Deferred Income Taxes

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Intermediate Accounting 2

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Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.

1. Fines and penalties paid are

a. deferred tax assets
b. deferred tax liabilities
c. temporary differences
d. permanent differences

Answer

D. Fines and penalties paid are never deductible for tax purposes. Items which do not get reported on the tax return as deductions or revenues are permanent differences.

2. Which of the following will not lead to a deferred tax account?

a. unearned revenues
b. prepaid expenses
c. expenses incurred and paid in the current period
d. revenues earned and collected in different periods

Answer
C. An expense that is paid and incurred in the same period is not a difference between book and tax. Temporary differences create deferred taxes. Unearned revenues are collected in this period and reported for tax and not recorded for books until a later period when earned. Unearned revenues is a deferred tax asset. More tax is paid in the current period and less will be paid in future periods. Prepaid expenses are paid and deducted for tax and not recorded for books until later when incurred. Prepaid expenses is a deferred tax liability. Less tax was paid in the current period and more will be paid in future periods. (d) creates a book tax difference and deferred tax.

3. Which of the following will create a deferred tax asset?

a. prepaid expenses
b. revenues earned and collected in the prior period
c. accelerated depreciation
d. unearned revenues

Answer
D. Unearned revenues is income for tax when collected and income for books later when earned. The revenue is recorded for tax now, which means there will not be taxable revenue later, which means lower taxable income, which means less tax is paid in the future, which is an asset. (b.) is not a temporary difference. Prepaid expense and accelerated depreciation give a higher deduction in the current period for tax, less deduction in future periods which means higher taxable income in the future; a liability.

4. Which of the following will create a deferred tax liability?

a. prepaid expenses
b. straight line depreciation for books and tax
c. bad debt expense
d. rent expense incurred this year and paid next year

Answer
A. Prepaid expense gives more deduction in the current period for tax and less deduction in future periods which means higher taxable income, pay more tax in the future; liability. (b.) is the same for books and tax and is not a temporary difference. Bad debt expense and rent expense are incurred this year and deducted for tax in future years. The tax deduction in the future will reduce taxable income and less taxes will be paid in the future; an asset.

5. A deferred tax asset gives a situation where

a. future taxes paid are equal to future tax expense
b. future taxes paid are less than future tax expense
c. future taxes paid are more than future tax expense
d. income before tax is less than taxable income

Answer
B. A deferred tax asset occurs when taxes paid in the future are expected to be less than book tax expense. This occurs when the company has future tax deductions that have already been expensed for books or collections reported for tax purposes that have not yet been earned for books. (c. and d.) create a deferred tax liability.

6. A tax valuation allowance is used to reduce

a. a deferred tax asset
b. a deferred tax asset or liability
c. taxable income in the future
d. book income in the future

Answer
A. A tax valuation allowance is used to reduce a deferred tax asset that is not considered realizable. Not realizable means the asset is not expected to be used to reduce taxes paid in the future. A deferred tax liability does not give future benefit and does not require a valuation allowance. The valuation allowance is a contra asset.

7. A tax receivable may be recorded when

a. the company has taxable income in the current year
b. the company has book income in the prior year
c. the company has taxable income in the prior year
d. the company elects to carry forward the net operating loss

Answer
C. A tax receivable may be recorded if the company elects to carry back a net operating loss (NOL) and the company has taxable income in the two prior years. A NOL is a taxable loss. When a company elects to carry back, the company is using current year tax losses to offset prior year taxable income and a refund of taxes paid in prior years for the offset amount is paid to the company. Book income is not relevant to an NOL.

8. A deferred tax liability gives a situation where

a. income before differences is greater for tax than for books
b. future taxes paid are less than future tax expense
c. future taxes paid are more than future tax expense
d. future income before tax is more than future taxable income

Answer
C. A deferred tax liability occurs when taxes paid in the future are expected to be more than future book tax expense. This occurs when the company has deductions in the current year that will be expensed for books in future years. (b. and d.) create a deferred tax asset. Income before differences is always the same for book and tax (a.).

9. According to the current tax law, a company may carry forward a net operating loss for how many years?

a. 5
b. 2
c. 17
d. 20

Answer
D. Under current tax law, the company may elect to carry forward and offset future taxable income within the next 20 years.

10. In its first year the company reports unearned revenue of $25,000 and a tax rate of 40%. The company will report

a. a deferred tax asset of 10,000
b. a deferred tax asset of 15,000
c. a deferred tax liability of 25,000
d. a deferred tax liability of 10,000

Answer
A. The company’s deferred tax will be the amount of the temporary difference x the future tax rate. 25,000 x 40% = 10,000. Since you are not told otherwise, assume the current rate is also the future tax rate. The company received cash which was taxable for income tax purposes in the current year and the amount was not recorded as book revenue. Higher taxable revenue now means less taxable revenue in the future, which is less taxable income, which is less taxes paid, which is an asset.
11. The company reported pretax accounting income of $100,000. The company has one expense with a book tax difference and taxable income is $50,000. This is the company’s first year of operations. The tax rate is 30% and is not expected to change. Record the tax journal entry for the current year.
Answer

Book income is $50,000 higher than tax income because a payment was deductible for tax in the current year and not expensed for books.

