Deferred Income Taxes

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Intermediate Accounting 2

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Hard Practice Test

Hard Practice Test

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1. Which of the following is required when recording income taxes?

a. The deferred tax method
b. The temporary identification method
c. The tax expense method
d. The asset / liability method

Answer
D. FASB required that the deferred tax accounts be reported at the cumulative difference multiplied by the future tax rate. This is known as the asset / liability method because the asset and liability are determined first and tax expense is a plug to balance the journal entry after recording the computed taxes payable.

2. Which of the following is not used when recording income taxes under GAAP?

a. the expected future tax rate
b. the difference in expenses incurred and expenses paid for all periods
c. the current tax rate
d. the present value of future deductions

Answer

D. FASB ignores present value. All other factors are considered when recording income taxes under FASB.

3. An increase in deferred tax liabilities is reported on the indirect statement of cash flows as

a. an increase to income tax expense
b. an addition to net income
c. a financing activity
d. an investing activity

Answer
B. The increase in deferred tax liabilities is a difference in tax expense and taxes paid. The increase in the liability means less tax is paid this year than tax expense so the difference is added to net income to get to cash from operations.

4. The amount of tax valuation allowance that is recorded in the current year is equal to

a. the total temporary difference multiplied by the future tax rate
b. the total deferred tax asset multiplied by the % believed to be unrealizable less the current balance in the allowance account
c. the total deferred tax asset multiplied by the % believed to be realized less the current balance in the allowance account
d. taxable income x the current tax rate x the % believed to be unrealizable

Answer
B. The amount of valuation allowance that is recorded in the current year is the difference in the required valuation allowance and the balance that was reported in the prior period. The change in the requirement is the amount that is recorded with an adjustment to tax expense.

5. The balance in a deferred tax liability account will be equal to

a. the current temporary difference divided by the future tax rate
b. the cumulative temporary difference up to this point multiplied by the current tax rate
c. the cumulative temporary difference in the future multiplied by the future tax rate
d. all book tax differences multiplied by the future tax rate

Answer

C. According to FASB, the balance in the deferred tax account must be equal to the cumulative future temporary differences multiplied by the future tax rate. It is an estimate of the impact to taxes payable in the future.

6. A company has a temporary difference of $1 million related to the use of accelerated depreciation for tax purposes. A portion of this difference will reverse next year. The company’s balance sheet will report

a. a current and a non current deferred tax liability
b. a current and a non current deferred tax asset
c. a current deferred tax liability only
d. a non current deferred tax liability only

Answer
D. GAAP states that the deferred tax item is to be reported in the same manner the related asset or liability is reported. Depreciation is related to non current assets and the deferred tax must be reported as non current also. A deferred tax item may be separated as current and non current when the related item is reported as a portion current and a portion non current (example: a 3 year warranty liability which is reported as current liability for those expected to be claimed in the next year and a non current liability for those claims expected in years 2 and 3)

7. An expense recorded for books related to employee stock options in the current year will give rise to

a. a deferred tax asset
b. a deferred tax liability
c. either a deferred tax asset or liability depending on the exercise price
d. a permanent difference

Answer
A. The company will deduct the cost in the future after the employee sells the stock purchased through the exercise of the option. The future deduction will reduce taxable income and income taxes paid in the future; therefore, it is a deferred tax asset.

8. When tax rates change after the temporary difference has created a deferred tax asset or deferred tax liability, the company must

a. retroactively adjust the deferred tax on all statements presented
b. adjust the deferred tax account similar to other changes in estimates
c. adjust only the current year difference for the new tax rate
d. ignore the new tax rate change for prior year differences

Answer
B. The cumulative temporary difference is multiplied by the new future tax rate to determine the required balance in the deferred tax accounts. The amount recorded in the current period is the amount it takes to adjust the total cumulative difference based on the new tax rate. It is recorded and reported as a change in estimate and no retroactive adjustment is required.

9. Which of the following will result in a decrease to a deferred tax liability

a. incurring operating expenses that are not yet paid
b. collecting revenues in advance of performing the service
c. paying claims on a warranty that was expensed in the prior period
d. none of the above.

Answer
D. All of the circumstances give rise to a deferred tax asset. Once a deferred tax asset it remains a deferred tax asset until the temporary difference is totally reversed.

