Intermediate accounting answer chap016

CHAPTER 16 ACCOUNTING FOR INCOME TAXESAACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise and problem in Intermediate Accounting, 5e with the following AACSB learning skills:QuestionsAACSB TagsExercises (cont.)AACSB Tags16-1Reflective thinking16-13Analytic16-2Reflective thinking16-14Analytic, Reflective thinking16-3Reflective thinking16-15Analytic16-4Reflective thinking16-16Analytic16-5Reflective thinking16-17Analytic16-6Reflective thinking16-18Analytic16-7Reflective thinking16-19Analytic16-8Reflective thinking16-20Analytic16-9Reflective thinking16-21Analytic16-10Reflective thinking16-22Analytic16-11Reflective thinking16-23Analytic16-12Reflective thinking16-24Analytic16-13Reflective thinking16-25Analytic, Diversity16-14Reflective thinking16-26Analytic, Reflective thinking16-15Reflective thinking16-27Analytic, Reflective thinkingBrief Exercises16-28Reflective thinking16-1Analytic16-29Reflective thinking16-2Analytic16-30Analytic16-3Analytic16-31Reflective thinking16-4AnalyticCPA/CMA16-5Analytic16-1Analytic16-6Reflective thinking16-2Analytic16-7Analytic16-3Analytic16-8Analytic16-4Analytic16-9Analytic16-5Analytic16-10Analytic16-6Analytic16-11Analytic16-7Reflective thinking16-12Analytic16-1Reflective thinking16-13Analytic16-2Analytic16-14Analytic16-3Analytic16-15AnalyticProblemsExercises16-1Analytic16-1Analytic16-2Analytic, Communications16-2Analytic16-3Analytic16-3Analytic16-4Analytic16-4Analytic16-5Analytic16-5Analytic, Diversity16-6Analytic, Communications16-6Analytic16-7Analytic, CommunicationsExercises (continued) Problems (continued)16-7Analytic16-8Analytic, Communications16-8Analytic16-9Analytic, Communications16-9Reflective thinking16-10Analytic, Communications16-10Analytic16-11Analytic, Communications16-11Analytic16-12Analytic, Communications16-12Analytic16-13Analytic, CommunicationsQUESTIONS FOR REVIEW OF KEY TOPICSQuestion 16-1Income tax expense is comprised of both the current and the deferred tax consequences of events and transactions already recognized. Specifically, it includes (a) the income tax that is payable currently and (b) the change in the deferred tax liability (or asset). Apparently, in the situation described, temporary differences required a $4.4 million increase in the deferred tax liability, a $4.4 million decrease in the deferred tax asset, or some combination of the two.Question 16-2Temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis are primarily caused by revenues, expenses, gains, and losses being included in taxable income in a year earlier or later than the year in which they are recognized for financial reporting purpose, although there are other, less common, events that can cause these temporary differences. Some temporary differences create deferred tax liabilities because they result in taxable amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse). An example is the receivable created when installment sale gross profit is recognized for financial reporting purposes. When this asset is recovered, taxable amounts are produced because the installment sale gross profit is then recognized for tax purposes. Some temporary differences create deferred tax assets because they result in deductible amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse). An example is the liability created when estimated warranty expense is recognized for financial reporting purposes. When this liability is settled, deductible amounts are produced because the warranty cost is then deducted for tax purposes. The deferred tax liability or asset each year is the tax rate times the temporary difference between the financial statement carrying amount of the receivable or liability and its tax basis. Question 16-3Future deductible amounts mean that taxable income will be decreased relative to pretax accounting income in one or more future years. Two examples are (a) estimated expenses that are recognized on income statements when incurred, but deducted on tax returns in later years when actually paid and (b) revenues that are taxed when collected, but are recognized on income statements in later years when actually earned. These situations have favorable tax consequences that are recognized as deferred tax assets. Question 16-4Deferred tax assets are recognized for all deductible temporary differences and operating loss carryforwards. However, a deferred tax asset is then reduced by a valuation allowance if it is “more likely than not that some portion or the entire deferred tax asset will not be realized. The decision as to whether a valuation allowance is needed should be based on the weight of all available evidence. Answers to Questions (continued)Question 16-5Nontemporary or “permanent differences are caused by transactions and events that under existing tax law will never affect taxable income or taxes payable. Some provisions of the tax laws exempt certain revenues from taxation and prohibit the deduction of certain expenses. Provisions of the tax laws, in some other instances, dictate that the amount of a revenue that is taxable or expense that is deductible permanently differs from the amount reported in the income statement. Non-temporary or “permanent differences are disregarded when determining both the tax payable currently and the deferred tax effect.Question 16-6Examples of nontemporary or “permanent differences are:Interest received from investments in bonds issued by state and municipal governments (not taxable)Investment expenses incurred to obtain tax-exempt income (not tax deductible)Life insurance proceeds upon the death of an insured executive (not taxable)Premiums paid for life insurance policies (not tax deductible)Compensation expense pertaining to some employee stock option plans (not tax deductible)Expenses due to violations of the law (not tax deductible)Portion of dividends received from U.S. corporations that is not taxable due to the “dividends received deduction Tax deduction for depletion of natural resources (percentage depletion) that permanently exceeds the income statement depletion