—one reversing in 2018; one originating in 2018.

d. 2018 expenses included a $17 million unrealized loss from reducing investments (classified as trading securities) to fair value. The investments were sold in 2019.

e. During 2017, accounting income included an estimated loss of $5 million from having accrued a loss contingency. The loss was paid in 2018, at which time it is tax deductible.

f. At January 1, 2018, Arndt had a deferred tax asset of $6 million and no deferred tax liability.

Required:

1. Which of the five differences described are temporary and which are permanent differences? Why?

2. Prepare a schedule that (a) reconciles the difference between pretax accounting income and taxable income and (b) determines the amounts necessary to record income taxes for 2018. Prepare the appropriate journal entry.

3. Show how any 2018 deferred tax amounts should be classified and reported on the 2018 balance sheet.

4. Prepare a schedule that (a) reconciles the difference between pretax accounting income and taxable income and (b) determines the amounts necessary to record income taxes for 2019. Prepare the appropriate journal entry.

5. Explain how any 2019 deferred tax amounts should be classified and reported on the 2019 balance sheet.

6. Suppose that during 2019, tax legislation was passed that will lower Arndt’s effective tax rate to 35% beginning in 2020. Repeat requirement 4.

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 explain: The described differences

Explanation of Solution

Among the five described differences, only the life insurance premium expense is a permanent difference each year as it has been stated in the income statement and is not tax deductible in any year; whereas all other described differences are temporary differences which can be reversed.

To determine

To prepare: The appropriate journal entry, a schedule that, reconciles the difference between pre-tax accounting income and taxable income and determines the amounts necessary to record income taxes for 2018.

Explanation of Solution

Determine the amount of income tax payable and deferred tax liability:

	Current Year	Future Taxable Amount	Future Deductible Amount
(All Amounts are in $ Millions)
	2018	2019	2019
Pretax accounting income	128
Permanent Difference:
Life Insurance Premiums	2
Temporary Difference:
Casualty insurance expense	(30)	30
Subscriptions (2017) (Reversing)	(10) (1)
Subscription (2018)	18 (1)		18
Unrealized loss	17		17
Loss contingency	(5)
Taxable income (tax return)	120
		30	35
Enacted tax rate	$\times$ 40%	$\times$ 40%	$\times$ 40%
Income Tax Payable	48 (4)
Deferred Tax Liability		12
Deferred Tax Assets			14

Table (1)

Determine desired balance of deferred tax liability and deferred tax asset:

	Deferred Tax Liability	Deferred Tax Assets
Ending balance (current balance needed)	$0	$8
Less: Beginning balance	$(12)	(14)
Change needed to achieve desired balance	$(12)	$(6)

Table (2)

The journal entry at the end of 2018 to record the income taxes in the books is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2018
		Income Tax Expense (5)		52
		Deferred Tax Asset (3)		8
		Deferred Tax Liability (2)			12
		Income Tax Payable (4)			48
		(To record income taxes)

Table (3)

Working Notes:

Compute the temporary differences for the subscriptions:

Details	2017	2018	2019
Earned in current year (Reported in income statement)		$25	$33
Collected in prior year, earned in current year (Reversing Difference)		(10)	(18)
Collected in current year, earned in following year (Original Difference) (1)	$(10)	18	20
Collected in current year (Reported on tax return)		$33	$35

Table (4)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax liability}\right)\text{-}\text{Deferred}\text{tax}\text{asset}\\ \text{= }\left(\text{\$48 million + 12 million}\right)\text{-}\text{8}\text{million}\\ \text{=\$52}\text{million}\end{array}$ (5)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $52 million.
• Deferred tax asset is an asset and is increased by 8 million. Therefore, debit deferred tax asset account with $8 million.
• Deferred tax liability is a liability and is increased by $12 million. Therefore, credit deferred tax liability account with $12 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $48 million.

To determine

To explain: How 2018 deferred tax amounts to be classified and shown in the 2018 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.

Here the deferred tax amounts are:

Deferred tax asset = $14 million

Deferred tax liability = $12 million

So, the net non-current deferred tax asset is $2 million $\left[\text{\$14}\text{million}\left(\begin{array}{l}\text{deferred}\\ \text{tax}\text{asset}\end{array}\right)\text{-}\text{\$12}\text{million}\left(\begin{array}{l}\text{deferred}\\ \text{tax}\text{liability}\end{array}\right)\right]$

To determine

To prepare: The appropriate journal entry, a schedule that, reconciles the difference between pre-tax accounting income and taxable income and determines the amounts necessary to record income taxes for 2019.

