SM ch13

Financial Reporting and Analysis
Chapter 13 Solutions
Income Tax Reporting
Exercises
Exercises
E13-1. Determining current taxes payable
(AICPA adapted)
The amount of current income tax liability that would be reported on Allen
Co.s December 31, 2005, balance sheet is determined as follows:
Net income before depreciation expense and income taxes $100,000
Depreciation expense (for tax purposes) (20,000)
Taxable income 80,000
Tax rate 30 %
Current income tax liability $24,000
E13-2. Determining deferred tax liability
(AICPA adapted)
To determine the deferred income tax liability reported on the December 31,
2006, balance sheet requires a calculation of the cumulative temporary
(timing) differences that give rise to future taxable amounts as of that date.
Gross margin temporary differences are as follows:
(Book purposes) (Tax purposes) Temporary Differences
Year Accrual Method Installment Method (Future Taxable Amount)
2005 $800,000 $300,000 $500,000
2006 1,300,000 700,000 600,000
Total temporary differences as of 12/31/06 $1,100,000
Tax rate in effect when differences will reverse 25 %
Deferred tax liability on 12/31/06 $275,000
13-1
E13-3. Determining deferred tax liability
(AICPA adapted)
Tows deferred tax liability for December 31, 2005, is computed as follows:
Year
Reversal of
Excess Tax
Deduction Enacted Tax Rate Deferred Tax Liability
2006 $50,000 35% $17,500
2007 40,000 35% 14,000
2008 20,000 25% 5,000
2009 10,000 25% 2,500
E13-4. Deferred tax effects on balance sheet
(AICPA adapted)
If the assets financial reporting basis exceeds its tax basis, it means that the
depreciation for tax purposes has been higher than depreciation for book
purposes. A taxable temporary difference and a deferred tax liability are the
result. Since the difference will reverse in future years when the enacted tax
rate is 40%, Noor should record a deferred tax liability of
Temporary depreciation difference $250,000
Tax rate when difference will reverse 40%
E13-5. Deferred tax effects on long-term contracts
(AICPA adapted)
Since income recognized for tax purposes exceeds the income recognized for
book purposes, Mill has cumulative temporary differences that result in future
deductible amounts giving rise to a deferred tax asset computed as follows:
Year
(Tax purposes)
Percentage-of-
completion
(Book purposes)
Completed
Contract
Temporary Difference
Increase (Decrease) in
Future Deductible Amounts
2005 $400,000 $0 $400,000
2006 625,000 375,000 250,000
2007 750,000 850,000 (100,000 )
Cumulative temporary difference on 12/31/2007 $550,000
Tax rate 40 %
Deferred tax asset on December 31, 2007 $220,000
13-2
E13-6. Determining current portion of tax expense
(AICPA adapted)
Requirement 1:
The current portion of tax expense is the tax payable to the IRS for 2005.
Taxable income $650,000
Tax rate 30%
Current portion of tax expense $195,000
Requirement 2:
Deferred portion of tax expense is determined by the depreciation timing
differences during the year.
Depreciation timing difference in 2005 ($750,000 - $650,000) $100,000
Tax rate 30%
Deferred portion of tax expense $30,000
Requirement 3:
Journal entry to record tax expense for 2005.
DR Tax expensecurrent ($650,000 x 30%) $195,000
DR Tax expensedeferred ($100,000 x 30%) 30,000
CR Deferred tax liability $30,000
CR Prepaid estimated tax payments* 90,000
CR Taxes payable ($195,000 - $90,000) 105,000
*This credit assumes the following entry was made when Tyre made its estimated tax
payment during 2005:
DR Prepaid estimated tax payments $90,000
CR Cash $90,000

