question #78 in the attached file.

Chapter 17 - Accounting for Income Taxes Chapter 17 Accounting for Income Taxes SOLUTIONS MANUAL Discussion Questions 1. [LO 1] Identify some of the reasons why accounting for income taxes is complex. Answer: U.S. tax laws are complex and ambiguous. A company often prepares its financial statements (Form 10-K) six months or more in advance of when the company files its corresponding income tax returns. The rules that apply to accounting for income taxes are not found exclusively in ASC 740 (for example, stock options and business combinations). 2. [LO 1] True or False: ASC 740 applies to all taxes paid by a corporation. Explain. Answer: False. ASC 740 only applies to income taxes paid by a corporation. 3. [LO 1]True or False: ASC 740 is the sole source for the rules that apply to accounting for income taxes. Explain. Answer: False. With the Accounting Standards Codification, the rules that apply to accounting for income taxes are found primarily in ASC 740. The codification includes rules previously found in pronouncements from the Emerging Issues Task Force, opinions from the former Accounting Principles Board, and pronouncements from the Securities and Exchange Commission. ASC 740 does not include the income tax accounting rules that apply to accounting for stock compensation or business combinations. 4. [LO 1] How does the fact that most corporations file their financial statements several months before they file their income tax returns complicate the income tax provision process? Answer: When a corporation files its financial statements in advance of its federal income tax return, management must use judgment to estimate the actual tax liability that will result when the tax return is filed. When the tax return is filed, the corporation must adjust its balance sheet to reflect the actual taxes payable and make any other adjustments to reflect the company's \"true\" current and deferred tax liabilities. This adjustment often is referred to as a \"provision-to-return\" adjustment. 17-1 Chapter 17 - Accounting for Income Taxes 5. [LO 1] What distinguishes an income tax from other taxes? Answer: The FASB defines an income tax as a tax \"based on income.\" This definition excludes property taxes, excise taxes, sales taxes, and value-added taxes, which are assessed based on sales or value. A company reports non-income taxes as expenses in the computation of net income before taxes. 6. [LO 1] Briefly describe the six step process by which a company computes its income tax provision. Answer: The steps to compute a company's federal income tax provision proceed as follows: 1. Adjust pre-tax net income for all permanent differences 2. Identify all temporary differences and tax carryforward amounts 3. Calculate the current income tax expense or benefit (refund) 4. Determine the ending balances in the balance sheet deferred tax asset and liability accounts 5. Evaluate the need for a valuation allowance for gross deferred tax assets 6. Calculate the deferred income tax expense or benefit 7. [LO 2] What are the two components of a company's income tax provision? What does each component represent about a company's income tax provision? Answer: A company computes its current income tax expense or benefit and its deferred income tax expense or benefit. The current income tax expense or benefit represents the income taxes payable or refundable in the current year. The deferred income tax expense or benefit represents the amount necessary to adjust the balance sheet liability or receivable for future income taxes payable or refundable that result from current and prior year transactions. 8. [LO 2] True or False: All differences between book and taxable income, both permanent and temporary, affect a company's effective tax rate. Explain. Answer: False. Permanent differences affect a company's effective tax rate. Temporary differences affect a company's effective tax rate only when the company adjusts its balance sheet deferred income tax asset or liability to reflect changes in the enacted tax rate or for changes in valuation allowances related to deferred tax assets (that is, for prior period adjustments). 2 Chapter 17 - Accounting for Income Taxes 9. [LO 2] When does a temporary difference resulting from an expense (deduction) create a taxable temporary difference? A deductible temporary difference? Answer: An expense results in a taxable temporary difference when the tax deduction precedes the book deduction, creating a future (deferred) tax liability in the period in which the book expense is recorded. An example is accelerated depreciation elected for tax purposes and straight line elected for book purposes. An expense results in a deductible temporary difference when the book deduction precedes the tax deduction, creating a future (deferred) tax asset in the period in which the tax expense is deducted. An example is using the accrual method to record bad debts for book purposes and the charge-off method for tax purposes. 10. [LO 2] When does a temporary difference resulting from income create a taxable temporary difference? A deductible temporary difference? Answer: Income results in a taxable temporary difference when the income is reported on the financial statement prior to being reported on the tax return, creating a future (deferred) tax liability in the period in which the income is reported on the tax return. An example is use of the installment method for tax purposes and full reporting of the income for book purposes. Income results in a deductible temporary difference when the income is reported on the tax return prior to being reported on the financial statement, creating a future (deferred) tax asset in the period in which the book income is reported. An example is reporting a prepayment of income on the tax return in the year received and reporting the income for book purposes in the year the income is earned. 