10. The cumulative effect of a change in a future tax rate is

a. reported as an extraordinary item
b. reported as a cumulative effect of a change in accounting
c. reported as part of income from continuing operations
d. reported as a correction of an error in the statement of stockholder’s equity

Answer
C. The change in tax rates is reported as a change in an estimate which changes the current tax expense and changes income from continuing operations.

11. The company began operations on January 1, 20X1 and reported taxable income of $129,000 for 20X1. The taxable loss in 20X2 was $22,000. Temporary differences between financial income and taxable income are:

20X1 20X2
Tax depreciation in excess of book depreciation $ 80,000 $120,000
Bad debt expense in excess of actual write-offs $125,000 $ 90,000
Cash collected for services performed
at a rate of 20% each year $150,000 $ 80,000

The tax rate is 40% for 20X1 and 30% for all future years. The company had non taxable municipal interest income of $10,000 in 20X2. The company elects to carry back net operating losses. One half of deferred tax assets are not expected to be realized.

A. Record all entries required for income taxes for 20X1.
B. Record all entries required for income taxes for 20X2.

Answer

6A. Set up the book tax format and plug in what you know.
Then work up, over to the left and back down.
Income before differences is always the same for both.

Book Tax Cumulative Difference
Income before diff. 59,000 = 59,000
Differences:
Depreciation      0 (80,000) 80,000 x .3 = 24,000 L
Bad debt expense (125,000)        0 125,000 x .3 = 37,500 A
Unearned revenue 30,000 150,000 120,000 x .3 = 36,000 A
Income before tax (36,000) 129,000 G
   Tax %    40%    40%__
Taxes    plug   51,600
Income Tax Expense   2,100
Deferred Tax Asset 73,500
            Deferred Tax Liability             24,000
            Income Tax Payable             51,600

The deferred tax asset is 50% unrealizable and a valuation allowance must be recorded. There is no prior year balance, so record 50% of D/T asset.

Income Tax Expense 36,750
            Tax Valuation Allowance             36,750

Note:

Depreciation is a liability for all future years, more tax deduction in 1st year, less tax deduction in future year, more tax income, pay more; liability

Bad Debt Expense is an asset for all future years.
Less tax deduction in 1st year, more tax deduction in future years, less tax income future years, pay less; asset.

Unearned Revenue is an asset for all future years.
More tax revenue in 1st year, less tax revenue in future years, less income, pay less; asset

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

  Book      Tax Cumulative Difference
Income before diff.  18,000     =    18,000
Differences:
Depreciation    0 (120,000) (120 + 80) x .3 = 60,000 L
Rent expense (90,000)       0 (90 + 125) x .3 = 64,500 A
Unearned revenue 46,000 **    80,000 (34 + 120) x .3 = 46,200 A
Income before tax (26,000)  (22,000) G
Permanent difference  (10,000) income not taxable, larger NOL
(32,000) NOL
     Tax % 30%     30%__
Taxes plug no tax payable

** Earned PY sales 150,000 x .20 + CY sales 80,000 x .20

The cumulative difference x future tax rate must be the balance in the deferred tax accounts. Do not record the computed amount in the entry except in the first year of operations.

D/T Asset D/T Liability
Current year balance 110,700 60,000
Prior year balance 73,500 24,000
Adjustment to be made 37,200 36,000
Deferred Tax Asset 37,200
         Deferred Tax Liability            36,000
         Income Tax Expense              1,200

The deferred tax asset is 50% unrealizable and a valuation allowance must
be recorded.

D/T Asset balance x 50% is the allowance required:

110,100 x 50% = 55,050 required

Current balance required 55,350
Prior year balance recorded 36,750
Adjustment required 18,600
Income Tax Expense 18,600
         Tax Valuation Allowance          18,600

Record the carry back associated with the NOL of $32,000. Prior year taxable income was $129,000 so the loss of $32,000 can all be carried back.

32,000 x prior year tax rate of 40% = 12,800 receivable

Income Tax Receivable 12,800
         Income Tax Expense          12,800
12. The company had a balance in the deferred tax asset account of $24,000 and the deferred tax liability account of $54,000 at the end of the prior year. Taxable income reported for the current year was $132,000. For the current year, the company had the following book tax differences.