E13-7. Determining current taxes payable
(AICPA adapted)
The calculation of the current income tax liability of Dunn Co. for the
December 31, 2005, balance sheet is as follows:
Pre-tax income (per books) $90,000
Adjustments for permanent differences:
- Interest on municipal bonds (20,000)
Adjustments for temporary differences:
+ Rent received in advance 16,000
- Excess of tax depreciation over book depreciation (10,000)
Tax rate 35 %
Current income tax liability on 12/31/05 $26,600
13-3
E13-8. Determining deferred tax liability and current portion of tax expense
(AICPA adapted)
Requirement 1:
Deferred tax liability on December 31, 2005
Cumulative temporary difference on 12/31/05 $20,000
Enacted tax rate when temporary differences will reverse 40 %
Deferred tax liability on 12/31/05 $ 8,000
Requirement 2:
Current portion of 2005 tax expense
Taxable income for 2005 $129,000
Enacted tax rate 40%
Current portion of tax expense in 2005 $ 51,600
E13-9. Determining deferred tax asset amounts
(AICPA adapted)
Rent revenue for tax purposes (total received in 2005) $36,000
Rent revenue earned in 2005 (1/2 x $36,000) (18,000)
Temporary difference (future deductible amount) $18,000
Enacted tax rate when temporary difference will reverse 40 %
Deferred tax asset on December 31, 2005 $ 7,200
E13-10. Determining deferred tax asset amounts
(AICPA adapted)
The warranty temporary differences give rise to future deductible amounts
and a deferred tax asset for Black Co. on December 31, 2005, computed as
follows:
Year
Reversal of Warranty
Temporary Difference
Enacted
Tax Rate
Deferred
Tax Asset
2006 $100,000 30% $30,000
2007 50,000 30% 15,000
2008 50,000 30% 15,000
2009 100,000 25% 25,000
Deferred tax asset on 12/31/05 $85,000
13-4
E13-11. Deferred portion of tax expense
(AICPA adapted)
To determine the deferred portion of Quinns 2006 income tax expense
requires the amount of temporary differences created in 2006 ($100,000
given) and the enacted (statutory) tax rate for 2006. Since the only
difference between pre-tax (book) income and taxable income is the
$100,000 temporary difference, this implies that the statutory (enacted) tax
rate is the same as Quinns effective (book) tax rate (since there are no
permanent differences). Thus, the deferred portion of the 2006 tax expense
is calculated as follows:
Temporary differences in 2006 $100,000
Enacted (statutory) tax rate 30 %
Deferred portion of 2006 tax expense $ 30,000
E13-12. Temporary and permanent differences
(AICPA adapted)
Taras equity in Flaxs 2005 earnings
40% x $750,000 = $300,000
- Taras share of Flaxs 2005 dividend distribution
40% x $250,000 = (100,000)
Taras share of Flaxs undistributed earnings $200,000
Less: 80% that will never be taxed (160,000)
Undistributed earnings that will be taxed in the
future when distributed as dividends (future
taxable amount) 40,000
Enacted tax rate in the future 25 %
Increase in deferred tax liability for 2005 $ 10,000
E13-13. Loss carrybacks and carryforwards
(AICPA adapted)
Requirement 1:
Tax benefit due to NOL carryback and carryforward is:
Amount of loss carryback $450,000
Amount of loss carryforward 150,000
$600,000
Tax rate 40 %
Total tax benefit reported on 2006 income statement $240,000
13-5
Requirement 2:
Deferred tax asset on December 31, 2006 balance sheet:
Amount of loss carryforward $150,000
Tax rate 40 %
Deferred tax asset $ 60,000
E13-14. Tax effects of loss carryback and carry forward
(AICPA adapted)
Requirement 1:
Tax benefit reported on 2005 income statement
Loss carried back to 2004 $100,000
Loss carried forward to 2006 100,000
Total $200,000
Tax rate 40 %
Tax benefit recognized in 2005 income statement $ 80,000
Requirement 2:
Deferred tax asset reported on 12/31/05 balance sheet
Operating loss carryforward $100,000
Tax rate 40 %
Deferred tax asset reported on 12/31/05
balance sheet $ 40,000
Requirement 3:
Amount reported as current taxes payable in 2006
Taxable income in 2006 $400,000
Less: Operating loss carryforward (100,000)
Taxable income after adjustment $300,000
Tax rate 40 %
Current taxes payable on 12/31/06 balance sheet $120,000
Entry to record taxes on 12/31/06: (not required)
DR Tax expense (40% x $400,000) $160,000
CR Deferred tax asset (40% x $100,000) $40,000
CR Current taxes payable 120,000
13-6
E13-15. Accounting for loss carryforwards
(AICPA adapted)
Requirement 1:
If the loss occurred in 2005, then the tax benefit reported in the 2005
income statement would be $180,000 x 30% = $54,000. If the loss occurred
prior to 2005, then no tax benefit would be reported in the 2005 income
statement because that benefit would have been recorded as a credit to
income in the year the loss occurred.
Requirement 2:
The additional account that would be debited when the loss carryforward is
recognized would be deferred tax assets for $54,000. The entry would be:
DR Deferred tax asset $54,000
CR Income tax expense (carryforward benefit) $54,000
E13-16.Accounting for loss carrybacks and carryforwards
(AICPA adapted)
Requirement 1:
Calculation of tax benefit and journal entry reported in 2005:
Loss carryback $300,000
Loss carryforward ($700,000 - $300,000) 400,000
Total 700,000
Tax rate 30 %
Tax benefit reported on 2005 income statement $210,000
Journal entry in 2005 to record tax benefit:
DR Deferred tax asset
(30% x $400,000 loss carryforward) $120,000
DR Tax refund receivable
(30% x $300,000 loss carryback) 90,000
CR Income tax expense
(carryback and carryforward benefit) $210,000
Requirement 2:
Amount reported as current income tax liability in 2006:
2006 Taxable income before NOL carryforward $1,200,000
Less: Operating loss carryforward (400,000 )
Taxable income after adjustment $ 800,000
Tax rate 30 %
Current income tax liability in 2006 $ 240,000
13-7
E13-17. Deferred tax asset and valuation allowance
(AICPA adapted)
Future deductible amount from warranty expense
temporary difference $300,000
Tax rate 30 %
Deferred tax asset before adjustment $ 90,000
Less: Valuation allowance (1/3 of $90,000) (30,000)
Deferred tax asset net of valuation allowance $ 60,000
E13-18. Deferred tax asset and valuation allowance
(AICPA adapted)
Tafts equity in Flames earnings $180,000
Less: Dividends received from Flame (30,000 )
Tafts equity in Flames undistributed earnings 150,000
Less: 80% that will never be taxed under dividend
exclusion rule (80% x $150,000) (120,000 )
Undistributed earnings that will be taxed in future
period when distributed as dividends (future
taxable amount) 30,000
Tax rate 30 %
Deferred tax liability reported on 12/31/05 $ 9,000
E13-19. Determining tax expense, taxes payable, and deferred taxes
(CMA adapted)
Requirements 1 and 2:
Calculation of taxable income and taxes payable for 2005:
Pre-tax book income $4,000,000
Adjustment for permanent difference:
Interest income (100,000)
Adjustment for temporary difference:
Rent revenue (80,000)
Taxable income $3,820,000
Tax rate x 40 %
Taxes payable $1,528,000
Requirement 3:
Change in deferred taxes for 2005:
Temporary difference
Rent revenuefuture taxable amount $80,000
Tax rate x 40 %
Increase in deferred tax liability $32,000
13-8
Requirement 4:
Calculation of income tax expense for 2005:
Income tax expense = Taxes payable + Increase in deferred tax liability
= $1,528,000 + $32,000
Income tax expense = $1,560,000
Requirement 5:
Repeat requirements (1)(4) for 2006
Calculation of taxable income and taxes payable for 2006:
Pre-tax book income $5,000,000
Adjustment for permanent difference:
Interest income (100,000)
Adjustment for temporary difference:
Rent revenue 80,000
Taxable income $4,980,000
Tax rate x 40 %
Taxes payable $1,992,000
Change in deferred taxes for 2006:
Reversal of temporary difference originating in 2005
Rent revenue ($80,000)
Tax rate x 40 %
Decrease in deferred tax liability ($32,000)
Income tax expense = Taxes payable - Decrease in deferred tax
liability
= $1,992,000 - $32,000
Income tax expense = $1,960,000
13-9
E13-20. Determining taxes payable, changes in deferred taxes, and tax
expense
Requirement 1:
The calculation of the current income tax liability of Millie Co. at December
31, 2005 is as follows:
Pretax income (per books) $400,000
+ Contingent liability, deductible in 2006 900,000
- Gross profit on installment sales,
taxable in 2006 & 2007 (800,000 )
Tax rate 30 %
Requirement 2:
Changes in deferred taxes for 2005:
Gross profitfuture taxable amount $800,000
Tax rate x 30 %
Contingent liabilityfuture deductible amount $900,000
Tax rate x 30 %
Increase in deferred tax asset $270,000
Requirement 3:
Increase in deferred tax asset
= $138,600 + $240,000 270,000
Income tax expense = $108,600
13-10
Problems
Problems
P13-1. Deferred tax amounts with different tax rates
(AICPA adapted)
Future Taxable
Amounts
Enacted Tax
Rate
Deferred
Tax Liability
2005 $50,000 30% $15,000
2006 75,000 30% 22,500
2007 100,000 25% 25,000
Deferred tax liability reported in 12/31/04
balance sheet
$62,500
P13-2. Temporary and permanent differences and tax entry
Requirement 1:
Calculation of temporary difference:
Income tax expense $52,000
- Income taxes payable (32,000)
Deferred taxes payable $20,000
Amount of temporary difference =
Deferred taxes
Tax rate
Temporary difference due to depreciation =
$20,000
= $50,000
.40
Since tax expense per books is greater than taxes payable per tax return,
taxable income is lower than book income.
13-11
Requirement 2:
Calculation of permanent difference:
Tax expense = Pre-tax book income (excluding permanent difference)
x tax rate
Let X = Pre-tax book income (excluding permanent difference)
$52,000 = .40X
$52,000/.40 = $130,000 = Pre-tax book income (excluding permanent
difference)
Book income (excluding permanent difference) $130,000
Book income before taxes (given) (106,000 )
Permanent difference $ 24,000
Book income will be lower than taxable income because of this permanent
difference.
Requirement 3:
Journal entry to record tax expense for year:
DR Tax expense (given) $52,000
CR Taxes payable (given) $32,000
CR Deferred taxes payable (see Req. 1) 20,000
Requirement 4:
Effective tax rate = Tax expense/Pre-tax book income
= $52,000/$106,000
Effective tax rate = 49.1%
The effective tax rate is higher than the statutory tax rate of 40% because the
goodwill deduction reported on Rameshs books is not deductible for tax
purposes.
P13-3. Deferred tax amount on income statement
(AICPA adapted)
Beginning balance, unearned royalties, 1/1/05 $400,000
Additional royalties received in 2005 600,000
Less: Unearned royalties on 12/31/05 (350,000)
Royalty income recognized for book purposes $650,000
Amount recognized for tax purposes:
Royalty collections in 2005 (600,000)
Temporary differences 50,000
Tax rate 50 %
Deferred income tax expense $25,000
13-12
Journal entry to record taxes for 2005 (not required):
DR Income tax expense (50% x $650,000) $325,000
CR Income taxes payable (50% x $600,000) $300,000
CR Deferred tax asset (50% x $50,000) 25,000
P13-4. Current and deferred portion of tax expense
(AICPA adapted)
Requirement 1:
Current provision for 2005 income tax expense is the taxes payable to the
IRS on 2005 income computed as:
Tax rate 35 %
Current provision for income taxes $157,500
Requirement 2:
Determination of deferred income taxes on 2005 income statement:
Construction revenue recorded on tax returns
but not on booksfuture deductible amount $100,000
Excess of accelerated depreciation for tax
over straight-line for booksfuture taxable amount (400,000)
Net future taxable amount (300,000)
35 %
Deferred portion of tax expense (DR) $105,000
Entry to record 2005 tax provision:
DR Tax expense $262,500
CR Taxes payable (current) $157,500
CR Deferred taxes payable 105,000
13-13
P13-5. Tax expense and deferred tax calculations
Requirement 1:
Computation of taxable income and financial reporting income:
2005 2006
Taxable Financial Taxable Financial
Revenue (less other expenses) $500,000 $500,000 $500,000 $500,000
Less:
- Depreciation expense -60,000
1
-45,000
2
- 30,000
1
- 45,000
2
- Goodwill write-off _ ______ _-50,000 _______ -50,000
Net income $440,000 $405,000 $470,000 $405,000
1
SYD method depreciation
2
Straight-line depreciation
2005 = 2/3 x 90,000 = $60,000 $90,000/2 years = $45,000
2006 = 1/3 x 90,000 = $30,000
Requirement 2:
A permanent difference item is a revenue or expense that is recognized for
book purposes but never for tax purposes or recognized for tax purposes but
never for book purposes. That is, GAAP and tax rules permanently differ in
how they recognize the revenue or expense item in question.
Goodwill write-off is an example of a permanent difference item for Nelson.
Other common permanent difference items include Interest on municipal
bonds and premiums paid on officers life insurance.
Temporary differences are revenue or expense items that are recognized in a
different period for book purposes than for tax purposes. GAAP and tax rules
agree that temporary differences are included in income determination, but
differ as to the timing of the recognition.
An example of a temporary difference for Nelson is the excess of sum-of-
years-digits depreciation for tax purposes over straight-line depreciation for
book purposes.
13-14
Requirement 3:
Ending Balance in Ending Balance in
Year Tax Liability Tax Expense Deferred Income Taxes
2005 $440,000 x 0.20 $455,000 x 0.20
= $88,000 = $91,000 $3,000 CR
1
2006 $470,000 x 0.20 $455,000 x 0.20
= $94,000 = $91,000 0
Note: Ignore goodwill write-off when computing tax expense:
1
Temporary depreciation difference = $60,000 - $45,000 = $15,000 x 20% = $3,000
Requirement 4:
Increase/decrease in deferred income taxes:
Change in tax rate x Future taxable amount due to depreciation timing
difference
(.30 - .20) x ($60,000 - $45,000)
= $1,500 increase in deferred tax liability
Journal entry required to accomplish this:
DR Income tax expense $1,500
Income Tax Liability for 2005:
Taxable income x tax rate =
$470,000 x 0.30 = $141,000
Income Tax Expense for 2005:
Pre-tax book income (excluding permanent differences x tax rate =
$455,000 x .30 = $136,500 + $1,500 from change in the tax rate applied
to future taxable amount
= $138,000
13-15
P13-6. Determining current and deferred portion of tax expense and
reconciling statutory and effective tax rates
Requirement 1:
Determining taxes payable:
(in $000)
Taxable income (given) $1,400
Tax rate 35%
Taxes payable $490
Requirement 2:
Change in deferred tax assets (liabilities):
Temporary differences giving rise to future taxable amounts:
Depreciation $800
Enacted tax rate 40%
Increase in deferred tax liability $320
Temporary differences giving rise to future deductible amounts:
Warranty costs* $ 400
Enacted tax rate 40 %
Increase in deferred tax asset 160
Rent received in advance** $ 600
Enacted tax rate applicable
to this temporary difference 35 %
210
Total Increase in deferred tax assets $ 370
*These costs will not be deductible for tax purposes until future periods when
the enacted tax rate will be 40%.
**Since this represents cash received in the current year that is taxed in the
current year, it is subject to the current years 75% tax rate.
Requirement 3:
Tax expense for 2005:
Tax expense = Taxes payable + Increase in deferred tax liability - Increase in
deferred tax asset
$440 = $490 + $320 - $370
13-16
Requirement 4:
Reconciliation of statutory and effective tax rates (amounts):
Effective (book) tax rate =

