taxing situations two cases on income taxes - an accounting case study
DESCRIPTION
Warranty expenses are shown on the income statement as reduced earnings, however taxes are not treated in the same manner. When a tax is paid in one year that should be matched against income of a later period, the tax charge is set aside until the proper time for appearance in the income statement. Therefore, the tax is said to be “deferred”.TRANSCRIPT
Taxing Situations: Two Cases on Income Taxes and Financial Reporting
1
Surf’s Up
1. Assuming no additional new equipment is acquired, how should the difference between taxes paid and the tax expense shown in the pro forma income
statements be reported, if at all?
The company earns $1,500,000 before depreciation and tax. Surf’s Up buys buys equipment for $1,000,000 and depreciates it straight line(modified) for reporting
purposes over 10 years. For tax purposes, MACRS schedule is used as provided in exhibit 1. Depreciation for the first year is $1,000,000 x 1/10 x 1/2 = $50,000
(Note: the ½ factor is for the first year as cited in the case). Depreciation for the first year (1990) is given as $200,000 in exhibit 1. For Reporting purposes, Income
is $1,500,000 - $50,000 = $1,450,000. Taxable income is $1,500,000-$200,000 = $1,300,000. With a tax rate of 40%, the taxes payable are $1,300,000 x .40 =
$520,000. Therefore, the deferred tax liability is ($200,000 - $50,000) x .40 = $60,000. Income tax expense is $520,000+$60,000 = $580,000. The income tax note
to the financial statements is as follows:
Income tax:
Current $520,000
Deferred $ 60,000
Tax expense $580,000
The tax expense of $580,000 is reported on the income statement.
Income before tax $1,450,000
Income tax expense 580,000
Net income $870,000
The deferred tax liability of $60,000 is reported on the balance sheet. This account will increase in the second year, because depreciation for tax purposes
($320,000 exhibit 1) will exceed depreciation for accounting purposes ($100,000). Note: Straight Line Depreciation is shown as stated in the case where for year
1990, only ½ of the depreciation amount is taken.
Tax Depreciation Worksheet
Year Straight MACRS Difference
1990 50000 200000 150000
1991 100000 320000 220000
1992 100000 192000 92000
1993 100000 115200 15200
1994 100000 115200 15200
1995 100000 57600 -42400
1996 100000 -100000
1997 100000 -100000
1998 100000 -100000
1999 100000 -100000
2000 50000 -50000
Total 1000000 1000000 0
Taxing Situations: Two Cases on Income Taxes and Financial Reporting
2
Income Statement
Years
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 All Net Rev Before Tax/Dep $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $16,500,000 Straight Line Depreciation (Modified) $50,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000.00 $100,000 $50,000 $1,000,000
MACRS Depreciation $200,000 $320,000 $192,000 $115,200 $115,200 $57,600 $0 $0 $0 $0 $0 $1,000,000 Net Revenue Before Tax $1,450,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,450,000
Income Tax Expense $580,000 $560,000 $560,000 $560,000 $560,000 $560,000 $560,000 $560,000 $560,000 $560,000 $580,000 $6,200,000 Income Tax Actual $520,000 $472,000 $523,200 $553,920 $553,920 $576,960 $600,000.00 $600,000 $600,000 $600,000 $600,000 $6,200,000
Deferred Income Tax $60,000 $88,000 $36,800 $6,080 $6,080 ($16,960.00) ($40,000) ($40,000) ($40,000) ($40,000) ($20,000) $0
Net Income $870,000 $840,000 $840,000 $840,000 $840,000 $840,000.00 $840,000 $840,000 $840,000 $840,000 $870,000 $9,300,000
2. What will be the balance in the deferred tax liability account in Surf’s Up’s Statement of Financial Position at the end of 1991? 1995? 2000?
