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Vikram Rathi - Taxing Situations

This document summarizes two cases involving differences between income taxes calculated for financial reporting purposes versus tax purposes. For the first case of Surf's Up company, the document shows the depreciation expense and resulting income/tax calculations for both tax and financial reporting purposes over 10 years. This creates a deferred tax liability each year. For the second case of Bug Off, Inc., the document shows how a one-year warranty expense is treated differently for tax versus financial reporting, creating a deferred tax asset in the initial year. The deferred tax asset decreases over time as the temporary difference is reversed.

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Vikram Rathi
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249 views2 pages

Vikram Rathi - Taxing Situations

This document summarizes two cases involving differences between income taxes calculated for financial reporting purposes versus tax purposes. For the first case of Surf's Up company, the document shows the depreciation expense and resulting income/tax calculations for both tax and financial reporting purposes over 10 years. This creates a deferred tax liability each year. For the second case of Bug Off, Inc., the document shows how a one-year warranty expense is treated differently for tax versus financial reporting, creating a deferred tax asset in the initial year. The deferred tax asset decreases over time as the temporary difference is reversed.

Uploaded by

Vikram Rathi
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Section B

Vikram Rathi

PGP2011939

Taxing Situtations: Two cases on Income Taxes and Financial Reporting


Executive summary: Surfs Up Surfs Up company purchases a single asset worth $1 million in the duration of 1990-2000. Its owner Jack is planning to use modified accelerated cost recovery system (MACRS) for depreciation for tax purposes. It would be a 5 year double decline depreciation with one-half of the full years depreciation in 1990. For financial statement purpose, machine is depreciated over 10 years with no salvage value via straight line method. Depreciation expense for year 1990 and 2000: 0.5*100,000 = 50,000 Depreciation expense for rest of the years: 1000,000/10 = 100,000 1990 1991 Income (before tax and depreciation) Depreciation (tax purpose) Depreciation (financial reporting purpose) Income before taxes Income tax expense (income statement) Net Income 1500 1500 200 320 1992 1500 192 100 1400 560 840 1993 1500 115.2 100 1400 560 840 1994 1500 115.2 100 1400 560 840 1995 1996 1997 1998 1999 2000 1500 1500 1500 1500 1500 1500 57.6 0 0 0 0 0

50 100 1450 1400 580 870 560 840

100 100 100 100 100 50 1400 1400 1400 1400 1400 1450 560 840 560 840 560 840 560 840 560 840 580 870

Taxable income 1300 1180 1308 1384.8 1384.8 1442.4 1500 1500 1500 1500 1500 Income tax payable (Balance sheet) 520 472 523.2 553.92 553.92 576.96 600 600 600 600 600 Deferred tax liability (Balance sheet) 60 148 184.8 190.88 196.96 180 140 100 60 20 0 Note: all figures are in 000. Ans. 1: Tax difference between taxes paid and the tax expense will be shown as deferred tax liability in the balance sheet and its balancing entry will be made as income tax payable( in the liability side) and income tax expense (in the retained earnings). Ans. 2: From above table, we can see the deferred tax liability account for all the years. Deferred tax liability = deferred tax liability from previous period + (income tax expense income tax payable) Bug Off, Inc. Bug Off offers one year money back warranty which creates interesting accounting issues. Warranty expense (6% of annual revenue) can be recognized on accrual basis in financial statements but

unfortunately tax authorities dont permit that. They allow expenses to be deducted only as they were incurred. In the year 1986, warranty expenditure was 0 but warranty expense was $6000. Thus created deferred tax asset: 0.4*6000 = 2400 ` Revenue Expenses ( materials, wages and dep.) Warranty expense (Income statement) Income before taxes Income tax expense Net Income Warranty expenditure (Tax return) Taxable Income Income tax payable (Balance sheet) Deferred tax asset Note: all figures are in 000. 1989 100 65 6 29 11.6 17.4 6 29 11.6 2.4 1990 200 110 12 78 31.2 46.8 6 84 33.6 4.8 1991 100 65 6 29 11.6 17.4 12 23 9.2 0 1992 100 65 6 29 11.6 17.4 6 29 11.6 2.4

Ans. 1: Since for initial years, income tax payable is more than income tax expense, difference will create deferred tax asset and will be recorded in Balance Sheet. It can be seen in the table above. Ans. 2: From above table, we can see that Deferred tax asset = deferred tax asset from previous period +( income tax payable Income tax expense) In the first year, 1986, deferred tax asset is created. Since after that every year tax expense is equal to tax payable and is constant, deferred tax asset is also constant. In 1990, tax expense changes to 12000 which creates more deferred tax asset. This additionally paid tax is adjusted in the next year. Hence, we can see that in both the cases, temporary tax difference is created which is nullified in the subsequent years.

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