Depreciation expense: Book expense greater than tax $ 45,000
Realized losses: Tax greater than book $ 65,000
Equity Investment revenue recorded on books,
first year book tax difference		 $ 18,000
Answer
D/T Asset D/T Liability
A.
Balance in account 24,000 54,000
  / tax rate .30 .30
Cumulative Difference 80,000 180,000

Use the future tax rate for deferred tax balances

Deferred tax asset: Book loss was greater than the tax loss
Deferred tax liability: Tax depreciation was higher than book depreciation

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

Book     Tax Cumulative Difference
Income before diff. 197,000    = 197,000
Differences:
Depreciation (45,000)       0    (180 – 45) x .3 = 40,500 L
Realized Loss         0 (65,000) (80 – 65) x .3 = 4,500 A
Investment revenue 18,000 **       0     18 x .3 = 5,400 L
Income before tax 170,000 132,000 G
   Tax %    30%     30%__
Taxes 51,000 39,600
Payable

The cumulative difference x future tax rate must be the balance in the deferred
tax accounts.

Do not record the computed amount for the cumulative difference in the tax entry except in the first year of operations.

D/T Asset D/T Liability
Current year balance 4,500 45,900
Prior year balance 24,000 54,000
Adjustment to be made (19,500) (8,100)
Income Tax Expense 51,000
Deferred Tax Liability   8,100
          Deferred Tax Asset           19,500
          Income Tax Payable           39,600

The deferred tax accounts decrease.
The temporary difference is reversing.
Tax expense is equal to the computed amount in the table because there is no future tax rate change or permanent differences.

13. The company began operations in 20X1 and follows the same accounting methods for financial accounting and for tax purposes with the exception of accounting for rental income and warranty expense. Information relative to temporary differences follows:

Tax Book
Rental Income 20X1 40,000 15,000
20X2 12,000
20X3 13,000
Tax Book
Warranty Expense 20X1 26,000 100,000
20X2 38,000
20X3 36,000

The tax rate for 20X1 is 40% and an increase to 35% for future years was known in 20X1. Taxable income for 20X1 is $260,000. Pretax financial loss for 20X2 is $365,000. The company elects to first carry back the NOL. The company has determined that 40% of the deferred tax asset is more likely than not to be realizable for 20X2.

Record the 20X2 required income tax entries.

Answer

A. 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 20X2
Cumulative Difference
 
Income before diff. (377,000)     = (377,000)
Differences:
Rent Income 12,000        0 (25 – 12) x .35 = 4,550 A
Warranty Expense        0      (38,000) (74 – 38) x .35 = 12,600 A
Income before tax (365,000) G (415,000) NOL
Tax %      35%         35%__
Taxes (127,750) 0 Payable

Rent income is all recorded for tax in the 1st year.
No income is reported for tax in future years, taxable income is less, less taxes will be paid, this is an asset.
Rent income difference remains a deferred tax asset until the difference goes away in year 3.

Less warranty expense is deducted for tax in the 1st year.
More warranty deduction will be taken for tax in future years.
More deduction means less taxes paid; a liability.

The cumulative difference x future tax rate must be the balance in the deferred
tax accounts.

Do not record the computed amount in the entry except in the first year of operations.

D/T Asset
Current year balance 17,150
Prior year balance 34,650
Adjustment to be made (17,500)
Income Tax Expense 17,500
          Deferred Tax Asset           17,500

DT Asset: Rent + Warranty is (25K +74K) x .35 = 34,650

Record the carry back – prior year income for the only year is $260,000

Current Year Taxable Loss  415,000
Less Prior year income (260,000) x .40 PY = 104,000
Left to Carry Forward 155,000 x .35 future = 54,250
Income Tax Receivable 104,000
Deferred Tax Asset   54,250
         Income Tax Expense             158,250

Establish the valuation allowance for the deferred tax asset

Total in Deferred Tax Asset Account     71,400
60% not realizable      x .60
Total valuation allowance required     42,840

(17,150 + 54,250 = 71,400)

Income Tax Expense 42,840
            Tax Valuation Allowance          42,840

Record the computed amount because there is no prior year balance in the tax valuation allowance account.