Tax expense (Req. 3)
Pre-tax income (given)
=
$440
$1,000
=44%
Percentage
of Pre-Tax
Amount Income
Expected tax expense at statutory rate
(35% x $1,000) $350 35%
Effect of permanent differences
Write-off of goodwill (35% x $400) 140 + 14
Interest on municipal bonds (35% x $200) (70) - 7
Effect of higher tax rates on temporary differences
Depreciation (5% x $800) 40 + 4
Warranty costs (5% x $400) (20 ) - 2
Effective tax rate ($440/$1,000) $440 44 %
P13-7. Entries for loss carrybacks and carryforwards
Requirement 1:
Smith Corporation will offset the 2008 loss against the 2006 income and a
portion of the income of year 2007 until the entire loss of $350,000 is fully
offset. Note that the income prior to 2006 is beyond the allowable 2-year
period.
Using the 2-year carryback rule, Smith Corporation will calculate its income
tax refund as follows:
Taxable Tax Tax Income
Year Income Rate Refund Remaining
2006 $250,000 35% $87,500 -
2007 _100,000 32% __32,000 $300,000
$350,000 $119,500
The tax refund is calculated using the tax rates prevailing in the respective
carryback years. Since the entire 2008 net loss is offset against past income
using the carryback provision, the income tax benefit will be identical to
income tax refund receivable. Consequently, the following journal entry will be
recorded in 2008:
13-17
Entry for 12/31/08:
DR Income tax refund receivable $119,500
CR Income tax expense or benefit $119,500
Note that the effective tax benefit rate during 2008 is 34.14%
($119,500/$350,000), which is more than the 2008 statutory tax rate of 30%.
This is because the carryback provision allows companies to obtain the tax
benefit based on the tax rates prevailing in the carryback years (i.e., 2006
and 2007).
Smith Corporation will offset the entire loss for the year 2009 against the
remaining income from 2007. Using the 2-year carryback rule, Smith
Corporation will calculate its income tax refund as follows:
2007 $275,000 32% $88,000 $25,000
$275,000 $88,000
The tax refund is calculated using the tax rate prevailing in the carryback
year. Since the entire 2009 net loss is offset against past income using the
carryback provision, the income tax benefit will be identical to income tax
refund receivable. Consequently, the following journal entry will be recorded
in 2009:
Entry for 12/31/09:
The effective tax benefit rate during 2009 is 32% ($88,000/$275,000), which
is more than the 2009 statutory tax rate of 30%. This is because the
carryback provision allows companies to obtain the tax benefit based on the
tax rates prevailing in the carryback years (i.e., 2007).
Smith Corporation will offset the 2014 net loss of $800,000 against the past
two years income beginning from 2012. Based on this carryback, Smith
Corporation will be eligible for an income-tax refund, calculated as follows:
2012 $275,000 30% $82,500 -
2013 300,000 35% 105,000 -
$575,000 $187,500
13-18
The following journal entry will be recorded in 2014 to show the income tax
refund:
Entry for 12/31/14:
Note, however, Smith Corporation had earned only $575,000 during the
previous two years. Consequently, the company needs to examine whether a
deferred tax asset should be created for the remaining 2014 loss of $225,000
($800,000 - $575,000). Based on the information in the problem, we create a
deferred tax asset assuming the tax benefits of this loss will be fully realized
at a rate of 35% ($225,000 x 0.35).
Entry for 12/31/14:
Recall that by 2015, Smith Corporation has completely exhausted the
benefits from the loss carryback provision. However, once again based on the
information in the problem, we create a deferred tax asset assuming the tax
benefits of this loss will be fully realized at a rate of 35% ($250,000 x 0.35).
Entry for 12/31/15:
At the end of 2015, the company has loss carryforwards of $475,000 -
$225,000 from 2014 and $250,000 from 2015. Consequently, when Smith
Corporation earned $150,000 net income during 2016, it was able to offset
this income against $150,000 of the 2014 loss carried forward. Without any
tax liability during 2016, the journal entry for the expense reflects the realized
tax benefit from the deferred tax assets ($150,000 x 0.35):
Entry for 12/31/16:
CR Deferred tax asset $52,500
Requirement 2:
In Requirement 2, it is more likely than not that only 40% of the tax benefits
will be realized through loss carryforward. Consequently, we need to create a
valuation allowance for 60% of the tax benefits not expected to be realized.
We do this in two steps. First, we record the journal entry assuming that all
the tax benefits will be realized (as in Requirement 1).
13-19
Entry for 12/31/14:
Next, we create a valuation account to reduce the carrying value of the
deferred tax asset account by 60% ($78,750 x 0.60). The purpose of the
Allowance account is to reduce the carrying value of the deferred tax asset
to net realizable value.
DR Income tax expense or benefit $47,250
CR Valuation allowance $47,250
At the end of 2014, the deferred tax asset will be reported in the balance
sheet as follows:
Tax benefit of loss carryforward $78,750
Less: Valuation allowance (47,250 )
$31,500
The journal entries for 2015 follow the same two steps:
Entry for 12/31/15:
Similar to 2014, we use the valuation account to reduce the carrying value of
the deferred tax asset account by 60% ($87,500 x 0.60).
DR Income tax expense or benefit $52,500
CR Valuation allowance $52,500
At the end of 2015, the deferred tax asset will be reported in the balance
sheet as follows:
Less: Valuation allowance (99,750 )
$66,500
At the end of 2016, the valuation allowance is eliminated since it is more likely
than not that the entire tax benefits will be realized.
13-20
Entry for 12/31/16:
DR Valuation allowance $99,750
As in Requirement 1, the following journal entry is recorded to show the tax
expense on the income of $150,000.
One interesting result is that, although the company reports a positive pre-tax
income for 2016, it reports no income tax expense. In fact, the reversal of the
valuation allowance results in an income tax benefit in the income statement.
Pre-tax income $150,000
+ Income tax benefit ($99,750 - $52,500) 47,250
Net income $197,250
P13-8. Entries for loss carrybacks and carryforwards
Barron Corporation will offset the 2009 loss against the 2007 and 2008
taxable incomes. Note that income prior to 2007 is beyond the allowable
2-year period.
Using the 2-year carryback rule, Barron Corporation will calculate its income
tax refund as follows:
2007 $ 90,000 40% $36,000 -
2008 60,000 40% 24,000 $140,000
$150,000 $60,000
Since the entire 2009 net loss is offset against past income using the
carryback provision, the income tax benefit will be identical to income tax
refund receivable. Consequently, the following journal entry will be recorded
in 2009:
13-21
Entry on 12/31/09:
(benefit from loss carryback) $60,000
Barron Corporation will offset the 2010 loss against the remaining income
from 2008. Using the carryback rule, Barron Corporation will calculate its
income tax refund as follows:
2008 $140,000 40% $56,000 -
$140,000 $56,000
The following journal entry will be recorded in 2010 to show the income tax
refund:
Entry on 12/31/10:
(benefit from loss carryback) $56,000
Note, however, Barron Corporation had only $140,000 of income available
during the carryback period. Consequently, the company needs to examine
whether a deferred tax asset should be created for the remaining 2010 loss of
$40,000 ($180,000 - $140,000). Based on the information in the problem, we
create a deferred tax asset assuming the tax benefits of this loss will be fully
realized at a rate of 40% ($40,000 x 0.40).
Entry on 12/31/10:
(benefit from loss carryforward) $16,000
At the end of 2010, the company has a loss carryforward of $40,000 from
2010. Consequently, when Barron Corporation earned $125,000 net income
during 2011, it was able to offset this income against $40,000 of the 2010
loss carried forward. The income tax liability for 2011 is calculated as follows:
13-22
2011 Taxable income $125,000
- 2010 Loss carryforward (40,000 )
Income subject to tax $ 85,000
Tax rate 40 %
Tax liability at 40% $ 34,000
The journal entry to record the 2011 income tax expense reflects the
realization of the deferred tax asset from the 2010 loss carryforward:
Entry on 12/31/11:
CR Income tax payable $34,000
CR Deferred tax asset 16,000
In 2012, the company incurred a net loss of $120,000. Only $85,000 of the
loss can be offset against the 2011 income under the carryback provision.
Recall that $40,000 of the 2011 net income was offset against the 2010 loss
under the carryforward provision.
The loss carryforward for 2012 is calculated as follows:
2012 Net loss ($120,000)
+ 2011 Income subject to tax 85,000
2012 Loss carryforward ($ 35,000 )
Therefore, the company is entitled to claim a refund for all the taxes paid on
the 2011 income. For the remainder of the loss, we record a deferred tax
asset to represent the future benefits from the carryforward provision
($35,000 x 0.40 = $14,000):
Entry on 12/31/12:
DR Deferred tax asset 14,000
13-23
P13-9. Reconciling statutory and effective tax rates
Requirement 1:
Determination of taxable income and taxes payable
Pre-tax accounting income (loss) per books ($1,500,000)
Less: Permanent difference items:
+ Charge for in-process technology 2,000,000
+ Impairment loss of goodwill 50,000
- Income from municipal bonds (80,000)
+ Management fee for municipal bond investments 10,000
+ Insurance premium on executives 15,000
- Insurance proceeds (250,000)
Pre-tax income adjusted for permanent differences 245,000
- Excess of bad debts written off over provision
for uncollectibles (75,000)
- Excess of accelerated depreciation for tax over S/L
depreciation for books ($210,000 - $140,000) (70,000)
Statutory tax rate 35 %
Taxes payable $ 35,000
Requirement 2:
Determination of change in deferred tax assets (liabilities):
Reversal of timing difference on bad debts
(Decrease in deferred tax asset) $75,000 x .35 = $26,250 CR
Originating temporary difference for depreciation
(Increase in deferred tax liability) $70,000 x .35 = $24,500 CR
Requirement 3:
Calculation of income tax expense:
Tax expense = Taxes payable + Decrease in deferred tax asset
+ Increase in deferred tax liability
= $35,000 + $26,250 + $24,500
= $85,750
Alternative calculation, since no change in tax rates:
GAAP income adjusted for permanent differences (see above) $245,000
Statutory tax rate 35 %
Tax expense $ 85,750
13-24
Requirement 4:
Effective tax book rate = $85,750/($1,500,000) = 5.72%
Reconciliation of effective and statutory tax rate:
Companies typically provide a table similar to the one shown below to explain
the difference between the statutory tax rate and the effective tax rate.
Tax Expense
(Credit)
Tax
Rate
Expected tax credit at the statutory rate
($1,500,000 loss x 35%) ($525,000) -35.00%
Effect of permanent differences:
+ Charge for in-process R&D (35% x $2 million) 700,000 46.67%
+ Impairment loss of goodwill (35% x $50,000) 17,500 1.17%
- Income from municipal bonds (35% x $80,000) (28,000) -1.87%
+ Management fee for municipal bonds
(35% x $10,000) 3,500 0.23%
+ Insurance premium on executives
(35% x $15,000) 5,250 0.35%
- Insurance proceeds ($250,000 x 35%) (87,500 ) -5.83%
Effective tax rate [$85,750/($1,500,000)] $ 85,750 5.72%
The expected tax credit at the statutory rate is calculated by multiplying the
loss before income taxes by 35%. Each item below is calculated by
multiplying the corresponding permanent difference by 35%. The tax rate
column is obtained by dividing each item in the tax expense column by the
loss before income taxes.
Note: The problem is loosely based on the 1996 financial statements of World
Com, Inc. The companys effective tax rate was substantially different from its
statutory tax rate due to the GAAP write-off of in-process technology.
Requirement 5:
The journal entry to record the tax expense is:
CR Deferred tax liability 24,500
Note that the higher bad debts written off indicates a reversing difference.
The company would have recorded a deferred tax asset initially when
recording the bad debt expense, which is being reversed when the bad debts
are written off.
13-25
In contrast, given the depreciation methods used by the company, the higher
depreciation expense indicates an originating difference. The company is
creating a deferred tax liability today when the tax depreciation is higher. This
will reverse ultimately when the financial accounting depreciation becomes
larger than the tax depreciation.
P13-10. Analytical insights from deferred tax account
Requirement 1:
