Question

During 2020, E Inc. reported $1,100,000 net income. Included in this amount was $120,000 of life insurance proceeds received upon the death of E’s CEO, $90,000 of interest income from investments in municipal bonds and life insurance premiums of $10,000 that E had paid for the policy on its CEO. E uses straight-line depreciation for book purposes and MACRS for tax. For 2020, E’s tax depreciation expense exceeded its financial depreciation expense by $50,000. This difference is expected to reverse in 2021. During 2020, E paid $90,000 estimated taxes and its tax rate for all years is 20%.

INSTRUCTIONS: A. Determine the current and deferred income tax expense that E will report on its 2020 income statement. B. Determine the deferred tax asset / liability that E will report on its 2020 balance sheet. C. Prepare the journal entry to record 2020 tax expense.

Answer 1

Deferred tax assets are often created due to taxes paid or carried forward but not yet recognized on the income statement. For example, deferred tax assets can be created due to the tax authorities recognizing revenue or expenses at different times than that of an accounting standard. This asset helps in reducing the company’s future tax liability. It is important to note that a deferred tax asset is recognized only when the difference between the loss-value or depreciation of the asset is expected to offset future profit.

Deferred tax liability is the amount of taxes a company has "underpaid"—which will (eventually) be made up in the future. By saying it has underpaid doesn't necessarily mean that it hasn't fulfilled its tax obligations, rather it is recognizing that the obligation is paid on a different timetable.

These deferred taxes are given effect to in the financial statements through Deferred Tax Asset and Liability as under:

Sl.No	Entity Profit Status	Entity – Current	Entity – Future	Effect
1	Book profit higher than the Taxable profit	Pay less tax now	Pay more tax in future	Creates Deferred Tax Liability (DTL)
2	Book profit is less than the Taxable profit	Pay more tax now	Pay less tax in future	Creates Deferred Tax Asset (DTA)

Book Profit = $ 11,00,000

Taxable Profit = $ (11,00,000 - 120,000 - 90,000 - 10,000 - 50,000)

= $ 8,30,000

Tax as per Book Profit = $ 220,000

Tax as per Taxable Profit = $ 166,000

DTL = $ 54,000

Current Tax = $ 220,000

In Balance Sheet Defred Tax Liability will be reflected by $ 54,000

Journal

Profit & Loss A/C          DR 220000/-

To Provision for Income Tax A/C   220000/-

(Being provision made for tax payable for current year)

Profit & Loss A/C DR 54000/-

To Deferred Tax liability A/C   54000/-

(Being Deferred Tax liability created on account of timing difference)