SMChap017

Chapter 17 - FASB ASC Topic 740: Income Taxes

Chapter 17 FASB ASC Topic 740: Income Taxes SOLUTIONS MANUAL Discussion Questions 1. (LO 1) Identify some of the reasons why accounting for income taxes is complex.

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U.S. tax laws are complex and ambiguous. A company often prepares its financial statements (Form 10-K) six months or more in advance of when the company files its corresponding income tax returns. The rules that apply to accounting for income taxes are not found exclusively in ASC 740 (for example, stock options and business combinations).

2. (LO 1) True or False: ASC 740 applies to all taxes paid by a corporation. Explain. False. ASC 740 only applies to income taxes paid by a corporation. 3. (LO 1) True or False: ASC 740 is the sole source for the rules that apply to accounting for income taxes. Explain. False. With the Accounting Standards Codification, the rules that apply to accounting for income taxes are found primarily in ASC 740. The codification includes rules previously found in pronouncements from the Emerging Issues Task Force, opinions from the former Accounting Principles Board, and pronouncements from the Securities and Exchange Commission. ASC 740 does not include the income tax accounting rules that apply to accounting for stock compensation or business combinations. These rules are found in ASC 718-740 and ASC 805-740. 4. (LO 1) 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? 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 when 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 “return-to-provision” adjustment or a “true-up.”

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5. (LO 1) What distinguishes an income tax from other taxes? 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. (LO 1) Briefly describe the six step process by which a company computes its income tax provision. The steps to compute a company’s federal income tax provision proceed as follows: 1. Adjust pre-tax net income for all permanent differences 2. Identify all temporary 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. (LO 2) What are the two components of a company’s income tax provision? What does each component represent about a company’s income tax provision? 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 represents the amount necessary to adjust the balance sheet liability or receivable for future income taxes payable or refundable that result from current and prior year transactions. 8. (LO 2) True or False: All differences between book and taxable income, both permanent and temporary, affect a company’s effective tax rate. Explain. False. Permanent differences affect a company’s effective tax rate. Temporary differences affect a company’s effective tax rate only when 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 adjustments).



9. (LO 2) When does a temporary difference resulting from an expense (deduction) create a taxable temporary difference? A deductible temporary difference? 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 period 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. (LO 2) When does a temporary difference resulting from income create a taxable temporary difference? A deductible temporary difference? Income results in a taxable temporary difference when the income is reported on the financial statement prior to being reported on the tax return, creating a future (deferred) tax liability in the period in which the income is reported on the tax return. An example is use of the installment 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 reported 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 prepayment 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. (LO 2) Briefly describe what is meant by the asset and liability or balance sheet approach taken by ASC 740 with respect to computing a corporation’s deferred tax provision. Under ASC 740, 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.



12. (LO 2) Why are cumulatively favorable temporary differences referred to as taxable temporary differences? 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 and decreases (draws down) the tax liability when the temporary difference reverses in a future period. 13. (LO 2) Why are cumulatively unfavorable temporary differences referred to as deductible temporary differences? Initially unfavorable temporary differences are those differences that cause the current 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 and decreases (draws down) the tax asset when the temporary difference reverses in a future period. 14. ([LO 2) In addition to the current year tax return taxes payable or refundable, what other transactions can affect a company’s current income tax provision? 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 were not previously recorded as temporary differences under ASC 718 or APB 25; or 4) increases in the unrecognized tax benefit (income taxes payable) under ASC 740.



15. (LO 2, 4) What is an unrecognized tax benefit and how does it affect a company’s current income tax expense? 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 are treated as part of the current income tax expense even if the corporation expects to resolve the uncertain tax position beyond the next 12 months. 16. (LO 2) 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. 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 new 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 period adjustment. 17. (LO 2) True or False: All temporary differences have a financial accounting basis. Explain. False. Not all temporary differences have a financial accounting basis. Net operating loss and net capital loss carryovers create deferred tax assets but do not have a financial accounting basis. Organizational expenditures also do not have an accounting basis on the balance sheet but result in a deferred tax asset if capitalized for tax purposes. 18. (LO 3) What is the purpose behind a valuation allowance as it applies to deferred tax assets? 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 realized in a future period (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.



19. (LO 3) What is the difference between recognition and realization as it applies to the recording of a deferred tax asset on a balance sheet? 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 whether 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. (LO 3) Briefly describe the four sources of taxable income a company evaluates in determining if a valuation allowance is necessary. 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. (LO 3) 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? 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 generally receive more weight when analyzing whether a valuation allowance is necessary.