expense (cost depletion)Question 16-7A deferred tax liability (or asset) is based on enacted tax rates and laws. Hudson should use the 35% rate, the currently enacted tax rate that will be effective in the year(s) the temporary difference reverses. Calculations are not based on anticipated legislation that would alter the companys tax rate. Question 16-8When a change in a tax law or rate occurs, a deferred tax liability or asset must be adjusted to reflect the amount to be paid or recovered in the future. If a deferred tax liability was established with the expectation that the future taxable amount would be taxed at 34%, it would now be adjusted to reflect taxation at 36% instead. The usual practice of recalculating the desired balance in a deferred tax liability each period and comparing that amount with any previously existing balance automatically takes into account tax rate changes. The effect is reflected in operating income (adjustment to income tax expense) in the year of the enactment of the change in the tax law or rate. Answers to Questions (continued)Question 16-9The income tax benefit of either an operating loss carryback or an operating loss carryforward is recognized for accounting purposes in the year the operating loss occurs. The net after-tax operating loss reflects the reduction of past taxes from the loss carryback or future tax savings that the loss carryforward is expected to create. An operating loss carryforward creates future deductible amounts, so a deferred tax asset is recognized for an operating loss carryforward. The deferred tax asset is then reduced by a valuation allowance if it is “more likely than not that some portion or all of the deferred tax asset will not be realized due to insufficient taxable income expected in the carryforward years. Question 16-10Deferred tax assets and deferred tax liabilities are not reported individually, but combined instead into a net current amount and a net noncurrent amount. Each is reported as either an asset if deferred tax assets exceed deferred tax liabilities, or as a liability if deferred tax liabilities exceed deferred tax assets. Deferred tax assets and deferred tax liabilities are classified as either current or noncurrent according to how the related assets or liabilities are classified for financial reporting. For instance, a deferred tax liability arising from estimated warranty expenses would be classified as current if the warranty liability is classified as current. A deferred tax asset or liability that is not related to a specific asset or liability should be classified according to when the underlying temporary difference is expected to reverse. Question 16-11Regarding deferred tax amounts reported in the balance sheet, disclosure notes should indicate (a) the total of all deferred tax liabilities, (b) the total of all deferred tax assets, (c) the total valuation allowance recognized for deferred tax assets, (d) the net change in the valuation allowance, and (e) the approximate tax effect of each type of temporary difference (and carryforward).Question 16-12Pertaining to the income tax expense reported in the income statement, disclosure notes should indicate (a) the current portion of the tax expense (or tax benefit), (b) the deferred portion of the tax expense (or tax benefit), with separate disclosure of amounts attributable to (c) the portion that does not include the effect of the following separately disclosed amounts, (d) operating loss carryforwards, (e) adjustments due to changes in tax laws or rates, (f) adjustments to the beginning-of-the-year valuation allowance due to revised estimates, (g) investment tax credits. Answers to Questions (concluded)Question 16-13FIN 48 creates a higher standard that tax benefits must meet before they can be recognized in a companys financial statements.The identified tax position must have a more-likely-than-not likelihood - a more than 50 percent chance - of being sustained on examination. The concept of being sustained means being capable of making it through the final level of appeal or litigation on the tax positions technical merits, assuming the examining jurisdictions have full knowledge of all facts and circumstances.Once a company concludes that a particular tax position has a more likely than not chance of being sustained, it should deal with step two in the FASBs model by measuring the dollar amount of benefit to recognize. Specifically, it should follow the Boards new cumulative probability methodology under which companies will record in the financial statements the largest benefit that cumulatively is greater than 50-percent likely to be sustained. Question 16-14Intraperiod tax allocation means the total income tax obligation for a reporting period is allocated among the income statement items that gave rise to the income tax. The following items should be reported net of their respective income tax effects: Income (or loss) from continuing operations Discontinued operations Extraordinary itemsQuestion 16-15Some accountants contend that the tax liability for certain recurring events will never be paid because such temporary differences recur frequently and new originating differences more than offset reversing differences. This causes the balance in the deferred tax liability account to continually get larger and never require payment. Therefore temporary differences for recurring items like temporary differences due to depreciation do not represent liabilities. Since no future tax payment will be required, no liability should be recorded. The counter argument that supports the FASBs view is that, although the aggregate amount of a deferred tax liability (such as that for depreciation differences) may get larger, the deferred tax liability for a specific temporary difference (such as for a particular depreciable asset) usually does require payment. This situation is similar to the total balance of accounts payable growing larger each year, but specific accounts payable requiring payment as they come due.BRIEF EXERCISES Brief Exercise 