11. [LO 2] Briefly describe what is meant by the asset and liability or balance sheet approach taken by ASC 740 with respect to computing a corporation's deferred tax provision. Answer: Under ASC 740, a company's primary objective is to report its deferred tax assets and liabilities on the balance sheet at the amounts the company expects to recover or pay using the enacted tax rate for the period in which the recovery or payment will take place. The amount necessary to adjust the beginning balance in the deferred tax accounts to the ending balance becomes the deferred income tax expense or benefit recorded as part of the income statement income tax provision. 12. [LO 2] Why are cumulatively favorable temporary differences referred to as taxable temporary differences? 17-3 Chapter 17 - Accounting for Income Taxes Answer: Initially favorable temporary differences are those differences that cause the current year's taxable income to be less than the corresponding net (book) income. As a result, the current year tax liability will be less than the provision that relates to net income. When the difference \"reverses\" in a future year, taxable income will exceed net income, and the current year tax liability will exceed the provision that relates to net income. A company records this future tax liability (deferred tax liability) in the year in which the favorable temporary difference arises. 13. [LO 2] Why are cumulatively unfavorable temporary differences referred to as deductible temporary differences? Answer: Initially unfavorable temporary differences are those differences that cause the current year's taxable income to be greater than the corresponding net (book) income. As a result, the current year tax liability will be greater than the provision that relates to net income. When the difference \"reverses\" in a future year, taxable income will be less than net income, and the current year tax liability will be less than the provision that relates to net income. A company records this future tax benefit (deferred tax asset) in the year in which the unfavorable temporary difference arises. 14. [LO 2] In addition to the current year tax return taxes payable or refundable, what other transactions can affect a company's current income tax provision? Answer: The current year income taxes payable or refundable also can be affected by 1) tax refunds or additional tax deficiencies from prior year tax returns that result from an IRS audit; 2) prior year income tax refunds from current year carrybacks; 3) the portion of tax benefits from the exercise of nonqualified stock options that were not previously recorded as temporary differences under ASC 718 or APB 25; or 4) increases in the unrecognized tax benefit (income taxes payable) under ASC 740 that the corporation expects to be resolved within the next 12 months. 15. [LO 2, 4] What is an unrecognized tax benefit and how does it affect a company's current income tax expense? 4 Chapter 17 - Accounting for Income Taxes Answer: An unrecognized tax benefit is the amount of income taxes a company expects to pay as the result of future income tax return audits by tax authorities. Thought of another way, it is the amount of income tax benefits the company will have to \"return\" in the future as a result of income tax return audits by tax authorities. Those taxes a company expects to pay within the next 12 months are classified as current taxes payable on the balance sheet. Additions to the unrecognized tax benefit that the company expects to pay within the next 12 months are treated as part of the current income tax expense. 16. [LO 2] True or False: When Congress changes the corporate tax rates, only the current year book-tax temporary differences are measured using the new rates. Explain. Answer: False. When Congress changes the enacted corporate tax rates, a company must adjust its total deferred tax asset and deferred tax liability accounts on its balance sheet to reflect the income tax benefit or expense that will result under the new rate in the future. The adjustment to the deferred tax accounts will be recorded as an increase or decrease to the deferred tax expense or benefit and will appear in the reconciliation of the company's effective tax rate as a prior period adjustment. 17. [LO 2] True or False: All temporary differences have a financial accounting basis. Explain. Answer: False. Not all temporary differences have a financial accounting basis. Net operating loss and net capital loss carryovers create deferred tax assets but do not have a financial accounting basis. 18. [LO 3] What is the purpose behind a valuation allowance as it applies to deferred tax assets? Answer: A valuation allowance operates as a \"contra account\" to the deferred tax assets on the balance sheet. If a company determines that it is more likely than not (a likelihood greater than 50%) that some portion or all of the deferred tax assets will not be realized in a future period (that is, reduce future taxable income or future tax liability), the company must offset the deferred tax assets with a valuation allowance to reflect the amount it does not expect to realize in the future. 19. [LO 3] What is the difference between recognition and realization as it applies to the recording of a deferred tax asset on a balance sheet? 17-5 Chapter 17 - Accounting for Income Taxes Answer: Recognition relates to whether it is \"probable\" the company has the right to a future tax benefit, in which case the company can record the deferred tax asset on the balance sheet. Realization relates to whether it is more likely than not the company expects to have sufficient taxable income or tax liability in the future to absorb the future tax deductions or credits when they are reported on the tax return or before they expire. 20. [LO 3] Briefly describe the four sources of taxable income a company evaluates in determining if a valuation allowance is necessary. Answer: The four sources of taxable income that are considered in the valuation allowance process are as follows: 1. Future reversals of existing favorable (taxable) temporary differences; 2. Taxable income in prior carryback year(s); 3. Expected future taxable income exclusive of reversing temporary differences and carryforwards; and 4. Taxable income that will result from prudent tax planning strategies. 