22. (LO 3) 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. ASC 740 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 credit 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. (LO 3) When does a company remove a valuation allowance from its balance sheet? 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. (LO 3) What is a company’s book equivalent of taxable income and how does this computation enter into the income tax provision process? A company computes its book equivalent of taxable income by adjusting pretax net income from continuing operations for permanent differences. 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. (LO 4) What motivated the FASB to issue FIN 48? The FASB issued FIN 48 (now codified in ASC 740-10) because it was concerned that there was “diversity in practice” in the way in which companies computed their income tax contingency reserve under FAS 5.



26. (LO 4) 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 ASC 740. ASC 740-10 applies a two-step process to evaluating tax positions. ASC 740 refers to the first step as recognition. A company must determine whether 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 at the court of last resort (the Supreme Court in the United States), based on the technical merits of the position. The second step is referred to as measurement. If the tax position meets the more-likelythan-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 morelikely-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. (LO 4) Distinguish between recognition and measurement as they relate to the computation of unrecognized tax benefits under ASC 740. 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. Measurement is the process of determining the amount of the tax benefit that can be recorded on the financial statements. 28. (LO 4) What is a tax position as it relates to the application of ASC 740 to uncertain tax positions? ASC 740-10 defines a tax position as any issue dealing with income taxes. ASC 740 pertains to tax positions taken on a current 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.



29. (LO 4) 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. False. A company must reassess its balance in its unrecognized tax benefit account when 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. (LO 4) True or False: ASC 740 requires that a company treat potential interest and penalties related to an unrecognized tax benefit as part of its income tax provision. Explain. False. ASC 740-10 allows a company to treat potential interest and penalties related to an unrecognized tax benefit as part of its income tax provision or as expenses deducted in the computation of its pre-tax income or loss from continuing operations. ASC 740 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 statements in a footnote to the financial statements (usually in the Income Taxes note). The liability related to interest and penalties is not included in the liability related to unrecognized tax benefits on the balance sheet, however. 31. (LO 4) Where on the balance sheet does a company report its unrecognized tax benefits? A company reports its unrecognized tax benefits as part of its income taxes payable or some other liability on the balance sheet. The additional tax that the company expects to pay in the next 12 months is classified as current income taxes payable. The tax the company expects to pay beyond the next 12 months is classified as long-term income taxes payable. 32. (LO 4) Why did many companies oppose FIN 48 when it was first proposed? Opponents of FIN 48 worried that the FIN 48 disclosures would provide a “roadmap” to the IRS to a company’s uncertain tax positions. The aggregate reporting of uncertain tax positions has provided the IRS with less information than it may have expected, which led the Treasury to create new Schedule UTP, on which a company is required to list its uncertain tax positions taken on its financial statements.



33. (LO 5) How does a company determine if a deferred tax asset or liability should be classified as current or noncurrent on its balance sheet? 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. (LO 5) Under what conditions can a company net its current deferred tax assets with its current deferred tax liabilities on the balance sheet? ASC 740 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 noncurrent deferred tax assets and liabilities as well. 35. (LO 5) 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. False. ASC 740 states that a publicly traded company should disclose the approximate “tax effect” of each type of temporary 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 temporary differences without disclosing the tax effects of each type. ASC 740 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.



36. (LO 5) 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? 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 or loss 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 taxes note to the financial statements. 37. (LO 5) Briefly describe the difference between a company’s effective tax rate, cash tax rate, and structural tax rate. The effective tax rate is the company’s total income tax expense or benefit divided by the company’s pre-tax 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 onetime (discrete) and non-recurring book-tax differences. It is usually interpreted as the company’s sustainable effective tax rate from operations. Problems 38. (LO 1) Which of the following taxes is not accounted for under ASC 740? 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 ASC 740 d. Property taxes paid to the city of Detroit are not income taxes because they are assessed based on value and not income. 39. (LO 1) Which of the following organizations can issue rules that govern accounting for income taxes? a. FASB b. SEC c. IRS d. a and b above e. All of the above organizations



