Taxing Situations Two Cases On Income Taxes - An Accounting Case Study

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
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)
-

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
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

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)

Taxing Situations Two Cases On Income Taxes - An Accounting Case Study

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What is the deferred tax liability balance at the end of 1991, 1995, and 2000 for Surf's Up?

How are warranty expenses accounted for differently for financial reporting vs tax purposes for Bug Off Inc.?

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Notice that in 2000 the balance is Zero as expected.

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Journal entry for taxes (40% tax rate):

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Income before Taxes

Income before Taxes

Taxing Situations: Two Cases on Income Taxes and Financial Reporting

Deferred Taxes - Balance Sheet Item

References and Data Sources

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