Depreciation and Compute Net Income for Book Purposes

					Chapter 17 - FAS 109: Accounting for Income Taxes




                                                                  Chapter 17
                                       FAS 109: Accounting for Income Taxes

                                SOLUTIONS MANUAL
Discussion Questions

1. Identify some of the reasons why accounting for income taxes is complex.

Ans wer:
    U.S. tax laws are complex and ambiguous.
    A company often pre pares its financial statements (Form 10-K) six months in
      advance of when the company files its corresponding federal income tax
      returns.
    The rules that apply to accounting for income taxes are not found exclusively
      in FAS 109.

2. True or False: FAS 109 applies to all taxes paid by a corporation. Explain.

Ans wer:
      False. FAS 109 only applies to income taxes paid by a corporation.

3. True or False: FAS 109 is the sole source for the rules that apply to accounting for
income taxes. Explain.

Ans wer:
      False. The rules that apply to accounting for income taxes also are found in
      other state ments of financial accounting standards (for example, FAS 123R,
      FAS 141R), pronouncements from the Emerging Issues Task Force, opinions
      from the former Accounting Principles Board, and pronounce ments from the
      Securities and Exchange Commission.

4. How does the fact that most corporations file their financial statements several months
before they file their income tax returns complicate the income tax provision process?

Ans wer:
      When a corporation files its financial statements in advance of its federal
      income tax return, management must use judgment to estimate the actual tax
      liability that will result whe n the tax return is filed. When the tax return is
      filed, the corporation must adjust its balance sheet to reflect the actual taxes
      payable and make any other adjustments to reflect the company’s “true”
      current and deferred tax liabilities. This adjustment often is referred to as a
      “provision-to-return” adjustme nt.




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Chapter 17 - FAS 109: Accounting for Income Taxes




5. What distinguishes an income tax from other taxes?

Ans wer:
      The FASB defines an income tax as a tax “based on income.” This definition
      excludes property taxes, excise taxes, sales taxes, and value -added taxes,
      which are assessed based on sales or value. A company reports non-income
      taxes as expenses in the computation of net income before taxes.

6. Briefly describe the six step process by which a company computes its income tax
provision.

Ans wer:
      The steps to compute a company’s federal income tax provision proceed as
      follows:
      1.     Adjust pretax net income for all permanent differences
      2.     Identify all te mporary differences and tax carryforward amounts
      3.     Calculate the current income tax expense or benefit (refund)
      4.     Determine the ending balances in the balance sheet deferred tax asset
             and liability accounts
      5.     Evaluate the need for a valuation allowance for gross deferred tax
             assets
      6.     Calculate the deferred income tax expense or benefit

7. What are the two components of a company’s income tax provision? What does each
component represent about a company’s income tax provision?

Ans wer:
      A company computes its current income tax expense or benefit and its
      deferred income tax expense or benefit. The current income tax expense or
      benefit represents the income taxes payable or refundable in the current
      year. The deferred income tax expense or benefit re presents the amount
      necessary to adjust the balance sheet liability or receivable for future income
      taxes payable or refundable that result from curre nt and prior year
      transactions.

8. True or False: All differences between book and taxable income, both permanent and
temporary, affect a company’s effective tax rate. Explain.

Ans wer:
      False. Permanent differences affect a company’s effective tax rate.
      Temporary differences affect a company’s effective tax rate only whe n the
      company adjusts its balance sheet deferred income tax asset or liability to
      reflect changes in the enacted tax rate or for changes in valuation allowances
      related to deferred tax assets (that is, for prior period adjustme nts).




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Chapter 17 - FAS 109: Accounting for Income Taxes




9. When does a temporary difference resulting from an expense (deduction) create a
taxable temporary difference? A deductible temporary difference?

Ans wer:
      An expense results in a taxable temporary difference when the tax deduction
      precedes the book deduction, creating a future (deferred) tax liability in the
      period in which the book expense is recorded. An example is accelerated
      depreciation elected for tax purposes and straight line elected for book
      purposes. An expense results in a deductible temporary difference when the
      book deduction precedes the tax deduction, creating a future (deferred) tax
      asset in the pe riod in which the tax expense is deducted. An example is using
      the accrual method to record bad debts for book purposes and the charge -off
      method for tax purposes.

10. When does a temporary difference resulting from income create a taxable temporary
difference? A deductible temporary difference?

Ans wer:
      Income results in a taxable temporary difference when the income is
      reported on the financial state ment prior to being reported on the tax return,
      creating a future (deferred) tax liability in the pe riod in which the income is
      reported on the tax return. An example is use of the installme nt method for
      tax purposes and full reporting of the income for book purposes. Income
      results in a deductible temporary difference when the income is reported on
      the tax return prior to being re ported on the financial statement, creating a
      future (deferred) tax asset in the period in which the book income is
      reported. An example is reporting a pre payment of income on the tax return
      in the year received and reporting the income for book purposes in the year
      the income is earned.

11. Briefly describe what is meant by the liability or balance sheet approach taken by
FAS 109 with respect to computing a corporation’s deferred tax provision.

Ans wer:
      Unde r FAS 109, a company’s primary objective is to report its deferred tax
      assets and liabilities on the balance sheet at the amounts the company expects
      to recover or pay using the enacted tax rate for the period in which the
      recovery or payment will take place. The amount necessary to adjust the
      beginning balance in the deferred tax accounts to the ending balance
      becomes the deferred income tax expense or benefit recorded as part of the
      income statement income tax provision.




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Chapter 17 - FAS 109: Accounting for Income Taxes




12. Why are initially favorable temporary differences referred to as taxable temporary
differences?

Ans wer:
      Initially favorable temporary differences are those differences that cause the
      current year’s taxable income to be less than the corresponding net (book)
      income. As a result, the current year tax liability will be less than the
      provision that relates to net income. When the difference “reverses” in a
      future year, taxable income will exceed net income, and the current year tax
      liability will exceed the provision that relates to net income. A company
      records this future tax liability (deferred tax liability) in the year in which
      the favorable temporary difference arises.

13. Why are initially unfavorable temporary differences referred to as deductible
temporary differences?

Ans wer:
      Initially unfavorable temporary differences are those diffe rences that cause
      the curre nt year’s taxable income to be greater than the corresponding net
      (book) income. As a result, the current year tax liability will be greater than
      the provision that relates to net income. When the difference “reverses” in a
      future year, taxable income will be less than net income, and the current year
      tax liability will be less than the provision that relates to net income. A
      company records this future tax benefit (deferred tax asset) in the year in
      which the unfavorable temporary difference arises.

14. In addition to the current year tax return taxes payable or refundable, what other
transactions can affect a company’s current income tax provision?

Ans wer:
      The current year income taxes payable or refundable also can be affected by
      1) tax refunds or additional tax deficiencies from prior year tax returns that
      result from an IRS audit; 2) prior year income tax refunds from current year
      carrybacks; 3) the portion of tax benefits from the exercise of nonqualified
      stock options that we re not previously recorded as temporary differences
      under FAS 123R or APB 25; or 4) increases in the unrecognized tax benefit
      (income taxes payable) unde r FIN 48 that the corporation expects to be
      resolved within the next 12 months.