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, but the IRS is restricted to writing rules and procedures related to the federal income tax. 40. ([LO 1) Find the paragraph(s) in ASC 740 that deal with the following items (you can access ASC 740 on the FASB website at http://www.fasb.org, and clicking on “View the Codification.” You will need a password from your instructor. a. The objectives and basic principles that underlie ASC 740 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 a. ASC 740: 740-10-10-1 b. 740-10-25-20 c. 740-10-30-19 d. 740-10-30-22 e. 740-10-50 41. (LO 2) Woodward Corporation reported pre-tax book income of $1,000,000. 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. $1,000,000 (200,000) 50,000 (100,000) 750,000  34% $255,000

Pre-tax book income Favorable temporary differences Unfavorable temporary differences Favorable permanent differences Taxable income  34% Current income tax expense

42. (LO 2) Cass Corporation reported pre-tax book income of $10,000,000. 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.



$10,000,000 100,000 (200,000) 25,000 (250,000) $9,675,000  34% $3,289,500

Pre-tax book income Increase in bad debt reserve Excess tax depreciation Excess tax over book gain Tax-exempt life insurance proceeds Taxable income  34% Current income tax expense

43. (LO 2) Grand Corporation reported pre-tax book income of $600,000. Tax depreciation exceeded book depreciation by $400,000. In addition, the company received $300,000 of taxexempt 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. Pre-tax book income Excess tax depreciation Tax-exempt interest income Net operating loss

$600,000 (400,000) (300,000) $(100,000)

NOL carryback to prior year  34% Current income tax benefit

$50,000  34% $17,000

The remaining $50,000 NOL carryover will be recorded as a deferred tax asset (benefit) of $17,000. 44. (LO 2) Chandler Corporation reported pre-tax book income of $2,000,000. 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. $2,000,000 (500,000) 100,000 $1,600,000  34% $544,000

Pre-tax book income Excess tax depreciation Increase in capitalized inventory costs Taxable income  34% Current income taxes payable



45. (LO 2) 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 above are correct e. Taxable temporary difference and favorable book-tax difference. 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. (LO 2) 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. Permanent difference b. Taxable temporary difference c. Deductible temporary difference d. Favorable book-tax difference e. Both b and d above are correct c. Deductible temporary difference. 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. (LO 2) 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 d. Nondeductible stock option compensation from exercising an ISO (incentive stock option). A company does not receive a tax deduction when an employee exercises an incentive stock option, making the book stock compensation deduction a permanent difference.



48. (LO 2) 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 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 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 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. (LO 2) Lodge, Inc. reported pre-tax book income of $5,000,000. During the year, the company increased its reserve for warranties by $200,000. The company deducted $50,000 on its tax return related to warranty payments made during the year. What is the impact on taxable income compared to pre-tax 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) b Unfavorable (increases taxable income). Book income would be $150,000 less than taxable income in the current year. 50. (LO 2) 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 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. (LO 2) Shaw Corporation reported pre-tax book income of $1,000,000. 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. Favorable temporary differences Unfavorable temporary differences Net increase in favorable temporary diff.  34% Net increase in deferred income tax liability

$(200,000) 50,000 $(150,000)  34% $ (51,000)

The net increase in the deferred income tax liability is recorded as the company’s deferred tax expense in the current year. Permanent differences do not affect the deferred income tax provision. 52. (LO 2) Shaw, Inc. reported pre-tax book income of $10,000,000. During the current year, the reserve for bad debts increased by $100,000. In addition, 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. Increase in bad debt reserve Excess tax depreciation Excess tax gain Net increase in favorable temporary diff.  34% Net increase in deferred income tax liability

$100,000 (200,000) 25,000 $ (75,000)  34% $ (25,500)

The net increase in the deferred income tax liability is recorded as the company’s deferred tax expense in the current year. Permanent differences do not affect the deferred tax provision. 53. (LO 2) Harrison Corporation reported pre-tax book income of $600,000. Tax depreciation exceeded book depreciation by $400,000. In addition, the company received $300,000 of taxexempt 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.