The following tables provide the balances in the deferred tax liability over
the equipment life:
Annual Cumulative Balance in
Depreci
ation
Difference in Difference in Deferred Tax
Year St. Line SOYD Depreciation Depreciation Liability
(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35
Year 1 $20,000 $30,000 $10,000 $10,000 $3,500
Year 2 20,000 20,000 - 10,000 3,500
Year 3 20,000 _10,000 (10,000 ) - -
$60,000 $60,000 $ - $ - $ -
The following table summarizes the balance in the deferred tax liability of
Weber, assuming it buys new equipment for $60,000 every year through the
year 2010:
Asset
Acquired in 12/31/05 12/31/06 12/31/07 12/31/08 12/31/09 12/31/10
2005 $3,500 $3,500 -
2006 3,500 $3,500 -
2007 3,500 $3,500 -
2008 3,500 $3,500 -
2009 3,500 $3,500
2010 3,500
$3,500 $7,000 $7,000 $7,000 $7,000 $7,000
13-26
Requirement 2:
The following tables provide the balances in the deferred tax liability over
the equipment life for each of the assets acquired during 2006 through 2010
[See (1) for the equipment acquired in 2005]:
Equipment acquired in 2006:
Depreciatio
n Expense
(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35
Year 1 $22,000 $33,000 $11,000 $11,000 $3,850
Year 2 22,000 22,000 - 11,000 3,850
Year 3 22,000 11,000 (11,000 ) - -
$66,000 $66,000 $ - $ - $ -
Depreciatio
n Expense
(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35
Year 1 $24,000 $36,000 $12,000 $12,000 $4,200
Year 2 24,000 24,000 - 12,000 4,200
Year 3 24,000 12,000 (12,000) - -
$72,000 $72,000 $ - $ - $ -
Depreciatio
n Expense
(a) (b) (c) = (b) (a) (d) (e) = (d) x .35
Year 1 $26,000 $39,000 $13,000 $13,000 $4,550
Year 2 26,000 26,000 - 13,000 4,550
Year 3 26,000 13,000 (13,000 ) - -
$78,000 $78,000 $ - $ - $ -
13-27
Depreciati
on
(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35
Year 1 $28,000 $42,000 $14,000 $14,000 $4,900
Year 2 28,000 28,000 - 14,000 4,900
Year 3 28,000 14,000 (14,000 ) - -
$84,000 $84,000 $ - $ - $ -
Depreciati
on
(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35
Year 1 $30,000 $45,000 $15,000 $15,000 $5,250
Year 2 30,000 30,000 - 15,000 5,250
Year 3 30,000 15,000 (15,000 ) - -
$90,000 $90,000 $ - $ - $ -
The following table summarizes the temporary differences and the balance
in the deferred tax liability of Weber assuming it buys new equipment every
year through the year 2010 (the cost of the equipment increases linearly
from $60,000 in 2005 to $90,000 in 2010):
Year
Book
Depreciation
Tax
Depreciation
Yearly
Difference
Cumulative
Difference
Balance in
Deferred
Tax Liability
Account
(a) (b) (c) (d) = b - a (e) = (d) x .35
2005 $20,000 $30,000 $10,000 $10,000 $3,500
2006 42,000 53,000 11,000 21,000 7,350
2007 66,000 68,000 2,000 23,000 8,050
2008 72,000 74,000 2,000 25,000 8,750
2009 78,000 80,000 2,000 27,000 9,450
2010 84,000 86,000 2,000 29,000 10,150
13-28
Requirement 3:
The answer to this requirement involves extending the last table for two
more years without considering any new equipment purchases:
Year
Book
Depreciation
Tax
Depreciation
Yearly
Difference
Cumulative
Difference
Balance in
Deferred
Tax Liability
Account
(a) (b) (c) (d) = b - a (e) = (d) x .35
2010 $84,000 $86,000 $2,000 $29,000 $10,150
2011 58,000 44,000 (14,000) 15,000 5,250
2012 30,000 15,000 (15,000) - -
Requirement 4:
Several generalizations can be made by examining the answers to the
above three requirements. One controversy pertains to whether a deferred
tax liability is really an economic liability. As discussed in the chapter, if a
company sells its equipment at its accounting book value, then it will end up
paying tax equal to the deferred tax liability for that equipment. In that
sense, one might consider a deferred tax liability as a true liability. For
instance, consider the equipment purchased for $60,000 on January 1,
2005. The following table summarizes the change in the deferred tax liability
with respect to this asset:
Depreciati
on
(a) (b) (c) = (b) - (a) (d) (e) = (d) x .35
Year 1 $20,000 $30,000 $10,000 $10,000 $3,500
Year 2 20,000 20,000 - 10,000 3,500
Year 3 20,000 10,000 (10,000 ) - -
$60,000 $60,000
$ - $ - $ -
Assume that this equipment is sold for its accounting book value on January
1, 2006. At the time of sale, the accounting book value of the asset is
$40,000 ($60,000 - $20,000), whereas its tax book value (referred to as tax
basis) is only $30,000 ($60,000 - $30,000). The company will report no gain
or loss in its financial reporting statements; however, it will report an income
of $10,000 in its tax statement. Consequently, it will end up paying tax equal
to $3,500 (35% of $10,000) in 2006. This $3,500 is exactly equal to the
deferred tax liability reported at the end of 2005.
However, companies typically invest in property, plant, and equipment not
with an objective of selling them, but with a view to using them in their
operations to generate revenues. Companies in growth or mature stages
13-29
are likely to continually reinvest in new property and equipment to meet their
increasing or continuing customer demands. For these firms, the deferred
tax liability might represent the present value of obligation that could be
postponed almost indefinitely through growth and expansion; consequently,
the present value of the obligation is likely to be substantially smaller than
the reported value of the deferred tax liability.
Note that in Requirement 1, when Weber is continuing to buy new
equipment at the rate of $60,000, the deferred tax liability remains stable at
$7,000 from 2006 to 2010. However, when the cost of the equipment
increases over time, the balance in deferred tax liability in fact keeps
increasing from $3,500 in 2005 to $10,150 in the year 2010. Many growth
companies invest increasingly larger amounts in property and equipment to
build capacity. Even mature companies that expect to maintain capacity
invest increasingly larger dollar amounts due to inflation in equipment
prices. In essence, Requirements 2 and 3 indicate that the economic value
of the deferred tax liability may be substantially lower than its reported
value.
Requirement 4 shows that a continuing decline in deferred tax liability might
indicate that a company is shrinking or declining since it is reducing its
Investment in new property and equipment.
P13-11. Determining taxable income and taxes payable
Requirement 1:
Calculation of taxable income for 2005:
The calculation of Madison Corporations taxable income at December 31,
2005 is as follows:
Pretax book income $101,500
+ Fine to State Corporation Commission 6,500
+ Rent expense not yet paid 25,000
- Unrealized gain, not yet received (13,000)
+ Excess depreciation expense for book puposes 50,000
Taxable income prior to application of NOL carryforward 170,000
Operating loss carryforward (66,000 )
Requirement 2:
Taxes payable for 2005:
Tax rate 40 %
Taxes payable for 2005 $ 41,600
13-30
P13-12. Determining taxes payable and changes in deferred taxes
Requirement 1:
The calculation of the current income tax liability of Delilah Corp. at
December 31, 2005 is as follows:
Pretax income (per books) $223,000
+ Bad debt expense, deductible when
accounts are written off 24,000
+ Revenue received and taxable prior to
Financial statement recognition 19,000
- Unrealized gain on trading securities;
To be taxed when realized (55,000)
Tax rate 40 %
Requirement 2:
Unrealized gainfuture taxable amount $55,000
Tax rate x 40 %
Revenue received in advancefuture deductible amount $19,000
Bad debt expense-future deductible amount 24,000
Total changes in deferred tax asset 43,000
Tax rate x 40 %
Increase in deferred tax asset $17,200
Requirement 3:
Increase in deferred tax asset
= $84,400 + $22,000 $17,200
13-31
P13-13. Determining pretax book income, changes in deferred tax accounts,
and tax expense
Requirement 1:
The calculation of Mozart Inc.s pretax financial income at December 31,
2005 is as follows:
Taxable income (given) $ 98,000
+ Goodwill impairment (3,000)
+ Excess depreciation subtracted for tax purposes 27,000
+ Insurance expense, deducted for tax purposes prior to
Financial statement recognition 30,000 *
Pretax book income $152,000
*This is $36,000 for tax purposes less $6,000 for financial statement purposes
($36,000 x 6/36).
Requirement 2:
Excess depreciationfuture taxable amount $27,000
Insurance expensefuture taxable amount 30,000
Total changes in deferred tax liability 57,000
Tax rate x 40 %
Requirement 3:
Taxes payable = $98,000 x 40% = $39,200
= $39,200 + $22,800
13-32
P13-14. Comprehensive tax allocation problem
Requirement 1:
First, let us calculate the depreciation expense for the computer equipment.
Under both the straight-line and SOYD methods, original cost minus the
estimated salvage value ($330,000 - $30,000) is depreciated over the useful
life. The SOYD depreciation figures will be used for calculating the income
tax liability.
Method 2005 2006 2007 2008 2009 Total
St. Line $60,000 $60,000 $60,000 $60,000 $60,000 $300,000
SOYD 100,000 80,000 60,000 40,000 20,000 300,000
Based on the straight-line method of depreciation, the financial reporting
income statements are provided below:
2005 2006
Sales revenue $1,000,000 $1,200,000
Income from municipal bonds 60,000 75,000
- Cost of goods sold (400,000) (504,000)
- Depreciation expense (60,000) (60,000)
- Warranty expense (100,000) (110,000)
- Provision for uncollectibles (8% of sales) (80,000) (96,000)
- Life insurance premium for executives (30,000) (30,000)
- Other operating expenses (300,000 ) (350,000 )
Income before income taxes 90,000 125,000
- Income tax expense (see below) (21,000 ) (28,000 )
Net income $ 69,000 $ 97,000
Effective tax rate (tax expense/pre-tax income) 23.33% 22.40%
After excluding the permanent differences, the income tax expense is
calculated as follows:
2005 2006
Income before income taxes $90,000 $125,000
- Income from municipal bonds (60,000) (75,000)
+ Life insurance premium for executives 30,000 30,000
Income before permanent differences $60,000 $80,000
Tax rate 35% 35%
Income tax expense at 35% $21,000 $28,000
13-33
Requirement 2:
To calculate the income tax liability, we need to prepare the income
statement for tax purposes. This requires two adjustments to the financial
reporting income statement. First, the permanent differences are excluded.
Second, the expenses that are subject to timing or temporary differences
are recalculated using the tax rules. The depreciation is calculated using the
SOYD method (see answer to Requirement 1). The actual warranty
expenditures made to correct defective products are shown as an expense.
Similarly, the actual bad debts written off are allowed as a deduction for tax
purposes.
The actual warranty expenditures are calculated by reconstructing the
T-account for warranty liability.
CR
Balance as of 1/1/05 -
Warranty expense for 2005 (per income statement) $100,000
Cash paid for warranty services 05 (plug) (85,000)
Balance as of 12/31/05 (given) 15,000
Warranty expense for 2006 (per income statement) 110,000
Cash paid for warranty services 06 (plug) (100,000)
Balance as of 12/31/06 $25,000
The bad debts written off are calculated by reconstructing the T-account for
allowance for uncollectibles.
CR
Balance as of 1/1/05 -
Provision for uncollectibles for 2005 (per Req. 1) $80,000
Bad debts written off (plug number) (30,000 )
Balance as of 12/31/05 (given) 50,000
Provision for uncollectibles for 2006 (per Req. 1) 96,000
Bad debts written off (plug number) (125,000)
Balance as of 12/31/06 (given)
$21,000
13-34
Based on the above calculations, the taxable income for tax purposes is
computed as follows:
Tax Income Statements for the Years Ended
2005 2006
Book income before tax $90,000 $125,000
Tax-exempt municipal bond interest (60,000) (75,000)
Nondeductible life insurance premiums 30,000 30,000
Book income adjusted for permanent differences 60,000 80,000
Additional tax depreciation (40,000)
1
(20,000)
2
Warranty expense (accrual to cash basis) 15,000
3
10,000
4
Bad debts (accrual to cash basis) 50,000
5
(29,000)
6
Taxable income $85,000 $41,000
Times tax rate x .35 x .35
Income tax liability $29,750 $14,350
1
$100,000 (tax) - $60,000 (book) = $40,000
2
$80,000 (tax) - $60,000 (book) = $20,000
3
$100,000 (book) - $85,000 (tax) = $15,000
4
$110,000 (book) - $100,000 (tax) = $10,000
5
$80,000 (book) - $30,000 (tax) = $50,000
6
$96,000 (book) - $125,000 (tax) = ($29,000)
Requirement 3:
2005 2006
Income tax expense at statutory
rate
$31,500 35.00% $43,750 35.00%
- Effect of non-taxable Income (21,000) -23.33% (26,250) -21.00%
+ Effect of nondeductible expense 10,500 11 .67% 10,500 _8 .40%
Income tax expense $21,000 22 .33% $28,000 22 .40%
13-35
Requirement 4:
Deferred Tax Accounts as of 12/31/2005
DR
Asset

