Financial Accounting: Liabilities & Equities
Question 1 (12 marks)
The records of Morgan Corporation provided the following data at the end of years 1
through 4 relating to income tax allocation:
Pre-tax accounting income
Taxable income
Tax rate
Year 1
Year 2
Year 3
Year 4
€58,000
28,000
30%
€70,000
80,000
35%
€80,000
90,000
40%
€88,000
98,000
40%
The above amounts include only one temporary difference; no other changes occurred.
At the end of year 1, the company prepaid an expense of €30,000, which was then
amortized for accounting purposes over the next three years (straight-line). The full
amount is included as a deduction in year 1 for income tax purposes. Each year’s tax rate
is enacted in each specific year — that is, the year 2 tax rate is enacted in year 2, and so
on.
Required
1. Calculate income tax payable for each year.
2. Calculate income tax expense.
3. Comment on the effect that use of the liability method has on income tax expense
when the income tax rate changes.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First
Edition (Toronto: McGraw-Hill Ryerson, 2000), Question P16-3, page 948. Adapted with
permission.
Question 2 (13 marks)
(3 marks for Requirement 1; 9 marks for Requirement 2; and 1 mark for
Requirement 3)
Note:
Answer requirement 2 for 20X7 only.
The Beeville Company has a future income tax liability in the amount of €6,000 at
December 31, 20X6, relating to a €20,000 receivable. This sale was recorded for
accounting purposes in 20X6, but is not taxable until the cash is collected. In 20X7,
€10,000 is collected. Warranty expense in 20X7 included in the determination of pre-tax
accounting income is €50,000, with the entire amount expected to be incurred and
deductible for tax purposes in 20X8. Pre-tax accounting income is €140,000 in 20X7.
The tax rate is 40% in 20X7.
Required
1. What is the accounting carrying value and the tax base of the account receivable, and
the warranty liability, at the end of 20X6 and 20X7? What was the tax rate before
20X7?
2. Calculate taxable income, income tax payable, compute the balance in the future
income tax accounts, and prepare journal entries for each year end.
3. Calculate the future income tax that would be reported on the balance sheet at the end
of 20X7.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First
Edition (Toronto: McGraw-Hill Ryerson, 2000), Question E16-11, page 944. Adapted
with permission.
Question 3 (21 marks)
(16 marks for Requirement 1 and 5 marks for Requirement 2)
At the beginning of 20X5, Farcus Corporation had the following future tax accounts:
Future tax asset
€19,600
Warranty expense to date has been €126,000; claims paid have been €70,000. There is a
€56,000 warranty liability included in short-term liabilities on the balance sheet.
Future tax liability
€497,000
The net book value of plant and equipment was €2,276,000 at the beginning of 20X5; the
tax base was €856,000. Over time, depreciation for tax purposes has been €1,420,000
higher than depreciation for accounting purposes.
Information relating to 20X5 and 20X6:
20X5
Net profit
Items included in net profit:
Golf dues
Gain on disposal of non-current asset (Note 1)
Tax penalties
Depreciation for accounting purposes
Warranty expense
Percentage of completion income (reported for the
first time in 20X5) (Note 2)
Other information
Depreciation for tax purposes
Warranty claims paid
Completed contract income (used for tax purposes)
Tax rate — enacted in each year
20X6
€625,000
€916,000
8,000
0
3,000
287,000
22,000
17,000
9,000
14,000
1,000
309,000
41,000
10,000
395,000
16,000
0
40%
116,000
50,000
27,000
42%
Note 1: €4,000 is the tax-free portion. The remainder is fully taxable.
Note 2: The construction-in-progress inventory is classified as a current asset.
Required
1. Indicate the amount and classification of all items that would appear on the balance
sheet in relation to income tax at the end of 20X5 and 20X6. Assume no tax is paid
until the subsequent year.