$600,000 (400,000) (300,000) $(100,000)

Pre-tax book income Excess tax depreciation Tax-exempt interest income Net operating loss

$50,000  34% $17,000

NOL carryback to prior year  34% Current income tax refundable Excess tax depreciation NOL carryover to 2014 Net increase in favorable temporary diff.  34% Net increase in deferred income tax liability

(400,000) 50,000 $(350,000)  34% $(119,000)

The net increase in the deferred income tax liability is recorded as the company’s deferred tax expense in the current year. This assumes the company does not record a valuation against the deferred tax asset created by the NOL carryover. Permanent differences do not affect the deferred tax provision. 54. (LO 2) Identify the following items as creating a temporary difference, permanent difference, or no difference. Item

Temporary

Permanent

No

Difference

Difference

Difference

Reserve for warranties

X

Accrued pension liability

X

Goodwill not amortized for tax purposes but subject to impairment under ASC 350

X

Meal and entertainment expenses

X

Life insurance proceeds

X

Net capital loss carryover

X

Nondeductible fines and penalties

X

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

X



55. (LO 2) Which of the following items is not a permanent book/tax difference? a. Tax-exempt interest income b. Tax-exempt insurance proceeds c. Domestic production activities deduction d. Non-deductible meals and entertainment expense e. First-year expensing under §179 e. First year expensing under §179. First year expensing will eventually be recovered as book depreciation. 56. (LO 2) Ann Corporation reported pre-tax book income of $1,000,000. 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, assuming a tax rate of 34%. $1,000,000 (100,000) 900,000  34% $306,000

Pre-tax book income Favorable permanent differences Book equivalent of taxable income  34% Total income tax provision

Book equivalent of taxable income takes into account only permanent differences. 57. (LO 2) Burcham Corporation reported pre-tax book income of $600,000. Tax depreciation exceeded book depreciation by $400,000. In addition, the Company received $300,000 of taxexempt 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, assuming a tax rate of 34%. $600,000 (300,000) 300,000  34% $102,000

Pre-tax book income Tax-exempt interest Book equivalent of taxable income  34% Total income tax provision

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



58. (LO 3) 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 b.

More likely than not

59. (LO 3) 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. e. The Company had a net operating loss carryover expire in the current year. ASC 740 lists the expiration of tax carryovers as a source of negative evidence. 60. (LO 3) 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 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.



61. (LO 3) 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. e. Both b and d constitute negative evidence in assessing the need for a valuation allowance. ASC 740 states that cumulative book losses constitute a source of negative evidence, as does the expiration of a net operating loss carryover. 62. (LO 3) Saginaw, Inc. completed its first year of operations with a pre-tax 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. Deferred tax asset* Deferred tax benefit *$600,000  34% Deferred tax expense Deferred tax liability* *$100,000  34% Deferred tax benefit* Valuation allowance *$($600,000 - $100,000)  34%

204,000 204,000

34,000 34,000 170,000 170,000

63. (LO3) Access Ford Motor Company’s Annual Report for 2011 from the company’s website (www.ford.com). What amount of valuation allowance against its deferred tax assets did the company release in 2011? What reasons did management give for releasing the valuation allowance? (Hint: Read Management’s Discussion and Analysis and the Income Taxes footnote.) What impact, if any, did release of the valuation allowance have on the company’s effective tax rate for 2011? Why did the valuation allowance release affect (not affect) the company’s ETR? Ford Motor Co. reduced its valuation allowance from $15,664 million in 2010 to $1,545 million in 2011. 17-20 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


Management gave the following reasons for reducing the valuation allowance in its Discussion and Analysis:



At December 31, 2010, our valuation allowance was $15.7 billion, leaving net deferred tax assets of about $900 million on our balance sheet. Prior to year-end 2011, the pattern of objectively-measured negative evidence of recent financial reporting losses outweighed the positive evidence of our growing profitability, despite the tangible progress we were making in implementing our One Ford plan. By the end of 2011, our U.S. operations had returned to a position of cumulative profits for the most recent three-year period. We concluded that this record of cumulative profitability in recent years, our ten consecutive quarters of pre-tax operating profits, our successful completion of labor negotiations with the UAW, and our business plan showing continued profitability, provided assurance that our future tax benefits more likely than not will be realized. Accordingly, at year-end 2011, we released almost all of our valuation allowance against net deferred tax assets for entities in the United States, Canada, and Spain, resulting in a $12.4 billion benefit in our provision for income taxes. The reduction in the valuation allowance reduced Ford’s effective tax rate by 172.3 percentage points! This percentage point decrease is computed by dividing the reduction in the valuation allowance of $14,119 million by pretax income of $8,181 million. The reduction in the valuation allowance impacts the current period effective tax rate because it is a prior period adjustment that runs through continuing operations for income tax accounting purposes. 64. (LO 4) 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 ASC 740. 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 ASC 740? a. Probable b. More likely than not c. Realistic possibility d. Reasonable e. More than remote b. More likely than not