C
R
Liability
Depreciation expense ($100,000 - $60,000) x 0.35 $14,000
Warranty expense ($100,000 - $85,000) x 0.35 $ 5,250
Bad debts ($80,000 - $30,000) x 0.35 17,500
Total $22,750 $14,000
Net deferred tax asset $ 8,750
Deferred Tax Liability for Depreciation Expense CR
Balance as of 12/31/05 $14,000
Additional timing difference ($80,000 - $60,000) x 0.35 7,000
Balance as of 12/31/06 $21,000
Deferred Tax Asset for Warranty Expense DR
Balance as of 12/31/05 $5,250
Additional timing difference ($110,000 - $100,000) x 0.35 3,500
Balance as of 12/31/06 $8,750
Deferred Tax Asset for Bad Debt Expense DR
Balance as of 12/31/05 $17,500
Reversal of timing difference ($125,000 - $96,000) x 0.35 (10,150 )
Balance as of 12/31/06 $ 7,350
DR CR
Deferred Tax Accounts as of 12/31/2006 Asset Liability
Depreciation expense $21,000
Warranty expense $ 8,750
Bad debts 7,350
Total $16,100 $21,000
Net deferred tax liability $ 4,900
13-36
Requirement 5:
2005 2006
Income tax expense $21,000 $28,000
Changes in deferred tax arising from:
Depreciation expense (14,000) (7,000)
Warranty expense 5,250 3,500
Bad debt expense 17,500 (10,150 )
Income tax liability $29,750 $14,350
The tables in the answers to Requirements 3 through 5 are commonly
provided in company annual reports.
Requirement 6:
Entry on 12/31/05:
DR Deferred tax asset 22,750
CR Income tax payable 29,750
The debit to deferred tax asset is due to warranty expense ($5,250) plus bad
debts ($17,500). The credit to deferred tax liability is due to accelerated
depreciation for tax purposes.
Entry on 12/31/06:
The net credit to deferred tax asset is due to the tax effect of $10,150 from
the reversal of the timing difference for bad debts offset by the debit from the
tax effect of $3,500 from the additional originating timing difference in
warranty expense. The credit to deferred tax liability is due to the additional
originating difference in depreciation expense.
13-37
P13-15. Determination of taxes payable, deferred taxes and tax
expense
Requirement 1:
Flower Company
Calculation of Taxable Income and Taxes Payable
Computation of Taxable Income:
Pre-tax accounting income (given) $450,000
- Proceeds of executive life insurance (200,000)
+ Environmental law fine 100,000
Adjustments for permanent differences (140,000 )
Income before adjustment for temporary differences $310,000
Adjustments for Temporary Differences:
Excess of tax depreciation over book depreciation (80,000)
1
Rent income included in book income in 2005, taxed in 2006 (800)
Rent expense deducted for tax purposes when paid,
expensed for book purposes in 2006 (6,000)
Land sale timing difference:
Amount recognized per books (360,000)
2
Amount recognized for tax 180,000
3
(180,000 )
Taxable income before application of NOL carryforward $43,200
Taxable income $ 21,200
Tax rate x 40 %
Taxes payable $ 8,480
1
Book depreciation = $600,000/5 years = $120,000
Tax depreciation = 200,000
Excess tax depreciation over book dep. $ 80,000
2
For book purposes the entire profit is recognized: $680,000 320,000.
3
For tax purposes, one-half of the cash has been collected, therefore one-half of the
profit is recognized. The remaining profit will be recognized in 2006 when the cash is
collected.
13-38

