Looking for help on an accounting for income tax assignment in the form of written lesson. I have been unable to answer the following attached assignment and I was hoping you could help.

PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Extra Corporation was formed in 1995. It is based in Kentucky and operates throughout the US southeast. Extra is owned by the Xavier family, one-third each by sister Carol (age 55), sister Joan (age 53), and brother Buddy (age 49). The company controls over $800 million in productive assets, most of which are located in Kentucky. Extra started out as a provider of materials to the manufacturers of PDAs like the Palm Pilot, and now it performs the same functions for various cell phone manufacturers like Samsung. The industry is concentrated among about a half-dozen competitors, most of which are located outside of the US. Extra has used its favorable location and low wage structure to remain profitable in most years, but it fears that the environmental problems created by its production processes will attract incremental local and US federal taxes, fines, and penalties in the next few years. Accordingly, the entity projects that it will show net book and tax losses for the next two to four years, after which regular profitability will return. Extra uses GAAP for its financial statements; although it is not yet publicly traded, the entity's lenders keep a close watch on annual book income/loss. The corporation employs a tax department of thirtyseven professionals, and an internal audit function includes twenty-five permanent positions. Extra uses your firm for its outside tax work, most of which is multijurisdictional tax planning, including the income tax return that it files with the federal government, seven states, and two cities. Extra generates no foreign-source income or deductions at this point. The entity is not subject to the alternative minimum tax this year. No tax rate changes have been enacted that will apply in future years. Extra does not record a valuation allowance to its tax deferrals. Extra holds only one carryforward to this tax year, a state and federal NOL of $120 million. The book expenses that are added to the unicap balance this year totaled $300 million (Under the unicap rules of IRC section 263A, certain costs that are generally expensed for book purposes are instead added to inventory cost for tax purposes, i.e. not deducted until recovered through cost of goods sold). Your present task is to convert the trial balance numbers into a worksheet that calculates both the current state and federal tax payable, and the total tax provision for Extra this year. The book trial balance has been prepared and is presented in summary form with annotations below. Page 1 of 4 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Extra Corporation Trial Balance Data, Condensed ($M) With annotations Notes re tax amounts ($M) Page 2 of 4 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION I Identify the book-tax differences that are apparent from the Extra trial balance. Classify them as temporary or permanent, and as current or non-current. Use a format like the worksheet below for this purpose. A few sample entries have been included in the template. Extra Corporation Book-Tax Difference Summary Item Advertising Costs Depreciation Fines, Penalties, Lobbying Expenditures Bad Debts No Book-Tax Difference Permanent Book-Tax Differences Temporary Current Non-Current II Use the trial balance data to construct Extra's tax expense (\"tax provision\") for the year. First determine the current tax payable amounts, state and federal, that will be reported on the year's tax returns. Then add the deferred tax items to compute the total income tax provision. Extra's statutory tax rates are 35 percent federal, and 5 percent blended state (before related federal effects). Federal income taxes are not deductible in any of the states in which Extra operates, but state income taxes are a proper federal tax deduction. All of the states with which Extra files income tax returns define taxable income in the same way. You might structure your computation as illustrated below. Make certain that your classifications of the book-tax differences match those that you developed in Part I. III Construct the journal entry to record Extra's current and deferred tax expense for the year. Page 3 of 4 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Extra Corporation Trial Balance to Tax Provision ($M) Item Pre-Tax Book Profits Temporary Book-Tax Differences Permanent Book-Tax Differences 505 Book-Tax Adjustments, Current Tax Payable State Taxable Income State Tax Payable Federal Taxable Income Federal Tax Payable Current Tax Payable, Total Deferred Tax Expense Total Temporary Differences Times Combined State and Federal Tax Rate (A) State (deductible for federal) .05 - (.35) (.05) = 3.25% plus Federal 35% Addition to Net Deferred Tax Asset (rounded) Tax Provision X .3825 (B) Current + Deferred (A + B) Page 4 of 4 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution INSTRUCTOR NOTE This case assumes that the student holds little or no knowledge about accounting for book-tax differences. Facts and comments are kept at an \"entry level\" throughout. You might distribute part 0 of this solution file to the students as a primer on the rules relating to accounting for income