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Chapter 17 - FAS 109: Accounting for Income Taxes




15. What is an unrecognized tax benefit and how does it affect a company’s current
income tax expense?

Ans wer:
      An unrecognized tax benefit is the amount of income taxes a company
      expects to pay as the result of future income tax return audits by tax
      authorities. Thought of another way, it is the amount of income tax benefits
      the company will have to “return” in the future as a result of income tax
      return audits by tax authorities. Those taxes a company expects to pay
      within the next 12 months are classified as current taxes payable on the
      balance sheet. Additions to the unrecognized tax benefit that the company
      expects to pay within the next 12 months are treated as part of the curre nt
      income tax expense.

16. True or False: When Congress changes the corporate tax rates, only the current year
book-tax temporary differences are measured using the new rates. Explain.

Ans wer:
      False. When Congress changes the enacted corporate tax rates, a company
      must adjust its total deferred tax asset and deferred tax liability accounts on
      its balance sheet to reflect the income tax benefit or expense that will result
      under the ne w rate in the future. The adjustment to the deferred tax
      accounts will be recorded as an increase or decrease to the deferred tax
      expense or benefit and will appear in the reconciliation of the company’s
      effective tax rate as a prior pe riod adjustment.

17. True or False: All temporary differences have a financial accounting basis. Explain.

Ans wer:
      False. Not all temporary differences have a financial accounting basis. Net
      operating loss and net capital loss carryove rs create deferred tax assets but
      do not have a financial accounting basis.

18. What is the purpose behind a valuation allowance as it applies to deferred tax assets?

Ans wer:
      A valuation allowance operates as a “contra account” to the deferred tax
      assets on the balance sheet. If a company determines that it is more likely
      than not (a likelihood greater than 50%) that some portion or all of the
      deferred tax assets will not be realize d in a future pe riod (that is, reduce
      future taxable income or future tax liability), the company must offset the
      deferred tax assets with a valuation allowance to reflect the amount it does
      not expect to realize in the future.




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Chapter 17 - FAS 109: Accounting for Income Taxes




19. What is the difference between recognition and realization as it applies to the
recording of a deferred tax asset on a balance sheet?

Ans wer:
      Recognition relates to whether it is “probable” the company has the right to a
      future tax benefit, in which case the company can record the deferred tax
      asset on the balance sheet. Realization relates to whethe r it is more likely
      than not the company expects to have sufficient taxable income or tax
      liability in the future to absorb the future tax deductions or credits when
      they are reported on the tax return or before they expire.

20. Briefly describe the four sources of taxable income a company evaluates in
determining if a valuation allowance is necessary.

Ans wer:
      The four sources of taxable income that are considered in the valuation
      allowance process are as follows:
      1.     Future reversals of existing favorable (taxable) temporary
             differences;
      2.     Taxable income in prior carryback year(s);
      3.     Expected future taxable income exclusive of reversing temporary
             differences and carryforwards; and
      4.     Taxable income that will result from prudent tax planning strategies.

21. Which of the four sources of taxable income are considered objective and which are
considered subjective? Which of these sources generally receives the most weight in
analyzing whether a valuation allowance is necessary?

Ans wer:
      The objective sources are future reversals of existing favorable (taxable)
      temporary differences and taxable income in prior carryback years. The
      subjective sources are expected future taxable income exclusive of reversing
      taxable temporary differences and carryforwards and taxable income that
      will result from tax planning strategies. Objective sources of taxable income
      receive more weight when analyzing whether a valuation allowance is
      necessary.




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Chapter 17 - FAS 109: Accounting for Income Taxes




22. What are the elements that define a tax planning strategy as it applies to determining
if a valuation allowance is necessary? Provide an example where a tax planning strategy
may be necessary to avoid recording a valuation allowance.

Ans wer:
      FAS 109 defines a tax planning strategy as an action that is 1) prudent and
      feasible, 2) is one that is not in the ordinary course of business but which a
      company would take to prevent an operating loss or tax cre dit carryforward
      from expiring unused, and 3) would result in realization of the deferred tax
      assets. An example of a tax planning strategy might be a company’s
      willingness to sell a parcel of land held for investment to create a capital gain
      that could be used to keep a net capital loss carryover from expiring unused.
      A company would have to rely on a tax planning strategy to avoid recording
      a valuation allowance when the other three sources of taxable income do not
      provide sufficient taxable income to absorb the recorded deferred tax assets.

23. When does a company remove a valuation allowance from its balance sheet?

Ans wer:
      A company removes a valuation allowance from its balance sheet when it
      determines that it is more-likely-than-not that, based on all available
      evidence, a deferred tax asset will be realized (that is, the tax benefit will be
      received) in a future period.

24. What is a company’s book equivalent of taxable income and how does this
computation enter into the income tax provision process?

Ans wer:
      A company computes its book equivalent of taxable income by adjusting
      pretax net income from continuing ope rations for permanent difference s.
      Multiplying the book equivalent of taxable income by the applicable tax rate
      provides a “back-of-the envelope” computation of the company’s total
      income tax provision, assuming there is no change in the company’s
      applicable tax rate during the period or other changes related to a prior
      period (for example, an adjustment of a valuation allowance).

25. What motivated the FASB to issue FIN 48?

Ans wer:
      The FASB issued FIN 48 because it was concerned that there was “dive rsity
      in practice” in the way in which companies computed their income tax
      contingency reserve under FAS 5.




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Chapter 17 - FAS 109: Accounting for Income Taxes




26. Briefly describe the two step process a company must undertake when it evaluates
whether it can record the tax benefit from an uncertain tax position under FIN 48.

Ans wer:
      FIN 48 applies a two-step process to evaluating tax positions. FIN 48 refers
      to the first step as recognition. A company must determine whethe r it is more
      likely than not (a greater than 50% probability) that a tax position will be
      sustained on examination by the IRS or other taxing authority, including
      resolution of any appeals within the court system, based on the technical
      me rits of the position.

        The second step is referred to as measurement. If the tax position meets the
        more-likely-than-not threshold (a subjective determination), the company
        must determine the amount of the benefit to record in the financial
        statements. The company records the largest amount of the benefit, as
        calculated on a cumulative probability basis, that is more -likely-than-not to
        be realized on the ultimate settlement of the tax position. The portion not
        recognized is referred to as an “unrecognized tax benefit” and is recorded as
        an increase in income taxes payable on the balance sheet.

27. Distinguish between recognition and measurement as they relate to the computation
of unrecognized tax benefits under FIN 48.

Ans wer:
      Recognition is the process of determining whether the company can record
      some portion or all of the tax benefit from the tax position on its financial
      statements. Measure ment is the process of determining the amount of the
      tax benefit that can be recorded on the financial state ments.