2. Draft the bottom section of the income statement for 20X6, beginning with “Income
before gain on disposal of non-current asset.” Show all required disclosures. Include
comparative data for 20X5.
Note:
For Requirement 1, complete the following table:
Income tax payable
Future income tax, long-term
Future income tax, short-term
20X5
20X6
_____
_____
_____
_____
_____
_____
Show calculations.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First
Edition (Toronto: McGraw-Hill Ryerson, 2000), Question P16-11, pages 952 and 953.
Adapted with permission.
Question 4 (16 marks)
(2 marks for Requirement 1; 1 mark each for Requirements 2, 3, and 4; 4 marks for
Requirement 5; 3 marks for Requirement 6; and 4 marks for Requirement 7)
Creek Ltd. shows the following on its December 31, 20X7, balance sheet:
Future income tax liability, long-term
€580,000
All this income tax liability relates to the difference between the NBV and tax base of
plant and equipment. At December 31, 20X7, NBV is €6,420,000 and the tax base is
€4,970,000.
In 20X5, 20X6, and 20X7, the company has reported a total taxable income of €216,500
and paid taxes of €54,300.
In 20X8, Creek Ltd. reported an accounting loss before tax of €320,000. Depreciation for
accounting purposes of €45,000 was included in this calculation. No depreciation for tax
purposes will be claimed in 20X8. The enacted tax rate was 40% in 20X8.
Required
1. Calculate the taxable loss in 20X8.
2. How much of the tax loss can be used as a loss carryback? What will be the benefit
of this loss carryback?
3. How much of the loss is available as a tax loss carryforward? What is the benefit of
this tax loss carryforward?
4. Under what circumstances can the benefit of the tax loss carryforward be recorded as
an asset?
5. Record income tax for 20X8 assuming that the tax loss carryforward can be
recorded.
6. Record income tax for 20X8 assuming that the tax loss carryforward cannot be
recorded.
7. Assume that accounting and taxable income was €100,000 in 20X9, and the enacted
tax rate was still 40%. Prepare the journal entry to record income tax in 20X9
assuming that the tax loss carry forward (a) was recorded in 20X8 as in
Requirement (5), and (b) was not recorded in 20X8 as in Requirement (6).
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
First Edition (Toronto: McGraw-Hill Ryerson, 2000), Question E17-11, page 991.
Adapted with permission.
Question 5 (20 marks)
(15 marks for Requirement 1 and 5 marks for Requirement 2)
Boom Corp. was incorporated in 20X7. Its records show the following:
20X7
Pre-tax income (loss)
Non-deductible expenses
Depreciation for accounting purposes
Depreciation for tax purposes
Tax base of plant and equipment (note 1)
Net book value of plant and equipment
(note 1)
Tax-free revenue
Tax rate — enacted at year end
20X8
20X9
€0
0
25,000
25,000
225,000
225,000
€(1,700,000)
40,000
150,000
0
3,220,000
3,070,000
€900,000
14,50,000
250,000
500,000
2,770,000
2,870,000
4,000
38%
10,000
40%
12,000
45%
Note 1: As calculated at year end after appropriate recognition of acquisitions and the
yearly charge for depreciation, both accounting- and tax-based, respectively.
Required
1. Present the lower portion of the 20X7 through 20X9 income statements. Assume that
the likelihood of the tax loss carryforward realization is probable in all years.
2. Repeat requirement (1) assuming the likelihood of the tax loss carryforward
realization is not probable in all years.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
First Edition (Toronto: McGraw-Hill Ryerson, 2000), Question P17-13, page 998.
Adapted with permission.
Question 6 (18 marks)
European Products Limited (EPL) is a large public company. Recently, the president
issued a public letter to standard-setters and to the Securities Commission complaining
about international tax standards.
We at EPL are very concerned that our current operating performance and debt-toequity position are grossly misstated due to the international standards for accounting
for income tax. These standards do not reflect the economic reality of our tax
position.