13-39
Requirement 2:
Computation of change in deferred tax asset and deferred tax liability
accounts:
Deferred Deferred
Temporary Difference Tax Asset Tax Liability
Depreciation
($200,000 - $120,000) 40% $32,000 CR
Rent income earned in 2005, taxed in
2006 40% ($800) 320 CR
Rent expensed in 2006, deductible in
2005 for tax purposes40% ($6,000) $2,400 CR
Land sale timing difference 40% ($180,000) 72,000 CR
Tax benefit of loss carryforward
40% ($22,000) (8,800 ) CR
Change in deferred tax asset (liability) $8,800 CR $106,720 CR
Requirement 3:
Determination of tax expense for 2005
Tax expense = Taxes payable + Increase in deferred tax liability +
Decrease in deferred tax asset
$124,000 = $8,480 + $106,720 + $8,800
P13-16. Determination of taxes payable, deferred taxes and tax expense
Requirement 1:
Jarvis Co.
Pretax accounting income (given) $ 90,000
+ Premiums on executive life insurance 42,000
- Interest on municipal bonds (100,000 )
Adjustments for permanent differences (58,000 )
Income before adjustment for temporary differences $ 32,000
13-40
Adjustments for Temporary Differences:
Excess of book depreciation over tax depreciation 50,000
Ocean liner sales revenue timing difference:
Amount recognized per books -0-
Amount recognized for tax 180,000 * 180,000
Taxable income before application of NOL carryforward $262,000
Taxable income $ -0-
*This is ($2,000,000 1,640,000 = $360,000 x 50%)
Since there is no taxable income, there is no tax due and payable at
December 31, 2005.
Requirement 2:
accounts:
Deferred Deferred
Temporary Difference Tax Asset Tax Liability
Depreciation
($200,000 - 150,000) x 40% $20,000 DR
Ocean liner revenue timing difference
40% ($180,000) 72,000 DR
Tax benefit of loss carryforward
40% ($262,000) (104,800 ) CR
Change in deferred tax asset (liability) $ 32,800 CR $20,000 DR
Requirement 3:
Determination of tax expense for 2005
Tax expense = Taxes payable - Decrease in deferred tax liability
+ Decrease in deferred tax asset (plus allowance)
Before allowance:
$12,800 = $0 - $20,000 + $32,800
+41,800 Allowance (see below)
$54,600
Deferred tax asset beginning balance $200,000
Decrease in 2005 (see Requirement 2) (32,800 )
167,200
x 25 %
Estimated allowance $ 41,800
13-41
P13-17. Determination of taxes payable, deferred taxes and tax expense
Requirement 1:
Reality Corp.
Pre-tax accounting income (given) $200,000
+ Premium on executive life insurance 3,000
- 80% equity in investees earnings (64,000)
Adjustments for permanent differences (66,000)
Income before adjustment for temporary differences $134,000
Excess of tax depreciation over book depreciation (125,000)
Excess of equity in investee earnings over dividends
Received, less portion considered permanent due to
80% dividend exclusion rule [20% x ($80,000 - $30,000)] (10,000)
Rent income included in book income in 2005, taxed in 2004 (4,000)
Rent received in advancetaxable in 2005 10,000
Temporary difference on sale of land:
Amount recognized per book (30,000)
Amount recognized for tax 10,000 (20,000)
Warranty timing difference:
Amount recognized per book 50,000
Amount recognized for tax (15,000) 35,000
Bad debt timing difference:
Amount recognized per book 15,000
Amount recognized for tax (6,000) 9,000
Operating loss carryforward (10,000)
Tax rate x 40 %
Taxes Payable $7,600
13-42
Requirement 2:
accounts
Deferred Tax Deferred Tax
Temporary Difference Asset Liability
(org) Depreciation
($225,000 - $100,000) x 40% $50,000 CR
(org) Equity in investee earnings
40% (20% x ($80,000 - $30,000)) 4,000 CR
(rev) Rental income earned in 2005, taxed
in 2004 40% ($4,000) ($1,600) CR
(org) Rent received in advance
40% ($10,000) 4,000 DR
(org) Deferred profit on sale of land
40% ($20,000) 8,000 CR
(org/rev) Warranty cost timing difference
40% ($35,000) 14,000 DR
(org/rev) Bad debt timing difference
40% ($15,000 - $6,000) 3,600 DR
(org/rev) Tax benefit of loss carryforward
40% ($10,000) (4,000 ) CR
Change in deferred tax asset (Liability) $16,000 DR $62,000 CR
Requirement 3: Determination of Tax Expense for 2005
Tax Expense = Taxes Payable + Increase in Deferred Tax Liability -
Increase in Deferred Tax Asset (less Allowance)
= $7,600 + $62,000 ($16,000 $11,200*)
= $64,800
*Valuation allowance:
Deferred Tax Asset Beginning Balance $40,000
Increase in 2005 (see requirement 2) 16,000
$56,000
x 20 %
Estimated Allowance $11,200
P13-18. Leasing and deferred taxes
Requirement 1:
2005 2006 2007
Income before lease transaction $100,000 $100,000 $100,000
Lease expense (10,000 ) (10,000 ) (10,000 )
Taxable income 90,000 90,000 90,000
Income tax liability at 40% $ 36,000 $ 36,000 $ 36,000
13-43
13-44
Requirement 2:
Note: Since the company leased the equipment for its entire useful life, it
must use capital lease accounting for financial reporting purposes. A
schedule showing the interest component (using the implicit interest rate)
and reduction of principal for each lease payment is shown below.
Year
Interest
Expense
Repayment
of Lease
Obligation
Balance
of Lease
Obligation
$24,869
2005 $2,487 $7,513 17,356
2006 1,736 8,264 9,092
2007 908 9,092 0
2005 2006 2007
Income before lease transaction $100,000 $100,000 $100,000
Interest on capital lease (2,487) (1,736) (908)
Depreciation expense (8,290 ) (8,290 ) (8,289 )
Income before income tax 89,223 89,974 90,803
Income tax expense at 40% (35,689 ) (35,990 ) (36,321 )
Net income $ 53,534 $ 53,984 $ 54,482
Requirement 3:
2005
DR Deferred income tax asset 311
CR Income taxes payable $36,000
2006
DR Deferred income tax asset 10
CR Income taxes payable $36,000
2007
CR Deferred income tax asset $321
13-45
Cases
Cases
C13-1. Mandalay Resort Group (Analysis of tax footnote)
Requirement 1:
Entry for 1/31/01:
DR Income tax expense $74,692,000
CR Income tax payable $55,133,000
CR Net deferred tax
asset/liability
19,559,000
Entry for 1/31/02:
DR Net deferred tax
asset/liability
623,000
Entry for 1/31/03:
CR Net deferred tax
asset/liability
29,919,000
Requirement 2:
Mandalay Resort Group specifically identifies six accounting items that cause
the income tax expense to be different from the taxes currently payable or
income tax liability in 2003. These items are (1) property and equipment,
(2) investments in unconsolidated affiliates, (3) accrued vacation benefits,
(4) bad debt reserve, (5) preopening expenses, and (6) pension plan. Note
that four of these items are reflected in Gross deferred tax assets while two
are included in Gross deferred tax liabilities. Recall that when expenses are
recorded first in the financial statements, and subsequently for tax purposes,
then they give rise to deferred tax assets (e.g., warranty expense). In
contrast, when expenses are recorded initially for tax purposes and
subsequently in the financial statements, then they give rise to deferred tax
liabilities (e.g., accelerated depreciation for tax purposes and straight-line for
book purposes).
13-46
First, lets turn our attention to the deferred tax expense for property and
equipment in Mandalays income tax disclosures. This item relates to
different depreciation methods (and probably asset lives) being used for book
and tax purposes. (Mandalay discloses that the company uses straight-line
depreciation for financial reporting). MACRS (used exclusively for tax
purposes) generally permits more rapid write-offs of plant and equipment than
GAAP based depreciation methods. Thus, early in an assets life, tax
depreciation exceeds book depreciation resulting in taxable income that is
lower than book income. Under such circumstances, taxes currently payable
are less than income tax expenses reported in the financial statements giving
rise to deferred tax expenses and an increase in the deferred tax liability.
When these timing differences reverse, the deferred tax liability will fall and a
tax benefit will be realized. Because Mandalay reported an increase in the
companys deferred tax liability attributable to property and equipment, this is
an originating difference.
Next, lets look at the originating difference related to investments in
unconsolidated affiliates. Use of the equity method of accounting for
investments in unconsolidated affiliates results in income being recognized
for financial reporting purposes as it is earned by the investee, but not being
recognized for tax purposes until dividends are received by the investor.
Thus, income from investments in unconsolidated affiliates is usually
recognized on the books before the tax return causing book income to initially
exceed taxable income and giving rise to a deferred tax liability, as is the
case here.
The third item in Mandalays temporary differences disclosure concerns
accrued vacation benefits. Accrued expenses give rise to timing differences
because these financial reporting expenses are not deductible for tax
purposes when initially recorded for book purposes. Deductions are allowed
for tax purposes only when paying cash discharges the resulting liabilities. An
examination of the deferred tax asset balance arising from accrued vacation
benefits indicates a reduction of the deferred tax asset (reversing difference)
for 2003, thus, for financial reporting, these expenses were lower than the
deduction for tax purposes during 2003. Therefore, book income was higher
than taxable income, resulting in a credit (reduction) to the related deferred
tax asset. In essence, more cash payments were made for this item, and thus
deducted on the current period tax return, than the amount accrued and
deducted for book purposes.
Next, let us focus on the deduction for bad debt expense on Mandalays
books versus tax return. While companies use the allowance method and
matching principle to estimate bad debt expense for financial reporting
purposes, they must wait until the bad debts are written off to claim a
deduction for tax purposes. Therefore, when a company records bad debt
expense on its books, this gives rise to a deferred tax asset debit
13-47
(originating difference) because the deduction for tax purposes will occur in
a later period. However, when the bad debt is realized and written off, the
corresponding deferred tax asset is eliminated or credited (reversing
difference). The fact that the deferred tax asset related to bad debt timing
differences increased from 2002 to 2003 implies that the bad debt expense
recorded on Mandalays books in 2003 exceeded the deduction taken on the
tax return for accounts written off during the period. That is, book income was
smaller than taxable income in 2003 due to this temporary (originating)
difference.
Preopening costs (consisting principally of direct incremental personnel costs
and advertising and marketing expenses) are expensed for financial reporting
purposes, but amortized over five years for tax purposes. Thus, most of this
expense affects the financial statements before the tax return. When a
company records preopening expenses on its books, a deferred tax asset is
debited (originating difference) because most of the deduction for tax
purposes will occur in later periods (some amortization for tax purposes
probably occurs in the year the costs are incurred). Then, as the preopening
costs are amortized for tax purposes, the corresponding deferred tax asset is
eliminated or credited (reversing difference). The fact that the deferred tax
asset related to preopening costs timing differences decreased from 2002 to
2003 implies that the preopening costs expense recorded on Mandalays
books in 2003 was less than the deduction taken on the tax return for
amortization during the period. That is, book income was greater than taxable
income in 2003 due to this temporary (reversing) difference.
The last of Mandalays deferred tax assets that changed during 2003 relates
to the companys pension plan. This originating difference is created by
pension plan expenses (which lower book income) that are not currently
deductible for tax purposes. Thus, book income (and tax expense) is lower
than income per the tax return (and taxes payable) creating an increase in
this deferred tax asset.
Requirement 3:
The current/deferred tax expense disclosure is limited to taxes related to
income from continuing operations so it is apparent from the discrepancy
between the balance sheet changes and the deferred tax disclosure that
some non-operating events have occurred. Items reported on a net of tax
basis in comprehensive income would certainly affect the deferred tax
asset/liability balances, but not income from continuing operations. However,
as shown by the following calculations and T-account analysis of the net
deferred tax liability, these items do not explain the noted differences but
rather exacerbate them.
13-48
First, lets determine the effect on deferred tax liabilities of the minimum
pension liability adjustment.
Let X = pre-tax increase in minimum pension liability ($ in thousands):
$ 5,571 (1 tax rate) = X
$ 5,571 (1 .35) = $8,571
Journalizing this increase in the accumulated other comprehensive loss
requires the following entry:

