Deferred Income Taxes

Medium Practice Test

Intermediate Accounting 2

Key Things To Know

j

Practice As You Learn

Self Test

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Easy Practice Test

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Medium Practice Test

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Hard Practice Test

Medium Practice Test

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

1. Which of the following is a temporary difference between taxable income and income reported on the income statement?

a. a net operating loss
b. computing depreciation using the tax depreciation tables
c. recording interest received as income
d. recording insurance expense when paid

Answer
B. Using tax tables to compute depreciation will give a different expense than using FASB methods for determining the expense. Over time total depreciation expense will be the same for book and for tax which makes it a temporary difference. A net operating loss is a taxable loss for the current year. Both (c.) and (d.) give the same for tax and books.

2. When the tax rate changes in future years, income tax expense will be

a. the difference between taxes payable and the change in the deferred tax accounts
b. the difference in income before taxes and the cumulative change in the temporary differences
c. income before taxes multiplied by the current tax rate
d. income before taxes multiplied by the future tax rate

Answer
A. According to FASB, the procedure is to compute tax payable and record the amount, record the deferred tax accounts as cumulative differences x future tax rate, and then plug the tax expense to balance the journal entry. The future tax rate change is reflected in the current tax expense.

3. A company that sells magazine subscriptions for the entire year and receives one annual payment prior to sending the monthly magazines to the subscriber will report a

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

Answer
A. Collecting cash prior to recording revenue will cause taxable income to be higher than book income in the current year. Higher taxable income now leads to lower taxable income in the future, which means less tax will be paid in the future, which gives a deferred tax asset.

4. When a company records a tax valuation allowance, the company believes that

a. it is more likely than not the deferred tax asset will be realized
b. it is more likely than not the deferred tax asset will not be realized
c. there is a greater than 35% chance the deferred tax asset will be realized
d. the tax receivable may not be collected

Answer
B. FASB stated that (b.) requires a tax valuation allowance to be recorded.
This means the company does not believe it is probable the deferred tax asset will be realized and reduce future taxes paid.

5. When preparing the balance sheet

a. total deferred assets and total deferred liabilities are reported
b. total current and non current deferred tax is reported
c. all deferred tax accounts are considered non current
d. the amount reported will equal the current temporary differences

Answer
B. Deferred tax items are sorted by current and non current based on the type of account the deferred tax item is associated with. Assets and liabilities are netted to get a total current amount and a total non current amount reported on the balance sheet.

6. A loss before tax reported on the income statement may be

a. carried forward only when there is taxable income in the past two years
b. carried back only when there is taxable income in the past two years
c. carried back or carried forward at the discretion of the tax payer
d. none of the above

Answer
D. A net operating loss (NOL) is the taxable loss per the tax return, not a loss on the income statement. The taxable loss may be carried back for 2 years or forward for 20 years at the discretion of the tax payer.

7. A company reports prepaid expenses of $40,000 on their balance sheet. The company’s tax rate is 30%. The company will also report on the balance sheet a

a. current deferred tax liability of $12,000
b. current deferred tax asset of $12,000
c. current deferred tax asset of $28,000
d. non current deferred tax asset of $12,000

Answer
A. Prepaid expense are a deferred tax liability. The expense will be recorded in the future for books when it is incurred. The deduction is taken for tax when paid and there will be no tax deduction in the future. No deduction means higher taxable income which means higher taxes will be paid; a liability. The amount is the future difference x future tax rate (40,000 to be expensed in the future x 30%). Prepaid tax is a current asset so the deferred tax is current also.

8. Which of the following are considered permanent differences?

a. fines and penalties paid by the company
b. municipal interest earned
c. life insurance proceeds received on key executives
d. all of the above

Answer
D. All of the above are permanent differences. These items are not reported on the tax return; however, they are recorded for books.

9. A tax carry forward will

a. increase the current period net income
b. increase the company’s receivables
c. increase the deferred tax asset account
d. both a. and c.

Answer
D. A tax carry forward is recorded with an increase (debit) to deferred tax asset and a decrease (credit) to tax expense. Lower tax expense increases net income.

10. An unrealized loss on investments will create a

a. permanent difference
b. deferred tax asset
c. deferred tax liability
d. tax carry forward

Answer
B. The unrealized loss has decreased income for books and not for tax until it is sold. When the investment is sold the loss will decrease taxable income in the future. Lower taxable income in the future causes lower taxes to be paid. Paying less tax in the future is an asset.

11. The company reported a taxable loss of $160,000 for the current year. Cumulative book tax differences for the current year and the only prior year were:

Prior Year Current Year
Unrealized gain $100,000 $200,000
Prepaid insurance expense $ 22,000 $ 32,000

The tax rate was 30% for the prior year, and 40% for the current year and future years (known in the prior year). In the prior year the company had taxable income of $40,000.
The company elects to carry back.

Record the income tax entry for the current year.