Our future income taxes balances arise because we are allowed to depreciate our
plant and equipment far more rapidly for tax purposes than they actually wear out.
Thus, deductible expenses for tax purposes exceed our book expenses. Last year, our
tax expense exceeded taxes payable by €17.2 million. When combined with prior
amounts, we have a cumulative difference of €190.6 million, and this difference is
expected to continue to increase.
We estimate that this year’s €17.2 million would not possibly be required to be repaid
for at least 12 years — and perhaps never if we continue to expand. I understand that
if we used partial allocation, we wouldn’t have to expense this amount at all this year.
That approach seems far more realistic.
We are also disturbed that discounting is not allowed for future tax amounts. If we
had any other non-interest-bearing, long-term liability on our books, discounting
would be considered appropriate. This inconsistency in the way supposedly
analogous liabilities are treated highlights the fact that the future income tax liability
is, in fact, different.
Another complicating factor is the effect of tax rate changes. If the tax rate were to go
up, and governments are notorious for increasing taxes, our income would decline by
the effect of the tax rate change on all outstanding tax balances. This is despite the
fact that we really don’t know when, if at all, we would have to pay the tax and what
the tax rate will be in the future. Because our tax balances are large, the potential
decrease in earnings would be material. Since we pride ourselves on stable earnings,
and we believe our shareholders react positively to such a trend, this uncontrollable
volatility is highly unwelcome.
We urge international standard-setters and market regulators to take a second look at
the standards governing accounting for corporate income taxes.
Required
Evaluate this statement, looking at both sides of each issue raised.
Note:
Your response should be written in essay format (not case analysis format) and limited to 1,000 words.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
First Edition (Toronto: McGraw-Hill Ryerson, 2000), Case 16-1, page 938. Adapted with
permission.
Suggested solutions
Question 1 (12 marks)
Requirement 1 (4 marks)
Year 1
Pre-tax accounting income ............. € 58,000
Prepaid expense .............................. (30,000)
Taxable income (given) .................. 28,000
Tax rate ...........................................
30%
Income tax payable ......................... € 8,400
Year 2
Year 3
Year 4
€70,000
10,000
80,000
35%
€28,000
€80,000
10,000
90,000
40%
€36,000
€88,000
10,000
98,000
40%
€39,200
€28,000
€36,000
€39,200
(2,000)
€26,000
(3,000)
€ 33,000
(4,000)
€ 35,200
Requirement 2 (6 marks)
Income tax payable ......................... € 8,400
Change in future income tax
See schedule, below ..................
9,000
€17,400
Tax basis
Carrying
Value
Temporary
Difference
Future
tax,
ending
Year 1 — 30%
Ppd expense €0
€30,000
(€30,000)
(€9,000)
Year 2 — 35%
Ppd expense
0
20,000
(20,000)
(7,000)
(9,000)
2,000
Year 3 — 40%
Ppd expense
0
10,000
(10,000)
(4,000)
(7,000)
3,000
Year 4 — 40%
Ppd expense
0
0
(4,000)
4,000
0
0
Future
tax,
beginning
0
Adjustment
(€9,000)
Requirement 3 (2 marks)
Under the liability method, the entire effect of a change in tax rate on existing future
income tax balances is reflected in income when the tax rate changes. This can distort
income tax expense and earnings.
Question 2 (13 marks)
Requirement 1 (3 marks)
20X6
Accounts receivable
Accounting carrying value (accounts receivable per books) € 20,000
Tax basis (no receivable recognized as no revenue
recognized unless cash is collected) ...................................
0
Warranty liability
Accounting basis (20X5 expense of €50,000, paid in 20X6)
0
Tax basis (no expense until paid) .......................................
0
20X7
€ 10,000
0
€ (50,000)
0
The income tax rate before 20X5 was 30% (€6,000 / €20,000)
Requirement 2 (9 marks)
20X7
€ 140,000
Pre-tax accounting income ................................................................