DR Accumulated other comprehensive loss $ 5,571
DR Net deferred tax liability 3,000
CR Minimum pension liability $ 8,571
Next, lets determine the effect on deferred tax liabilities of the adjustment to
interest rate swaps. Note that Mandalay reports its swap related assets and
liabilities on a net basis in Other long-term liabilities.
Let X = pre-tax decrease in other long-term liabilities ($ in thousands):
$ 10,553 (1 tax rate) = X
$ 10,553 (1 .35) = $16,235
To record this decrease in the accumulated other comprehensive loss
requires this journal entry:

DR Other long-term liabilities $ 16,235
CR Net deferred tax liability $ 5,682
CR Accumulated other comprehensive loss 10,553
Using the above entries and data in Mandalays income taxes disclosure
permits the following T-account to be constructed to help explain changes in
the net deferred tax liability.
13-49
Net deferred tax liability
$ 181,702 Beginning balance 1/31/02
29,919 2003 Deferred tax expense
Minimum pension liability $3,000 5,682 Interest rate swaps
Unknown net debit 3,174
$ 211,129 Ending balance 1/31/03
As can be seen from the above T-account, the deferred tax effects of the two
items recorded in accumulated other comprehensive loss do notin and of
themselvesaccount for the noted difference between 2003 deferred taxes
and the increase in the net deferred tax liability. Rather, changes in the
deferred tax asset/liability accounts resulting from non-operating items remain
unidentified. The net effect of these unidentified items is a $3,174 debit to the
net deferred tax liability.
C13-2. Sara Lee Corp. (LR) (Analysis of tax footnotes)
Requirement 1: Book journal entry for tax expense in 2002
($ in millions)
DR Income tax expense $175
CR Deferred tax asset/liability $21
CR Income tax payable 154
Requirement 2: Sara Lees pre-tax book income for 2002
Let X = pre-tax book income ($ in millions):
$ 415 = .35 X
$1,185.7 = X
Requirement 3: Overall effective tax rate for 2002
Income tax expense (per books)
=
$175
= 14.76%
Pre-tax book income $1,185.7
13-50
Requirement 4: Taxable income as per tax return in 2002
Let X = taxable income as per tax return ($ in millions)
Income Tax Payable = Statutory Tax Rate * X
$154 = .35X
X = $440
Requirement 5: Depreciation expense difference between tax return and
books in 2002
Because temporary differences related to depreciation resulted in a deferred
tax benefit, tax depreciation was apparently lower than book depreciation
causing taxable income (and taxes payable) to exceed book income (and tax
expense). This benefit was most likely a reversal of previous temporary
differences that created deferred tax liabilities in prior periods. The amount of
the implied depreciation difference is determined as follows:

Let X = difference between tax return and book income ($ in millions)
Deferred Tax Benefit = Statutory Tax Rate x X
$27 = .35X
X = $77.14
Requirement 6: Difference between tax return and book income in 2002
related to nondeductible reserves.
The disclosed $7 million related to nondeductible reserves increased a
deferred tax liability or reduced a deferred tax asset. Thus, tax expenses
related to this item must exceed taxes currently payable. Suppose this item
related to bad debt expenses that are accrued under the allowance method
for financial reporting purposes, but written off when incurred (the direct write-
off method) for tax purposes. Expenses would thus affect the books before
the tax return initially leading to lower book income and tax expenses and
thereby creating a deferred tax asset. When these nondeductible reserves
are later deducted on the tax return, a credit (reversal) to the previously
created deferred tax asset is recorded. Because Sara Lee is recording a
credit to deferred taxes of $7 million related to this item, this appears to be a
reversing difference. The amount by which the tax expense exceeds the book
expense can be determined as follows:
Let X = difference between tax return and book income ($ in millions)
Reduction in Deferred Tax Asset = Statutory Tax Rate x X
$7 = .35X
X = $20
13-51
C13-3. Motorola vs. Intel: Adjusting for depreciation differences
Requirement 1:
Begin by looking at the edited financial statement disclosures from the Year 2
10K of Motorola, which shows the balances in the sub-components of
the deferred tax account. The highlighted depreciation item reflects the
$213 million cumulative deferred tax liability arising from book versus tax
depreciation expense at December 31, Year 2. The liability rose by
$16 million during Year 2 ($213 million minus $197 million).
The change in the deferred income tax liability arising from depreciation is:
Change = (Tax depreciation - Book depreciation) x Effective tax rate
Motorolas effective tax rate is 35% and the depreciation deferred tax change
was $16 million as shown in the edited Year 2 10K of Motorola. Substituting
these values into the equation above, we get:
$16 = (Tax depreciation - Book depreciation) x .35
Dividing both sides by .35 yields:
$45.7 = (Tax depreciation - Book depreciation)
Since the edited financial statement disclosures show Motorolas book
depreciation was $2,308 million, tax depreciation must have been $2,308
million + $45.7 million = $2,353.7 million, which was 2% higher.
The highlighted portion of the financial statement disclosures show that Intels
depreciation-related deferred income tax liability was $573 millionan
increase of $98 million in one year. Repeating the analytical approach we
used for Motorola:
Change = (Tax Depreciation - Book Depreciation) x Effective Tax Rate
or:
$98 = (Tax Depreciation - Book Depreciation) x .35
or:
$280 = (Tax Depreciation - Book Depreciation)
Intels book depreciation was $1,888 million (from disclosures), so tax
depreciation must have been $1,888 million + $280 million = $2,168 million,
an increase of 14.8%.
13-52
Requirement 2:
Adjusting both firms financial reporting to the same rate and useful lives used
for tax purposes lowers Motorolas pre-tax income by 2.6% ($45.7 million
$1,775 million). Intels pre-tax income is lowered by 3.5% ($280 million
$7,934 million).
Requirement 3:
Since the adjusted figures are not affected by variations in depreciation
reporting choices across firms, it becomes easier to compare the operating
results of the two companies. The unadjusted numbers are difficult to
compare since they reflect differences in depreciation accounting methods as
well as differences in underlying operating performance.
C13-4. Circuit City Stores Inc. (KR) (Analysis of tax footnotes)
Requirement 1: ($ in thousands)
Entry on 2/28/01:
DR Provision for income taxes $70,637
CR Net deferred tax asset/liability $ 9,798
CR Income taxes payable 60,839
Entry on 2/28/02:
Entry on 2/28/03:
Consistent with the terminology used by Circuit City, we have used the term
provision for income taxes to indicate income tax expense.
Requirement 2:
It is possible for the deferred portion of the tax provision in a given year to not
equal the change in the net deferred tax liability. Such differences could be
attributable to multiple sources. For example, suppose that Circuit City
reports in its income statement that they have discontinued operations net of
tax effects. The tax effects that arise from discontinued operations are not
included in the journal entry for the year in question because this entry relates
to tax effects of continuing operations. Another possible explanation if such a
difference occurs could be that acquisitions were made during the fiscal year.
Acquisitions often result in changes in the deferred tax account because the
13-53
acquired subsidiary often holds assets that have a tax basis that differs from
their financial accounting basis. The result is seen in changes in the deferred
tax accounts on the consolidated balance sheet.
Requirement 3:
Since cash is received up-front on the sale of gift cards, the revenue is
included in the tax income statement at the time of sale. However, for
financial reporting purposes, gift card revenue is deferred until the cards are
redeemed. Because the company levies a service fee on cards that are not
redeemed within 24 months, and reports service fee revenue in 2003,
apparently not all gift cards are promptly redeemed. Thus book revenue
recognized to date on gift card sales lags tax return revenue, giving rise to a
deferred tax asset. Circuit City only lists two deferred tax assets: Accrued
expenses and Other. Since the gift card deferred tax asset is obviously not
related to accrued expenses, it must be included in the Other category.
Requirement 4:
The formula for calculating the earnings conservatism ratio (EC) is given
below:
= Pre-Tax book income .
Taxable Income as per tax return
Note that the information on pre-tax book income and taxable income are not
directly provided in the case. However, the ratio can be estimated by dividing
provision for income taxes by income tax liability. The numerator and the
denominator of this ratio each differs from EC by a factor equal to the
effective tax rate. Since this affects both the numerator and the denominator
in a similar fashion, their effects cancel each other through division.
For the years ended
2/28/03 2/28/02 2/28/01
Provision for Income Taxes $25,475 $78,446 $70,637
Income Tax Liability 19,758 50,442 60,839
EC Ratio 1.29 1.56 1.16
In 2001, the ratio is relatively close to 1.00 suggesting conservative financial
reporting. However, one interesting trend is that this ratio has increased
somewhat from 20012003, with a spike in 2002, thus implying less
conservative financial reporting than in 2001.
Note to the instructor: Circuit Citys 2000 annual report stated that the
company sells its own extended warranty contracts and extended warranty
contracts on behalf of unrelated third parties. The contracts extend beyond
the normal manufacturers warranty period between 12 and 60 months.
13-54
Revenue from the sale of Circuit Citys own warranties is deferred and
amortized over the life of the warranty while revenue from the sale of the
third-party warranties is recognized immediately (for both book and tax
purposes). The companys 2003 annual report only mentions revenue
recognition policies from the sale of third-party warranties, implying that
Circuit City discontinued its own extended warranty program prior to 2003.
Assuming this to be the case, one explanation for the increase in the earnings
conservatism ratio is that revenue is still being recognized for book purposes
by amortizing deferred revenue originating when Circuit City was selling its
own warranties; no revenue is recognized on these warranties for tax
purposes as none are now being originated.
C13-5. ABC Inc. (KR): Interpreting tax footnotes and reconciling statutory and
effective rates
Requirement 1:
Tax Amount Tax Rate
Tax expense at statutory rate of 34% $3,812 35.00%
Amortization of cost in excess of net assets
of acquired companies 1,076 9.88%
State taxes 927 8.51%
Change in the valuation allowance for
deferred tax assets (2,122) -19.48%
Others (plug number) (426 ) - 3 .91%
Tax provision at actual rate $3,267 30 .00%
The expense at the statutory rate is calculated by multiplying the earnings
before income taxes of $10,891 by 35%. The tax effects of amortization of
goodwill (or cost in excess of net assets of acquired companies) and state
taxes are given in the problem. The effect of change in the valuation
allowance is calculated by subtracting the 2004 balance from its 2005
balance ($15,710 - $13,588). The tax provision at actual (or effective) rate is
the income tax expense of $3,267. The others figure is a plug number.
The tax rate column is calculated by dividing the tax amount column values
by the earnings before income taxes.
Requirement 2:
DR Valuation allowance 2,122
$5,389 $5,390
13-55
13-56
The credit to the income tax liability represents the current portion of the
income tax expense. The decrease in the deferred tax asset ($47,652 -
$49,286) and the increase in the deferred tax liability ($12,957 - $10,957) are
obtained from comparing the 2005 and 2004 balance sheet values. The one
dollar difference between the total debit and total credit appears to be
rounding error.
Requirement 3:
The decrease in the deferred tax asset for accounts receivable suggests that
the bad debts written off during the year was greater than the provision for
uncollectibles (or bad debt expense).
The deferred tax asset for inventories is due to additional costs inventoried for
tax purposes and financial statement allowances. It appears that certain costs
that are considered as product costs for tax purposes are considered as
period costs for financial reporting purposes. In addition, it seems that certain
writedown of inventories (financial statement allowances) are not allowed for
tax purposes until the loss due to writedown of inventories is realized through
the sale of inventories. Since certain costs are considered as product costs
for tax purposes only, the expense for tax purposes is likely to be lower than
that for the financial statement purposes when inventories are building up. In
essence, these product costs are included in the inventory book values at the
end of 2005 for tax purposes, whereas they have been expensed in the
financial statements as part of operating expenses. Thus, the increase in the
deferred tax asset for inventories is consistent with the inventory buildup
indicated by the change in the balance sheet value from 2004 to 2005.
The deferred tax asset for employee benefits suggests that the company is
using the accrual basis for expensing the cost of employee benefits in the
financial statements while using the cash basis for tax purposes. The
decrease in the deferred tax asset for employee benefits suggests that ABC
Inc. paid more of the employee benefits in cash when compared to the tax
expense during 2005. Another possibility to consider is that, since the
company has gone through significant restructuring, the reduction in the
deferred tax asset might be indicative of the reduction in the liability for
employee benefits from contract renegotiations. In fact, the income statement
of the company reported a $6,000 credit from reduction in the employee
benefit obligation (not provided in the problem).
The reduction in the deferred tax asset for accrual for costs of restructuring is
consistent with the current payment for restructuring charges that were
accrued in the GAAP income statement of the previous years. Alternatively, it
might also indicate that the company had overprovided for restructuring
charges in the past which are being reversed in the current year.
13-57
The deferred tax asset for accrual for disposal of discontinued operations was
created to record the expected tax benefit from the loss on discontinued
operations reported in the GAAP financial statements of the previous years.
The reduction in this deferred tax asset suggests that a portion of the loss has
been realized during the current year, thereby realizing the tax benefit.
Since the company reports a deferred tax liability for plant and equipment, it
must mean that ABC Inc. is using a more accelerated depreciation for tax
purposes compared to the financial reporting depreciation. However, the
decrease in the deferred tax liability suggests that the 2001 depreciation
expense for financial reporting purposes was higher than that for the tax
purposes. Another explanation is that, since the company was involved in
significant restructuring, it might have sold a portion of its depreciable assets,
which would eliminate the corresponding deferred tax liability.
C13-6. Understanding footnote disclosures
Requirement 1: Book journal entry for tax expense in 2002
($ in thousands)
CR Income tax currently payable 164,088
Requirement 2:
Wrigley deferred $17,808 in taxes in 2002. This deferral resulted in an
increase in net deferred tax liabilities from $3,434 (2001) to $21,244 (2002).
Note to the instructor: The difference in the net deferred tax balances
between 2001 and 2002 is $17,810, not $17,808. This slight difference may
be attributable to rounding or to some small changes in deferred tax
asset/liability balances attributable to non-operating items.
Requirement 3:
Let X = pre-tax book income ($ in thousands):
$ 204,197 = .35 X
$ 583,421 = X
Overall effective tax rate for 2002
Income tax expense (per books)
=
$181,896
= 31.7%
Pre-tax book income $583,421
13-58
Note that the denominator in the above computation is pre-tax book income
(i.e., book income before adjustments for permanent differences). Pre-tax
book income can be determined (as shown above) by dividing the amount
disclosed by Wrigley as Provision at U.S. Federal Statutory Rate ($204,197)
by the statutory tax rate of 35%.
Note to the instructor: This calculation yields the same result as adding the
pretax foreign ($421,775) and domestic ($161,646) income for 2002
disclosed in Wrigleys tax footnote.
Requirement 4:
The tax jurisdictions in which the firm chooses to operateindicated by the
$27,045 reduction in taxes attributed to foreign tax ratesaccount for much
of the difference between Wrigleys effective tax rate and the U.S. statutory
tax rate. Note that Wrigley may chose to operate in low tax rate countries for
operational reasons and not purely on the basis of tax rate differences. For
example, labor rates may be lower in these other countries, or they may be
located in close proximity to raw materials and customers.
Note to the instructor: Wrigleys tax footnote breaks down 2002 pretax income
(in thousands) between domestic and foreign sources as follows: $161,646
domestic and $421,775 foreign.
Requirement 5:
Wrigley reported deferred tax assets in 2002 related to accrued
compensation, pension and post-retirement benefits. These items are
deductible for financial reporting purposes when they are accrued, but not for
tax purposes until they are paid. Thus, these items (often) affect (lower)
financial reporting income before taxable income giving rise to a deferred tax
asset.
Requirement 6:
Wrigley did not have any significant changes in its net deferred tax liability
during 2002 related to non-operating items.
2002 Net deferred tax liability $ (21,244)
2001 Net deferred tax liability (3,434)
Increase in net deferred tax liability $ (17,810)
This increase in net deferred tax liability very closely corresponds to the
$17,808 (see answer to requirement 1) reported as deferred taxes in 2002.
The $2 difference is likely due to rounding, but may be attributable to minor
13-59
changes in deferred tax asset/liability balances due to non-operating items.
Had there been any significant intraperiod tax allocation during 2002 due to
13-60
discontinued operations, extraordinary items, or cumulative effects of
changes in accounting principles the change in net deferred tax liability would
not be almost equal to 2002s deferred taxes.
C13-7. Waste Management: Analysis of tax footnote
Lets begin by looking for clues about unreported extension of asset useful
lives. One way to do this is to compute the ratio of average gross depreciable
book value to depreciation expense and thereby approximate average
depreciation life for a straight-line firm. We have enough data to calculate this
ratio for the three year period 1994-1996:
1993 1994 1995 1996
(1) Year-end gross book value of
property and equipment $11,804,857 $12,788,971 $13,335,376 $14,121,217
(2) Excluding land: - 3,625,412 - 4,162,418 - 4,553,717 - 5,019,065
(3) Book value minus land $ 8,179,445 $ 8,626,553 $ 8,781,659 $ 9,102,152
(4) Depreciation and amortization
(from cash flow statement) $ 880,466 $ 885,384 $ 920,686
(5) Implied straight-line useful life
excluding land
[ (3) (4) ] 9.54 9.83 9.71
(6) Implied straight-line useful life
including land 13.97 14.75 14.91
[ (1*) (4) ]
*Average of item (1) for 1993 and 1994 4
These data are only partially revealing. The ratio increase between 1994 and
1996 is only a 1.8% extension in percentage terms. The extension of useful
lives is larger (6.7%) if we focus on book value including land. (The reason
for including land is that disposal sites have a finite life and are depreciated.)
But there is, of course, another place for the sophisticated analyst to lookin
the income tax footnote. Here the illumination is even better!
In the Annual Report Note on Income Taxes, there is a line-item disclosure of
the deferred tax liability resulting from book versus tax differences in
depreciation and amortization. This arises becauselike most firmsWaste
Management uses straight-line depreciation for book purposes and the
maximum allowable accelerated method for tax purposes. The interpretation
of each line is straightforward. Well take 1994 as the example.
13-61