21. [LO 3] Which of the four sources of taxable income are considered objective and which are considered subjective? Which of these sources generally receives the most weight in analyzing whether a valuation allowance is necessary? Answer: The objective sources are future reversals of existing favorable (taxable) temporary differences and taxable income in prior carryback years. The subjective sources are expected future taxable income exclusive of reversing taxable temporary differences and carryforwards and taxable income that will result from tax planning strategies. Objective sources of taxable income generally receive more weight when analyzing whether a valuation allowance is necessary. 22. [LO 3] What are the elements that define a tax planning strategy as it applies to determining if a valuation allowance is necessary? Provide an example where a tax planning strategy may be necessary to avoid recording a valuation allowance. 6 Chapter 17 - Accounting for Income Taxes Answer: ASC 740 defines a tax planning strategy as an action that is 1) prudent and feasible, 2) is one that is not in the ordinary course of business but which a company would take to prevent an operating loss or tax credit carryforward from expiring unused, and 3) would result in realization of the deferred tax assets. An example of a tax planning strategy might be a company's willingness to sell a parcel of land held for investment to create a capital gain that could be used to keep a net capital loss carryover from expiring unused. A company would have to rely on a tax planning strategy to avoid recording a valuation allowance when the other three sources of taxable income do not provide sufficient taxable income to absorb the recorded deferred tax assets. 23. [LO 3] When does a company remove a valuation allowance from its balance sheet? Answer: A company removes a valuation allowance from its balance sheet when it determines that it is more-likely-than-not that, based on all available evidence, a deferred tax asset will be realized (that is, the tax benefit will be received) in a future period. 24. [LO 3] What is a company's book equivalent of taxable income and how does this computation enter into the income tax provision process? Answer: A company computes its book equivalent of taxable income by adjusting pretax net income from continuing operations for permanent differences. Multiplying the book equivalent of taxable income by the applicable tax rate provides a \"back-of-the envelope\" computation of the company's total income tax provision, assuming there is no change in the company's applicable tax rate during the period or other changes related to a prior period (for example, an adjustment of a valuation allowance). 25. [LO 4] What motivated the FASB to issue FIN 48? Answer: The FASB issued FIN 48 (now codified in ASC 740) because it was concerned that there was \"diversity in practice\" in the way in which companies computed their income tax contingency reserve under FAS 5. 26. [LO 4] Briefly describe the two step process a company must undertake when it evaluates whether it can record the tax benefit from an uncertain tax position under ASC 740. 17-7 Chapter 17 - Accounting for Income Taxes Answer: ASC 740 applies a two-step process to evaluating tax positions. ASC 740 refers to the first step as recognition. A company must determine whether it is more likely than not (a greater than 50% probability) that a tax position will be sustained on examination by the IRS or other taxing authority, including resolution of any appeals within the court system, based on the technical merits of the position. The second step is referred to as measurement. If the tax position meets the more-likelythan-not threshold (a subjective determination), the company must determine the amount of the benefit to record in the financial statements. The company records the largest amount of the benefit, as calculated on a cumulative probability basis, that is morelikely-than-not to be realized on the ultimate settlement of the tax position. The portion not recognized is referred to as an \"unrecognized tax benefit\" and is recorded as an increase in income taxes payable on the balance sheet. 27. [LO 4] Distinguish between recognition and measurement as they relate to the computation of unrecognized tax benefits under ASC 740. Answer: Recognition is the process of determining whether the company can record some portion or all of the tax benefit from the tax position on its financial statements. Measurement is the process of determining the amount of the tax benefit that can be recorded on the financial statements. 28. [LO 4] What is a tax position as it relates to the application of ASC 740 to uncertain tax positions? Answer: ASC 740 defines a tax position as any issue dealing with income taxes. ASC 740 pertains to tax positions taken on a current or previously filed tax return or a tax position that will be taken on a future tax return that is reflected in the financial statements as a deferred tax asset or liability. A tax position also relates to tax returns that the company has not filed in a tax jurisdiction but could be required to file in the future on audit. 29. [LO 4] True or False: A company determines its unrecognized tax benefits with respect to a transaction only at the time the transaction takes place; subsequent events are ignored. Explain. 8 Chapter 17 - Accounting for Income Taxes Answer: False. A company must reassess its balance in its unrecognized tax benefit account when subsequent events occur (for example, the issuance of regulations, rulings, court opinions) that might change the company's assessment of whether a tax position will be sustained on audit and litigation. As facts and circumstances change, a company must reevaluate the tax benefit amount they expect to realize in the future. 