Temporary differences
Account receivable collection......................................................
Warranty expense ........................................................................
Taxable income..................................................................................
Tax rate ..............................................................................................
Income tax payable ............................................................................
10,000
50,000
200,000
 0.40
€ 80,000
Income tax expense
Income tax payable ............................................................................
Change in future tax
Accounts receivable .....................................................................
Warranty liability .........................................................................
Income tax expense............................................................................
€ 80,000
(2,000)
(20,000)
€ 58,000
Future tax Opening
Tax Accounting Temporary (Liab)/Asset Balance
Basis
Basis
Difference
@40%
(given) Adjustment
20X7
Accounts receivable
Warranty
0
0
10,000
(50,000)
(10,000)
50,000
(4,000)
20,000
(6,000)
0
2,000
20,000
The journal entry to record income tax for 20X7 is
Income tax expense ...........................................................................
Future tax asset — receivable ............................................................
Future tax asset — warranty .............................................................
Income tax payable ......................................................................
58,000
2,000
20,000
80,000
Requirement 3 (1 mark)
Future tax asset (current) (€20,000 – €4,000)....................................
€ 16,000
Question 3 (21 marks)
Requirement 1 (16 marks: In the schedule below, 4 marks each for 20X5 income tax
payable and for 20X6 income tax payable; 2 marks each for future income tax
balances)
20X5
20X6
Income tax payable (A) ...................................................... € 206,800 cr
Future tax liability, long-term (B) ......................................
611,200 cr
Future tax asset, short-term, net (C) ...................................
18,000 dr
€ 477,540 cr
560,700 cr
22,260 dr
Calculations
(A) Income tax payable
20X5
Profit (excluding ex. item) .........................................
Permanent differences
Golf dues ..............................................................
Tax penalties ........................................................
Temporary differences
Warranty expense ................................................
Warranty claims paid ...........................................
Depreciation (accounting) ...................................
Depreciation (tax) ................................................
Percentage-of-completion income .......................
Completed contract income .................................
Tax payable (40%, 42%) ...........................................
20X6
€ 625,000
€
8,000
3,000
9,000
1,000
22,000
(16,000)
287,000
(395,000)
(17,000)
0
€ 517,000
€ 206,800
Gain on disposal of non-current asset ........................
Tax-free portion ...................................................
Taxable portion ....................................................
Tax payable on gain .............................................
0
0
0
0
Total tax payable........................................................
€ 206,800
916,000
41,000
(50,000)
309,000
(116,000)
(10,000)
27,000
€ 1,127,000
€ 473,340
14,000
(4,000)
10,000
4,200
€
477,540
(B) Future tax liability
Tax
Basis
Carrying
Value
Temp.
Diff.
Future
Tax Liability
@.40 @ .42
Opening
Balance Adjustment
Property, plant and equipment
20X5 € 461,0001 € 1,989,0002 € (1,528,000) € (611,200) € (497,000) € (114,200)
20X6
345,0003 1,680,0004
(1,335,000)
(560,700)
(611,200)
50,500
Warranty
20X5
20X6
0
0
(62,000)5
(53,000)6
% of Completion
20X5
0
20X6
0
17,000
0
62,000
53,000
24,800
22,260
19,600
24,800
5,200
(2,540)
(17,000)
0
(6,800)
0
0
(6,800)
(6,800)
6,800
1
2
3
€856,000 – € 395,000
€2,276,000 – € 287,000
€461,000 – €116,000
4
5
6
€1,989,000 – €309,000
€56,000 + €22,000 – €16,000
€62,000 + €41,000 – €50,000
(C) €24,800 (above) – €6,800 (above) = €18,000
€22,260 above
Requirement 2 (5 marks)
20X6
Income before tax ..............................
Income tax expense (D)
current (E) ....................................
future (F) ......................................
Income before gain on disposal
of non-current asset................
Gain on disposal of non-current
asset, net of tax (G) ................