[(1) (2)]
$8,402,999
1 2 4 4 4 3 4 4 4

$8,704,106
1 2 4 4 4 3 4 4 4

$8,941,906
1 2 4 4 4 3 4 4 4
The reported deferred tax liability is $1,106,155. This number (at the then
prevailing statutory marginal tax rate of 35%) is interpreted as follows:
Deferred tax amount .35 = (Tax return depreciation Book depreciation)
or
$1,106,155 .35 = (Tax return depreciation Book depreciation)
or
$3,160,443 = (Tax return depreciation Book depreciation)
In words, this means that the cumulative pre-tax excess of tax over book
depreciation at December 31, 1994 was $3,160,443. Using the same formula
for 1995, the excess increases to $3,815,833, which is an increase of 20.7%.
Of course, the same 20.7% number results if we work directly with the
change in the deferred tax amount (i.e., [$1,335,559 - $1,106,155]
$1,106,155 = 20.7%); however, students often need to be reminded about
what the change in deferred tax amounts really represents in more concrete
terms. For simplicity, we will simply use the reported year-to-year change in
the deferred tax amounts from the footnote:

(As of December 31,) 1993 1994 1995 1996
Deferred tax liability:
Depreciation and amortization $948,024 $1,106,155 $1,335,559 $1,384,164
Year-to-year percentage change 16.7% 20.7% 3.6%
This computation immediately reveals that there is a considerable increase in
the excess of tax over book depreciation between each of the three years,
but the widening is especially large between 19934 and 19945.
Why is this happening? The first (and usually most likely?) explanation is that
capital expenditures have been growing. If so, and if the firm is using
accelerated depreciation for these growing expenditures on the tax return,
the tax versus book depreciation difference would clearly widen. Accordingly,
lets examine capital expenditures on assets that are depreciated or
amortized over this period to ascertain whether capital expenditures have
actually been growing. A detailed breakdown is provided in the case.
1993 1994 1995 1996
Total $2,162.7 $1,512.4 $1,541.1 $1,216.9
Less: Land 660 .2 582 .3 517 .2 467 .7
Net change in depreciable
and amortizable assets $1,502.5 $ 930.1 $1,023.9 $ 749.2
% change between years -38.1% +10.1% -26.8%
% change between years
including land -30.1% + 1.9% -21.0%
13-62
A puzzling disparity is now revealed. The book versus tax depreciation
difference widens in each of the three year-to-year comparisons while capital
expenditures actually fall in two of the three years and go up by much less
(+10.1% or +1.9% depending on whether land is included) than the
1994-1995 percentage increase (20.7%). So long as a firm is sufficiently
mature that book versus tax reversals occuri.e., so long as we are not
dealing with a start-up firmthen one would expect that the percentage
change in the book versus tax depreciation difference would roughly parallel
the percentage change in capital expenditures. Since it does not, one can
infer that the disparity is being driven by an extension of useful lives for book
depreciation purposes. The intent, of course, is to reduce the otherwise
ensuing amount of depreciation expense and thereby bolster profits. (Total
depreciation expense still rises, of course, since the total dollar amount of
depreciable assets keeps increasing.)
Assessing the adequacy of the reserves for environmental liabilities is more
straightforward. The case gives us the total amounts recorded for closure,
post-closure monitoring and environmental remediation costs. Excluding
amounts to be provided in the future, these are:
1993 1994 1995 1996
(1) Total costs recorded $ 876,500 $ 812,765 $ 759,719 $ 665,932
(2) December 31 ending
balance in land account 3,625,412 4,162,418 4,553,717 5,019,065
(3) Ratio of liability to land
balance 24.2% 19.5% 16.7% 13.3%
[ (1) (2) ]
As the ratios show, the proportion of liability to land balance decreased over
the entire period while the dollar amount of land was increasing. This is
consistent with an underprovision for environmental liability. Of course, it
represents a signal that ought to be investigated by the careful analyst. It
does not provide conclusive evidence of underprovision.
13-63

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Financial Reporting and Analysis

Effective (book) tax rate =

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