Suggested Answer:

Chapter 15 - Additional Case Key Points

Key Points

This question requires students to identify and calculate temporary differences for income tax purposes and to determine the impact these differences will have on a company’s financial statements. Included in the scenario is the sale of capital assets on which there are nontaxable permanent differences.

Sale of Land and Building: Computations

COMMENTS

The income statement will record a gain on the sale of capital assets of $5,300,000. This gain should be deducted from the income. The taxable amount to be added is the taxable capital gain on the sale of the land of $1,250,000. The taxable capital gain on the sale of the building and the recapture will be deferred by deducting it from the cost of the new building. Therefore, these two amounts are not included in income for 2005.

Accounting Gain				$5,300,000
Less taxable Gain				(1,250,000)
Difference				$4,050,000
Deferred Capital Gain and Recapture ($500,000+$1,173,000)				$1,673,000
Permanent differences calculated above ($1,250,000+$500,000)				1,750,000
Tax basis of the capital assets (building):UCC		$2,827,000
Carrying Value of the building (NBV)		(2,200,000)
Temporary differences (taxable)				627,000
Reconciliation of the difference				$4,050,000

The company is entitled to defer all taxable capital gain of $500,000 and the taxable recapture of $1,173,000 for tax purposes as a consequence of the purchase of replacement property. A note to the financial statements will be required to disclose this deferral. The tax basis for the building will be cost of $5,000,000, less $500,000 (taxable capital gain on sale of building), and less $1,173,000 (recapture), to equal $3,327,000.

SUMMARY

Next we will calculate the accounting income subject to income tax, the taxable income, and the current taxes payable.

Income for accounting purposes:
Accounting income before adjustments				$2,000,000
Accounting gain on sale of assets				5,300,000
Less amortization				(200,000)
Accounting income before tax				$7,100,000
Permanent difference:
Non taxable gain (half of capital gain)				(1,750,000)
Accounting income subject to tax				$5,350,000
Temporary differences:
Amortization expense		$200,000
CCA		(50,000)		150,000
Product development-deductible				(1,000,000)
Accounting gain on sale of assets
($5,300,000-$1,250,000)				(4,050,000)
Taxable gain on sale of land				1,250,000
Taxable Income				$1,700,000
Tax Rate				40%
Income Tax payable				$680,000
Less: Investment tax credit				(300,000)
Tax payable				$380,000

Product Development Expenses: Computations

Deferred development expenses		$1,000,000
Cost		300,000
Investment Tax Credit		$700,000
Deferred Tax Credit
Deferred deduction/deferred for accounting		$1,000,000
Tax basis		0
Future Income Tax Liability ($1,000,000 x 40%)		$400,000

COMMENTS

The balance sheet will show deferred development expenses of $700,000. The net amount will be amortized on the basis selected for development costs. The $400,000 will be added to the long-term future income tax liabilities on the balance sheet. This temporary difference will reverse as development costs are amortized.

The amount of investment tax credits recognized in the financial statements will be disclosed in the notes thereto.

The fact that development expenses have been written off for income tax purposes will be disclosed in the notes to the financial statements.

Investment Tax Credit: Computations

Investment tax credit taxable next year		$300,000
Tax @ 40%		$120,000

COMMENTS

As the $300,000 will be taxable next year, the balance sheet will show a current deferred income tax credit of $120,000. This amount will reverse next year when the company will have to declare the income for tax purposes and pay the tax thereon.

The amount of $120,000 will be deducted from long-term future income tax liabilities on the balance sheet.

Balance in the building account at the end of 2004:

UCC balance		$2,827,000
Net book value ($2,200,000 + $200,000)		2,400,000
		427,000
Tax Rate		40%
Future Income Tax balance		$170,800

Using the balance sheet approach, we calculate the future income tax liabilities:

	(1) Tax Basis	(2) Carrying Value	(3)=(1)-(2) Temporary Difference Deductible (Taxable)	(4)=(3) x 40% Future Tax Asset (Liability) Year End	(5) Less Beginning Balance Dr (Cr)	(6)=(4)-(5) Adjustment For Current Year Dr (Cr)
2004 Building	$2,827,000	$2,400,000	$427,000	$170,800	0	0
2005 Building	$3,327,000	$4,800,000	$(1,473,000)	$(589,200)	$170,800	$(760,000)
Development Costs	0	$1,000,000	$(1,000,000)	$(400,000)	0	$(400,000)

SUMMARY INCOME TAX JOURNAL ENTRY FOR 2005

Income Tax Expense		1,960,000
Income Tax Payable				380,000
Future tax liability-building				760,000
Future tax liability-development expense				400,000
Future tax liability-deferred income tax credit				120,000
Deferred development expense				300,000

 
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