30. [LO 4] True or False: ASC 740 requires that a company treat potential interest and penalties related to an unrecognized tax benefit as part of its income tax provision. Explain. Answer: False. ASC 740 allows a company to treat potential interest and penalties related to a tax contingency reserve as part of its income tax provision or as expenses deducted in the computation of its pre-tax income or loss from continuing operations. ASC 740 requires that the company apply its election consistently from period to period and disclose how it is treating the interest and penalties in its financial statements in a footnote to the financial statements (usually in the Income Taxes note). The liability related to interest and penalties is not included in the liability related to unrecognized tax benefits, however. 31. [LO 4] Where on the balance sheet does a company report its unrecognized tax benefits? Answer: A company reports its unrecognized tax benefits as part of its income taxes payable or some other liability on the balance sheet. The additional tax that the company expects to pay in the next 12 months is classified as current income taxes payable. The tax the company expects to pay beyond the next 12 months is classified as long-term income taxes payable. 32. [LO 4] Why did many companies oppose FIN 48 when it was first proposed? Answer: Opponents of FIN 48 worried that the FIN 48 disclosures would provide a \"roadmap\" to the IRS to a company's uncertain tax positions. The aggregate reporting of uncertain tax positions has provided the IRS with less information than it may have expected, which led the Treasury to create new Schedule UTP, on which a company is required to list its uncertain tax positions taken on its financial statements. 33. [LO 5] How does a company determine if a deferred tax asset or liability should be classified as current or noncurrent on its balance sheet? 17-9 Chapter 17 - Accounting for Income Taxes Answer: A company classifies its deferred tax assets and liabilities based on the classification of the asset or liability to which the deferred tax account relates. Deferred tax liabilities related to a long-term asset (for example, depreciation of a fixed asset) are classified as noncurrent because the related asset is classified as noncurrent on the balance sheet. A deferred tax asset related to uncollectible accounts receivable would be classified as a current asset because accounts receivable is treated as a current asset. Deferred tax liabilities and assets not related to a specific asset (for example, a net operating loss carryover or organizational expenditures capitalized for tax purposes) are classified based on the expected reversal date of the temporary difference. 34. [LO 5] Under what conditions can a company net its current deferred tax assets with its current deferred tax liabilities on the balance sheet? Answer: ASC 740 permits netting of current deferred tax assets and liabilities if they are attributable to the same tax jurisdiction or relate to the same components of the enterprise (for example, a subsidiary that is part of the consolidated financial statements and part of the consolidated income tax return). The same netting rule applies to noncurrent deferred tax assets and liabilities as well. 35. [LO 5] True or False: A publicly traded company must disclose all of the components of its deferred tax assets and liabilities in a footnote to the financial statements. Explain. Answer: False. ASC 740 states that a publicly traded company should disclose the approximate \"tax effect\" of each type of temporary difference and carryforward that gives rise to a \"significant\" portion of net deferred tax liabilities and deferred tax assets. A privately held company only needs to disclose the types of significant temporary differences without disclosing the tax effects of each type. ASC 740 does not define the term significant, although the SEC requires a publicly traded company to disclose separately the components of its total deferred tax assets and liabilities that are 5% or more of the total balance. 10 Chapter 17 - Accounting for Income Taxes 36. [LO 5] What is a company's hypothetical income tax provision and what is its importance in a company's disclosure of its income tax provision in the tax footnote? Answer: A company's hypothetical income tax provision is the income tax provision or benefit that would result from applying the company's U.S. statutory tax rate (34% or 35%) to its pretax income from continuing operations. The hypothetical income tax provision is the amount that is reconciled with the company's actual income tax provision or benefit in the effective tax rate reconciliation component of the company's income tax note. 37. [LO 5] Briefly describe the difference between a company's effective tax rate, cash tax rate, and structural tax rate. Answer: The effective tax rate is the company's total income tax expense or benefit divided by the company's pre-tax net income or loss from continuing operations. The effective tax rate often serves as a benchmark for companies in the same industry. A company's cash tax rate is the effective tax rate taking into account only taxes actually paid or refunded during the year. Taxes paid or refunded usually is reported in the company's Statement of Cash Flows. A company's structural tax rate is the effective tax rate adjusted for onetime (discrete) and non-recurring book-tax differences. It is usually interpreted as the company's sustainable effective tax rate from operations. Problems 38. [LO 1] Which of the following taxes is not accounted for under ASC 740? a. Income taxes paid to the U.S. government b. Income taxes paid to the French government c. Income taxes paid to the city of Detroit d. Property taxes paid to the city of Detroit e. All of the above taxes are accounted for under ASC 740 Answer: d. Property taxes paid to the city of Detroit are not income taxes because they are assessed based on value and not income. 