28. What is a tax position as it relates to the application of FIN 48?

Ans wer:
      FIN 48 defines a tax position as any issue dealing with income taxes. FIN 48
      pertains to tax positions taken on a curre nt or previously filed tax return or a
      tax position that will be taken on a future tax return that is reflected in the
      financial statements as a deferred tax asset or liability. A tax position also
      relates to tax returns that the company has not filed in a tax jurisdiction but
      could be required to file in the future on audit.




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Chapter 17 - FAS 109: Accounting for Income Taxes




29. True or False: A company determines its unrecognized tax benefits with respect to a
transaction only at the time the transaction takes place; subsequent events are ignored.
Explain.

Ans wer:
      False. A company must reassess its balance in its unrecognized tax benefit
      account whe n subsequent events occur (for example, the issuance of
      regulations, rulings, court opinions) that might change the company’s
      assessment of whether a tax position will be sustained on audit and litigation.
      As facts and circumstances change, a company must reevaluate the tax
      benefit amount they expect to realize in the future.

30. True or False: FIN 48 requires that a company treat potential interest and penalties
related to an unrecognized tax benefit as part of its income tax provision. Explain.

Ans wer:
      False. FIN 48 allows a company to treat potential inte rest and penalties
      related to a tax contingency reserve as part of its income tax provision or as
      expenses deducted in the computation of its pretax income or loss from
      continuing operations. FIN 48 requires that the company apply its election
      consistently from period to period and disclose how it is treating the interest
      and penalties in its financial state ments in a footnote to the financial
      statements (usually in the Income Taxes note).

31. Where on the balance sheet does a company report its unrecognized tax benefits
calculated under FIN 48?

Ans wer:
      A company reports its unrecognized tax benefits as part of its income taxes
      payable or some othe r liability on the balance sheet. The additional tax that
      the company expects to pay in the next 12 months is classified as current
      taxes payable. The tax the company expects to pay beyond the next 12
      months is classified as long-term taxes payable.

32. Why did many companies oppose FIN 48 when it was first proposed?

Ans wer:
      Opponents of FIN 48 worried that the FIN 48 disclosures would provide a
      “roadmap” to the IRS to a company’s uncertain tax positions.




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Chapter 17 - FAS 109: Accounting for Income Taxes




33. How does a company determine if a deferred tax asset or liability should be classified
as current or noncurrent on its balance sheet?

Ans wer:
      A company classifies its deferred tax assets and liabilities based on the
      classification of the asset or liability to which the deferred tax account
      relates. Deferred tax liabilities related to a long-term asset (for example,
      depreciation of a fixed asset) are classified as noncurrent because the related
      asset is classified as noncurrent on the balance sheet. A deferred tax asset
      related to uncollectible accounts receivable would be classified as a current
      asset because accounts receivable is treated as a current asset. Deferred tax
      liabilities and assets not related to a specific asset (for example, a net
      operating loss carryover or organizational expenditures capitalized for tax
      purposes) are classified based on the expected reversal date of the temporary
      difference.

34. Under what conditions can a company net its current deferred tax assets with its
current deferred tax liabilities on the balance sheet?

Ans wer:
      FAS 109 permits netting of current deferred tax assets and liabilities if they
      are attributable to the same tax jurisdiction or relate to the same components
      of the enterprise (for example, a subsidiary that is part of the consolidated
      financial statements and part of the consolidated income tax return). The
      same netting rule applies to noncurre nt deferred tax assets and liabilities as
      well.

35. True or False: A publicly traded company must disclose all of the components of its
deferred tax assets and liabilities in a footnote to the financial statements. Explain.

Ans wer:
      False. FAS 109 states that a publicly traded company s hould disclose the
      approximate “tax effect” of each type of te mporary difference and
      carryforward that gives rise to a “significant” portion of net deferred tax
      liabilities and deferred tax assets. A privately held company only needs to
      disclose the types of significant te mporary differences without disclosing the
      tax effects of each type. FAS 109 does not define the term significant,
      although the SEC requires a publicly traded company to disclose separately
      the components of its total deferred tax assets and liabilities that are 5% or
      more of the total balance.




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Chapter 17 - FAS 109: Accounting for Income Taxes




36. What is a company’s hypothetical income tax provision and what is its importance in
a company’s disclosure of its income tax provision in the tax footnote?

Ans wer:
      A company’s hypothetical income tax provision is the income tax provision or
      benefit that would result from applying the company’s U.S. statutory tax rate
      (34% or 35%) to its pretax income from continuing operations. The
      hypothetical income tax provision is the amount that is reconciled with the
      company’s actual income tax provision or benefit in the effective tax rate
      reconciliation component of the company’s income tax note.

37. Briefly describe the difference between a company’s effective tax rate, cash tax rate,
and structural tax rate.

Ans wer:
      The effective tax rate is the company’s total income tax expense or benefit
      divided by the company’s pretax net income or loss from continuing
      operations. The effective tax rate often serves as a benchmark for companies
      in the same industry. A company’s cash tax rate is the effective tax rate
      taking into account only taxes actually paid or refunded during the year.
      Taxes paid or refunded usually is reported in the company’s Statement of
      Cash Flows. A company’s structural tax rate is the effective tax rate adjusted
      for one-time (discrete) and non-recurring book-tax differences. It is usually
      interpreted as the company’s sustainable effective tax rate from operations.

Problems

38. Which of the following taxes is not accounted for under FAS 109?
      A.       Income taxes paid to the U.S. government
      B.       Income taxes paid to the French government
      C.       Income taxes paid to the city of Detroit
      D.       Property taxes paid to the city of Detroit
      E.       All of the above taxes are accounted for under FAS 109

Ans wer:
      D. Prope rty taxes paid to the city of Detroit are not income taxes because
      they are assessed based on value and not income.

39. Which of the following organizations can issue rules that govern accounting for
income taxes?
      A.       FASB
      B.       SEC
      C.       IRS
      D.       A and B
      E.       All of the above organizations




                                               17-11
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      D. Both the FASB and SEC can issue rules that govern accounting for
      income taxes. Congress also can issue rules that govern accounting for
      income taxes.

40. {research} Find the paragraph(s) in FAS 109 (paragraphs 1-59) that deal with the
following items (you can access FAS 109 on the FASB website, www.fasb.org, and
clicking on “FASB Pronouncements and EITF Abstracts.”
        A.    The objectives and basic principles that underlie FAS 109
        B.    Examples of book-tax differences that create temporary differences
        C.    The definition of a “tax planning strategy”
        D.    Examples of positive evidence in the valuation allowance process
        E.    Rules relating to financial statement disclosure

Ans wer:


41. Woodward Corporation reported pretax book income of $1,000,000 in 2009.
Included in the computation were favorable temporary differences of $200,000,
unfavorable temporary differences of $50,000, and favorable permanent differences of
$100,000. Assuming a tax rate of 34%, compute the Company’s current income tax
expense or benefit for 2009.

