Question

Terry’s auditors have approached the management team with their concern that Terry has not been properly recording deferred taxes. In particular, they are concerned that Terry is simply recognizing 25% as the company’s income tax expense. They have asked the company to make a thorough review of the company’s tax liability utilizing the services of professional tax accountants. The review revealed three book/tax differences in Terry’s financial information: The review revealed three book/tax differences in Terry’s financial information:

1.Terry’s management opened a new life insurance policy this year on the CEO. The premium for this new policy is $917/month. The policy cannot be prepaid.

2. Up through Year 2, Terry had no book/tax differences for amortization and depreciation. This happens when companies use the MACRS tables for determining their depreciation and amortization expenses for both GAAP and tax purposes, a common practice among small companies (like Terry). However, in Year 3, Terry decided to switch to the straight-line depreciation method for GAAP purposes. Since this is a change in estimate, it did not require any special changes to Terry’s GAAP accounting, but it does create a difference for tax purposes. A summary of the book/tax differences will be provided by the instructor after we have completed Terry #3. In addition, the experts feel that Terry’s tax rate will change to 24% in Year 5 and to 23% in Years 6 & 7 due to new tax laws passed and signed into law during Year 3.

CALCULATIONS 1. Make the appropriate journal entry to correctly record income tax expense for Year 3.

yr 3	4	5	6
(1998000)	(1998000)	(1998000)	(1998000)
(3036960)	(2733264)	(2221776)	0

1st row for GAAP

2nd row for Tax

Critical Thinking

5. What do you think investors’ reaction will be to the adjustment for deferred taxes (if any)? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with these changes? Why or why not?

6. Who might be affected by Terry’s decision not to recognize deferred taxes appropriately in past years? How could this decision affect each individual or group?

Answer 1