Question

The information that follows pertains to Esther Food Products:

At December 31, 2018, temporary differences were associated with the following future taxable (deductible) amounts

Depreciation	$	60,000
Prepaid expenses		17,000
Warranty expenses		(12,000	)

No temporary differences existed at the beginning of 2018.

Pretax accounting income was $80,000 and taxable income was $15,000 for the year ended December 31, 2018.

The tax rate is 40%.

Answer 1

Before solving this problem I would like to share one Blind Rule which is always applicable in case Accounting of Taxes on Income.

1) Expenses as per accounting records is HIGHER than income tax records then Recorgnise DTA subject to prudence (i.e. Accounting profit is lower than Taxable profit)

2) 1) Expenses as per accounting records is LOWER than income tax records then Recorgnise DTL subject to prudence (i.e. Accounting profit is Higher than Taxable profit)

What is a Temporary Difference?

A temporary difference is the difference between the carrying amount of an asset or liability in the balance sheet and its tax base. A temporary difference can be either of the following:

Deductible.: A deductible temporary difference is a temporary difference that will yield amounts that can be deducted in the future when determining taxable profit or loss.

Taxable : A taxable temporary difference is a temporary difference that will yield taxable amounts in the future when determining taxable profit or loss.

In both cases, the differences are settled when the carrying amount of the asset or liability is recovered or settled.

Examples of Temporary Difference

Depreciation.

Most accounting books emphasize this example of a temporary difference: For book purposes, the company may use straight-line depreciation, whereas for tax purposes, it may use a more accelerated method, such as IRC Section 179. Under certain circumstances, IRC Section 179 allows a business to write off 100 percent of the cost of the asset in the first year of use.

Financial depreciation methods, on the other hand, call for the asset to be expensed over both the contemporaneous and future years.

Because of temporary differences, the expense that an entity incurs in a reporting period usually comprises both current tax expense or income, and deferred tax expense or income.

Estimates.

Estimates are any expenses for which the company figures a reasonable amount, such as warranty costs, which is the cost to repair items sold to customers, or allowance for bad debts, which is how much in accounts receivable the company reckons it won’t collect from customers.

A company can’t deduct estimates as an expense on its tax return until it actually incurs the cost. The IRC has strict criteria for deducting bad debts. For example, a bona fide creditor–debtor relationship must exist, and the debt must be positively uncollectible (for example, the debtor files for bankruptcy and the company is not a secured creditor).

Solution to the Answer

Tax as per Accounting Profit = $80,000*40% = $32,000

Tax as per Taxable Profit = $15,000*40%= $6,000

Deferred Tax arising from the following

Depreciation = $60,000*40% = $24,000. This is Deferred Tax Liablility ( See explanation above and also see the blind rule).

Prepaid Expenses = $17,000*40% = $6,800.This is Deferred Tax Liablility ( See explanation above and also see the blind rule).

Warranty Expense = $12,000*40% = $4,800.This is Deferred Tax Asset ( See explanation above and also see the blind rule)..

No Net Deferred Tax Liablility is = $24,000+$6,800-$4,800=$26,000

So The entry will be

Income Tax expense as per book income Debit $32,000

Income Tax payable as per Tax Income Credit $6,000

Deferred Tax Liablility Credit $26,000

Equation can be also given :

Tax expense as per book = Tax expense as per taxable income + Deferred Tax Liablity - Deferred tax asset.