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Chapter16: Accounting for Income Taxes

Broaden Your Perspective

Apply your critical-thinking ability to the knowledge you've gained. These cases will provide you an opportunity to develop your research, analysis, judgment, and communication skills. You also will work with other students, integrate what you've learned, apply it in real world situations, and consider its global and ethical ramifications. This practice will broaden your knowledge and further develop your decision-making abilities.

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Analysis Case 16-1 Basic concepts 
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One of the longest debates in accounting history is the issue of deferred taxes. The controversy began in the 1940s and has continued, even after the FASB issued Statement of Financial Accounting Standards No. 109 [FASB ASC 740: Income Taxes] in 1992. At issue is the appropriate treatment of tax consequences of economic events that occur in years other than that of the events themselves.

p. 927

Required:

1.

 

Distinguish between temporary differences and permanent differences. Provide an example of each.

2.

 

Distinguish between intraperiod tax allocation and interperiod tax allocation (deferred tax accounting). Provide an example of each.

3.

 

How are deferred tax assets and deferred tax liabilities classified and reported in the financial statements?

Integrating Case 16–2 Postretirement benefits 
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FASB ASC 715–60: Compensation–Retirement Benefits–Defined Benefit Plans–Other Postretirement (previously Statement of Financial Accounting Standards No. 106) establishes accounting standards for postretirement benefits other than pensions, most notably postretirement health care benefits. Essentially, the standard requires companies to accrue compensation expense each year employees perform services, for the expected cost of providing future postretirement benefits that can be attributed to that service. Typically, companies do not prefund these costs for two reasons: (a) unlike pension liabilities, no federal law requires companies to fund nonpension postretirement benefits and (b) funding contributions, again unlike for pension liabilities, are not tax deductible. (The costs aren't tax deductible until paid to, or on behalf of, employees.)

Required:

1.

 

As a result of being required to record the periodic postretirement expense and related liability, most companies now report lower earnings and higher liabilities. How might many companies also report higher assets as a result of GAAP for postretirement plans?

2.

 

One objection to current GAAP as cited in the chapter is the omission of requirements to discount deferred tax amounts to their present values. This objection is inappropriate in the context of deferred tax amounts necessitated by accounting for postretirement benefits. Why?

Trueblood Accounting Case 16-3 Valuation allowance 
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The following Trueblood case is recommended for use with this chapter. The case provides an excellent opportunity for class discussion, group projects, and writing assignments. The case, along with Professor's Discussion Material, can be obtained from the Deloitte Foundation at its website: www.deloitte.com/us/truebloodcases.

Case 07–6: Graphic Inc.

This case gives the students an opportunity to understand that judgment is involved in determining whether a valuation allowance should be recorded on deferred income tax assets. Students will identify and weigh positive and negative evidence to assess whether or how much of a valuation allowance should be recorded against an entity's deferred income tax assets.

Integrating Case 16-4 Income taxes and investment securities; Dominion Resources 
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Dominion Resources,Inc. is one of the nation's largest producers of energy. Corporate headquarters are in Richmond, Va. The following is an excerpt from a recent annual report.

Real World Financials


INVESTMENT SECURITIES (IN PART)
Available-for-sale securities are reported at fair value with realized gains and losses and any other-than-temporary declines in fair value included in other income and unrealized gains and losses reported as a component of AOCI, net of tax.

   Dominion's statement of comprehensive income reported an “Unrealized gain on investment securities, net of $83 million tax expense of $126 million.”

Required:

1.

 

Explain how investment securities classified as available for sale are accounted for.

2.

 

What would have been Dominion's journal entry to reflect the fair value of the investments?

Integrating Case 16–5 Tax effects of accounting changes and error correction; six situations 
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Williams-Santana, Inc. is a manufacturer of high-tech industrial parts that was started in 1997 by two talented engineers with little business training. In 2011, the company was acquired by one of its major customers. As part of an internal audit, the following facts were discovered. The audit occurred during 2011 before any adjusting entries or closing entries were prepared. The income tax rate is 40% for all years.

