Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Surfs Up
1. Assuming no additional new equipment is acquired, how should the difference between taxes paid and the tax expense shown in the pro forma income
statements be reported, if at all?
The company earns $1,500,000 before depreciation and tax. Surfs Up buys buys equipment for $1,000,000 and depreciates it straight line(modified) for reporting
purposes over 10 years. For tax purposes, MACRS schedule is used as provided in exhibit 1. Depreciation for the first year is $1,000,000 x 1/10 x 1/2 = $50,000
(Note: the factor is for the first year as cited in the case). Depreciation for the first year (1990) is given as $200,000 in exhibit 1. For Reporting purposes, Income
is $1,500,000 - $50,000 = $1,450,000. Taxable income is $1,500,000-$200,000 = $1,300,000. With a tax rate of 40%, the taxes payable are $1,300,000 x .40 =
$520,000. Therefore, the deferred tax liability is ($200,000 - $50,000) x .40 = $60,000. Income tax expense is $520,000+$60,000 = $580,000. The income tax note
to the financial statements is as follows:
Income tax:
Current
$520,000
Deferred
$ 60,000
Tax expense $580,000
The tax expense of $580,000 is reported on the income statement.
Income before tax
$1,450,000
Income tax expense
580,000
Net income
$870,000
The deferred tax liability of $60,000 is reported on the balance sheet. This account will increase in the second year, because depreciation for tax purposes
($320,000 exhibit 1) will exceed depreciation for accounting purposes ($100,000). Note: Straight Line Depreciation is shown as stated in the case where for year
1990, only of the depreciation amount is taken.
Tax Depreciation
Worksheet
Year

Straight

MACRS

Difference

1990

50000

200000

150000

1991

100000

320000

220000

1992

100000

192000

92000

1993

100000

115200

15200

1994

100000

115200

15200

1995

100000

57600

-42400

1996

100000

-100000

1997

100000

-100000

1998

100000

-100000

1999

100000

-100000

2000

50000

Total

1000000

-50000
1000000

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Income Statement
Years
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$1,500,000

$16,500,000

$50,000

$100,000

$100,000

$100,000

$100,000

$100,000

$100,000

$100,000

$100,000.00

$100,000

$50,000

$1,000,000

$200,000

$320,000

$192,000

$115,200

$115,200

$57,600

$0

$0

$0

$0

$0

$1,000,000

$1,450,000

$1,400,000

$1,400,000

$1,400,000

$1,400,000

$1,400,000

$1,400,000

$1,400,000

$1,400,000

$1,400,000

$1,450,000

$580,000

$560,000

$560,000

$560,000

$560,000

$560,000

$560,000

$560,000

$560,000

$560,000

$580,000

$6,200,000

$520,000

$472,000

$523,200

$553,920

$553,920

$576,960

$600,000.00

$600,000

$600,000

$600,000

$600,000

$6,200,000

Deferred
Income Tax

$60,000

$88,000

$36,800

$6,080

$6,080

($16,960.00)

($40,000)

($40,000)

($40,000)

($40,000)

($20,000)

$0

Net Income

$870,000

$840,000

$840,000

$840,000

$840,000

$840,000.00

$840,000

$840,000

$840,000

$840,000

$870,000

$9,300,000

Net Rev
Before
Tax/Dep
Straight Line
Depreciation
(Modified)
MACRS
Depreciation
Net
Revenue
Before Tax
Income Tax
Expense
Income Tax
Actual

All

2. What will be the balance in the deferred tax liability account in Surfs Ups Statement of Financial Position at the end of 1991? 1995? 2000?

As can be seen above the balance in the deferred tax liability account in Surfs Up Balance Sheet will be:
1990
1991
1992
1993
1994
1995
1996
1997
1998
Defererred Tax
Liability Beg.
Balance
Period Change
Ending Balance

$60,000
$60,000

$60,000
$88,000
$148,000

$148,000
$36,800
$184,800

$184,800
$6,080
$190,880

$190,880
$6,080
$196,960

Notice that in 2000 the balance is Zero as expected.

$196,960
($16,960)
$180,000

$180,000
($40,000)
$140,000

$140,000
($40,000)
$100,000

$100,000
($40,000)
$60,000

1999
$60,000
($40,000)
$20,000

2000
$20,000
($20,000)
-

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Bug Off, Inc.

1. Prepare pro forma income statements for Bug Off, Inc., for 1990 through 1992 as they will appear in financial reports and in the
companys income tax returns. How do you account for the difference in taxes occasioned by the difference in accounting for warranty
expense in the accrual method financial reports and in the companys tax returns?

Warranty expenses are shown on the income statement as reduced earnings, however taxes are not treated in the same manner. When a
tax is paid in one year that should be matched against income of a later period, the tax charge is set aside until the proper time for
appearance in the income statement. Therefore, the tax is said to be deferred.
According to standard accounting and IRS regulations, the warranty expenses can be deducted for tax purposes only as these expenses
are actually incurred. However, since the exact warranty expense is not known until the customer requests the warranty service, it must
be estimated. In the case of Bug Off, Inc. this is estimated as 6% of sales. The percentage is derived from past experience.
Journal entry to accrue warranty expense:
Warranty expense
Estimated Warranty Payable

Sales * .06
Sales * .06

Journal entry for taxes (40% tax rate):

Prepaid (Deferred) Income Tax Charge
Income Tax Expense
(Note:To reduce tax expense, treat as prepaid 40%
of the amount accrued as warranty expense not
currently tax deductible)

.40*Sales*.06
.40 *Sales*.06

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Book Income
Revenues

1990
$200,000

1991
$100,000

1992
$100,000

Expenses
Materials
Salaries
Depreciation
Warranty Acrrual
Total

$50,000
$55,000
$5,000
$12,000
$122,000

$25,000
$35,000
$5,000
$6,000
$71,000

$25,000
$35,000
$5,000
$6,000
$71,000

Income before Taxes

$78,000

$29,000

$29,000

Tax Rate

40.00%

40.00%

40.00%

Taxes Expense

$31,200

$11,600

$11,600

Net Income

$46,800

$17,400

$17,400

Revenues

1990
$200,000

1991
$100,000

1992
$100,000

Expenses
Materials
Salaries
Depreciation
Warranty Expenditure
Total

$50,000
$55,000
$5,000
$6,000
$116,000

$25,000
$35,000
$5,000
$12,000
$77,000

$25,000
$35,000
$5,000
$6,000
$71,000

$84,000

$23,000

$29,000

Tax Income

Income before Taxes

54,400

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Tax Rate

40.00%

40.00%

40.00%

Taxes Expense

$33,600

$9,200

$11,600

Net Income

$50,400

$13,800

$17,400

54,400

2. How should the deferred taxes be reported in Bug Offs Statement of Financial Position in each year?
According to the asset and liability approach prescribed by FASB 109, the amount of deferred tax assets and liabilities are computed
annually and placed on the balance sheet.
Warranty Reserve - Balance Sheet Item
Begin. Balance
$6,000
Warranty Accrual
$12,000
Warranty Expenditure
($6,000)
Ending Balance
$12,000

Deferred Taxes - Balance Sheet Item

Book Taxes
$31,200
Taxes Paid
$33,600
Deferred Taxes
($2,400)

$12,000
$6,000
($12,000)
$6,000

$6,000
$6,000
($6,000)
$6,000

$11,600
$9,200
$2,400

$11,600
$11,600
-

References and Data Sources

Proposed Interpretation of Statement of Financial Accounting Standards No. 109 (FASB 2005)