A lower taxable income this year means taxable income will be higher in the future meaning more tax will be paid in the future which is a deferred tax liability.

Determine what will happen in the future:
Pay more tax than tax expense in the future creates a liability

Accounting income x tax rate = tax expense
100,000 x 30% = 30,000

Taxable income x tax rate = tax payable
50,000 x 30% = 15,000

Difference x tax rate = deferred tax account balance
50,000 x 30% = 15,000

Income Tax Expense                       30,000
           Deferred Tax Liability                     15,000
           Income Taxes Payable                    15,000
12. The company reported pretax accounting income of $300,000. The company has one temporary book tax revenue difference. This is the company’s second year of operations. The balance in the deferred tax asset account at the beginning of the year is $22,000 created by the cumulative book tax difference of $55,000. Taxable income is $450,000. The current year tax rate is 40% and next year’s tax rate is expected to change to 35%. Record the entry to record income tax for the current year.
Answer

Set up the book tax format and plug in what you know.
Then work up, over to the right and back down.
Income before differences is always the same for both.

Book Tax Cumulative Difference
Income before diff. 300,000         = 300,000
Differences:       55,000 prior year
        Revenue           0        150,000 + 150,000 current year
Income before tax 300,000 G 450,000 G     205,000 cumulative
   Tax % 40% 40%__
Taxes 120,000 180,000
Expense Payable

Cumulative book tax difference x future tax rate = required balance

$205,000 x 35% = $71,750 required balance

Required balance 71,750
Prior year balance 22,000
Current year adjustment 49,750

Record the difference
Income Tax Expense 130,250
Deferred Tax Asset   49,750
            Income Tax Payable                         180,000

Note:
The revenue book tax difference is an asset because it reports more taxable income for the current year, which gives less taxable income in future years and less taxable income means pay less taxes, which is an asset.

What happens in the future determines it is an asset.

Income tax expense is not equal to the computed amount because of the tax rate change. FASB requires you to plug the tax expense to account for the future tax rate change in the current period.

13. In the first year of operations, the Company accrued (for books) bad debt expense of $100,000 related to current year sales. Tax deductions related to bad debt expense taken in the current year were $24,000. The tax rate was 40% in the current year and 35% in future years. Book income before tax for the current year was $220,000. Bad debt expense was the only temporary difference. Prepare the journal entry to record income taxes for the current year for the Company using the liability method. Show supporting calculations
Answer

Set up the book tax format and plug in what you know.
Then work up, over to the right and back down.
Income before differences is always the same for both.

Book Tax Cumulative Difference
 
Income before diff. 320,000       = 320,000
Differences:
Bad debt expense (100,000) (24,000) + 76,000
Income before tax 220,000 G 296,000 x 35% = 26,600
Tax % 40% 40%__
Taxes 88,000 118,400
Expense Payable

Differences:
Expenses are always shown as negative numbers
Revenues are always shown as positive numbers

First year – no prior year differences to consider.
Record the difference x the future tax rate as the deferred tax asset.

Income Tax Expense 91,800
Deferred Tax Asset 26,600
           Income Tax Payable             118,400

Note:
The bad debt book tax difference is an asset because it reports more taxable income for the current year,

which gives less taxable income in future years, pay less taxes in future years; an asset

14. For each situation below, determine the type of deferred tax account that will be created from the difference. Deferred tax asset (A), Deferred tax liability (L),
neither (N).

a. _______ Prepaid insurance

b. _______ Accelerated depreciation for taxes

c. _______ Unearned revenue

d. _______ Revenue earned, not yet collected

e. _______ Interest earned on municipal bonds

f. _______ Research and development costs that are capitalized for books

g. _______ Rent incurred and not yet paid

h. _______ Unrealized gain on investments

i. _______ Investment revenue earned on equity method investments

j. _______ A current year taxable loss that is carried forward

Answer

a. L cash paid and deduct for tax now, less deduction in future years, more taxable income in future years, pay more tax in future years; liability
b. L more deduction for tax now, less deduction in future years, more taxable income in future years, pay more tax in future years; liability
c. A more revenue for tax now, less revenue later, less taxable income; asset
d. L less revenue for tax now, more revenue later, more future taxable income, pay more taxes in the future; liability
e. N This is a permanent difference, never taxable
f. L cash paid and deduct for tax now, less deduction in future years, more taxable income in future years, pay more tax in future years; liability
g. A less tax deduction now, more deduction in the future, less taxable income in the future; asset
h. L no taxable gain now, taxable gain in the future, more taxable income in the future, pay more tax in the future; liability
i. L no cash collected for tax now, more taxable revenue in the future, more taxable income in the future; liability
j. A the loss can be used to reduce taxable income in the future, pay less; asset