Question

On December 31, 2019, Novak Inc. has taxable temporary differences of $2.21 million and a deferred tax liability of $618,800. These temporary differences are due to Novak having claimed CCA in excess of book depreciation in prior years. Novak’s year end is December 31. At the end of December 2020, Novak’s substantively enacted tax rate for 2020 and future years was changed to 30%. For the year ended December 31, 2020, Novak’s accounting loss before tax was $494,500. The following data are also available. 1. Pension expense was $87,600 while pension plan contributions were $111,000 for the year. (Only actual pension contributions are deductible for tax.) 2. Business meals and entertainment were $38,000. (They are one-half deductible for tax purposes.) 3. For the three years ended December 31, 2019, Novak had cumulative, total taxable income of $123,300 and total income current tax expense/income tax payable of $34,524. 4. During 2020, the company booked estimated warranty costs of $31,300 and these costs are not likely to be incurred until 2024. 5. In 2020, the company incurred $150,000 of development costs (only 50% of which are deductible for tax purposes). 6. Company management has determined that it is probable that only one half of any loss carryforward at the end of 2020 will be realized. 7. In 2020, the amount claimed for depreciation was equal to the amount claimed for CCA.

Prepare income tax reconciliation statement Prepare the journal entries to record income taxes for the year ended December 31, 2020, and the income tax reconciliation note.

Answer 1

Answer:

Prior year tax rate:  $618,800 / $2,210,000 = 28%

Statement of Financial Position			Deductible (Taxable)		Deferred Tax	If (ASPE) Current
Account	Tax	Carrying	Temporary	Tax	Asset	Long-
Dec. 31, 2020	Base*	Amount*	Differences	Rate	(Liability)	Term
PP&E before change in tax rate			($2,210,000)	28%	($618,800)	LT
Increase in deferred tax liability due to change in tax rate ($2,210,000 X 2%), and deferred tax expense adjustment	(44,200)
Deferred tax liability (related to PP&E), Dec. 31/20	($663,000)

* not provided; no change in amount of PP&E temporary difference since Dec. 31/19

Statement of Financial Position			Deductible (Taxable)		Deferred Tax	If (ASPE) Current
Account	Tax	Carrying	Temporary	Tax	Asset	Long-
Dec. 31, 2020	Base*	Amount*	Differences	Rate	(Liability)	Term
PP&E			($2,210,000)	30%	($663,000)	LT
Pension liability			(23,400)	30%	(7,020)	LT
Warranty liability			31,300	30%	9,390	C
Deferred tax liability, Dec. 31/20	($660,630)
Deferred tax liability before adjustment Decrease (net) needed in deferred tax liability, and net deferred tax benefit	( 663,000) $     2,370	$

* not given in the problem.

Calculation of loss for tax purposes and loss carryforward:

Accounting loss                                                                                  ($494,500)

Permanent differences:

            Development costs (50% X $150,000)                                        75,000

            Meals and entertainment (50% X $38,000)                                 19,000

Reversing differences:

            Warranty expense                                                                        31,300

            Pension funding > expense                                                        (23,400)*

Loss for income tax purposes                                                              (392,600)

Carryback to prior years                                                                         123,300

Loss available for carryforward                                                            (269,300)

50% realization probable                                                                           50%

Portion of loss to recognize as benefit                                                  (134,650)

Tax rate                                                                                                         30%

Deferred tax asset and current benefit                                                 ($40,395)

* ($87,600 – $111,000 = –$23,400)

2020 Income tax journal entries:

Income Tax Receivable ($123,300 x 28%)……..........................        34,524

          Current Tax Benefit ..........................................................                                34,524

Deferred Tax Expense…………………………….....................        44,200

          Deferred Tax Liability (incr. in tax rate)…........................                                44,200

Deferred Tax Liability …………………………..                                 2,370

         Deferred Tax Benefit …………………….. 2,370

Deferred Tax Liability (loss carryforward)..................................        40,395

          Deferred Tax Benefit (loss carryforward).........................                                40,395

Instead of the three deferred tax entries above, one entry could have been made as follows:

Deferred Tax Expense …………………………........................          1,435

          Deferred Tax Liability ………………………..................                                  1,435

          ($44,200 - $2,370 - $40,395)

Income statement (partial)

Loss before income tax                                                                                ($494,500)

Income taxbenefit (expense)                                                            

            Current– loss carryback                                         $34,524

            Deferred                                                                    (1,435)*               33,089

Net income (loss) ($461,411)

*($40,395 – $44,200 + $9,390 – $7,020 = $(1,435)

Reconciliation – Statutory rate to effective rate:

						÷ Account
				@ 30%		ing  loss
Loss before taxes	$494,500		$148,350		30.00%
Non-deductible: Development costs	75,000		(22,500)		(4.55%)
Meals/entertainment	19,000		(5,700)		(1.15%)
				120,150		24.30%
Tax rate adjustment on reversing differences ($2,210,000 x .02)	2,210,000		(44,200)		(8.94%)
½ of loss carryforward recovery not probable	134,650		(40,395)		(8.17%)
Tax rate adjustment on loss carryback ($123,300 x .02)	123,300		(2,466)		(0.50%)
			$33,089		6.69%
Effective tax rate ($33,089 / $494,500 = 6.69%)				6.69%

Novak Inc.’s effective tax rate differs from the statutory rate due to permanent differences that will never be subject to tax; a change in tax rate that impacts temporary differences that are being carried forward; not recognizing the deferred tax benefit of half of the loss carryforward; and, recovery of prior year income taxes at a tax rate different than the current year rate.