65. (LO 4) Which of the following statements about uncertain tax positions (UTP) is correct? a. UTP applies only to tax positions accounted for under ASC 740 taken on a filed tax return. b. UTP applies to all tax positions accounted for under ASC 740, regardless of whether the item is taken on a filed tax return. c. UTP 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 ASC 740. e. Statements b, c, and d are correct. b. UTP applies to all tax positions accounted for under ASC 740, regardless of whether the item is taken on a filed tax return. 66. (LO 4) Cadillac Square Corporation determined that $1,000,000 of its domestic production activities 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 Benefit (000s) $340,000 272,000 170,000 0

Individual Probability of Occurring (%) 40 25 20 15

Cumulative Probability of Occurring 40 65 85 100

What amount of the tax benefit related to the uncertain tax position from the DPAD can Cadillac Square Corporation recognize in calculating its income tax provision in the current year? $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. (LO 4) How would your answer to Question 66 change if management determined that there was only a “50/50” chance any portion of the $1,000,000 domestic production activity deduction (DPAD) would be sustained on audit? No amount of the tax benefit from the deduction could be recognized. The recognition threshold has not been met (more likely than not), and therefore, 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. (LO 4) As part of its UTP 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 d. Penobscot can elect to record the entire amount as part of its income tax provision or separate from its income tax provision as a pre-tax operating expense, provided the Company discloses which option it is using. 69. (LO5) What was IBM’s accounting effective tax rate for 2011? What items caused the company’s accounting effective tax rate to differ from the “hypothetical” tax rate of 35%? What was the company’s cash effective tax rate for 2011? What factors cause a company’s cash tax rate to differ from its accounting effective tax rate? You can access IBM’s annual report for 2011 at http://www.ibm.com. IBM’s accounting effective tax rate for 2011 was 24.5% ($5,148/$21,003). IBM reports that its effective tax rate decreased 10 percentage points from the “foreign tax rate differential,” increased 2 percentage points from “state and local taxes,” and decreased 2 percentage points by “other.” IBM’s cash effective tax rate for 2011 was 19.8% ($4,168/$21,003). The cash effective tax rate can differ from the accounting effective tax rate because of additional taxes or refunds received from audits of prior year tax returns and from the tax benefits related to the exercise of nonqualified stock options.



70. (LO 5) Beacon Corporation recorded the following deferred tax assets and liabilities: Current deferred tax assets Current deferred tax liabilities Non-current deferred tax assets Non-current deferred tax liabilities Net deferred tax liabilities

$650,000 (400,000) 1,000,000 (2,500,000) $(1,250,000)

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 noncurrent 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 noncurrent 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. The netting is required because the deferred tax accounts all arose in the same tax jurisdiction (ASC 740-10-45-6). 71. (LO 5) ASC 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 b. Significant 72. (LO 5) 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



e. Both a and d create a current 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 current assets.



73. (LO 5) Which formula represents the calculation of a company’s effective tax rate? a. Income taxes paid / Taxable income b. Income taxes paid / Pre-tax income from continuing operations c. Income tax provision / Taxable income d. Income tax provision / Pre-tax income from continuing operations d. Income tax provision / Pre-tax income from continuing operations 74. (LO 5) 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 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. (LO 5) Randolph Company reported pre-tax 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. b. c.

a.

Compute Randolph Company’s current income tax expense. Compute Randolph Company’s deferred income tax expense or benefit. 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%. $800,000 (200,000) 80,000 (180,000) 500,000  34% $170,000

Pre-tax net income Favorable temporary difference Unfavorable temporary difference Favorable permanent difference Taxable income  34% Current income tax payable



b.

Favorable temporary difference Unfavorable temporary differences Net favorable temporary difference  34% Deferred tax expense (liability)

(200,000) 80,000 (120,000)  34% $(40,800)

Total income tax provision = $170,000 + $40,800 = $210,800 Effective tax rate = $210,800 / $800,000 = 26.35% c.

d.