taxes. You might give some or all of the following items to the students, as a hint or prompt to help in crafting the solution that is turned in. I You will use the completed listing of book-tax differences as a checklist to make certain that your tax provision computations in part II are complete. Not all of the listed trial balance amounts constitute a book-tax difference. Almost all of the transactions of a business entity receive identical treatment for book and tax purposes. II When determining the current tax payable (\"cash tax\") from the trial balance, first compute state taxable income and tax, as this amount is a federal tax deduction for the year. Now compute the deferred tax expense. This is the combined state and federal tax rate times the total temporary differences. Formula is = .35 + (5 x (1 - .35)) Make certain that you keep your positiveegative signs correct as you compute the addition to the deferred tax asset account. The largest temporary difference is the add-back to book income due to changes in the unicap balance; this is a temporary increase in tax liabilities. The tax provision (\"tax expense\") is the sum of the current and deferred income tax amounts. III The deferred tax amount is classified as current and non-current, based on the assets underlying the income/deduction. Of Extra's temporary differences, only the NOL carryforward and the accelerated depreciation appear to relate to a non-current item. Page 1 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution 0 The expense for income taxes typically is one of the largest items on the income statement of a business. Entities make interperiod allocations of the income tax expense because financial accounting and the taxing system use different rules to accomplish different objectives. 1 Income tax rules are created by a large number of governmental jurisdictions, and financial accounting rules are created by several different bodies as well. Some observers believe that the book expenses for income taxes for the year should simply be the \"cash tax\" amount payable on the income tax returns for the period, but this approach would ignore the matching principle of financial accounting, and it often takes longer in time for a client to determine tax payable amounts than is required to compute book income for reporting purposes. Instead, ASC 740 / FAS 109 requires that the book tax expense relate to the income that is reported for the period. If book income includes taxable or deductible amounts that are recognized in future time periods, a deferred tax asset and/or liability is created on the balance sheet. This balance sheet approach to the accounting for income taxes means that an asset or liability is created when a tax amount that relates to current book income actually is recognized in a future period. The ASC 740 / FAS 109 rules assume that all deferred tax assets and liabilities are realized in full in the future. Permanent and Temporary Book-Tax Differences The vast majority of items encountered by a business enterprise are treated identically for financial reporting and tax purposes. But some items receive differing treatment, and they are known as book-tax differences. Book-tax differences for revenue and expense items are classified as permanent or temporary. Permanent differences are book items that never affect the taxable income computation. Permanent differences affect the effective tax rate of the entity for the period (Pre-Tax Book Income / Tax Expense), as reported in a footnote to the GAAP financial statements. A permanent difference might arise because: The tax law permanently excludes an income item. This reduces the entity's effective tax rate. The tax law disallows a deduction for a book expense item in computing taxable income. This increases the entity's effective tax rate. The entity operates in a jurisdiction, say the US state of Nevada or the Cayman Islands, that does not levy an income tax. This reduces the entity's effective tax rate. Temporary differences are book items that are recognized on the tax return in future reporting periods. Temporary differences are summarized and accounted for on the balance sheet as deferred tax assets or liabilities. This requires that the entity make journal entries to record the 1 Thor Power Tool, 99 SCt 773 (1979). Page 2 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution income tax expense (also called the income tax provision) and any deferrals due to book-tax differences. A book-tax difference that relates to taxable income that will be recognized in the future is a taxable temporary difference, and it creates a deferred tax liability. A book-tax difference that relates to a deduction that will be recognized in the future is a deductible temporary difference, and it creates a deferred tax asset. Book amounts for future tax benefits are not recorded under financial accounting rules unless it is more likely than not (> 50 percent probability) that they will occur.2 Temporary differences further are classified as current or non-current, as to their placement on the balance sheet. The temporary differences are current if they relate to deferrals concerning current assets and liabilities, and they are non-current if they relate to assets and liabilities that are not current in the balance sheet presentation. Usually, temporary differences are recorded in