39. [LO 1] Which of the following organizations can issue rules that govern accounting for income taxes? a. FASB b. SEC c. IRS d. A and B e. All of the above organizations 17-11 Chapter 17 - Accounting for Income Taxes Answer: d. Both the FASB and SEC can issue rules that govern accounting for income taxes. Congress also can issue rules that govern accounting for income taxes. 40. [LO 1] {research} Find the paragraph(s) in ASC 740 that deal with the following items (you can access ASC 740 on the FASB websitehttp://www.fasb.org, and clicking on \"View the Codification.\" You will need a password from your instructor a. The objectives and basic principles that underlie ASC 740 b. Examples of book-tax differences that create temporary differences c. The definition of a \"tax planning strategy\" d. Examples of positive evidence in the valuation allowance process e. Rules relating to financial statement disclosure Answer: a. The objectives and basic principles that underlie ASC 740: 740-10-10-1 b. Examples of book-tax differences that create temporary differences: 740-10-25-20 c. The definition of a \"tax planning strategy\": 740-10-30-19 d. Examples of positive evidence in the valuation allowance process: 740-10-30-22 e. Rules relating to financial statement disclosure: 740-10-50 41. [LO 2] Woodward Corporation reported pre-tax book income of $1,000,000. Included in the computation were favorable temporary differences of $200,000, unfavorable temporary differences of $50,000, and favorable permanent differences of $100,000. Assuming a tax rate of 34%, compute the company's current income tax expense or benefit. Answer: Pre-tax book income Favorable temporary differences Unfavorable temporary differences Favorable permanent differences Taxable income 34% Current income tax expense $1,000,000 (200,000) 50,000 (100,000) 750,000 34% $255,000 42. [LO 2] Cass Corporation reported pre-tax book income of $10,000,000. During the current year, the reserve for bad debts increased by $100,000. In addition, tax depreciation exceeded book depreciation by $200,000. Cass Corporation sold a fixed asset and reported book gain of $50,000 and tax gain of $75,000. Finally, the company received $250,000 of tax-exempt life insurance proceeds from the death of one of its officers. Assuming a tax rate of 34%, compute the company's current income tax expense or benefit. 12 Chapter 17 - Accounting for Income Taxes Answer: Pre-tax book income Increase in bad debt reserve Excess tax depreciation Excess tax over book gain Tax-exempt life insurance proceeds Taxable income 34% Current income tax expense $10,000,000 100,000 (200,000) 25,000 (250,000) $9,675,000 34% $3,289,500 43. [LO 2] Grand Corporation reported pre-tax book income of $600,000. Tax depreciation exceeded book depreciation by $400,000. In addition, the company received $300,000 of taxexempt municipal bond interest. The company's prior year tax return showed taxable income of $50,000. Assuming a tax rate of 34%, compute the company's current income tax expense or benefit. Answer: Pre-tax book income Excess tax depreciation Tax-exempt interest income Net operating loss $600,000 (400,000) (300,000) $(100,000) NOL carryback to prior year 34% Current income tax benefit $50,000 34% $17,000 The remaining $50,000 NOL carryover will be recorded as a deferred tax asset (benefit) of $17,000. 44. [LO 2] Chandler Corporation reported pre-tax book income of $2,000,000. Tax depreciation exceeded book depreciation by $500,000. During the year the Company capitalized $250,000 into ending inventory under 263A. Capitalized inventory costs of $150,000 in beginning inventory were deducted as part of cost of goods sold on the tax return. Assuming a tax rate of 34%, compute the company's taxes payable or refundable. Answer: Pre-tax book income Excess tax depreciation Increase in capitalized inventory costs Taxable income 34% Current income taxes payable $2,000,000 (500,000) 100,000 $1,600,000 34% $544,000 17-13 Chapter 17 - Accounting for Income Taxes 45. [LO 2] Davison Company determined that the book basis of its office building exceeded the tax basis by $800,000. This basis difference is properly characterized as: a. Permanent difference b. Taxable temporary difference c. Deductible temporary difference d. Favorable book-tax difference e. Both B and D are correct Answer: e. Taxable temporary difference and favorable book-tax difference. Future taxable income will increase by $800,000 compared to future book income as the excess book basis is recovered, resulting in a future tax payable. 46. [LO 2] Abbot Company determined that the book basis of its allowance for bad debts is $100,000. There is no corresponding tax basis in this account. The basis difference is properly characterized as: a. Permanent difference b. Taxable temporary difference c. Deductible temporary difference d. Favorable book-tax difference e. Both C and D are correct Answer: c. Deductible temporary difference. Future taxable income will decrease by $100,000 compared to future book income as the bad debts are charged off, resulting in a future tax benefit. 47. [LO 2] Which of the following items is not a temporary book-tax basis difference? a. Warranty reserve accruals b. Accelerated depreciation c. Capitalized inventory costs under 263A d. Nondeductible stock option compensation from exercising an ISO e. All of the above are temporary differences Answer: d. Nondeductible stock option compensation from exercising an ISO (incentive stock option). A company does not receive a tax deduction when an employee exercises an incentive stock option, making the book stock compensation deduction a permanent difference. 