Answer

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. (150,000) (150,000)
Differences:
Unrealized gain 100,000       0 200,000 x .4 = 80,000 L
Prepaid Insurance      0     (10,000) 32,000 x .4 = 12,800 L
Income before tax (50,000) (160,000) G
Tax %    40%     40%__ Total Liab. 92,800
Taxes (20,000) (64,000)
   NOL

Differences:
Revenues and gains are always positive numbers on the table
Expenses and losses are always negative numbers on the table

When all you know is the difference, make one 0, so the difference is as given

Determine the balance in the deferred tax accounts at the end of the 1st year:

Unrealized Gain    100,000 x .40  = 40,000   liability
PP Insurance          22,000 x .40   =   8,800      liability
Total Deferred tax liability                48,800

Determine the adjustment that must be made to get to the current year balance

Current year deferred tax balance  92,800
Less prior year deferred tax balance (48,800)
      Adjustment to be made  44,000
Income Tax Expense 44,000
         Deferred Tax Liability           44,000

There is no tax payable with a NOL, plug to tax expense

Note: The book tax differences are liabilities because they reports less taxable income for the current year, which gives more taxable income in future years and more taxable income means pay more taxes, which is a liability.

What happens in the future determines the asset or liability.

You must now record the Net Operating Loss Carry Back using the prior year tax rate

Prior year income x prior year tax rate = tax refund

40,000 x 30% = 12,000 tax receivable

120,000 x 40% = 48,000 deferred tax asset (carry forward the amount left)
$160,000 loss less 40,000 CB

 

Income Tax Receivable 12,000
Deferred Tax Asset 48,000
        Income Tax Expense              60,000

12. The company reported book income before tax of $829,000 for the first year of operations and income of $750,000 on its tax return for the second year of operations. Temporary differences for each year between financial income and taxable income are as follow:

Year 1 Year 2
Tax depreciation in excess of book depreciation $ 80,000 $60,000
Accrue 1-year warranty liability in excess of actual claims $125,000 $82,000

The company paid fines in the amount of $10,000 that are not tax deductible in year 1.
The tax rate is 40% for year 1 and 30% for all subsequent years.

A. Compute tax payable for the 1st year of operations.
B. Compute the balance in the deferred tax account for the 1st year of operations
C. Compute tax payable for the 2nd year of operations.
D. Compute the adjustments made for the deferred tax account for the 2nd year
E. Record entry to record income tax for the 1st and 2nd year
F. What will be reported on the balance sheet at the end of the 2nd year?

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 Cumulative Difference
 
Income before diff. 954,000      = 954,000 B.
Differences:
Depreciation       0 (80,000) 80,000 x .3 = 24,000 L
Warranty (125,000)      0    125,000 x .3 = 37,500 A
Income before tax 829,000 G 874,000
Permanent Difference   10,000 add: expense is not
884,000          deductible
    Tax %     40%       40%__
Taxes 331,600 353,600 A.
Payable
Income Tax Expense 340,100
Deferred Tax Asset   37,500
         Deferred Tax Liability                  24,000
         Income Tax Payable                353,600

There is no prior year deferred tax balance, so record the cumulative amount calculated above.

C. 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. 810,000 810,000
Differences:
Depreciation: 0 (60,000) 80K + 60K x .3 = 42,000 L
 
Warranty (82,000)       0     125K + 82K x .3 = 62,100 A
Income before tax 728,000 750,000 Given
Tax % 30%      30%__
Taxes 218,400 225,000 C.
Payable

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 62,100 42,000
Prior year balance 37,500 24,000
D. Adjustment to be made 24,600 18,000

E.

Income Tax Expense 218,400
Deferred Tax Asset   24,600
        Deferred Tax Liability             18,000
        Income Tax Payable           225,000

F.    Reported on the balance sheet will be the cumulative current year balance for the
deferred tax accounts.

The depreciation is noncurrent (PPE is noncurrent) and the warranty expense is current (1-year warranty).

The company will report:

Noncurrent deferred tax liability 42,000
Current deferred tax asset 62,100

13. In the current year, the first year offering warranties, the Company accrued for book purposes warranty expense of $80,000. Tax deductions related to warranty expense taken for the current year were $32,000. Depreciation expense was $25,000 higher for books than tax for the current year. For all prior years, depreciation expense was $175,000 higher for tax than books. The tax rate is 30% for the current year and 35% thereafter. The tax change was not known at the end of the prior year). Taxable book income for the current year was $10,000. The company elects to carry forward net operating losses and has determined 30% of deferred tax assets will not be realizable.

Record the entries for income taxes for the current year.

Answer

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. 115,000     = 115,000
Differences:
Depreciation (25,000)      0    see below ** L
Warranty (80,000) (32,000) 48,000 x .35 = 16,800 A
Income before tax 10,000 G 83,000
   Tax %    30%     30%__
Taxes   3,000 24,900
Payable

** Depreciation cumulative difference

Prior year 175,000 tax deduction higher than book
Current year (25,000) tax deduction lower than book
Cumulative 150,000
Deferred tax liability:  Cum Diff. x Future rate
Prior year balance 175,000 x 30% = 52,500
Current year balance 150,000 x 35% = 52,500
No Adjustment required 0       

For prior year, the current year tax rate was used because the tax rate increase to 35% was not known at the end of the prior year.

Deferred tax asset – no prior year balance, so record above amount

Income Tax Expense   8,100
Deferred Tax Asset 16,800
         Income Tax Payable            24,900

The deferred tax asset is 30% unrealizable and a valuation allowance must be recorded

Income Tax Expense 5,040
        Tax Valuation Allowance        5,040

Prior year balance in the allowance account is $0. Record the computed amount.
16,800 x 30% = 5,040 less prior year balance of 0 = 5,040

Note:
Depreciation is a liability for both years, once a liability always a liability.
More tax deduction in 1st year, less deduction in future, liability

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