Chapter 16, Problem 16.6P

Multiple differences; temporary difference yet to originate; multiple tax rates

• LO16–5, LO16–6

You are the new accounting manager at the Barry Transport Company. Your CFO has asked you to provide input on the company’s income tax position based on the following:

1. Pretax accounting income was $41 million and taxable income was $8 million for the year ended December 31, 2018.

2. The difference was due to three items:

a. Tax depreciation exceeds book depreciation by $30 million in 2018 for the business complex acquired that year. This amount is scheduled to be $60 million in 2019 and to reverse as ($50 million) and ($40 million) in 2020 and 2021, respectively.

b. Insurance of $9 million was paid in 2018 for 2019 coverage.

c. A $6 million loss contingency was accrued in 2018, to be paid in 2018.

3. No temporary differences existed at the beginning of 2018.

4. The tax rate is 40%.

Required:

1. Determine the amounts necessary to record income taxes for 2018, and prepare the appropriate journal entry.

2. Assume the enacted federal income tax law specifies that the tax rate will change from 40% to 35% in 2020. When scheduling the reversal of the depreciation difference, you were uncertain as to how to deal with the fact that the difference will continue to originate in 2019 before reversing the next two years. Upon consulting PricewaterhouseCoopers’ Comperio database, you found:

.441 Depreciable and amortizable assets

Only the reversals of the temporary difference at the balance sheet date would be scheduled. Future originations are not considered in determining the reversal pattern of temporary differences for depreciable assets. FAS 109 [FASB ASC 740– Income Taxes] is silent as to how the balance sheet date temporary differences are deemed to reverse, but the FIFO pattern is intended.

You interpret that to mean, when future taxable amounts are being scheduled, and a portion of a temporary difference has yet to originate, only the reversals of the temporary difference at the balance sheet date can be scheduled and multiplied by the tax rate that will be in effect when the difference reverses. Future originations (like the depreciation difference the second year) are not considered when determining the timing of the reversal. For the existing temporary difference, it is assumed that the difference will reverse the first year the difference begins reversing.

Determine the amounts necessary to record income taxes for 2018, and prepare the appropriate journal entry.

To determine

Temporary Difference

Temporary difference refers to the difference of one income recognized by the tax rules and accounting rules of a company in different periods. Consequently, the difference between the amount of assets and liabilities reported in the financial reports and the amount of assets and liabilities as per the company’s tax records, is known as temporary difference.

Multiple Temporary Difference

It is very unlikely to have a single temporary difference in any company. In that case, the same concept of temporary difference will be applicable for multiple temporary difference. In case of multiple temporary difference, we have to categorize all temporary difference into future taxable amount and future deductible amounts. The total amount of future taxable amounts multiplied by future tax rate will generate deferred tax liability and total amount of future deductible amount multiplied by future tax rate will generate deferred tax asset.

To prepare: The appropriate journal entry to record the income taxes.

Explanation of Solution

The journal entry to record the income taxes in the books is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2018
		Income Tax Expense (4)		16.4
		Deferred Tax Asset (2)		2.4
		Deferred Tax Liability (1)			15.6
		Income Tax Payable (3)			3.2
		(To record income taxes)

Table (1)

Working Notes:

Calculate the value of deferred tax liability

$\begin{array}{c}\text{Deferred}\text{Tax}\text{Liability}\text{=}\text{Future}\text{taxable}\text{amount}\text{×}\text{Tax}\text{Rate}\\ \text{=}\left(\text{Depreciation}\text{+}\text{Prepaid}\text{Insurance}\right)\text{×}\text{Tax}\text{Rate}\\ \text{=}\left(\text{\$30}\text{+}\text{\$9}\right)\text{×}\text{40\%}\\ \text{=\$15}\text{.6}\text{million}\end{array}$ (1)

Calculate the value of deferred tax asset

$\begin{array}{c}\text{Deferred}\text{Tax}\text{Asset}\text{=}\text{Future}\text{taxable}\text{amount}\text{×}\text{Tax}\text{Rate}\\ \text{=}\left(\text{Loss}\text{Contingency}\right)\text{×}\text{Tax}\text{Rate}\\ \text{=}\text{\$6}\text{×}\text{40\%}\\ \text{=\$2}\text{.4}\text{million}\end{array}$ (2)

