Question

Problem: Permanent and Timing Differences/Tax Rate Changes

Martin Inc. purchased machinery at the beginning of 20X0 for $120,000.  For financial reporting purposes, management used the straight-line method to depreciate the cost and sum of the years’ digits ($80,000 and $40,000) to depreciate the cost for tax purposes.  The life of the machinery was estimated to be two years and the salvage value was estimated at zero.  Revenues less expenses other than depreciation and tax expense equaled $600,000 for 20X0 and 20X1.  Martin pays income tax at the rate of 20% of taxable income.  Included in the income number for each year was $40,000 of tax-free municipal bond interest. (As with the previous problem, this one has a similar cascade effect. For partial credit LABEL and show the calculations.)

Required:

1. Compute the IRS taxable income and the financial reporting/GAAP taxable income (before tax) for the years 20X0 and 20X (6 pts.)

2.         Complete the following table based on your answer to requirement 1. (2 pts for each cell; 12 total)

Year	End. Bal. in Tax Liability	Tax Expense	End. Bal. in Deferred Inc. Taxes
20X0
20X1

3. Assume that the tax rate was changed by the federal government to 30% effective the beginning of 20X1.  Also assume the change was known in 20X0.  Compute the following amounts and give the  related journal entry for 20X1 (6 pts. Total):
   1. Deferred income taxes
   2. Income tax liability for 20X1 (also known as the current provision for income taxes)
   1. Income tax expense for 20X1

Extra Credit

4. Assume the same details as above except that the tax rate change was not known until 20X1. Compute the following amounts and give the related journal entry, for 20X1. (4 possible additional points)
   1. Deferred income taxes
   2. Income tax liability for 20X1
   3. Income tax expense for 20X1.

Answer 1

1.IRS taxable income and the financial reporting/GAAP taxable income (before tax) for the years 20X0 and 20X1:

Depreciation Chart

Year	Description	Straight-Line Method	Sum of years' Digits Method
20X0	Purchase of Asset	120,000	120,000
	Depreciation	-60,000	-80,000
20X1	Opening Balance	60,000	40,000
	Depreciation	-60,000	-40,000
	Residual Value	-	-

GAAP Taxable Income

Description	20X0 ($)	20X1 ($)
Gross Profit	600,000	600,000
Less: Depreciation	-60,000	-60,000
Net Profit	540,000	540,000
Less: Tax-free Bond Income (exempted)	-40,000	-40,000
Taxable Income	500,000	500,000

IRS Taxable Income

Description	20X0 ($)	20X1 ($)
Gross Profit	600,000	600,000
Less: Depreciation (financial)	-60,000	-60,000
Net Profit	540,000	540,000
Add: Depreciation (financial)	60,000	60,000
	600,000	600,000
Less: Depreciation (Tax purpose)	-80,000	-40,000
Gross Taxable Income	520,000	560,000
Less: Tax-free Bond Income (exempted)	-40,000	-40,000
Taxable Income	480,000	520,000

2.

Year	End. Bal. in Tax Liability	Tax Expense	End. Bal. in Deferred Inc. Taxes
20X0	96000	100000	-4000
20X1	104000	100000	4000

Assuming the federal tax change to 30% from 20X1 and known in 20X0

There will not be any change in the deferred tax in 20X1 even after the federal tax changed since the WDV of the assets in both the methods is Zero.

Therefore,

1. Deferred income taxes

Year	End. Bal. in Tax Liability	Tax Expense	End. Bal. in Deferred Inc. Taxes
20X0	96,000	100,000	-4,000
20X1	156,000	152,000	4,000

Journal Entry:

20X1 Tax Expenses A/c Dr. $4000

To Deferred Tax Asset/Liability A/c $4000

(Being Deferred Tax Asset transferred to Tax Expenses)

2. 20X1 Tax Expenses A/c Dr. $152,000

To Income Tax Payable A/c $152,000

(Being Income Tax Provision provided for 20X1)

Income tax liability for 20X1

Description	20X0 ($)	20X1 ($)
Gross Profit	600,000	600,000
Less: Depreciation (financial)	-60,000	-60,000
Net Profit	540,000	540,000
Add: Depreciation (financial)	60,000	60,000
	600,000	600,000
Less: Depreciation (Tax purpose)	-80,000	-40,000
Gross Taxable Income	520,000	560,000
Less: Tax-free Bond Income (exempted)	-400,00	-40,000
Taxable Income	480,000	520,000
Income Tax Liability	96,000	156,000

Income tax expense for 20X1

Description	20X0 ($)	20X1 ($)
Income Tax Liability	96,000	156,000
Less: Deferred Tax Liability/(Asset)	-4,000	-4,000
Net Tax Liability	92,000	152,000