Ans wer:
      Pretax book income                                      $1,000,000
      Favorable temporary differences                           (200,000)
      Unfavorable temporary differences                           50,000
      Favorable permanent differences                           (100,000)
      Taxable income                                             750,000
       34%                                                        34%
      Curre nt income tax expense                               $255,000

42. Cass Corporation reported pretax book income of $10,000,000 in 2009. During the
current year, the reserve for bad debts increased by $100,000. In addition, tax
depreciation exceeded book depreciation by $200,000. Cass Corporation sold a fixed
asset and reported book gain of $50,000 and tax gain of $75,000. Finally, the Company
received $250,000 of tax-exempt life insurance proceeds from the death of one of its
officers. Assuming a tax rate of 34%, compute the Company’s current income tax
expense or benefit for 2009.




                                               17-12
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      Pretax book income                                   $10,000,000
      Increase in bad debt reserve                             100,000
      Excess tax depreciation                                 (200,000)
      Excess tax over book gain                                 25,000
      Tax-exempt life ins urance proceeds                     (250,000)
      Taxable income                                        $9,675,000
       34%                                                      34%
      Curre nt income tax expense                           $3,289,500

43. Grand Corporation reported pretax book income of $600,000 in 2009. Tax
depreciation exceeded book depreciation by $400,000. In addition, the Company
received $300,000 of tax-exempt municipal bond interest. The Company’s prior year tax
return showed taxable income of $50,000. Assuming a tax rate of 34%, compute the
Company’s current income tax expense or benefit for 2009.

Ans wer:
      Pretax book income                                      $600,000
      Excess tax depreciation                                 (400,000)
      Tax-exempt inte rest income                             (300,000)
      Net operating loss                                     $(100,000)

        NOL carryback to prior year                            $50,000
         34%                                                    34%
        Curre nt income tax benefit                            $17,000

        The remaining $50,000 NOL carryover to 2010 will be recorded as a deferred
        tax asset (benefit) of $17,000.

44. Chandler Corporation reported pretax book income of $2,000,000 in 2009. Tax
depreciation exceeded book depreciation by $500,000. During the year the Company
capitalized $250,000 into ending inventory under §263A. Capitalized inventory costs of
$150,000 in beginning inventory were deducted as part of cost of goods sold on the tax
return. Assuming a tax rate of 34%, compute the Company’s taxes payable or refundable
for 2009.

Ans wer:
      Pretax book income                                    $2,000,000
      Excess tax depreciation                                 (500,000)
      Increase in capitalized inventory costs                  100,000
      Taxable income                                        $1,600,000
       34%                                                      34%
      Curre nt income taxes payable                           $544,000




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Chapter 17 - FAS 109: Accounting for Income Taxes




45. Davison Company determined that the book basis of its office building exceeded the
tax basis by $800,000. This basis difference is properly characterized as:
        A.     Permanent difference
        B.     Taxable temporary difference
        C.     Deductible temporary difference
        D.     Favorable book-tax difference
        E.     Both B and D are correct

Ans wer:
      E. Taxable temporary difference and favorable book-tax diffe rence. Future
      taxable income will increase by $800,000 compared to future book income as
      the excess book basis is recovered, resulting in a future tax payable.

46. Abbot Company determined that the book basis of its allowance for bad debts is
$100,000. There is no corresponding tax basis in this account. The basis difference is
properly characterized as:
       A.      A permanent difference
       B.      A taxable temporary difference
       C.      A deductible temporary difference
       D.      A favorable book-tax difference
       E.      Both B and D are correct

Ans wer:
      C. Deductible temporary differe nce. Future taxable income will decrease by
      $100,000 compared to future book income as the bad debts are charged off,
      resulting in a future tax benefit.

47. Which of the following items is not a temporary book-tax basis difference?
      A.       Warranty reserve accruals
      B.       Accelerated depreciation
      C.       Capitalized inventory costs under §263A
      D.       Nondeductible stock option compensation from exercising an ISO
      E.       All of the above are temporary differences

Ans wer:
      D. Nondeductible stock option compe nsation from exercising an ISO
      (incentive stock option). A company does not receive a tax deduction whe n
      an employee exercises an incentive stock option, making the book
      compensation deduction a permanent difference.

48. Which of the following book-tax differences does not create a favorable temporary
book-tax basis difference?
       A.      Tax depreciation for the period exceeds book depreciation
       B.      Bad debts charged off in the current period exceed the bad debts accrued
               in the current period




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Chapter 17 - FAS 109: Accounting for Income Taxes




        C.      Inventory costs capitalized under §263A deducted as part of current yea r
                tax cost of goods sold are less than the inventory costs capitalized in
                ending inventory
        D.      Vacation pay accrued for tax purposes in a prior period is deducted in the
                current period
        E.      All of the above create a favorable temporary book/tax temporary
        difference

Ans wer:
      C. Inventory costs capitalized under §263A deducted as part of current year
      tax cost of goods sold are less than the inventory costs capitalized in ending
      inventory. In this case, book income would exceed taxable income, creating
      an unfavorable book-tax difference.

49. Lodge, Inc. reported pretax book income of $5,000,000 in 2009. During the year, the
Company increased its reserve for warranties by $200,000. The Company deducted
$50,000 on its 2009 tax return related to warranty payme nts made during the year. What
is the impact on taxable income compared to pretax book income of the book-tax
difference that results from these two events?
         A.     Favorable (decreases taxable income)
         B.     Unfavorable (increases taxable income)
         C.     Neutral (no impact on taxable income)

Ans wer:
      B. Unfavorable (increases taxable income). Book income would be $150,000
      less than taxable income in 2009.

50. Which of the following book-tax basis differences results in a deductible temporary
difference?
        A.     Book basis of a fixed asset exceeds its tax basis
        B.     Book basis of a pension-related liability exceeds its tax basis
        C.     Prepayment of income included on the tax return but not on the income
               statement (the transaction is recorded as a liability on the balance sheet)
        D.     All of the above result in a deductible temporary difference
        E.     Both B and C result in a deductible temporary difference

Ans wer:
      E. The future payment of the accrued pension liability and the future
      recording of previously recorded taxable income will result in future taxable
      income being less than book income, resulting in a future tax benefit.

51. Shaw Corporation reported pretax book income of $1,000,000 in 2009. Included in
the computation were favorable temporary differences of $200,000, unfavorable
temporary differences of $50,000, and favorable permanent differences of $100,000.
Assuming a tax rate of 34%, compute the Company’s deferred income tax expense or
benefit for 2009.



                                               17-15
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      Favorable temporary differences                          $(200,000)
      Unfavorable temporary differences                           50,000
      Net increase in favorable temporary diff.                $(150,000)
       34%                                                        34%
      Net increase in deferred income tax liability            $ (51,000)

        The net increase in the deferred income tax liability is recorded as the
        company’s deferred tax expense in 2009. Pe rmanent differences do not affect
        the deferred income tax provision.

52. Shaw, Inc. reported pretax book income of $10,000,000 in 2009. During the current
year, the reserve for bad debts increased by $100,000. In additio n, tax depreciation
exceeded book depreciation by $200,000. Shaw, Inc. sold a fixed asset and reported
book gain of $50,000 and tax gain of $75,000. Finally, the Company received $250,000
of tax-exempt life insurance proceeds from the death of one of its officers. Assuming a
tax rate of 34%, compute the Company’s deferred income tax expense or benefit for
2009.