Calculate the value of income tax payable

$\begin{array}{c}\text{Income}\text{tax}\text{payable}\text{=}\text{Taxable}\text{income}\text{×}\text{Tax}\text{Rate}\\ \text{=}\text{\$8 ×}\text{40\%}\\ \text{=\$3}\text{.2}\text{million}\end{array}$ (3)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax liability}\right)\text{-}\text{Deferred}\text{tax}\text{asset}\\ \text{= }\left(\text{\$3}\text{.2 million + 15}\text{.6 million}\right)\text{-}\text{2}\text{.4}\text{million}\\ \text{=\$16}\text{.4}\text{million}\end{array}$ (4)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $16.4 million.
• Deferred tax asset is an asset and is increased by $2.4 million. Therefore, debit deferred tax asset account with $2.4 million.
• Deferred tax liability is a liability and is increased by $15.6 million. Therefore, credit deferred tax liability account with $15.6 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $3.2 million.

To determine

The amount necessary to record income taxes for 2018 and prepare appropriate journal entry to record the income taxes.

Explanation of Solution

Determine the amounts necessary to record income taxes for 2018

	Current Year	Future Taxable (Deductible) Amounts			Deferred Tax
	2018	2019	2020	2021	Liability	Asset
Pretax accounting income	41
Temporary Differences:
Depreciation	(30)		30
Prepaid Insurance	(9)	9
Future Tax rate		40%	35%
Deferred tax liability		3.6	10.5		14.1
Loss Contingency	6		(6)
Future Tax rate			35%
Deferred tax asset			2.1			(2.1)
Taxable Income	8
Tax rate	40%
Income Tax payable	3.2 (5)

Table (2)

Compute deferred tax asset and deferred tax liability amount

	Deferred tax liability (in million)	Deferred tax assets (in million)
Ending balance (current balance needed)	$14.1	$2.1
Less: Beginning balance	$0	$0
Change needed to achieve desired balance	$14.1 (6)	$2.1 (7)

Table (3)

Calculate the value of income tax expenses

$\begin{array}{c}\text{Income tax expense=}\left(\text{Income tax payable +}\text{Deferred tax liability}\right)\text{-}\text{Deferred}\text{tax}\text{asset}\\ \text{= }\left(\text{\$3}\text{.2 million + 14}\text{.1 million}\right)\text{-}\text{2}\text{.1}\text{million}\\ \text{=\$15}\text{.2}\text{million}\end{array}$ (8)

The journal entry to record the income taxes at the end of 2018 is as follows:

Date		Account Titles and Explanation	Post Ref.	Debit ($) (in millions)	Credit ($) (in millions)
2018
		Income Tax Expense (8)		15.2
		Deferred Tax Asset (7)		2.1
		Deferred Tax Liability (6)			14.1
		Income Tax Payable (5)			3.2
		(To record income taxes)

Table (4)

• Income Tax Expense is an expense account and it decreases the value of shareholders’ equity account. So, debit Income Tax Expense account with $15.2 million.
• Deferred tax asset is an asset and is increased by $2.1 million. Therefore, debit deferred tax asset account with $2.1 million.
• Deferred tax liability is a liability and is increased by $14.1 million. Therefore, credit deferred tax liability account with $14.1 million.
• Income Tax Payable is a liability account has increased because the taxable income has increased. So, credit Income Tax Payable account with $3.2 million.

Note:

When a portion of temporary difference is yet to generate in future period, we have to consider only the reversals of temporary difference at balance sheet date e.g., $ 30 for depreciation. Future temporary difference of depreciation has not taken into consideration. We assume that existing difference reverses in the first year after the difference no longer is originating (in this case year 2020). If we consider future originations of temporary difference then the deferred tax liability would be $7.5 million instead of $10.5 million.

	Current Year	Future Taxable (Deductible) Amounts			Total
	2018	2019	2020	2021
Depreciation	(30)	(60)	50	40
Future Tax rate		40%	35%	35%
Deferred tax liability		(24)	17.5	14	7.5

Table (5)