LESSON 6
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.
Financial Accounting: Liabilities & Equities
Suggested solutions 6  1
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)....................................
Suggested solutions 6  2
€ 16,000
Financial Accounting: Liabilities & Equities
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
Financial Accounting: Liabilities & Equities
62,000
53,000
24,800
22,260
19,600
24,800
5,200
(2,540)
Suggested solutions 6  3
% of Completion
20X5
0
20X6
0
1
2
3
17,000
0
€856,000 – € 395,000
€2,276,000 – € 287,000
€461,000 – €116,000
(17,000)
0
4
5
6
(6,800)
0
0
(6,800)
(6,800)
6,800
€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]
Suggested solutions 6  4
Financial Accounting: Liabilities & Equities
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 .......
Financial Accounting: Liabilities & Equities
40,000
23,400
16,600
40,000
40,000
23,400
23,400
Suggested solutions 6  5
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)
Tax
Accounting Temporary
(in 000s)
basis
basis
difference
20X7 — 38%
Property, plant, and equipment
€ 225
€ 225
€
0
LCF
4
20X8 — 40%
Property, plant, and equipment
3,220
3,070
LCF
20X9 — 45%
Property, plant, and equipment
2,770
2,870
LCF
1
150
1,524
(100)
8361
Future
income
tax
€ 0.00
1.52
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
Suggested solutions 6  6
Financial Accounting: Liabilities & Equities
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....................................................
Future income tax (TDs) ......................................
Income tax payable (€688,000  0.45) ................
Income tax payable (€688,000  0.45) ......................
Income tax expense (recovery)(LCF) ..................
Financial Accounting: Liabilities & Equities
60,000
60,000
414,600
105,000
309,600
309,600
309,600
Suggested solutions 6  7
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.
100
Suggested solutions 6  8
Financial Accounting: Liabilities & Equities