53. Harrison Corporation reported pretax book income of $600,000 in 2009. Tax
depreciation exceeded book depreciation by $400,000. In additio n, the Company
received $300,000 of tax-exempt municipal bond interest. The Company’s prior year tax
return showed taxable income of $50,000. Assuming a tax rate of 34%, compute the
Company’s deferred income tax expense or benefit for 2009.




                                               17-16
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      Pretax book income                                         $600,000
      Excess tax depreciation                                    (400,000)
      Tax-exempt inte rest income                                (300,000)
      Net operating loss                                        $(100,000)

        NOL carryback to prior year                               $50,000
         34%                                                      34%
        Curre nt income tax refundable                            $17,000

        Excess tax depreciation                                  (400,000)
        NOL carryover to 2009                                      50,000
        Net increase in favorable temporary diff.               $(350,000)
         34%                                                       34%
        Net increase in deferred income tax liability           $(119,000)

        The net increase in the deferred income tax liability is recorded as the
        company’s deferred tax expense in 2009. This assumes the Company does
        not record a valuation against the deferred tax asset created by the NOL
        carryove r. Pe rmanent differences do not affect the deferred tax provision.

54. Identify the following items as creating a temporary difference, permanent difference,
or no difference.




                                               17-17
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
                                                       Temporary    Permanent        No
                      Item
                                                       Difference   Difference    Difference

Reserve for warranties                                     X

Accrued pension liability                                  X

Goodwill not amortized for tax purposes                                 X
but subject to impairment under FAS 142
Meal and entertainment expenses                                         X

Life insurance proceeds                                                 X

Net capital loss carryove r                                X

Nondeductible fines and penalties                                       X

Accrued vacation pay liability paid
within the first 2½ months of the next tax                                            X
year

55. Which of the following items is not a permanent book/tax difference?
      A.       Tax-exempt interest income
      B.       Tax-exempt insurance proceeds
      C.       Domestic manufacturing deduction
      D.       Non-deductible meals and entertainment expense
      E.       First year expensing under §179

Ans wer:
      E. First year expensing under §179. First year expensing will eventually be
      recovered as book de preciation.

56. Ann Corporation reported pretax book income of $1,000,000 in 2009. Included in the
computation were favorable temporary differences of $200,000, unfavorable temporary
differences of $50,000, and favorable permanent differences of $100,000. Compute the
Company’s book equivalent of taxable income. Use this number to compute the
Company’s total income tax provision or benefit for 2009, assuming a tax rate of 34%.

Ans wer:
      Pretax book income                                            $1,000,000
      Favorable permanent differences                                 (100,000)
      Book equivalent of taxable income                                900,000
       34%                                                              34%
      Total income tax provision                                      $306,000


                                               17-18
Chapter 17 - FAS 109: Accounting for Income Taxes




        Book equivalent of taxable income takes into account only permanent
        differences.

57. Burcham Corporation reported pretax book income of $600,000 in 2009. Tax
depreciation exceeded book depreciation by $400,000. In addition, the Company
received $300,000 of tax-exempt municipal bond interest. The Company’s prior year tax
return showed taxable income of $50,000. Compute the Company’s book equivalent of
taxable income. Use this number to compute the Company’s total income tax provision
or benefit for 2009, assuming a tax rate of 34%.

Ans wer:
      Pretax book income                                      $600,000
      Tax-exempt inte rest                                    (300,000)
      Book equivalent of taxable income                        300,000
       34%                                                      34%
      Total income tax provision                              $102,000

        Book equivalent of taxable income takes into account only permanent
        differences.




                                               17-19
Chapter 17 - FAS 109: Accounting for Income Taxes




58. Adams Corporation has total deferred tax assets of $3,000,000 at year-end.
Management is assessing whether a valuation allowance must be recorded against some
or all of the deferred tax assets. What level of assurance must management have, based
on the weight of available evidence, that some or all of the deferred tax assets will not be
realized before a valuation allowance is required?
         A.      Probable
         B.      More likely than not
         C.      Realistic possibility
         D.      Reasonable
         E.      More than remote

Ans wer:
      B.        More likely than not

59. Which of the following evidence would not be considered positive in determining
whether Adams Corporation needs to record a valuation allowance for some or all of its
deferred tax assets?
        A.     The Company forecasts future taxable income because of its backlog of
        orders
        B.     The Company has unfavorable temporary differences that will create
               future taxable income when they reverse
        C.     The Company has tax planning strategies that it can implement to create
               future taxable income
        D.     The Company has cumulative net income over the current and prior two
               years
        E.     The Company had a net operating loss carryover expire in the current year

Ans wer:
      E. The Company had a net operating loss carryove r expire in the current
      year. FAS 109 lists the expiration of tax carryovers as a source of negative
      evidence.

60. As of the beginning of the year, Gratiot Company recorded a valuation allowance of
$200,000 against its deferred tax assets of $1,000,000. The valuation allowance relates to
a net operating loss carryover from the prior year. During the year, management
concludes that the valuation allowance is no longer necessary because it forecasts
sufficient taxable income to absorb the NOL carryover. What is the impact of
management’s reversal of the valuation allowance on the Company’s effective tax rate?
        A.      Increases the ETR
        B.      Decreases the ETR
        C.      No impact on the ETR

Ans wer:
      B. Decreases the ETR. Removing the valuation allowance creates an increase
      in the Company’s income tax benefit, which is treated as a prior period
      adjustment and causes the effective tax rate to decrease.



                                               17-20
Chapter 17 - FAS 109: Accounting for Income Taxes




61. Which of the following evidence would be considered negative in determining
whether Gratiot Corporation needs to record a valuation allowance for some or all of its
deferred tax assets?
        A.     The Company forecasts future taxable income because of its backlog of
        orders
        B.     The Company has a cumulative net loss over the current and prior two
               years
        C.     The Company has unfavorable temporary differences that will create
               future taxable income when they reverse
        D.     The Company had a net operating loss carryover expire in the current year
        E.     Both B and D constitute negative evidence in assessing the need for a
               valuation allowance


62. Saginaw, Inc. completed its first year of operations with a pretax loss of $500,000.
The tax return showed a net operating loss of $600,000, which the Company will carry
forward. The $100,000 book-tax difference results from excess tax depreciation over
book depreciation. Management has determined that they should record a valuation
allowance equal to the net deferred tax asset. Assuming the current tax expense is zero,
prepare the journal entries to record the deferred tax provision and the valuation
allowance.

Ans wer:
      Deferred tax asset*                           204,000
             Deferred tax benefit                          204,000
      *$600,000  34%

        Deferred tax expense                         34,000
               Deferred tax liability*                        34,000
        *$100,000  34%

        Deferred tax benefit*                       170,000
               Valuation allowance                         170,000
        *$($600,000 - $100,000)  34%

63. {research} What reasons did General Motors management give for their
establishment of a 39 billion valuation allowance in the third quarter of 2007? You can
access the Company’s Form 10-Q for the third quarter, 2007, from the Company’s
website, www.gm.com.




