CA19-3 (Identify Temporary Differences and Classification Criteria) The asset-liability approach for recording deferred income taxes is an integral part of generally accepted accounting principles. Instructions (a) Indicate whether each of the following independent situations should be treated as a temporary difference or as a permanent difference and explain why. The U.S. GAAP rules for depreciation will be followed and will be used for the value of assets at the end of the year. The difference may be MARCS when it comes to income tax purposes for depreciation rates or method. The temporary difference is in net income and income because of the difference in the value of U.S. GAAP AND MARCS. (1) Estimated warranty costs (covering a 3-year warranty) are expensed for financial reporting purposes at the time of sale but deducted for income tax purposes when paid. When payment is received, timing difference deduction will be allowed but at the time of sale the deduction will not be allowed. Therefore, situation stated above is to be treated as a temporary difference. It is a temporary difference due to the cost of the warranty extending over a three-year period, requiring a deferment of the taxable amounts associated with its cost till future periods. The estimated amount utilized for book purposes will be reduced as taxable income is produced each year that a loss is incurred through the fulfillment of the warranty (Kieso, Weygandt, & Warfield, 2016). Although the cost of the warranty is a liability to the paying entity, since the cost is deductible for income tax purposes it creates a deferred tax asset upon the settlement of the liability (Kieso, Weygandt, & Warfield, 2016). (2) Depreciation for book and income tax purposes differs because of different bases of carrying the related property, which was acquired in a trade-in. The different bases are a result of different rules used for book and tax purposes to compute the basis of property acquired in a trade-in. The situation described is considered a temporary difference. The depreciation of the property differs for book and tax purposes due to the differences in the carrying of the property and the difference in the rules for computation of the book and tax basis of the property (Kieso, Weygandt, & Warfield, 2016). Upon the recovery of the amount associated with the asset either through its use or sale, the tax basis of the asset will be exceeded (Kieso, Weygandt, & Warfield, 2016). This factor will result in a deferred tax liability for the asset and therefore make the transaction for the acquired asset a temporary difference (Kieso, Weygandt, & Warfield, 2016). (3) A company properly uses the equity method to account for its 30% investment in another company. The investee pays dividends that are about 10% of its annual earnings. The situations stated above consist of both temporary and permanent differences. Accounting for the 30% investment using the equity method is considered a temporary difference since it is the revenues or gains from the investment will be recognized at some point in the future and are a part of pretax financial income (Kieso, Weygandt, & Warfield, 2016). Therefore, the future taxable amounts will result in a deferred tax liability upon the investment being recovered (Kieso, Weygandt, & Warfield, 2016). The payment of dividends is, however, is partially a permanent and a temporary difference. The company accounting for their investment has a significant stake in the investees organization. The payment of dividends by the investee reduces the net asset for the investing company due to their proportionate share of earnings (Kieso, Weygandt, & Warfield, 2016). The dividend will be partially tax-exempt due to the 70% - 80% dividends received deduction making it a permanent difference (Kieso, Weygandt, & Warfield, 2016). However, the other 30% -20% is taxable and therefore apart of pretax financial income and considered a temporary difference, if, upon the receiving of dividends, the pretax amounts are reversible (Kieso, Weygandt, & Warfield, 2016). (4) A company reports a gain on an involuntary conversion of a nonmonetary asset to a monetary asset. The company elects to replace the property within the statutory period using the total proceeds, so the gain is not reported on the current years tax return. Reporting the above situation is as a temporary difference because there are future taxable amounts from the gain of the conversion. The reason for this is because the tax basis of the replacement property is lower than the carry over value. The difference is what will be deferred for future taxes. This will happen only for tax purposes. For financial purposes the gain must be reported at the time the conversion is made. (b) Discuss the nature of the deferred income tax accounts and the manner in which these accounts are to be reported on the balance sheet. The accounts for deferred income tax accounts are deferred tax assets and liabilities. These are registered and calculated separately. These are classified as net non-current amounts and are offset on the balance sheet.