one period and then \"reverse\" in the future, perhaps over a period of years. Examples of book-tax differences include: Municipal bond interest (permanent) Bad debt reserves (current temporary, relating to accounts receivable) Depreciation computations (non-current temporary, relating to fixed assets) Many balance sheets include both deferred tax assets and deferred tax liabilities, because these accounts relate to various transactions and taxing jurisdictions, and to current and non-current items. GAAP rules also discourage the \"netting\" of large tax deferral amounts against each other, so that the balance sheet and its footnotes lose transparency as to operating results that might be important to those who wish to analyze the financial statements thoroughly. Tax Provision v Tax Payable The tax payable (sometimes called cash tax) is the amount determined on the entity's currentyear tax returns. This amount is calculated under the taxing rules of the various jurisdictions in which the business operates. For most entities, these include taxes imposed by governments such as the US federal, one or more US states, other countries, and states/provinces/etc within the other countries. Tax payable generally is computed relative to taxable income, and then certain tax credits and carryovers are allowed. A tax provision (tax expense) is the amount used on financial accounting records to reduce book income. The financial accounting rules of the US and other countries are used to summarize the entity's current-year results on its financial statements. The tax expense can be seen as the tax payable amount adjusted for current-year tax deferrals relating to both taxable and deductible items. 2 ASC 740-10 / FIN 48. Page 3 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution GAAP provisions concerning tax deferrals are found chiefly in ASC 450 / FAS 5 and ASC 740 / FAS 109. Under the rules of the International Financial Reporting Standards (IFRS), IAS 12 (1996) uses many of the same rules and concepts as have been developed in GAAP. The IFRS approach harmonizes the varying treatments of income tax accounting that had been used in other developed countries. The partial recognition approach to income tax deferrals had been used in the UK and other countries, and the UK had allowed a discounting to present value of the tax deferrals. But the ASC 740 / FAS 109 complete recognition balance sheet approach generally is becoming the worldwide standard. For instance, some discussion about the proper accounting for income taxes asserts that tax deferrals are not legally enforceable assets or liabilities of the entity, ie their recognition depends fully upon future events, such that they are not balance sheet items similar to others included in the balance sheet. Examples of seemingly-contingent subsequent events include the recognition of taxable income in future tax years, so that a loss or credit carryforward can be used, or the fulfilling of statutory requirements to avoid the pay-back of a tax credit, say because the required number of jobs were created by the entity under the terms of the credit as granted by the taxing jurisdiction. Applicable Tax Rates Deferred tax accounts on the balance sheet are not discounted to their present values. The ASC 740 / FAS 109 rules require that computations of the tax deferrals apply the tax rates that are scheduled to be in effect in the future years when the temporary differences are expected to reverse. In the US, only rarely are schedules of future tax rate changes enacted by Congress. This means that current rates usually are expected to be used in the future, although expected income and loss amounts might push the entity into higher or lower rates on a progressive tax rate schedule. A zero rate, though, never should be used in constructing the tax deferral amounts. If tax rates do change between the dates of the tax deferral and its recognition, the balance sheet accounts are adjusted when the legislative change occurs. Valuation Allowance A deferred tax asset is created when, say, the entity generates a tax net operating loss that it carries forward to future years. The deferred tax asset, though, might be offset by a balance sheet contra-asset account known as a valuation allowance. This book-only allowance is derived when the entity's management applies its professional judgment to determine that it is more likely than not (> 50 percent probability) that some portion of the deferred tax asset never will be recognized on the income statements of the business. For instance, if taxable income projections are so low as to call into question whether an NOL carryforward actually will be used, the entity creates a valuation allowance against the deferred tax asset. Management can take into account its various tax planning strategies, eg to accelerate taxable income into the period of the NOL carryforward, in constructing the valuation allowance. Page 4 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution Summary of the Steps ASC 740 / FAS 109 rules summarize the procedures used to construct a full accounting for the entity's current and deferred income tax expense. Identify the types and amounts of permanent and temporary book-tax differences that relate to current-year book income For taxable temporary differences, use the applicable current and future tax rates to