                                               17-21
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      1. A three-year historical cumulative loss in the U.S., Canada, and Germany
         on an adjusted basis
      2. Ongoing weakness at GMAC, resulting in a significantly reduced near-
         term profit forecast
      3. Challenging near-term automotive market conditions in the U.S. and
         Germany, resulting in lowe r projected earnings in the near-term than
         previously anticipated
      4. A greater percentage of the company’s deferred tax assets were going to
         be subject to expiration in the near term

        Source: GM Form 10-Q for the 3rd Quarte r, 2007, page 57.

64. Montcalm Corporation has total deferred tax assets of $3,000,000 at year-end. Of
that amount, $1,000,000 results from the current expensing of an expenditure that the IRS
might assert must be capitalized on audit. Management is trying to determine if it should
not recognize the deferred tax asset related to this item under FIN 48. What confidence
level must management have that the item will be sustained on audit before it can
recognize any portion of the deferred tax asset under FIN 48?

        A.      Probable
        B.      More likely than not
        C.      Realistic possibility
        D.      Reasonable
        E.      More than remote

Ans wer:
      B. More likely than not

65. Which of the following statements about FIN 48 is correct?
      A.       FIN 48 applies only to tax positions accounted for under FAS 109 taken
               on a filed tax return.
      B.       FIN 48 applies to all tax positions accounted for under FAS 109,
               regardless of whether the item is taken on a filed tax return.
      C.       FIN 48 deals with both the recognition and realization of deferred tax
               assets.
      D.       If a tax position meets the more likely than not standard, the entire amount
               of the deferred tax asset or current tax benefit related to the tax position
               can be recognized under FIN 48.
      E.       Statements B, C, and D are correct.

Ans wer:
      B. FIN 48 applies to all tax positions accounted for under FAS 109,
      regardless of whethe r the item is taken on a filed tax return.




                                               17-22
Chapter 17 - FAS 109: Accounting for Income Taxes




66. Cadillac Square Corporation determined that $1,000,000 of its domestic
manufacturing deduction on its current year tax return was uncertain, but that it was more
likely than not to be sustained on audit. Management made the following assessment of
the Company’s potential tax benefit from the deduction and its probability of occurring.

        Potential Estimated       Individual Probability   Cumulative Probability
           Benefit (000s)            of Occurring (%)          of Occurring
           $340,000                       40                          40
            272,000                       25                          65
            170,000                       20                          85
                   0                      15                        100

What amount of the tax benefit related to the uncertain tax benefit from the domestic
manufacturing deduction can Cadillac Square Corporation recognize in calculating its
income tax provision in the current year?

Ans wer:
      $272,000, the amount that has a cumulative probability of more than 50% of
      occurring. Cadillac Square Corporation would record an increase in its
      income taxes payable (income tax expense) of $68,000, the difference between
      the full benefit received on the tax return and the expected benefit to be
      received after audit by the IRS.

67. How would your answer to Question 67 change if management determined that there
was only a “50/50” chance any portion of the $1,000,000 domestic manufacturing
deduction would be sustained on audit?

Ans wer:
      No amount of the tax benefit from the deduction could be recognized. The
      recognition threshold has not been met (more likely than not), and the refore,
      the measurement step is not taken. Cadillac Square Corporation would
      record an increase in its income taxes payable (income tax expense) of
      $340,000, the full benefit received on the tax return.

68. As part of its FIN 48 assessment, Penobscot Company records interest and penalties
related to its tax contingency amount of $500,000. Which of the following statements
about recording this amount is most correct?
        A.       Penobscot must include the amount in its income tax provision
        B.       Penobscot must record the amount separate from its income tax provision
        C.       Penobscot can elect to allocate a portion of the amount to both its income
                 tax provision and its general and administrative expenses provided the
                 Company discloses which option it chose
        D.       Penobscot can elect to record the entire amount as part of its income tax
                 provision or separate from its income tax provision, provided the
                 Company discloses which option it chose
        E.       Statements C and D are both correct



                                               17-23
Chapter 17 - FAS 109: Accounting for Income Taxes




69. {research} By what amount did Intel Corporation adjust its Retained Earnings in
2007 after adopting FIN 48? What amount of its tax contingenc y reserve did Intel
reclassify as noncurrent on its balance sheet for 2007? You can access the Company’s
Annual Report at www.intel.com.

Ans wer:
      Intel makes the following disclosure regarding FIN 48 in its Income Taxes
      footnote to its financial statements:

        Effective at the beginning of the first quarter of 2007, we adopted the provisions
        of FIN 48. As a result of the implementation of FIN 48, we reduced the liability
        for net unrecognized tax benefits by $181 million, and accounted for the
        reduction as a cumulative effect of a change in accounting principle that
        resulted in an increase to retained earnings of $181 million. (Intel Annual
        Report, page 80.)

        Intel makes the following disclosure regarding its classification of the
        unrecognize d tax benefits on its balance sheet in its Income Taxes footnote to
        its financial statements:

        We have historically classified unrecognized tax benefits in current taxes
        payable. As a result of adoption of FIN 48, we reclassified unrecognized tax
        benefits to long-term income taxes payable. Long-term income taxes payable
        include uncertain tax positions, reduced by the associated federal deduction for
        state taxes and non-U.S. tax credits, and may also include other long-term tax
        liabilities that are not uncertain but have not yet been paid. (Intel Annual
        Report, page 80.)

        The amount reported as Long-Term Income Taxes Payable on the balance
        sheet is $785 million. (Intel Annual Report, page 48.)

70. Beacon Corporation recorded the following deferred tax assets and liabilities:

        Current deferred tax assets                              $650,000
        Current deferred tax liabilities                         (400,000)
        Non-current deferred tax assets                         1,000,000
        Non-current deferred tax liabilities                   (2,500,000)
         Net deferred tax liabilities                         $(1,250,000)




                                               17-24
Chapter 17 - FAS 109: Accounting for Income Taxes




All of the deferred tax accounts relate to temporary differences that arose as a result of
the company’s U.S. operations. Which of the following statements describes how
Beacon should disclose these accounts on its balance sheet?
        A.      Beacon reports a net deferred tax liability of $1,250,000 on its balance
                sheet
        B.      Beacon nets the deferred tax assets and the deferred tax liabilities and
                reports a net deferred tax asset of $1,650,000 and a net deferred tax
                liability of $2,900,000 on its balance sheet.
        C.      Beacon can elect to net the current deferred tax accounts and the non-
                current tax accounts and report a net current deferred tax asset of $250,000
                and a net deferred tax liability of $1,500,000 on its balance sheet.
        D.      Beacon is required to net the current deferred tax accounts and the non-
                current tax accounts and report a net current deferred tax asset of $250,000
                and a net deferred tax liability of $1,500,000 on its balance sheet.