Explanation of Solution

Determine the amount of income tax payable and deferred tax liability:

	Current Year	Future Taxable Amount	Future Deductible Amount
(All Amounts are in $ Millions)
	2019	2020	2020
Pretax accounting income	183
Permanent Difference:
Life Insurance Premiums	2
Temporary Difference:
Casualty insurance expense	(30)
Subscriptions (2018) (Reversing)	(18)
Subscription (2019)	20		(20)
Unrealized loss (Reversing)	(17)
Taxable income (tax return)	200
		0	(20)
Enacted tax rate	$\times$ 40%	$\times$ 40%	$\times$ 40%
Income Tax Payable	80 (7)
Deferred Tax Liability		0
Deferred Tax Assets			(8)

Table (5)

Determine desired balance of deferred tax liability and deferred tax asset:

	Deferred Tax Liability	Deferred Tax Assets
Ending balance (current balance needed)	$0	$8
Less: Beginning balance	$(12)	(14)
Change needed to achieve desired balance	$(12) (8)	$(6) (9)

Table (6)

The journal entry at the end of 2019 to record the income taxes in the books is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2019
		Income Tax Expense (10)		74
		Deferred Tax Liability (8)		12
		Deferred Tax Asset (9)			6
		Income Tax Payable (7)			80
		(To record income taxes)

Table (7)

Working Notes:

Compute the temporary differences for the subscriptions:

Details	2017	2018	2019
Earned in current year (Reported in income statement)		$25	$33
Collected in prior year, earned in current year (Reversing Difference)		(10)	(18)
Collected in current year, earned in following year (Original Difference)	$(10)	18(6)	20(6)
Collected in current year (Reported on tax return)		$33	$35

Table (8)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax asset}\right)\text{-}\text{Deferred}\text{tax}\text{liability}\\ \text{= }\left(\text{\$80 million + 6 million}\right)\text{-}\text{12}\text{million}\\ \text{=\$74}\text{million}\end{array}$ (10)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $74 million.
• Deferred tax liability is a liability and is decreased by 12 million. Therefore, debit deferred tax liability account with $12 million.
• Deferred tax asset is an asset and decreased by $6 million. Therefore, credit deferred tax asset account with $6 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $80 million.

To determine

To explain: How 2019 deferred tax amounts to be classified and shown in the 2019 balance sheet.

Explanation of Solution

The net non-current deferred tax asset is $8 million to be shown in the 2019 balance sheet.

To determine

To prepare: The appropriate journal entry, a schedule that, reconciles the difference between pre-tax accounting income and taxable income and determines the amounts necessary to record income taxes for 2019.

Explanation of Solution

Determine the amount of income tax payable and deferred tax liability:

	Current Year	Future Taxable Amount	Future Deductible Amount
(All Amounts are in $ Millions)
	2019	2020	2020
Pretax accounting income	183
Permanent Difference:
Life Insurance Premiums	2
Temporary Difference:
Casualty insurance expense	(30)
Subscriptions (2016) (Reversing)	(18)
Subscription (2017)	20		(20)
Unrealized loss (Reversing)	(17)
Taxable income (tax return)	200
		0	(20)
Enacted tax rate	$\times$ 40%	$\times$35%	$\times$ 35%
Income Tax Payable	80 (11)
Deferred Tax Liability		0
Deferred Tax Assets			(7)

Table (9)

Determine desired balance of deferred tax liability and deferred tax asset:

	Deferred Tax Liability	Deferred Tax Assets
Ending balance (current balance needed)	$0	$7
Less: Beginning balance	$(12)	(14)
Change needed to achieve desired balance	$(12) (12)	$(7) (13)

Table (10)

The journal entry at the end of 2019 to record the income taxes in the books is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2019
		Income Tax Expense (14)		75
		Deferred Tax Liability (12)		12
		Deferred Tax Asset (13)			7
		Income Tax Payable (11)			80
		(To record income taxes)

Table (11)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax asset}\right)\text{-}\text{Deferred}\text{tax}\text{liability}\\ \text{= }\left(\text{\$80 million + 7 million}\right)\text{-}\text{12}\text{million}\\ \text{=\$75}\text{million}\end{array}$ (14)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $75 million.
• Deferred tax liability is a liability and is decreased by 12 million. Therefore, debit deferred tax liability account with $12 million.
• Deferred tax asset is an asset and decreased by $7 million. Therefore, credit deferred tax asset account with $7 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $80 million.