The
asset-liability approach for recording future income taxes is an integral part
of generally accepted accounting principles.
Instructions
(a)
Indicate whether each of the following independent situations results in a
reversing difference or a permanent difference in the year. Explain your
answer. Be sure to note any differences between PE GAAP and IFRS.
1.
Estimated warranty costs (covering a three-year warranty) are expensed for
financial reporting purposes at the time of sale but deducted for income tax
purposes when they are paid.
2.
Equity investments have a quoted market value that is recorded at fair value
through net income and is adjusted to their fair value at the balance sheet
date.
3.
The depreciation on equipment is different for book and income tax purposes
because of different bases of carrying the asset, which was acquired in a
trade-in. The different bases are a result of different rules that are used for
book and tax purposes to calculate the cost of assets acquired in a trade-in.
4.
A company properly uses the equity method to account for its 30% investment in
another taxable Canadian corporation. The investee pays non-taxable dividends
that are about 10% of its annual earnings.
5.
Management determines that the net realizable value of the inventory is below
cost, causing a writedown in the current year.
6.
A company reports a contingent loss that it expects will result from an ongoing
lawsuit. The loss is not reported on the current year’s tax return. Half the
loss is a penalty it expects to be charged by the courts. This portion of the loss
is not a tax-deductible expenditure, even when it is paid.
7.
The company uses the revaluation model for reporting its land and buildings.
Due to current economic conditions, the fair value of the properties declined
and the writedown was recorded against the revaluation surplus reported in
equity.
8.
The company settles its retirement obligation on a drilling platform that is
put out of service. The actual settlement was less than the amount accrued, and
the company recognizes a gain on settlement in its accounting net income.
(b)
Discuss the nature of any future income tax accounts that result from the
situations in (a) above, including their possible classifications in the
company’s balance sheet. Indicate how these accounts should be reported. Note
any differences between IFRS and the asset-liability method under PE GAAP.
(a) 1. Reversing
difference. The full, estimated, three years of warranty costs reduce the
current year’s pretax accounting income, but they will reduce taxable income in
varying amounts each respective year, as paid. Assuming the estimate as to each
warranty is valid, the total amounts deducted for accounting and for tax
purposes will be equal over the three-year period for a given warranty. This is
an example of an expense that in the first period reduces pretax accounting
income more than taxable income and in later years reverses. This type of temporary
difference will result in future deductible amounts, which will give rise to
the current recognition of a future income tax asset. Another way to evaluate
this situation is to compare the carrying value of the warranty liability with its tax basis (which is
zero). When the liability is settled in a future year, an expense will be
recognized for tax purposes but none will be recognized for financial reporting
purposes. Therefore, tax benefits for the tax deductions should result from the
future settlement of the liability.
2. Reversing difference. While the change in
value is included in income in the current year, it will not be
taxable/deductible until sold. Therefore, it is a reversing difference.
3. Permanent difference. The difference is not
due to different methods of depreciation, but due to different amounts accepted
as “cost”. Since only the amount accepted originally as its tax cost can be
amortized in the future, the difference is a permanent one.
4. Permanent difference. The investor’s share of earnings of an
investee accounted for by the equity method is included in accounting income,
while dividends received from taxable Canadian corporations are excluded from
taxable income. The amount included in accounting income is a permanent
difference deducted when computing taxable income.
5. Reversing
difference. The write down in the inventory is recognized for accounting purposes in the current year, but the loss is
not allowed to be deducted for tax purposes until the inventory is sold. Hence, it is a reversing difference.
6. Permanent
and reversing difference. For financial reporting purposes, any loss from a
litigation accrual would not be deductible for tax purposes until paid. This is a reversing difference arising in the
year accrued. For the portion of the loss that is expected to be a penalty, which
cannot be used as a deductible expense for tax purposes, this amount will be a
permanent difference.
7.
Reversing difference under IFRS only (PE
GAAP does not allow the revaluation model to be used). This write down for the properties will cause
the future tax accounts to change, but the loss is not reported for current tax
purposes. Once the land and buildings
are actually disposed, the taxable income will be impacted by difference
between the original cost and the proceeds on disposal. (At this time, a
portion of the difference may be shown as recaptured capital cost allowance and
a portion as capital gains, but this will not be known until the actual sale
proceeds are determined.)
8. Reversing
difference – When the retirement obligation is settled, the full cash amount
paid will be reflected as a reduction of taxable income. However, in the accounting records, this has
been reported each year since the obligation was originally accrued, along with
the gain on settlement in the final year.
As a result, there will be an amount in future tax liabilities with
respect to this obligation. When the
obligation is paid, this future tax liability will be reversed, and the full
amount of taxes now owing will be recorded as income taxes payable.
(b)
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Future income tax accounts
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1.
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The estimated warranty costs will be deductible in future periods and
cause taxable income to be less than accounting income in the future.
à Future income tax asset (Classified as non-current, assuming the three-year warranty liability is classified as non-current
liability) under both IFRS and PE GAAP.
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2.
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Holding/unrealized gains à will be taxable when realized à Current future income tax liability.
Holding/unrealized losses à will be deductible when realized à Current future income tax asset.
(Similar treatment under PE GAAP and IFRS).
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3.
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No related future income tax accounts.
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4.
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No related future income tax accounts.
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5.
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The impairment loss will be deductible in future periods and cause
taxable income to be less than accounting income in the future.
à Future income tax asset (Classified as current under PE GAAP and non-current
under IFRS).
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6.
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The penalty portion does not have related future income tax accounts. The
rest of it results in future income tax asset. (Classified as current or non-current based on the expected reversal
date under PE GAAP and only non-current under IFRS).
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7.
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This is not allowed under PE GAAP. Under IFRS, the loss will be deductible in
future periods and cause taxable income to be less than accounting income in
the future.
à Future income tax asset (or a reduction in the
related future tax liability account) (Classified as non-current under IFRS).
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8.
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The cash settlement of the retirement obligation results in the current
taxable income being lower than the current accounting income. As such, there will be a reduction in the
future tax asset account that had been increasing in previous years as the
expense was recorded for accounting purposes but not yet for tax purposes. The related future tax asset should be
eliminated with this settlement.
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