Ans wer:
      D. Beacon is required to net the current deferred tax accounts and the non-
      current tax accounts and report a net current deferred tax asset of $250,000
      and a net deferred tax liability of $1,500,000 on its balance sheet. The netting
      is required because the deferred tax accounts all arose in the same tax
      jurisdiction (FAS 109, ¶42).

71. FAS 109 requires a company to disclose those components of its deferred tax assets
and liabilities that are considered
        A.       Relevant
        B.       Significant
        C.       Important
        D.       Major


72. Which of the following temporary differences creates a current deferred tax asset?
      A.       Allowance for bad debts
      B.       Goodwill amortization
      C.       Accumulated depreciation
      D.       Inventory capitalization under §263A
      E.       Both A and D create a current deferred tax asset

Ans wer:
      E. Both A and D create a curre nt deferred tax asset. Deferred tax accounts
      are classified based on the balance sheet classification of the item to which
      they relate. Accounts receivable and inventory are both classified as curre nt
      assets.




                                               17-25
Chapter 17 - FAS 109: Accounting for Income Taxes




73. Which formula represents the calculation of a company’s effective tax rate?
      A.      Income taxes paid / Taxable income
      B.      Income taxes paid / Pretax income from continuing operations
      C.      Income tax provision / Taxable income
      D.      Income tax provision / Pretax income from continuing operations

Ans wer:
      D. Income tax provision / Pretax income from continuing operations

74. Which of the following items is not a reconciling item in the income tax footnote?
      A.       State income taxes
      B.       Foreign income taxes
      C.       Accrued pension liabilities
      D.       Dividends received deduction
      E.       Tax exempt municipal bond interest

Ans wer:
      C. Accrued pension liabilities. Accrued pension liabilities is a temporary
      difference and does not appear in the effective tax rate reconciliation unless
      the company makes an adjustment to the account that relates to a prior
      period.

75. Randolph Company reported pretax net income from continuing operations of
$800,000 and taxable income of $500,000. The book-tax difference of $300,000 was due
to a $200,000 favorable temporary difference relating to depreciation, an unfavorable
temporary difference of $80,000 due to an increase in the reserve for bad debts, and a
$180,000 favorable permanent difference from the receipt of life insurance proceeds.
Randolph Company’s applicable tax rate is 34%.
        A.     Compute Randolph Company’s current income tax expense.
        B.     Compute Randolph Company’s deferred income tax expense or benefit.
        C.     Compute Randolph Company’s effective tax rate.
        D.     Provide a reconciliation of Randolph Company’s effective tax rate with its
               hypothetical tax rate of 34%.




                                               17-26
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      Pretax net income                                      $800,000
      Favorable temporary difference                         (200,000)
      Unfavorable temporary difference                         80,000
      Favorable permanent difference                         (180,000)
      Taxable income                                          500,000
       34%                                                     34%
      Curre nt income tax payable                            $170,000

        Favorable temporary difference                       (200,000)
        Unfavorable temporary differences                      80,000
        Net favorable temporary difference                   (120,000)
         34%                                                   34%
        Deferred tax expense (liability)                     $(40,800)

        Total income tax provision = $170,000 + $40,800 = $210,800

        Effective tax rate = $210,800 / $800,000 = 26.35%

        ETR reconciliation
         Income tax expense at 34% (hypothetical)*            $272,000
         Tax benefit from pe rmanent diffe rence**           ( 61,200)
         Income tax provision                                 $210,800
          *$800,000  34%
          **$180,000 x 34%

          Hypothetical income tax rate                        34.00%
          Tax benefit from pe rmanent diffe rence*            (7.65%)
          Effective tax rate                                  26.35%
           *$61,200 / $800,000

76. Which of the following pronouncements should a company consult in computing its
quarterly income tax provision?
        A.     FAS 109
        B.     APB 23
        C.     APB 28
        D.     FIN 48
        E.     SarbOX 404

Ans wer:
      C. APB 28




                                               17-27
Chapter 17 - FAS 109: Accounting for Income Taxes




Comprehensive Problems


77. You have been assigned to compute the income tax provision for Motown Memories,
Inc. (MM) as of December 31, 2009. The Company’s federal income tax rate is 34%.
The Company’s Income Statement for 2009 is provided below:

                                         Motown Memories, Inc.
                                         Statement of Operations

 at December 31                                                                       2009

 Net sales                                                                     $50,000,000
 Cost of sales                                                                  28,000,000
    Gross profit                                                                22,000,000

 Compens ation                                                                   2,000, 000
 Selling expenses                                                                1,500, 000
 Depreciation and amortization                                                   4,000, 000
 Other ex pens es                                                                  500,000
     Total operating expenses                                                    8,000, 000
 Income from operations                                                        $14,000,000
 Interest and other income                                                       1,000, 000
 Income before income taxes                                                    $15,000,000


You have identified the following permanent differences:
   Interest income from municipal bonds: $50,000
   Nondeductible meals and entertainment expenses: $20,000




                                               17-28
Chapter 17 - FAS 109: Accounting for Income Taxes




     Domestic manufacturing (§199) deduction: $250,000
     Nondeductible fines: $5,000


MM prepared the following schedule of temporary differences from the beginning of the
year to the end of the year:

                                                Motow n Memories, Inc.
                                     Temporary Difference Scheduling Template



                                   BOY              Beginning            Current         EOY             Ending
     Taxable (Favorable)         Cumulative         Deferred              Year         Cumulative       Deferred
 Temporary Differences              T/D          Taxes (@ 34%)           Change           T/D         Taxes (@ 34%)


Non-current
Accumulated depreciation          (8,000,000)         (2,720,000)        (1,000,000)    (9,000,000)       (3,060,000)



                                   BOY              Beginning            Current          EOY            Ending
 Deductible (Unfavorable)        Cumulative          Deferred             Year         Cumulative       Deferred
  Temporary Differences             T/D           Taxes (@ 34%)          Change           T/D         Taxes (@ 34%)


Current
Allowance for bad debts              200,000                 68,000          50,000        250,000            85,000
Reserve for warranties               100,000                 34,000          20,000        120,000            40,800
Inventory §263A adjustment           240,000                 81,600          60,000        300,000           102,000
 Total current                       540,000                183,600         130,000        670,000           227,800


Non-Current
Deferred compensation                 50,000                 17,000          10,000         60,000            20,400
Accrued pension liabilities         3,000,000            1,020,000          250,000       3,250,000        1,105,000
 Total non-current                  3,050,000            1,037,000          260,000       3,310,000        1,125,400


                         Total      3,590,000            1,220,600          390,000       3,980,000        1,353,200




1.         Compute MM’s current income tax expense or benefit for 2009.
2.         Compute MM’s deferred income tax expense or benefit for 2009.
3.         Prepare a reconciliation of MM’s total income tax provision with its hypothetical
           income tax expense in both dollars and rates.


Ans wer:
      See attached spreadsheet solutions.



