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. (Please see the hints section for help with making these entries!)

	Year 3	Year 4	Year 5	Year 6
GAAP	($1,998,000)	($1,998,000)	($1,998,000)	($1,998,000)
Tax	($3,036,960)	($2,733,264)	($2,221,776)	$0

Answer 1

		Year 3	Year 4	Year 5	Year 6	Notes
	GAAP	1,998,000	1,998,000	1,998,000	1,998,000
	Tax	3,036,960	2,733,264	2,221,776	-
	Tax provision as per GAAP	499,500	499,500	479,520	459,540	percentage on the profits
	Tax provision as per tax books	759,240	683,316	533,226	-	percentage on the profits
	Tax provision to be made	759,240	683,316	533,226	-
	Deferred tax	(259,740)	(183,816)	(53,706)	459,540	Difference between tax as per GAAP and tax books
	Journal Entries
1)	Tax charge                                                Dr	759,240	683,316	533,226	-
	Federal Income Taxes payable         Cr	759,240	683,316	533,226	-
2)	Deferred tax asset                                 Dr	259,740	183,816	53,706
	Tax charge                                               Cr	259,740	183,816	53,706
3)	Tax charge                                               Dr				459,540
	Deferred tax liability                             Cr				459,540
	Deferred tax asset Balance till 4th Year	443,556				259,740 plus 183,816
	Rate changed from 25 to 24 %
	Opening deferred tax at old rate	443,556
	Opening deferred tax at new rate	425,814
	Entry to be passed to this effect					If the tax rate has changed, the opening deferred tax must be recalculated with the new rate
4)	Tax charge                                                Dr			17,742		Differential of 443,556 and 425,814
	Deferred tax asset                                 Cr			17,742
	Deferred tax asset Balance till 5th Year	479,520				259,740 plus 183,816 plus 53,706 minus 17,742
	Rate changed from 24 to 23 %
	Opening deferred tax at old rate	479,520
	Opening deferred tax at new rate	459,540
	Entry to be passed to this effect					If the tax rate has changed, the opening deferred tax must be recalculated with the new rate
5)	Tax charge                                                Dr			19,980
	Deferred tax asset                                 Cr			19,980
	In absence of details regarding the policy of the CEO, the same has not been taken into consideration. Please ask for further details from your instructor
	If the policy is allowed to be debited as per GAAP but to be amortised as per Tax books then this also has to be considered to calculating the deferred taxes.
	If the policy is allowed to be debited as pe GAAP but not allowed as per tax books then this will not be used for the purpose of deferred taxes calculation.

	Entries to be passed in Year 3
1)	Tax charge                                                Dr	759,240
	Federal Income Taxes payable         Cr	759,240
2)	Deferred tax asset                                 Dr	259,740
	Tax charge                                               Cr	259,740
	Entries to be passed in Year 4
1)	Tax charge                                                Dr	683,316
	Federal Income Taxes payable         Cr	683,316
2)	Deferred tax asset                                 Dr	183,816
	Tax charge                                               Cr	183,816
	Entries to be passed in Year 5
1)	Tax charge                                                Dr	533,226
	Federal Income Taxes payable         Cr	533,226
2)	Deferred tax asset                                 Dr	53,706
	Tax charge                                               Cr	53,706
3)	Tax charge                                                Dr	17,742
	Deferred tax asset                                 Cr	17,742
	Entries to be passed in Year 6
1)	Tax charge                                               Dr	459,540
	Deferred tax liability                             Cr	459,540
2)	Tax charge                                                Dr	19,980
	Deferred tax asset                                 Cr	19,980