Question

Delta Catfish Company has taken a position in its tax return to claim a tax credit of $15 million (direct reduction in taxes payable) and has determined that its sustainability is “more likely than not,” based on its technical merits. Delta has developed the probability table shown below of all possible material outcomes:

Probability Table ($ in millions)
Amount of the tax benefit that management expects to receive	$	15			$	12.0			$	9.0			$	6.0			$	3.0
Percentage likelihood that the tax benefit will be sustained at this level		10	%			20	%			25	%			20	%			25	%

Delta’s taxable income is $90 million for the year. Its effective tax rate is 40%. The tax credit would be a direct reduction in current taxes payable.

Required:
1. At what amount would Delta measure the tax benefit in its income statement?
2. Prepare the appropriate journal entry for Delta to record its income taxes for the year.
  

Answer 1

Solution:

Tax benefit of a position taken by a company in its return should be recognized by it in its financial statement , only if it is more likely than not that the company will be able to sustain its tax return position based on its technical merits.

Once the " more likely than not" criterion is met, the amount of tax benefit to be recognized in the financial statement should be measured as the largest amount of benefit that has a cumulative probability of greater than 50% of being realized.

1)

Using the probability table given in the question the amount at which Delta catfish company will measure the tax benefit in its income statement should be determined as follows

	A	B	C	D	E	F
1	Probability Table($ in million)
2	Amount of tax benefit that management expects to receive	$ 15	$ 12	$ 9	$ 6	$ 3
3	Percentage likelihood that the tax benefit will be sustained at this level	10%	20%	25%	20%	25%
4	Cumulative probability that the tax position will be upheld	10%	30%	55%	75%	100%

The largest amount of benefit for which the cumulative probability that the tax position will be upheld is greater than 50% is $8 million.

therefore Delta catfish company will measure the tax benefit in its income statement at $8 million

Working note:

	A	B	C	D	E	F
1	Probability Table($ in million)
2	Amount of tax benefit that management expects to receive	$ 15	$ 12	$ 9	$ 6	$ 3
3	Percentage likelihood that the tax benefit will be sustained at this level	0.1	0.2	0.25	0.2	0.25
4	Cumulative probability that the tax position will be upheld	=B3	=B4+C3	=C4+D3	=D4+E3	=E4+F3

2)

The company has a taxable income of $85 million and the effective tax rate is 40%

Therefore

Income tax expense before any tax benefit is recognized =$90 million * 40%

                                                                                                      =$36 million

The company should record income tax expense for the year as if there is a tax benefit of $8 million. Therefore income tax expense for the year will be recorded at $28 million ($36 million - $8 million )

however, income tax payable for the year should reflect the entire $10 million tax benefit .Therefore , income tax payable for the year will be recorded at $11 million ($36 million - $15 million)

The difference between income tax expense and income tax payable should be recorded as a future obligation to pay additional taxes if the deduction for entire $ 10 million is not upheld . Therefore , a liability for potential additional tax of $17 million($28 million - $11 million ) should be recorded.

Prepare the journal entry to record Delta Catfish company's income taxes for the year by debiting income tax expense by $28 million and crediting income tax payable and liability - potential additional tax by $11 million and $17 million respectively

Account Title and Explanation	Debit($)	Credit($)
Income tax expense	28,000,000
Income taxa payable		11,000,000
Liability potential additional tax		17,000,000
(To record income taxes for the year)