14 Chapter 17 - Accounting for Income Taxes 48. [LO 2] Which of the following book-tax differences does not create a favorable temporary book-tax basis difference? a. Tax depreciation for the period exceeds book depreciation b. Bad debts charged off in the current period exceed the bad debts accrued in the current period c. Inventory costs capitalized under 263A deducted as part of current year tax cost of goods sold are less than the inventory costs capitalized in ending inventory d. Vacation pay accrued for tax purposes in a prior period is deducted in the current period e. All of the above create a favorable temporary book/tax temporary difference Answer: c. Inventory costs capitalized under 263A deducted as part of current year tax cost of goods sold are less than the inventory costs capitalized in ending inventory. In this case, book income would exceed taxable income, creating an unfavorable book-tax difference. 49. [LO 2] Lodge, Inc. reported pre-tax book income of $5,000,000. During the year, the company increased its reserve for warranties by $200,000. The company deducted $50,000 on its tax return related to warranty payments made during the year. What is the impact on taxable income compared to pre-tax book income of the book-tax difference that results from these two events? a. Favorable (decreases taxable income) b. Unfavorable (increases taxable income) c. Neutral (no impact on taxable income) Answer: b Unfavorable (increases taxable income). Book income would be $150,000 less than taxable income in the current year. 50. [LO 2] Which of the following book-tax basis differences results in a deductible temporary difference? a. Book basis of a fixed asset exceeds its tax basis b. Book basis of a pension-related liability exceeds its tax basis c. Prepayment of income included on the tax return but not on the income statement (the transaction is recorded as a liability on the balance sheet) d. All of the above result in a deductible temporary difference e. Both B and C result in a deductible temporary difference Answer: e. The future payment of the accrued pension liability and the future recording of previously recorded taxable income will result in future taxable income being less than book income, resulting in a future tax benefit. 17-15 Chapter 17 - Accounting for Income Taxes 51. [LO 2] Shaw Corporation reported pre-tax book income of $1,000,000. Included in the computation were favorable temporary differences of $200,000, unfavorable temporary differences of $50,000, and favorable permanent differences of $100,000. Assuming a tax rate of 34%, compute the company's deferred income tax expense or benefit. Answer: Favorable temporary differences Unfavorable temporary differences Net increase in favorable temporary diff. 34% Net increase in deferred income tax liability $(200,000) 50,000 $(150,000) 34% $ (51,000) The net increase in the deferred income tax liability is recorded as the company's deferred tax expense in the current year. Permanent differences do not affect the deferred income tax provision. 52. [LO 2] Shaw, Inc. reported pre-tax book income of $10,000,000. During the current year, the reserve for bad debts increased by $100,000. In addition, tax depreciation exceeded book depreciation by $200,000. Shaw, Inc. sold a fixed asset and reported book gain of $50,000 and tax gain of $75,000. Finally, the company received $250,000 of tax-exempt life insurance proceeds from the death of one of its officers. Assuming a tax rate of 34%, compute the company's deferred income tax expense or benefit. Answer: Increase in bad debt reserve Excess tax depreciation Excess tax gain Net increase in favorable temporary diff. 34% Net increase in deferred income tax liability $100,000 (200,000) 25,000 $ (75,000) 34% $ (25,500) The net increase in the deferred income tax liability is recorded as the company's deferred tax expense in the current year. Permanent differences do not affect the deferred tax provision. 53. [LO 2] Harrison Corporation reported pre-tax book income of $600,000. Tax depreciation exceeded book depreciation by $400,000. In addition, the company received $300,000 of taxexempt municipal bond interest. The company's prior year tax return showed taxable income of $50,000. Assuming a tax rate of 34%, compute the company's deferred income tax expense or benefit. 16 Chapter 17 - Accounting for Income Taxes Answer: Pre-tax book income Excess tax depreciation Tax-exempt interest income Net operating loss $600,000 (400,000) (300,000) $(100,000) NOL carryback to prior year 34% Current income tax refundable $50,000 34% $17,000 Excess tax depreciation NOL carryover to 2009 Net increase in favorable temporary diff. 34% Net increase in deferred income tax liability (400,000) 50,000 $(350,000) 34% $(119,000) The net increase in the deferred income tax liability is recorded as the company's deferred tax expense in the current year. This assumes the company does not record a valuation against the deferred tax asset created by the NOL carryover. Permanent differences do not affect the deferred tax provision. 54. [LO 2] Identify the following items as creating a temporary difference, permanent difference, or no difference. 17-17 Chapter 17 - Accounting for Income Taxes Answer: Item Temporary Permanent No Difference Difference Difference Reserve for warranties X Accrued pension liability X Goodwill not amortized for tax purposes but subject to impairment under ASC 350 X Meal and entertainment expenses X Life insurance proceeds X Net capital loss carryover Nondeductible fines and penalties X X Accrued vacation pay liability paid within the first 2 months of the next tax year X 55. [LO 2] Which of the following items is not a permanent book/tax difference? a. Tax-exempt interest income b. Tax-exempt insurance proceeds c. Domestic production activities deduction d. Non-deductible meals and entertainment expense e. First-year expensing under 179 Answer: e. First year expensing under 179. First year expensing will eventually be recovered as book depreciation. 56. [LO 2] Ann Corporation reported pre-tax book income of $1,000,000. Included in the computation were favorable temporary differences of $200,000, unfavorable temporary differences of $50,000, and favorable permanent differences of $100,000. Compute the Company's book equivalent of taxable income. Use this number to compute the Company's total income tax provision or benefit, assuming a tax rate of 34%. 