Profit ............................................
(D) Income tax payable ......................
Less: tax related to gain on disposal
of non-current asset
(€14,000 – €4,000)  0.42 ...........
Plus/minus change in future tax:
Property, plant, and equipment ....
Warranty ......................................
% of completion ...........................
20X5
€ 916,000
€ 473,340
(54,760)
418,580
€ 625,000
€ 206,800
115,800
322,600
497,420
302,400
9,800
€ 507,220
—
€ 302,400
€ 477,540 cr
€ 206,800 cr
4,200 dr
50,500 dr
2,540 cr
6,800 dr
€ 418,580
0
114,200 cr
5,200 dr
6,800 cr
€ 322,600
(E) €477,540 – € 4,200; income tax payable (€206,800) for 20X1
(F) – (€50,500 – €2,540 + €6,800); for 20X1, €114,200 + €6,800 – €5,200
(G) €14,000 – [(€14,000 – €4,000)  0.42]
Question 4 (16 marks)
Requirement 1 (2 marks)
Taxable loss
Accounting loss ...................................................
Add back: depreciation ........................................
Taxable loss .........................................................
€ (320,000)
45,000
€ (275,000)
Requirements 2, 3, and 4 (3 marks)
The loss carryback will be €216,500, resulting in a refund of €54,300 (1 mark). This
leaves €58,500 (€275,000 – €216,500) as a tax loss carryforward. The benefit of this tax
loss carryforward is €23,400 at 20X8 tax rates of 40% (1 mark). The tax loss can be
recorded as an asset if it is probable that the company will realize the tax loss
carryforward in the carryforward period (1 mark).
Requirement 5 (4 marks)
Income tax receivable ................................................
54,300
Future income tax (LCF) ...........................................
23,400
Future income tax (€562,000 – €580,000)*...............
18,000
Income tax expense (recovery) ............................
* €4,970,000 – (€6,420,000 – €45,000) = (€1,405,000)  0.4
= €562,000 vs. €580,000 opening
95,700
Requirement 6 (3 marks)
Income tax receivable ................................................
Future income tax ......................................................
Income tax expense (recovery) ............................
54,300
18,000
72,300
Requirement 7 (4 marks)
(a) LCF has been recorded
Income tax expense (€100,000  0.4) ..................
Future income tax (LCF) ...............................
Income tax payable (€41,500  0.4) ..............
(b) LCF has not been recorded
Income tax expense..............................................
Income tax payable .......................................
Income tax payable ..............................................
Income tax expense — LCF recognition .......
40,000
23,400
16,600
40,000
40,000
23,400
23,400
Question 5 (20 marks)
Requirement 1 (15 marks: 5 marks for calculation of taxable income/loss; 4 marks
for calculation of future income tax; 4 marks for calculation of income tax expense;
and 2 marks for income statement format)
20X7
20X8
20X9
Income before income tax ......................................... €
— € (1,700,000) € 900,000
Income tax expense (recovery) .................................. (1,520)
(668,080)
338,400
Profit .......................................................................... € 1,520 € (1,031,920) € 561,600
Taxable income
(in thousands)
20X7
Income before income tax ......................................... €
Plus/minus:
Non-deductible expenses ...........................................
Non-taxable revenues ................................................
Plus/minus:
Excess of tax versus accounting depreciation ...........
Taxable income (loss) ................................................
Tax payable ................................................................
—
20X8
€
20X9
(1,700) €
900
—
(4)
40
(10)
50
(12)
—
(4)
n/a
150
(1,520)
n/a €
(250)
688
309.6
Schedule of Temporary Differences
(amounts in thousands)
Future
Tax
basis
Accounting Temporary
basis
difference
(in 000s)
20X7 — 38%
Property, plant, and equipment
€ 225
€ 225
LCF
20X8 — 40%
Property, plant, and equipment
3,220
3,070
LCF
€
0
4
€ 0.00
1.52
150
1,524
20X9 — 45%
Property, plant, and equipment
2,770
2,870
LCF
1
income
tax
(100)
8361
Opening
balance Adjustment
€
0
0
€ 0.00
1.52
60
609.6
0.00
1.52
60.00
608.08
(45)
376.2
60.0
609.6
(105)
(233.4)
€1,524,000 – €688,000 = €836,000
Entries (not required)
20X7 Future income tax (LCF; €4,000  0.38) ...................