                                                    17-29
Chapter 17 - FAS 109: Accounting for Income Taxes




78. You have been assigned to compute the income tax provision for Tulip City Flowers,
Inc. (TCF) as of December 31, 2009. The Company’s federal income ta x rate is 34%.
The Company’s Income Statement for 2009 is provided below:

                                            Tulip City Flowers, Inc.
                                           Statement of Operations

 at December 31                                                                                                    2009

 Net sales                                                                                               $20,000,000
 Cost of sales                                                                                            12,000,000
    Gross profit                                                                                           8,000, 000

 Compens ation                                                                                               500,000
 Selling expenses                                                                                            750,000
 Depreciation and amortization                                                                             1,250, 000
 Other ex pens es                                                                                          1,000, 000
     Total operating expenses                                                                              3,500, 000
 Income from operations                                                                                   $4,500,000
 Interest and other income                                                                                    25,000
 Income before income taxes                                                                               $4,525,000


You have identified the following permanent differences:
  Interest income from municipal bonds: $10,000
  Nondeductible stock compensation: $5,000
  Domestic manufacturing deduction: $8,000
  Nondeductible fines: $1,000

TCF prepared the following schedule of temporary differences from the beginning of the
year to the end of the year:

                                               Tulip City Flow ers, Inc.
                                   Temporary Difference Scheduling Template



                                  BOY              Beginning               Current        EOY             Ending
  Taxable (Favorable)         Cumulative            Deferred                Year        Cumulative       Deferred
 Temporary Differences            T/D           Taxes (@ 34%)              Change          T/D         Taxes (@ 34%)


Non-current
Accumulated depreciation         (5,000,000)          (1,700,000)           (500,000)    (5,500,000)       (1,870,000)




                                                   17-30
Chapter 17 - FAS 109: Accounting for Income Taxes




                                  BOY                 Beginning              Current         EOY            Ending
 Deductible (Unfavorable)       Cumulative            Deferred                Year        Cumulative       Deferred
  Temporary Differences            T/D             Taxes (@ 34%)             Change          T/D         Taxes (@ 34%)


Current
Allowance for bad debts             100,000                   34,000             10,000       110,000            37,400
Prepaid income                               0                      0            20,000        20,000             7,000
 Total current                      100,000                   34,000             30,000       130,000            44,400


Non-Current
Deferred compensation                50,000                   17,000             10,000        60,000            20,400
Accrued pension liabilities         500,000                  170,000            100,000       600,000           204,000
 Total non-current                  550,000                  187,000            110,000       660,000           224,400


                        Total       650,000                  221,000            140,000       790,000           268,800




1.         Compute TCF’s current income tax expense or benefit for 2009.
2.         Compute TCF’s deferred income tax expense or benefit for 2009.
3.         Prepare a reconciliation of TCF’s total income tax provision with its hypothetical
           income tax expense in both dollars and rates.
4.         Assume TCF’s tax rate increased to 35% in 2008. Recompute TCF’s deferred
           income tax expense or benefit for 2009 using the following template:

                                                 Tulip City Flow ers, Inc.
                                    Temporary Difference Scheduling Template



                                  BOY                Beginning               Current        EOY             Ending
     Taxable (Favorable)        Cumulative            Deferred                Year        Cumulative       Deferred
 Temporary Differences             T/D            Taxes (@ 34%)              Change          T/D         Taxes (@ 35%)


Non-current
Accumulated depreciation         (5,000,000)            (1,700,000)           (500,000)    (5,500,000)



                                  BOY                 Beginning              Current         EOY            Ending
 Deductible (Unfavorable)       Cumulative            Deferred                Year        Cumulative       Deferred
  Temporary Differences            T/D             Taxes (@ 34%)             Change          T/D         Taxes (@ 35%)


Current
Allowance for bad debts             100,000                   34,000             10,000       110,000
Prepaid income                               0                      0            20,000        20,000
 Total current                      100,000                   34,000             30,000       130,000


Non-Current
Deferred compensation                50,000                   17,000             10,000        60,000
Accrued pension liabilities         500,000                  170,000            100,000       600,000




                                                     17-31
Chapter 17 - FAS 109: Accounting for Income Taxes




 Total non-current                 550,000             187,000   110,000   660,000


                     Total         650,000             221,000   140,000   790,000



Ans wer:
      See attached spreadsheet solutions.


79. [LO 4] Access the 2007 Annual Report for Johnson & Johnson Company and answer
the following questions. You can access the annual report at www.jnj.com.

         A. Using information from the Company’s Income Statement and Income Taxes
         footnote, what was the Company’s effective tax rate for 2007? Show how the rate
         is calculated.

Ans wer:
      The Company re ports an effective tax rate of 20.4% for 2007, computed as
      $2,707 / $13,283.

         B. Using information from the Statement of Cash Flows, calculate the Company’s
         cash tax rate.

Ans wer:
      The Company’s cash tax rate for 2007 was 30.9%, computed as $4,099 /
      $13,283.

         C. What does the Company’s Income Taxes Note tell you about where the
         company earns its international income? Why does earning inco me in these
         countries cause the effective tax rate to decrease?

Ans wer:
      In the effective tax rate reconciliation, the Company informs investors that it
      earns income in Puerto Rico, Ireland, and other jurisdictions. Earning
      income in these countries causes the Company’s effective tax rate to decrease
      because these countries tax income at rates lower than the U.S. rate of 35%.
      Unde r U.S. tax laws, the income earned in these countries is not subject to
      U.S. tax until repatriated to the United States.

         D. What item creates the Company’s largest deferred tax asset? Explain why this
         item creates a deductible temporary difference.




                                               17-32
Chapter 17 - FAS 109: Accounting for Income Taxes




Ans wer:
      The Company’s largest deferred tax asset relates to “International R&D
      capitalized for tax.” The temporary difference results because the R&D
      expense has been expensed for financial reporting purposes and capitalized
      for tax purposes. The R&D will be amortize d (deducted) on future tax
      returns. This creates a future tax benefit as the R&D is amortized (deferred
      tax asset).

        E. What item creates the Company’s largest deferred tax liability? Explain why
        this item creates a taxable temporary difference.

Ans wer:
      Non-deductible intangibles. The temporary difference results because the
      Company has created a financial accounting basis in these assets under FAS
      141 as a result of business acquisitions. These assets did not receive a
      corresponding tax basis. This creates a taxable temporary difference that
      will result in a future tax liability as the basis of the intangibles is recovered
      (either through amortization or impairment).

        F. How does the Company classify its tax contingency reserve under FIN 48 on
        the balance sheet?

Ans wer:
      The Company states in its Income Taxes footnote that it classifies liabilities
      for unrecognized tax benefits as long-term liabilities (Johnson & Johnson
      Annual Report, page 57). The Company does not identify the dollar amount
      related to the long te rm income taxes payable related to FIN 48.

        G. How does the Company treat interest and penalties related to its tax
        contingency reserve under FIN 48?

Ans wer:
      The Company states in its Income Taxes footnote that it classifies interest
      and penalties related to its unrecognized tax benefits as income tax expense.
      (Johnson & Johnson Annual Report, page 57).




                                               17-33

				
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