18 Chapter 17 - Accounting for Income Taxes Answer: Pre-tax book income Favorable permanent differences Book equivalent of taxable income 34% Total income tax provision $1,000,000 (100,000) 900,000 34% $306,000 Book equivalent of taxable income takes into account only permanent differences. 57. [LO 2] Burcham Corporation reported pre-tax book income of $600,000. Tax depreciation exceeded book depreciation by $400,000. In addition, the Company received $300,000 of taxexempt municipal bond interest. The Company's prior year tax return showed taxable income of $50,000. Compute the Company's book equivalent of taxable income. Use this number to compute the Company's total income tax provision or benefit, assuming a tax rate of 34%. Answer: Pre-tax book income Tax-exempt interest Book equivalent of taxable income 34% Total income tax provision $600,000 (300,000) 300,000 34% $102,000 Book equivalent of taxable income takes into account only permanent differences. 58. [LO 3] Adams Corporation has total deferred tax assets of $3,000,000 at year-end. Management is assessing whether a valuation allowance must be recorded against some or all of the deferred tax assets. What level of assurance must management have, based on the weight of available evidence, that some or all of the deferred tax assets will not be realized before a valuation allowance is required? a. Probable b. More likely than not c. Realistic possibility d. Reasonable e. More than remote Answer: b. More likely than not 17-19 Chapter 17 - Accounting for Income Taxes 59. [LO 3] Which of the following evidence would not be considered positive in determining whether Adams Corporation needs to record a valuation allowance for some or all of its deferred tax assets? a. The Company forecasts future taxable income because of its backlog of orders b. The Company has unfavorable temporary differences that will create future taxable income when they reverse c. The Company has tax planning strategies that it can implement to create future taxable income d. The Company has cumulative net income over the current and prior two years e. The Company had a net operating loss carryover expire in the current year Answer: e. The Company had a net operating loss carryover expire in the current year. ASC 740 lists the expiration of tax carryovers as a source of negative evidence. 60. [LO 3] As of the beginning of the year, Gratiot Company recorded a valuation allowance of $200,000 against its deferred tax assets of $1,000,000. The valuation allowance relates to a net operating loss carryover from the prior year. During the year, management concludes that the valuation allowance is no longer necessary because it forecasts sufficient taxable income to absorb the NOL carryover. What is the impact of management's reversal of the valuation allowance on the company's effective tax rate? a. Increases the ETR b. Decreases the ETR c. No impact on the ETR Answer: b. Decreases the ETR. Removing the valuation allowance creates an increase in the company's income tax benefit, which is treated as a prior period adjustment and causes the effective tax rate to decrease. 61. [LO 3] Which of the following evidence would be considered negative in determining whether Gratiot Corporation needs to record a valuation allowance for some or all of its deferred tax assets? a. The company forecasts future taxable income because of its backlog of orders b. The company has a cumulative net loss over the current and prior two years c. The company has unfavorable temporary differences that will create future taxable income when they reverse d. The company had a net operating loss carryover expire in the current year e. Both B and D constitute negative evidence in assessing the need for a valuation allowance 20 Chapter 17 - Accounting for Income Taxes Answer: e. Both b and d constitute negative evidence in assessing the need for a valuation allowance. ASC 740 states that cumulative book losses constitute a source of negative evidence, as does the expiration of a net operating loss. 62. [LO 3] Saginaw, Inc. completed its first year of operations with a pre-tax loss of $500,000. The tax return showed a net operating loss of $600,000, which the Company will carry forward. The $100,000 book-tax difference results from excess tax depreciation over book depreciation. Management has determined that they should record a valuation allowance equal to the net deferred tax asset. Assuming the current tax expense is zero, prepare the journal entries to record the deferred tax provision and the valuation allowance. Answer: Deferred tax asset* Deferred tax benefit *$600,000 34% 204,000 204,000 Deferred tax expense Deferred tax liability* *$100,000 34% 34,000 34,000 Deferred tax benefit* 170,000 Valuation allowance *$($600,000 - $100,000) 34% 170,000 63. [LO 3] {research} What is the amount of Ford Motor Company's valuation allowance against its deferred tax assets in 2010? What factors led management to establish a valuation allowance against its deferred tax assets (hint: read the management discussion and analysis section of the annual report). Why is the valuation allowance amount less than the total amount of deferred tax assets? You can access Ford's annual report for 2010 at htp://www.ford.com. 17-21 Chapter 17 - Accounting for Income Taxes Answer: 1. Ford's valuation allowance against its deferred tax assets at 12/31/10 is $15.7 billion. 