16-1Since taxable income is less than pretax accounting income, a future taxable amount will occur when the temporary difference reverses. This means a deferred tax liability should be recorded to reflect the future tax consequences of the temporary difference:($ in millions)Income tax expense (to balance)4.0Deferred tax liability ($10 - 7 x 40%)1.2Income tax payable ($7 x 40%) 2.8Brief Exercise 16-2Since taxable income is more than pretax accounting income, a future deductible amount will occur when the temporary difference reverses. This means a deferred tax asset should be recorded to reflect the future tax savings from the temporary difference:($ in millions)Income tax expense (to balance)4.0Deferred tax asset ($12 - 10 x 40%).8Income tax payable ($12 x 40%) 4.8Brief Exercise 16-3($ in millions)Income tax expense (to balance)52Deferred tax asset ($50 x 40%)20Income tax payable ($180 x 40%)72Brief Exercise 16-4($ in millions)Income tax expense (to balance)84Deferred tax asset ($20 $40 x 40%)4Income tax payable ($200 x 40%)80Brief Exercise 16-5($ in millions)Income tax expense (to balance)2Deferred tax asset ($30 x 40%)12Income tax payable ($35 x 40%) 14Income tax expense3Valuation allowance deferred tax asset (1/4 x $12)3Brief Exercise 16-6Deferred tax assets are recognized for all deductible temporary differences and operating loss carryforwards. Deferred tax assets are then reduced by a valuation allowance if it is “more likely than not that some portion or all of the deferred tax assets will not be realized. That would be the case if management feels taxable income will not be sufficient in future years to permit gaining the benefit of reducing taxable income by the future deductible amounts. This apparently is the case with Hypercom, which reported large losses in 2006 and prior years, perhaps indicative of insufficient taxable income in coming years to benefit from the tax savings. Brief Exercise 16-7Since tax depreciation to date has been $100,000 more than depreciation for financial reporting purposes, a future taxable amount will occur when the temporary difference reverses. This means a deferred tax liability should be reported to reflect the future tax consequences of the temporary difference. At this point, that amount is $100,000 times 40%, or $40,000.If the balance was $32,000 last year, we need an increase of $8,000. The entry to record income taxes is:Income tax expense (to balance)1,608,000Deferred tax liability ($40,000 32,000)8,000Income tax payable ($4,000,000 x 40%)1,600,000Brief Exercise 16-8Since taxable income to date has been $40 million less than pretax accounting income because of the temporary difference, a future taxable amount of $40 million will occur when the temporary difference reverses. This means a deferred tax liability should be reported to reflect the future tax consequences of the temporary difference. That amount is $40 million times 40%, or $16 million.Brief Exercise 16-9Current yearFuture taxable amountPretax accounting income $ 900,000Non-temporary difference: Municipal bond interest (20,000)Temporary difference: Depreciation (120,000)*$120,000Taxable income (tax return)$ 760,000 Enacted tax rate 40% 40% Tax payable currently $ 304,000 Deferred tax liability $ 48,000Journal entry Income tax expense (to balance)352,000Deferred tax liability ($120,000 x 40%)48,000Income tax payable (determined above) 304,000* tax depreciation: $800,000 x 40%$320,000 straight-line depreciation: $800,000 / 4 years 200,000 difference the first year$120,000Brief Exercise 16-10 ($ in 000s)CurrentFuture YearDeductible 2021AmountsTotal2021 2021 2021 Pretax accounting income291Temporary difference: Warranty expense 9(3)(3)(3)Taxable income (tax return)300Enacted tax rate 40%40%30%30% Tax payable currently 120 Deferred tax asset()(.9)(.9)(3)Journal entry at the end of 2021Income tax expense (to balance)117Deferred tax asset (determined above)3Income tax payable ($300 x 40%) 120Brief Exercise 16-11 Superior should reduce its deferred tax liability this year by $4.5 million:($ in millions)Deferred tax liability last year$8.0($20 future taxable amount x 40%)Deferred tax liability this year($10 future taxable amount x 35%)Reduction needed to achieve desired balanceBrief Exercise 16-12Because the loss year is the Nile s first year of operations, the carryback option is unavailable. The loss is carried forward.Journal entry Deferred tax asset ($15 million x 40%)6,000,000Income tax benefit operating loss6,000,000Brief Exercise 16-13Because the operating loss is less than the previous two years taxable income, AirParts cannot get back all taxes paid those two years. It can reduce taxable income from two years ago by $15 million (to zero) and last years taxable income by $10 million and get a refund of $10 million of the taxes paid those years.Journal entry Receivable income tax refund ($25 million x 40%)10,000,000Income tax benefit operating loss 10,000,000Brief Exercise 16-14Taxable income reflects the benefit of the interest being tax-free, so the tax currently payable is $55 million x 40% or $22 million. But, since its more likely than not that the interest isnt tax-free, that benefit cant be recognized in the tax expense. So, First Bank would record tax expense as if the interest is fully taxable, income tax payable that reflects its tax-free benefits, and a liability that represents the potential obligation to pay the additional taxes if the tax-free status is not ultimately upheld:($ in millions)Income tax expense ($55 + 5 x 40%)24Income tax payable ($55 x 40%)22Liability unrecognized tax benefit2The $2 million difference is the tax benefit not recognized in the income statement, but potentially due if the deduction is not upheld. Because the ultimate outcome probably wont be known within the upcoming year, the Liability unrecognized tax benefit likely will be reported as a long-term liability.Brief Exercise 16-15Intraperiod tax allocation means the total income tax obligation for a reporting period is allocated among the income statement items that gave rise to the inco