    

a.

 

A five-year casualty insurance policy was purchased at the beginning of 2009 for $35,000. The full amount was debited to insurance expense at the time.

b.

 

On December 31, 2010, merchandise inventory was overstated by $25,000 due to a mistake in the physical inventory count using the periodic inventory system.

c.

 

The company changed inventory cost methods to FIFO from LIFO at the end of 2011 for both financial statement and income tax purposes. The change will cause a $960,000 increase in the beginning inventory at January 1, 2010.

d.

 

At the end of 2010, the company failed to accrue $15,500 of sales commissions earned by employees during 2010. The expense was recorded when the commissions were paid in early 2011.

e.

 

At the beginning of 2009, the company purchased a machine at a cost of $720,000. Its useful life was estimated to be 10 years with no salvage value. The machine has been depreciated by the double declining-balance method. Its carrying amount on December 31, 2010, was $460,800. On January 1, 2011, the company changed to the straight-line method.

p. 928

f.

 

Additional industrial robots were acquired at the beginning of 2008 and added to the company's assembly process. The $1,000,000 cost of the equipment was inadvertently recorded as repair expense. Robots have 10-year useful lives and no material salvage value. This class of equipment is depreciated by the straight-line method for both financial reporting and income tax reporting.

Required:

For each situation:

1.

 

Identify whether it represents an accounting change or an error. If an accounting change, identify the type of change.

2.

 

Prepare any journal entry necessary as a direct result of the change or error correction as well as any adjusting entry for 2011 related to the situation described. Any tax effects should be adjusted for through the deferred tax liability account.

3.

 

Briefly describe any other steps that should be taken to appropriately report the situation.

Communication Case 16-6 Deferred taxes, changing rates; write a memo 
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You are the new controller for Engineered Solutions. The company treasurer, Randy Patey, believes that as a result of pending legislation, the current 40% income tax rate will be decreased for 2012 to 35% and is uncertain which tax rate to apply in determining deferred taxes for 2011. Patey also is uncertain which differences should be included in that determination and has solicited your help. Your accounting group provided you the following information.

   Two items are relevant to the decisions. One is the $50,000 insurance premium the company pays annually for the CEO's life insurance policy for which the company is the beneficiary. The second is that Engineered Solutions purchased a building on January 1, 2010, for $6,000,000. The building's estimated useful life is 30 years from the date of purchase, with no salvage value. Depreciation is computed using the straight-line method for financial reporting purposes and the MACRS method for tax purposes. As a result, the building's tax basis is $5,200,000 at December 31, 2011.

Required:

Write a memo to Patey that:

    

a.

 

Identifies the objectives of accounting for income taxes.

b.

 

Differentiates temporary differences and permanent differences.

c.

 

Explains which tax rate to use.

d.

 

Calculates the deferred tax liability at December 31, 2011.

Real World Case 16-7 Disclosure issues; balance sheet classifications; Walmart Stores 
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The income tax disclosure note accompanying the January 31, 2009, financial statements of Walmart Stores is reproduced below:

Real World Financials

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Required:

p. 929

1.

 

In its 2009 balance sheet, Walmart reported as a noncurrent liability, “Deferred income taxes” of $3,076 million. Why is this different from the $1,605 million “net deferred tax liability” reported in the disclosure note?

2.

 

Re-create the journal entry that summarizes the entries Walmart used to record its 2009 income taxes.

Research Case 16-8 Researching the way tax deductions are reported on a corporation tax return; retrieving a tax form from the Internet 
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The U.S. Treasury maintains an information site on the Internet. As part of this site the Internal Revenue Service provides tax information and services. Among those services is a server for publications and forms which allows a visitor to download a variety of IRS forms and publications.

Required:

1.

 

Access the Treasury site on the Internet. The web address is www.ustreas.gov. After exploring the information available there, navigate to the IRS server for forms and publications via the IRS home page.

2.

 

Download the corporation tax return, Form 1120.

3.