determine any deferred tax liability For deductible temporary differences, use the applicable current and future tax rates to determine any deferred tax asset If it is more likely than not that some or all of a deferred tax asset will not be realized, measure and apply a valuation allowance to offset the asset Track specific deferred tax assets and liabilities over their life cycle and adjust them on future financial statements due to changes in management expectations, tax planning techniques, tax rates, and tax laws Example Trucco Limited has one book-tax difference to report. It uses accelerated tax depreciation for its operating equipment, classified as a long-term asset on the balance sheet. This year, Trucco is subject to a blended 40 percent income tax rate. Its pre-tax book income totals $75, and the excess of tax over book depreciation is $15. Here is the journal entry to record the deferred tax liability relating to the depreciation. Income Tax Expense (.40 x $75) Income Tax Payable [.40 x ($75 - 15)] Deferred Tax Liability - Non-Current 30 24 6 Here is the presentation of the deferral on Trucco's income statement. Pre-Tax Book Income Income Tax Expense Current Deferred $75 $24 6 (30) Page 5 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution Financial Accounting Net Income $45 Example Fallert Limited generated a book and tax net operating loss (NOL) this year of $35. It is subject to a 30 percent blended income tax rate. The NOL is carried back for two tax years, but there is only $5 of positive taxable income in the carryback period, so Fallert posts a refund receivable of $1.5 (30% x $5). Next, the remaining $30 NOL is carried forward to future tax years, to offset positive taxable income recognized then. Here is the journal entry to account for the current-year Fallert NOL. The two debits are balance sheet items, and the two credits show up on the income statement as an offset to the book net operating loss. The loss to Fallert is really only $24.5 ($35 - 10.5), because of the tax benefits (current and future tax savings in cash) from the NOL. Income Tax Refund Receivable (.30 x $5) Deferred Tax Asset, NOL - Non-Current Income Tax Benefit, NOL carryback Income Tax Benefit, NOL carryforward 1.5 9.0 1.5 9.0 Now assume that management projects that there will be positive operating income during the tax NOL carryforward period sufficient only to use up one-third of the carryforward, several years from now. A valuation allowance is created to reduce the deferred tax asset accordingly. The journal entry as revised for this additional information is: Income Tax Refund Receivable (.30 x $5) Deferred Tax Asset, NOL - Non-Current Income Tax Benefit, NOL carryback Income Tax Benefit, 1/3 of NOL carryforward Valuation Allowance to Reduce Deferred Tax Asset to Realizable Value - NOL Carryforward 1.5 9.0 1.5 3.0 6.0 The Fallert balance sheet is affected by the receivable, deferred tax asset, and valuation allowance. The income tax benefit to reduce the $35 operating loss on the income statement is now only $4.5. Combined with the valuation allowance, the deferred tax asset nets to only $3, the tax benefit that is more likely than not to be realized. Other Financial Reporting for Taxes The footnotes to the financial statements report the entity's effective tax rate that falls on current book income, often separately for US federal, US state/local, and international taxing jurisdictions. Some detail is required to be disclosed as to the specific temporary book-tax differences that lead to the balance sheet amounts. Other footnotes, eg relating to accounting methods and policies, the use of stock options, and pension obligations, also include some information about the entity's income tax positions. Page 6 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution In addition, a \"rate reconciliation\" is used to explain why the entity's effective rate of income tax for the period (Pre-tax Book Income / Tax Provision) is greater or less than its expected combined federal, state/local, and international statutory tax rate. The rate reconciliation provides some detail concerning the permanent book-tax differences that the entity employed for the reporting period, eg concerning the non-taxable portion of dividend income received. It further might disclose the tax benefit resulting from the entity's use of reduced tax rates available through a treaty with another country. Changes in the tax deferral accounts also are reflected in the entity's statement of cash flows, usually classified with continuing operating activities.3 For instance, an increase in the deferred tax liability account relating to the current-year tax provision generally is a positive amount in the cash flow statement. This entry also should include adjustments to the deferrals that are caused by pertinent tax rate and tax law changes.4 The income statement also discloses the entity's obligations for other taxes, eg sales, property, excise, and payroll taxes incurred. Book-tax differences from these items are rare, except as they might relate to audit adjustments, and to governmental challenges over whether there is a need for the taxpayer to pay taxes at all (these often are known as nexus or permanent establishment issues). But those obligations are reported under the general GAAP rules for measuring contingent liabilities,5 not ASC 