Income tax expense (recovery) ............................
1,520
20X8 Future income tax (TDs; see above) ..........................
Future income tax (LCF; see above) .........................
Income tax expense (recovery) ............................
60,000
608,080
20X9 Income tax expense....................................................
Future income tax (TDs) ......................................
Income tax payable (€688,000  0.45) ................
Income tax payable (€688,000  0.45) ......................
Future income tax (LCF) .....................................
Income tax expense (LCF; rate change)* ............
414,600
1,520
668,080
105,000
309,600
309,600
233,400
76,200
* €1,524,000  (0.40 – 0.45)
Requirement 2 (5 marks)
20X7
Income (loss) before income tax....................
Income tax expense (recovery)* ....................
Profit
................................................... €
€
0
—
—
€
20X8
€ (1,700,000)
(60,000)
(1,640,000) €
20X9
€ 900,000
105,000*
795,000
* €414,600 – €309,600; components may be disclosed separately.
20X7 no entry; likelihood of tax loss carryforward realization is not probable.
20X8 Future income tax (TDs; see above) ..........................
Income tax expense (recovery) ...........................
20X9 Income tax expense....................................................
60,000
60,000
414,600
Future income tax (TDs) ......................................
Income tax payable (€688,000  0.45) ................
Income tax payable (€688,000  0.45) ......................
Income tax expense (recovery)(LCF) ..................
105,000
309,600
309,600
309,600
Question 6 (18 marks)
Note:
Students do have to cover all the points or issues. Up to 6 marks each are to be awarded for an appropriate
answer.
Issues raised:
1.
Probable non-reversal of temporary differences.
The president is viewing his plant and equipment as one amount, and points out that if
these assets grow indefinitely, temporary differences will not reverse. This is true.
However, for each individual asset, future income tax does reverse by the time the asset
is sold or retired. This reversal may not be visible when it is masked by new originating
temporary differences from new assets. The assertion that temporary differences do not
reverse is simply not true.
Accounts payable are repaid and replaced by new accounts payable when new inventory
is bought: their relative permanence on the balance sheet is no argument that they should
not be recognized.
The future is uncertain. Who is to say that circumstances for this company will never
change? Past growth does not guarantee future growth. Tax rules could also change to
affect the rate and nature of reversals. Accounting cannot be based on uncertain future
predictions.
2.
Partial tax allocation
The president is correct in saying that, under partial tax allocation, the company’s
temporary differences would not have to be recognized. Under partial allocation, it might
be suggested that the company need only recognize temporary differences that will
reverse in say, the next five years. The danger is in the potential for error and bias in
estimating reversals over the next five years. If the financial position were consistently
misstated due to such bias, the credibility of the accounting model would be seriously
hurt.
3.
Discounting
The conceptual arguments in favour of discounting are very appealing. If the future
income taxes are to be classified as a liability, then to be consistent with the accounting
practices for other low-interest or non-interest-bearing debt, discounting should be used.
Discounting would also have the happy effect of decreasing the size of the future income
tax amounts on the balance sheets. Future income would be decreased by the annual
interest recognized, and the liability would grow over time because of the interest
accrual.
Unfortunately, discounting is not a practical alternative. In order to be workable, the
discount rate and the stream of cash payments has to be established in a relatively
objective fashion. In the case of future income tax, the appropriate discount rate to use is
not clear, and the cash flow stream is dependent on various assumptions about the
reversal of temporary differences.