ETR reconciliation Income tax expense at 34% (hypothetical)* Tax benefit from permanent difference** Income tax provision *$800,000 x 34% **$180,000 x 34% Hypothetical income tax rate Tax benefit from permanent difference* Effective tax rate *$61,200 / $800,000

$272,000 ( 61,200) $210,800

34.00% (7.65%) 26.35%

76. (LO 5) Which of the following pronouncements should a company consult in computing its quarterly income tax provision? a. ASC 740 b. ASC 230 c. ASC 718 d. ASC 810 e. SarbOX 404 a. ASC 740



Comprehensive Problems 77. You have been assigned to compute the income tax provision for Motown Memories, Inc. (MM) as of December 31, 2013. The Company’s federal income tax rate is 34%. The Company’s Income Statement for 2013 is provided below: Motown Memories, Inc. Statement of Operations at December 31, 2013

Net sales Cost of sales Gross profit

$50,000,000 28,000,000 22,000,000

Compensation Selling expenses Depreciation and amortization Other expenses Total operating expenses Income from operations Interest and other income Income before income taxes

2,000,000 1,500,000 4,000,000 500,000 8,000,000 $14,000,000 1,000,000 $15,000,000

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


T/D

Taxes (@ 34%)

Change

T/D

Taxes (@ 34%)

Current Allowance for bad debts

200,000

68,000

50,000

250,000

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

540,000

183,600

130,000

670,000

227,800

Total current

85,000

Non-Current Deferred compensation Accrued pension liabilities Total non-current Total

50,000

17,000

10,000

60,000

20,400

3,000,000

1,020,000

250,000

3,250,000

1,105,000

3,050,000

1,037,000

260,000

3,310,000

1,125,400

3,590,000

1,220,600

390,000

3,980,000

1,353,200

a.

Compute MM’s current income tax expense or benefit for 2013.

b.

Compute MM’s deferred income tax expense or benefit for 2013.

c.

Prepare a reconciliation of MM’s total income tax provision with its hypothetical income tax expense in both dollars and rates. See attached spreadsheet solutions.



78. You have been assigned to compute the income tax provision for Tulip City Flowers, Inc. (TCF) as of December 31, 2013. The Company’s federal income tax rate is 34%. The Company’s Income Statement for 2013 is provided below: Tulip City Flowers, Inc. Statement of Operations at December 31, 2013

Net sales Cost of sales Gross profit

$20,000,000 12,000,000 8,000,000

Compensation Selling expenses Depreciation and amortization Other expenses Total operating expenses Income from operations Interest and other income Income before income taxes

500,000 750,000 1,250,000 1,000,000 3,500,000 $4,500,000 25,000 $4,525,000

You have identified the following permanent differences: Interest income from municipal bonds: $10,000 Nondeductible stock compensation: $5,000 Domestic production activities 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 Flowers, Inc. Temporary Difference Scheduling Template

BOY

Beginning

Current

EOY

Ending

Taxable (Favorable)

Cumulative

Deferred

Year

Cumulative

Deferred


T/D

Taxes (@ 34%)

Change

T/D

Taxes (@ 34%)


(5,000,000)

(1,700,000)

(500,000)

(5,500,000)

(1,870,000)

BOY

Beginning

Current

EOY

Ending


Cumulative

Deferred

Year

Cumulative

Deferred


T/D

Taxes (@ 34%)

Change

T/D

Taxes (@ 34%)

Current Allowance for bad debts Prepaid income Total current

100,000

34,000

10,000

110,000

0

0

20,000

20,000

37,400 6,800

100,000

34,000

30,000

130,000

44,200


50,000

17,000

10,000

60,000

20,400

500,000

170,000

100,000

600,000

204,000

550,000

187,000

110,000

660,000

224,400

650,000

221,000

140,000

790,000

268,600

a.

Compute TCF’s current income tax expense or benefit for 2013.

b.

Compute TCF’s deferred income tax expense or benefit for 2013.

c.

Prepare a reconciliation of TCF’s total income tax provision with its hypothetical income tax expense in both dollars and rates.

d.

Assume TCF’s tax rate increased to 35% in 2013. Recompute TCF’s deferred income tax expense or benefit for 2013 using the following template:



Tulip City Flowers, Inc. Temporary Difference Scheduling Template

BOY

Beginning

Current

EOY

Ending

Taxable (Favorable)

Cumulative

Deferred

Year

Cumulative

Deferred


T/D

Taxes (@ 34%)

Change

T/D

Taxes (@ 35%)


(5,000,000)

(1,700,000)

(500,000)

(5,500,000)

BOY

Beginning

Current

EOY

Ending


Cumulative

Deferred

Year

Cumulative

Deferred


T/D

Taxes (@ 34%)

Change

T/D

Taxes (@ 35%)