2. In the MD&A section of the annual report, Ford management gave the following reason for recording a full valuation allowance against it net deferred tax assets: In 2006, our net deferred tax position in the United States changed from a net deferred tax liability position to a net deferred tax asset position. In our assessment of the need for a valuation allowance, we heavily weighted the negative evidence of cumulative financial reporting losses in then-recent periods and the positive evidence of future reversals of existing temporary differences. Although a sizable portion of our North American losses in then-recent years were the result of charges incurred for restructuring actions, impairments, and other special items, even without these charges we still would have incurred significant operating losses. Accordingly, we considered our pattern of then-recent losses to be relevant to our analysis. Considering this pattern of then-recent relevant losses and the uncertainties associated with projected future taxable income exclusive of reversing temporary differences, we gave no weight to projections showing future U.S. taxable income for purposes of assessing the need for a valuation allowance. As a result of our assessment, we concluded that the net deferred tax assets of our U.S. entities required a full valuation allowance. We also recorded a full valuation allowance on the net deferred tax assets of certain foreign entities, such as Germany, Canada, and Spain, as the realization of these foreign deferred tax assets are reliant upon U.S.source taxable income. 3. The valuation allowance is less than the gross deferred tax assets because the deferred tax liabilities can be treated as a source of future taxable income. The valuation allowance is recorded based on net deferred tax assets. 64. [LO 4] Montcalm Corporation has total deferred tax assets of $3,000,000 at year-end. Of that amount, $1,000,000 results from the current expensing of an expenditure that the IRS might assert must be capitalized on audit. Management is trying to determine if it should not recognize the deferred tax asset related to this item under ASC 740. What confidence level must management have that the item will be sustained on audit before it can recognize any portion of the deferred tax asset under ASC 740? a. b. c. d. e. 22 Probable More likely than not Realistic possibility Reasonable More than remote Chapter 17 - Accounting for Income Taxes Answer: b. More likely than not 65. [LO 4] Which of the following statements about uncertain tax positions (UTP) is correct? a. UTP applies only to tax positions accounted for under ASC 740 taken on a filed tax return. b. UTP applies to all tax positions accounted for under ASC 740, regardless of whether the item is taken on a filed tax return. c. UTP deals with both the recognition and realization of deferred tax assets. d. If a tax position meets the more likely than not standard, the entire amount of the deferred tax asset or current tax benefit related to the tax position can be recognized under ASC 740. e. Statements b, c, and d are correct. Answer: b. UTP applies to all tax positions accounted for under ASC 740, regardless of whether the item is taken on a filed tax return. 66. [LO 4] Cadillac Square Corporation determined that $1,000,000 of its domestic production activities deduction on its current year tax return was uncertain, but that it was more likely than not to be sustained on audit. Management made the following assessment of the Company's potential tax benefit from the deduction and its probability of occurring. Potential Estimated Benefit (000s) $340,000 272,000 170,000 0 Individual Probability of Occurring (%) 40 25 20 15 Cumulative Probability of Occurring 40 65 85 100 What amount of the tax benefit related to the uncertain tax position from the DPAD can Cadillac Square Corporation recognize in calculating its income tax provision in the current year? Answer: $272,000, the amount that has a cumulative probability of more than 50% of occurring. Cadillac Square Corporation would record an increase in its income taxes payable (income tax expense) of $68,000, the difference between the full benefit received on the tax return and the expected benefit to be received after audit by the IRS. 67. [LO 4] How would your answer to Question 66 change if management determined that there was only a \"50/50\" chance any portion of the $1,000,000 domestic manufacturing deduction would be sustained on audit? 17-23 Chapter 17 - Accounting for Income Taxes Answer: No amount of the tax benefit from the deduction could be recognized. The recognition threshold has not been met (more likely than not), and therefore, the measurement step is not taken. Cadillac Square Corporation would record an increase in its income taxes payable (income tax expense) of $340,000, the full benefit received on the tax return. 68. [LO 4] As part of its UTP assessment, Penobscot Company records interest and penalties related to its tax contingency amount of $500,000. Which of the following statements about recording this amount is most correct? a. Penobscot must include the amount in its income tax provision b. Penobscot must record the amount separate from its income tax provision c. Penobscot can elect to allocate a portion of the amount to both its income tax provision and its general and administrative expenses provided the company discloses which option it chose d. Penobscot can elect to record the entire amount as part of its income tax provision or separate from its income tax provision, provided the company discloses which option it chose e. Statements c and d are both correct Answer: d. Penobscot can elect to record the entire amount as part of its income tax provision or separate from its income tax provision as a pre-tax operating expense, provided the Company discloses which option it is using. 69. {research} What was IBM's accounting effective tax rate for 2010? What items caused the company's accounting effective tax rate to differ from the \"hypothetical\" tax rate of 35%? What was the company's cash effective tax rate for 2010? What factors cause a company's cash tax rate to differ from its accounting effective tax rate? You can access IBM's annual report for 2010 at http://www.ibm.com. Answer: IBM's accounting effective tax rate for 2010 was 24.8% ($4,890/$19,723). IBM reports that its effective tax rate was decreased 10 percentage points from the \"foreign tax rate differential\