740 / FAS 109, which relates only to income tax expenses and obligations. Ethical Considerations Tax deferral accounts, and especially those relating to changes in the valuation allowances, turn to a great extent on subjective decisions and projections that are made by management. Thus, some observers maintain that there is an opportunity for the tax accounts to be used to \"manage the income\" of the entity to meet or beat the expectations of analysts or the markets. The valuation allowance rules require that a more-likely-than-not standard be met as to anticipated future events before the allowance is adjusted. Documentation should be generous and contemporaneous in providing a rationale for the changes in the valuation allowance. Conceivably, changes to the valuation allowance are assessed and measured every reporting quarter for the business. If an income-smoothing strategy is being executed and the business is profitable, one might expect that the tax deferral valuation allowances would increase. But proper unbiased documentation could be available to back up such an increase in the allowance as correct. Summary Here is a summary of the most commonly encountered adjustments used by C corporations in completing the Schedules M-1 and M-3. 3 ASC 230 / FAS 95. 4 ASC 740 / FAS 109, 45. 5 ASC 450 / FAS 5. Page 7 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution Item Type Depreciation Temporary Muni Bond Interest Dividends Received Permanent Permanent Meals and Entertainment Net Capital Loss Permanent Federal Income Tax State/Local Income Tax Bad Debts Permanent Temporary Excessive Compensation Permanent Qualified Plans Temporary Political Contributions, Most Lobbying Expenditures Unicap Costs Permanent Inventory Reserves Temporary LIFO Reserves Temporary Self-Insurance Reserves Warranty Reserves Temporary Temporary Temporary Temporary Temporary General Tax Treatment Various accelerated methods Exclude Exclude 70,80, or 100 percent Deduct 50 percent Only to offset capital gains Do not deduct Deduct General Book Treatment Straight line, or some acceleration IRC Section Reference 167,168, others Include Include 103 243,245,246 Expense 100 percent Subtract as incurred Expense Expense per provision amount Expense using allowance 274 Expense 162 Deduct per actuary, with 8 month grace period Do not deduct Expense 404 Expense 162 Capitalize into inventory Reserves not allowed Reserves not allowed Reserves not allowed Reserves not allowed Usually expense 263A Reserves allowed 471 Reserves allowed 472 Reserves allowed 461 Reserves allowed 461 Deduct per specific writeoff Deduction limited to $1M if publicly traded 1211 275 164 166 Page 8 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution Item Type Accrued Vacation and Bonus Temporary Domestic Production Activities Deduction Organization Costs Permanent Gain/Loss on Asset Sale Temporary Installment Sale Gain Temporary Gifts to Charity Temporary Prepaid Rent Income Goodwill, purchased Temporary Covenants not to Compete Software Developed Temporary Premiums Paid, Key Employee Life Insurance Permanent Temporary Temporary Temporary General Tax Treatment Deduct as paid, with 2 month grace period Deduct General Book Treatment Reserves allowed IRC Section Reference 404 Do not expense 199 Amortize over 180 months; one-year rule; may deduct up to $5,000 currently Reflect tax basis Expense as incurred 248 Reflect book cost 168,1245 Recognize gross profit over collection period Deduct with 2 month grace period, within income limits, carryforward excess Include as received Amortize over 15 years Realize in year of sale 453, others Expense 170 Realize as earned 451 Expense per impairment of value Expense over contract term Amortize over useful life 197 Expense 264 Amortize over 15 years Immediate deduction, or 3 year amortization Do not deduct 197 167 Page 9 of 10 PwC Case Studies in Taxation, 2013, PwC, LLP EXTRA CORPORATION Suggested Solution Item Type Permanent General Tax Treatment Exclude General Book Treatment Include IRC Section Reference 101 Cash Surrender Value Increase, Key Employee Life Insurance Proceeds Received, Key Employee Life Insurance Permanent Exclude Include 101 Expenditures for R&D Temporary Expense as work is carried out 41,174 Luxury box, club dues Futures and Options Permanent Deduct as paid, harmonize with credit Do not deduct Expense 274 Include markto-market amount at year-end Include as earned 1256 Temporary Page 10 of 10 Note consider the entire differnce as non current Note consider the entire differnce as current See other book-tax differences provided in case study Extra Corporation Book-Tax Difference Summary Book-Tax Differences Item No Book-Tax Permanent Difference Temporary Current Advertising Costs Depreciation Fines, Penalties, Lobbying Expenditures Bad Debts NonCurrent Extra Corporation Trial Balance to Tax Provision ($M) Temporary Book-Tax Differences Item Pre-Tax Book Profits 505 Book-Tax Adjustments, Current Tax Payable State Taxable Income State Tax Payable Federal Taxable Income Federal Tax Payable Current Tax Payable, Total Deferred Tax Expense Total Temporary Differences (A) State (deductible for federal) .05 - Times Combined State and Federal (.35)(.05) = Tax Rate 3.25% X .3825 plus Federal 35% Addition to Net Deferred Tax Asset (rounded) Tax Provision (B) Current + Deferred (A + B) Permanent Book-Tax Differences