Current Allowance for bad debts Prepaid income Total current

100,000

34,000

10,000

0

0

20,000

110,000 20,000

100,000

34,000

30,000

130,000


50,000

17,000

10,000

60,000

500,000

170,000

100,000

600,000

550,000

187,000

110,000

660,000

650,000

221,000

140,000

790,000

See attached spreadsheet solutions. 79. Access the 2011 Annual Report for Google and answer the following questions. You can access the annual report at http://www.google.com. a. Using information from the company’s Income Statement and Income Taxes footnote, what was the company’s effective tax rate for 2011? Show how the rate is calculated. The company reports an effective tax rate of 21% for 2011, computed as $2,589 / $12,326.



b. Using information from the Statement of Cash Flows, calculate the company’s cash tax rate. The company’s cash tax rate for 2011 was 11.9%, computed as $1,471 / $12,326. c. What does the company’s Income Taxes note tell you about where the company earns its international income? Why does earning income in these countries cause the effective tax rate to decrease? In the Income Taxes note (Note 15), the company informs investors that “substantially all of the income from foreign operations was earned by an Irish subsidiary. Earning income in Ireland causes the company’s effective tax rate to decrease because Ireland taxes income at a tax rate of 12.5%, which is significantly lower than the U.S. rate of 35%. Under U.S. tax laws, the income earned in these countries is not subject to U.S. tax until repatriated to the United States. For an interesting discussion of Google’s international operations, see Jesse Drucker, “The Tax Haven That’s Saving Google Billions,” Businessweek, October 21, 2010. d. What item creates the company’s largest deferred tax asset? Explain why this item creates a deductible temporary difference. The company’s largest deferred tax asset relates to “Stock-based compensation expense.” The temporary difference results because the company accrues stock-based compensation under ASC 718 but cannot deduct the expense for tax purposes until the employees exercise the stock options or earn the right to receive the stock. e. What item creates the company’s largest deferred tax liability? Explain why this item creates a taxable temporary difference. Depreciation and amortization. The temporary difference results because the company depreciates and amortizes its assets for tax purposes using a more accelerated method than for financial accounting purposes. This creates a taxable temporary difference that will result in a future tax liability when the book depreciation begins to exceed the tax depreciation in future periods.



f. How does the company classify its unrecognized tax benefits on the balance sheet? The company does not specifically state in its Income Taxes note how it classifies liabilities for unrecognized tax benefits. However, the company lists non-current Income Taxes Payable on the balance sheet at $1,693 million, which is close to the $1,564 million of unrecognized tax benefits identified in the Income Taxes note. g. How does the company treat interest and penalties related to its unrecognized tax benefits? The company states in its Income Taxes note that it classifies interest and penalties related to its unrecognized tax benefits as part of its income tax provision. 80. Spartan Builders Corporation is a builder of high end housing with locations in major metropolitan areas throughout the Midwest. At June 30, 2013, the company has deferred tax assets totaling $10 million and deferred tax liabilities of $5 million, all of which relate to U.S. temporary differences. Reversing taxable temporary differences and taxable income in the carryback period can be used to support approximately $2 million of the $10 million gross deferred tax asset. The remaining $8 million of gross deferred tax assets will have to come from future taxable income. The company has historically been profitable. However, significant loses were incurred in fiscal years 2011 and 2012. These two years reflect a cumulative loss of 10 million, with losses of $3 million expected in 2013. $7 million of the losses was due to a write-down of inventory. Beginning in fiscal 2014, management decided to get out of the metropolitan Chicago market, which had become over-saturated with new houses. Evaluate the company’s need to record a valuation allowance for the $10 million of gross deferred tax assets . What positive and negative evidence would you weigh? Positive evidence: The reversing taxable temporary differences and taxable income in the carryback period is objective information and supports $2 million of deferred tax assets. In addition, the company has historically been profitable. Subjective positive evidence is management’s decision to leave an unprofitable market and concentrate on profitable markets. Negative evidence: The company will have cumulative book loss of $13 million over three years at the end of 2013. ASC 740 states that cumulative losses is negative evidence that is difficult to overcome. Even if the write-down of inventory is excluded from the computation because it is an aberration, there still is a cumulative loss of $6 million over the current and prior two years. It appears the objective negative evidence outweighs the subjective positive evidence, and the company should consider recording a valuation allowance for the remaining $8 million of deferred tax assets.


SMChap017

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