 

Note the specific deductions listed that are deductible from total income to arrive at taxable income. Are any deductions listed that might not also be included among expenses in the income statement?

4.

 

One of the deductions indicated is “net operating loss deduction.” Under what circumstances might a company report an amount for this item?

5.

 

Based on how taxable income is determined, how might temporary differences be created between taxable income and pretax income in the income statement?

Analysis Case 16-9 Reporting deferred taxes 
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Access the financial statements and related disclosure notes of Google Inc. from its website at investor.google.com. In Google's balance sheet, deferred income taxes in 2008 are reported as both an asset ($286,105 thousand) and a liability ($12,515 thousand).

Real World Financials

Required:

1.

 

Explain why deferred income taxes can be reported as both an asset and a liability. Why is the deferred tax asset reported as current and the deferred tax liability as long term in 2008? Is that also the situation in 2007?

2.

 

Note 14 in the disclosure notes indicates that deferred tax assets are $650,634 thousand in 2008 and deferred tax liabilities are $377,044 thousand. How can that be explained in light of the two amounts reported in the balance sheet?

3.

 

Does Google feel the need to record a valuation allowance for its deferred tax assets?

Analysis Case 16-10 Consult financial statements; analyze tax disclosures; recreate journal entry 
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Kroger Co. is one of the largest retail food companies in the United States as measured by total annual sales. The Kroger Co. operates supermarkets, convenience stores, and manufactures and processes food that its supermarkets sell. Kroger's stores operate under names such as Dillon Food Stores, City Market, Sav-Mor, Kwik Shop, and Ralph's.

Real World Financials

   Like most corporations, Kroger has significant deferred tax assets and liabilities. Using Edgar (www.sec.gov) or the company's website check the company's annual report for the year ended February 1, 2009.

Required:

1.

 

From the income statement, determine the income tax expense for the most recent year. What is the current portion and the deferred portion of the expense? (See the “Taxes Based on Income” note in the Notes to Consolidated Financial Statements.) Why is the income tax expense from the income statement different from the “provision for income taxes in the disclosure note”?

2.

 

How are the deferred taxes classified in Kroger's balance sheet? (See the “Taxes Based on Income” note in the Notes to Consolidated Financial Statements.) What amounts are reported among current assets or liabilities and among noncurrent assets or liabilities? Why?

Judgment Case 16-11 Analyzing the effect of deferred tax liabilities on firm risk; Macy's, Inc. 
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The following is a portion of the January 31, 2009 and 2008, balance sheets of Macy's, Inc.:

Real World Financials

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Macy's debt to equity ratio for the year ended January 31, 2009 was 3.8, calculated as $17,499 ÷ $4,646. Some analysts argue that long-term deferred tax liabilities should be excluded from liabilities when computing the debt to equity ratio.

Required:

1.

 

What is the rationale for the argument that long-term deferred tax liabilities should be excluded from liabilities when computing the debt to equity ratio?

2.

 

What would be the effect on Macy's debt to equity ratio of excluding deferred tax liabilities from its calculation? What would be the percentage change?

3.

 

What might be the rationale for not excluding long-term deferred tax liabilities from liabilities when computing the debt to equity ratio?

Judgment Case 16-12 Intraperiod tax allocation 
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Russell-James Corporation is a diversified consumer products company. During 2011, Russell-James discontinued its line of cosmetics, which constituted discontinued operations for financial reporting purposes. As vice president of the food products division, you are interested in the effect of the discontinuance on the company's profitability. One item of information you requested was an income statement. The income statement you received was labeled preliminary and unaudited:

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p. 931

   You are somewhat surprised at the magnitude of the loss incurred by the cosmetics division prior to its disposal. Another item that draws your attention is the apparently low tax rate indicated by the statement ($22 ÷ 150 = 15%). Upon further investigation you are told the company's tax rate is 40%.

Required:

1.

 

Recast the income statement to reflect intraperiod tax allocation.

2.

 

How would you reconcile the income tax expense shown on the statement above with the amount your recast statement reports?

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