As can be seen above the balance in the deferred tax liability account in Surf’s Up Balance Sheet will be:
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Defererred Tax Liability Beg. Balance - $60,000 $148,000 $184,800 $190,880 $196,960 $180,000 $140,000 $100,000 $60,000 $20,000
Period Change $60,000 $88,000 $36,800 $6,080 $6,080 ($16,960) ($40,000) ($40,000) ($40,000) ($40,000) ($20,000)
Ending Balance $60,000 $148,000 $184,800 $190,880 $196,960 $180,000 $140,000 $100,000 $60,000 $20,000 -
Notice that in 2000 the balance is Zero as expected.
Taxing Situations: Two Cases on Income Taxes and Financial Reporting
3
Bug Off, Inc.
1. Prepare pro forma income statements for Bug Off, Inc., for 1990 through 1992 as they will appear in financial reports and in the
company’s income tax returns. How do you account for the difference in taxes occasioned by the difference in accounting for warranty
expense in the accrual method financial reports and in the company’s tax returns?
Warranty expenses are shown on the income statement as reduced earnings, however taxes are not treated in the same manner. When a
tax is paid in one year that should be matched against income of a later period, the tax charge is set aside until the proper time for
appearance in the income statement. Therefore, the tax is said to be “deferred”.
According to standard accounting and IRS regulations, the warranty expenses can be deducted for tax purposes only as these expenses
are actually incurred. However, since the exact warranty expense is not known until the customer requests the warranty service, it must
be estimated. In the case of Bug Off, Inc. this is estimated as 6% of sales. The percentage is derived from past experience.
Journal entry to accrue warranty expense:
Warranty expense Sales * .06
Estimated Warranty Payable Sales * .06
Journal entry for taxes (40% tax rate):
Prepaid (Deferred) Income Tax Charge .40*Sales*.06
Income Tax Expense .40 *Sales*.06
(Note:To reduce tax expense, treat as prepaid 40%
of the amount accrued as warranty expense – not
currently tax deductible)
Taxing Situations: Two Cases on Income Taxes and Financial Reporting
4
Book Income
1990 1991 1992
Revenues $200,000 $100,000 $100,000
Expenses
Materials $50,000 $25,000 $25,000
Salaries $55,000 $35,000 $35,000
Depreciation $5,000 $5,000 $5,000
Warranty Acrrual $12,000 $6,000 $6,000
Total $122,000 $71,000 $71,000
Income before Taxes $78,000 $29,000 $29,000
Tax Rate 40.00% 40.00% 40.00%
Taxes Expense $31,200 $11,600 $11,600 54,400
Net Income $46,800 $17,400 $17,400
Tax Income
1990 1991 1992
Revenues $200,000 $100,000 $100,000
Expenses
Materials $50,000 $25,000 $25,000
Salaries $55,000 $35,000 $35,000
Depreciation $5,000 $5,000 $5,000
Warranty Expenditure $6,000 $12,000 $6,000
Total $116,000 $77,000 $71,000
Income before Taxes $84,000 $23,000 $29,000
Taxing Situations: Two Cases on Income Taxes and Financial Reporting
5
Tax Rate 40.00% 40.00% 40.00%
Taxes Expense $33,600 $9,200 $11,600 54,400
Net Income $50,400 $13,800 $17,400
2. How should the “deferred taxes” be reported in Bug Off’s Statement of Financial Position in each year?
According to the asset and liability approach prescribed by FASB 109, the amount of deferred tax assets and liabilities are computed
annually and placed on the balance sheet.
Warranty Reserve - Balance Sheet Item
Begin. Balance $6,000 $12,000 $6,000
Warranty Accrual $12,000 $6,000 $6,000
Warranty Expenditure ($6,000) ($12,000) ($6,000)
Ending Balance $12,000 $6,000 $6,000
Deferred Taxes - Balance Sheet Item
Book Taxes $31,200 $11,600 $11,600
Taxes Paid $33,600 $9,200 $11,600
Deferred Taxes ($2,400) $2,400 -
References and Data Sources
Proposed Interpretation of Statement of Financial Accounting Standards No. 109 (FASB 2005)