Chapter 18, Problem 9P

1.

To determine

Determine the taxable income of Company P for 2016.

Explanation of Solution

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.

Determine the taxable income of Company P for 2016:

Computation of taxable income
Particulars	Amount
Pre-tax financial income	$66,000
Add: Excess of depreciation in financial reporting over tax income (1)	$8,000
Excess of warranty expense in financial reporting over tax income (2)	$7,000
Non-deductible  officer's insurance premium for tax purpose	$15,000
	$96,000
Less: Non-taxable interest of Municipal bonds	($25,000)
Excess of depletion percentage over cost depletion	($10,000)
Excess of gross profit recognized for financial reporting over tax purpose (3)	($11,000)
Taxable Income	$50,000

Table (1)

Thus, the taxable income of Company P is $50,000.

Working Note 1: Determine the Excess of depreciation in financial reporting over tax income:

$\begin{array}{c}\text{Excess of depreciation=}\left(\begin{array}{l}\text{Depreciation taken for }\\ \text{financial reporting purposes}\end{array}\right)-\left(\begin{array}{l}\text{Depreciation taken}\\ \text{ for tax purposes}\end{array}\right)\\ \text{= \$48,000}-\text{\$40,000}\\ \text{ = \$8,000}\end{array}$

Working Note 2: Determine the Excess of depreciation in financial reporting over tax income:

$\begin{array}{c}\text{Excess of warranty expense=}\left(\begin{array}{l}\text{Estimated product warranty}\\ \text{ as per financial records}\end{array}\right)-\left(\begin{array}{l}\text{Actual product warranty }\\ \text{deducted for tax purporse}\end{array}\right)\\ \text{ = \$27,000}-\text{\$20,000}\\ \text{ = \$7,000}\end{array}$

Working Note 3: Determine the Excess gross profit recognized for financial reporting over tax purpose:

$\begin{array}{c}\text{Excess of gross profit = \$91,000}-\text{\$80,000}\\ \text{ = \$11,000}\end{array}$

2.

To determine

Record the income tax entry for Company P.

Explanation of Solution

Income Tax Expenses: The expenses which are related to the taxable income of the individuals and business entities for an accounting period, and are recognized by them for the purpose of federal government and state government tax are called as income tax expenses.

Record the income tax entry for Company P.

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
2016
December 31	Income Tax Expense (Balancing figure)		13,800
	Deferred Tax Asset- Warranty expense (4)		2,100
	Deferred Tax Liability- Depreciation expense (5)		2,400
	Income Tax Payable (6)			15,000
	Deferred Tax Liability-Accrual basis sales (7)			3,300
	(To record income tax expense with deferred tax asset and deferred tax liability)

Table (2)

• Income Tax Expense is a component of stockholders’ equity and decreases, so debit it for $13,800.
• Deferred Tax Asset is an asset and increased, so debit it for $2,100.
• Deferred Tax Liability is a liability and decreases, so debit it for $2,400.
• Income Tax Payable is a liability and increases, so credit it for $15,000.
• Deferred Tax Liability is a liability and increases, so credit it for $3,300.

Working note 4: Determine the deferred tax asset – warranty expense:

$\begin{array}{c}\text{Deferred tax asset}=\left[\begin{array}{l}\text{Future deductible amount}\\ \times \text{Applicable tax rate}\end{array}\right]-\text{Beginning deferred asset}\\ \text{=}\left(\text{\$56,500}\times 30\text{\%}\right)-\$14,850\\ =\$16,950-\$14,850\\ \text{=\$2,100}\end{array}$

Working note 5: Determine the deferred tax liability – depreciation expense:

$\begin{array}{c}\text{Deferred tax liability}=\left[\begin{array}{l}\text{Future taxable amount}\\ \times \text{Applicable tax rate}\end{array}\right]-\text{Beginning deferred liability}\\ \text{=}\left(\text{\$33,800}\times 30\text{\%}\right)-\$12,540\\ =\$10,140-\$12,540\\ \text{=}\left(\text{\$2,400}\right)\end{array}$

Thus, there is a decrease of ($2,400) in deferred tax liability.

Working note 6: Compute the income tax payable:

$\begin{array}{c}\text{Income tax payable}=\text{Taxable income}\times \text{Corporate tax rate}\\ \text{=\$50,000}\times 30\text{\%}\\ \text{=\$15,000}\end{array}$

Working note 7: Determine the deferred tax liability – accrual sales basis:

$\begin{array}{c}\text{Deferred tax asset}=\left[\begin{array}{l}\text{Future deductible amount}\\ \times \text{Applicable tax rate}\end{array}\right]-\text{Beginning deferred asset}\\ \text{=}\left(\text{\$26,700}\times 30\text{\%}\right)-\$4,710\\ =\$8,010-\$4,710\\ \text{=\$3,300}\end{array}$

3.

To determine

Determine the permanent differences in Items 1 through 8 and elaborate the reasons for accounting the deferred tax items in requirement 2.

Explanation of Solution

The permanent differences in items 1 through 8 are as follows:

• Officer’s life insurance premium expense.
• Non-taxable interest revenue form municipal bonds.
• Percentage of depletion in excess of cost exhaustion.

These items are considered as permanent difference and would never be reversed in future (since the pre-tax financial income and taxable income are always different) and hence are not considered as deferred tax items for which the journal entries are recorded as per requirement 2.