Inc. began business on January 1, 2007. Its pretax financial income for the first 3 years was as follows:
2007 $240,000
2008 560,000
2009 725,000
The following items caused the only differences between pretax financial income and taxable income.
- On January 2, 2007, heavy equipment costing $500,000 was purchased. The equipment had a life of 5 years and no salvage value. The straight-line method of depreciation is used for book purposes and the MACRS tax deduction taken each year is shown in the table below:
| 2007 | 2008 | 2009 | 2010 | 2011 | Total | |
| For tax | $120,000 | $200,000 | $150,000 | $30,000 | 0 | $500,000 |
| For accounting | 100,000 | 100,000 | 100,000 | 100,000 | 100,000 | 500,000 |
- In 2007, the company collected $180,000 of rent; of this amount, $60,000 was earned in 2007; the other $120,000 will be earned equally over the 2008-2009 period. The full $180,000 was included in taxable income in 2007.
- The company pays $10,000 a year for life insurance on officers.
- In 2008, the company had a long-term construction contract on which it recognized a gross profit of $90,000 on the income statement. For tax purposes, the company uses the completed contract method. The total estimated gross profit is $270,000 and the remaining 180,000 is expected to be realized equally in 2009 and 2010.
The enacted tax rates existing at December 31, 2007 are:
2007 35% 2009 40%
2008 40% 2010 40%
Instructions
(a) Compute taxable income and income tax payable/receivable for the 2007 and 2008.
(b) Prepare an inventory of the deferred tax (asset) and liability and determine the net deferred tax asset or liability as of 12/31/07 and 12/31/08.
(c) Prepare the journal entry to record income tax expense, deferred taxes, and the income taxes payable for 2007.
(d) What amounts will appear on the 2008 balance sheet related to the deferred taxes? Be sure to tell me whether the amount is classified as current or noncurrent.
(e) For up to 5 points extra credit – IF YOU HAVE TIME, you may also do 2009 journal entry.
Show your computations and answers as instructed on the next page.
Answers for Problem 2
(a) Compute taxable income and income tax payable/receivable for the 2007 and 2008.
I can grade from workpaper if used
(b) Prepare an inventory of the deferred tax (asset) and liability and determine the net deferred tax asset or liability as of 12/31/07 and 12/31/08.
I can grade from workpaper if used
(c) Prepare the journal entry to record income tax expense, deferred taxes, and the income taxes payable for 2007. (Workpaper answer is NOT sufficient for this one!)
(d) What amounts will appear on the 2008 balance sheet related to the deferred taxes? Be sure to tell me whether the amount is classified as current or noncurrent. (Workpaper answer is NOT sufficient for this one!)
Amounts on 12/31/08 balance sheet related to deferred income taxes:
| Deferred Tax Problems – Worksheet | 2007 | 2008 | 2009 |
| Pre-tax accounting income | 240,000 | 560,000 | 725,000 |
| Permanent differences: | |||
| Life insurance premiums | 10,000 | 10,000 | 10,000 |
| Book TI | 250,000 | 570,000 | 735,000 |
| Temporary differences: | |||
| Depreciation | (20,000) | (100,000) | (50,000) |
| Prepaid rental income | 120,000 | (60,000) | (60,000) |
| Construction contract | (90,000) | (90,000) | |
| Taxable income (a) | 350,000 | 320,000 | 535,000 |
| Applicable tax rate | 35% | 40% | 40% |
| Income taxes payable/(receivable) (a) | 122,500 | 128,000 | 214,000 |
| Inventory of temporary differences (b) | |||
| Depreciation | (20,000) | (120,000) | (170,000) |
| Prepaid rental income | 120,000 | 60,000 | – |
| Construction contract | – | (90,000) | (180,000) |
| 0 | – | – | – |
| Total net temp differences | 100,000 | (150,000) | (350,000) |
| Applicable tax rate | 40% | 40% | 40% |
| Deferred taxes (net) ending | 40,000 | (60,000) | (140,000) |
| Deferred taxes (net) beginning | – | 40,000 | (60,000) |
| Change in net deferred taxes | 40,000 | (100,000) | (80,000) |
| Taxes (payable)/receivable from above | (122,500) | (128,000) | (214,000) |
| Income tax expense | 82,500 | 228,000 | 294,000 |
| Classification on balance sheet (d) | |||
| Current deferred tax assets | 24,000 | 24,000 | |
| Noncurrent deferred tax assets | 16,000 | ||
| Current deferred tax liabilities | (72,000) | ||
| Noncurrent deferred tax liabilities | (84,000) | (68,000) | |
| Total net deferred tax | 40,000 | (60,000) | (140,000) |
| TRUE | TRUE | TRUE |
(a), (b) and (d) on working paper above
(c) Income Tax Expense ($122,500 – $70,000)…………………………………… 82,500
Deferred Tax Asset………………………………………………………………… 40,000
Income Tax Payable ($350,000 × 35%)…………………………….. 122,500
Comments: The tricky item is the $120,000 in unearned rent revenue because only half is current and the other half will not be on tax return for 2 years. We present deferred taxes on the balance sheet as two amounts by netting the current items and then netting the noncurrent items. For 2007 (not required) we have a current deferred tax asset of $24,000 (120,000/2 * 40%) and a noncurrent deferred tax asset of $16,000 {computation = [(20,000) + 60,000] * 40%}. For 2008, it is easier since the $60,000 of rent will be deductible in one year (60,000 * 40%) and gives us a current deferred tax asset. Both the depreciation is noncurrent because it is related to noncurrent assets and the construction accounting deferral is long-term because the taxes will not be due on the contract for 2 more years. Thus the noncurrent deferred tax liability is $84,000 {(120,000 + 90,000)* 40%}. We use 40% for all deferred tax amounts because the enacted law contains the 40% tax rate in 2007.
