Chapter 16, Problem 16.12P

1.

To determine

Temporary Difference

The amount of difference between the pre-tax accounting income and taxable income, and the difference between the amount of assets and liabilities reported in the financial reports and the amount of assets and liabilities as per the company’s tax records, is referred as temporary difference.

Deferred tax asset

When the Income Tax Expense account i.e. the estimated income tax amount is more than the outstanding amount of income tax i.e. the Income Tax Payable account, the difference is to be debited to Deferred Tax Asset account.

Deferred tax liability

When the Income Tax Expense account i.e. the estimated income tax amount is less than the outstanding amount of income tax i.e. the Income Tax Payable account, the difference is to be credited to Deferred Tax Liability account.

To determine:  Income tax expense and net income for the year ended December 31, 2016

Explanation of Solution

Amount ($)

Income before income taxes900,000

Income tax expense:

Current (1)336,000

Deferred tax liability (2)24,000360,000

Net Income540,000

Hence, the income tax expense and net income for the year ended December 31, 2016 is $360,000 and $540,000 respectively.

Working Notes:

Compute current portion of tax expense value.

$\begin{array}{c}\begin{array}{l}\text{Current}\text{portion}\text{of}\\ \text{income tax expense}\end{array}\}\text{=}\text{Taxable}\text{income×}\text{Tax}\text{rate}\\ \text{=}\left(\text{\$900,000}\text{-}\text{\$60,000}\right)\text{×}\text{40\%}\\ \text{=}\text{\$336,000}\end{array}$ (1)

Compute deferred tax liability value.

 Compute desired ending balance of deferred tax liability amount for 2016 and 2017.

1. (A) For 2016

	Current Year	Future Taxable Amount
	2016	2017	2018	2019
Pretax accounting income	$9,00,000
Temporary difference:
Depreciation	($60,000)	$20,000	$30,000	$40,000
Taxable income (tax return)	$8,40,000
Enacted tax rate	40%	40%	40%	40%
Income Tax Payable	$3,36,000 (1)
Deferred tax liability		$8,000	$12,000	$16,000

Table (1)

Total deferred tax liability on December 31, 2016 is $36,000 $\left(\text{\$8,000+ \$12,000 + \$16,000}\right)$

1. (B) For 2017

	Current Year	Future Taxable Amount
	2017	2016	2017	2018	2019
Temporary difference:
Depreciation		($60,000)	$20,000	$30,000	$40,000
Enacted tax rate		40%	40%	40%	40%
Deferred tax liability		($24,000)	$8,000	$12,000	$16,000

Table (2)

Total deferred tax liability on December 31, 2017 is $12,000 $\left[\left(\text{\$24,000}\right)\text{ + \$8,000 + \$12,000 + \$16,000}\right]$

 Compute deferred tax liability amount at December 31, 2016.

	Deferred tax liability
Ending balance (current balance needed)	$36,000
Less: Beginning balance	$12,000
Change needed to achieve desired balance (2)	$24,000

Table (3)

2.

To determine

To determine:  Interest expense for the year ended December 31, 2016.

Explanation of Solution

	(Amount in $)
Interest expense on capital lease obligation (3) (A)	7,367
Bonds payable (4)  (B)	36,568
Total interest expense (A+B)	43,935

Table (4)

Working Notes:

Compute interest expense on capital lease obligation.

The balance of capital lease obligation at December 31, 2016 is $73,677 and rate of interest is 10% p.a.

$\begin{array}{c}\begin{array}{l}\text{Interest}\text{expense }\\ \text{on}\text{capital}\text{lease}\end{array}\}\text{=}\left(\begin{array}{l}\text{Balance}\text{of capital}\\ \text{lease}\text{obligation}\end{array}\right)\text{×}\text{Interest}\text{rate}\\ \text{=}\text{\$73,677}\text{×}\text{10\%}\\ \text{=}\text{\$7,367}\end{array}$ (3)

Compute interest expense on bond payable.

Step a:

Interest on bond is payable half yearly i.e. January 1 and July 1. For calculating interest expense on bond at December 31, 2016, we have to consider the July 1- December 31, 2016 time period i.e. six months.

Rate of yield is 10% p.a. that is 5% per six months, so for calculating interest expense for six months we have to consider 5%.

$\begin{array}{c}\text{Interest amount of bond }\left(\text{Per annum}\right)\text{=}\text{Bond}\text{Value}\text{×}\text{Interest}\text{rate}\text{of}\text{bond}\\ \text{=}\text{\$800,000}\text{×}\text{9\%}\\ \text{=}\text{\$72,000}\end{array}$

$\begin{array}{c}\text{Interest amount per six months}\text{=}\frac{\text{\$72,000}}{\text{2}}\\ \text{=}\text{\$36,000}\end{array}$

Step b:

Present value of face value of bond.

Amount ($)

Face value of bond   800,000

PV factor at an annual market rate of 5% for 40 periods (a)× 0.14205

Present value of face value of bond  113,640

Note: Bond maturity period is 20 years but interest is payable half yearly, so the total time period will be 20 × 2 = 40 periods. Similarly, half yearly market rate (yield rate) is 5% $\left(\frac{\text{10\%}}{\text{2}}\right)$.

The present value of $1 for 40 periods at 5% is 0.14205 (refer present value table).

Step c:

Present value of interest payments.

Amount ($)

Interest amount per six months     36,000

PV factor at an annual market rate of 5% for 40 periods (b)× 17.15909

Present value of interest payments   617,727

The present value of an ordinary annuity of $1 for 40 periods at 5% is 17.15909 (refer annuity present value table).

Step d:

Calculate price of bond

$\begin{array}{c}\text{Price of bond}\text{=}\text{Present}\text{value}\text{of}\text{principle}\text{+}\text{Present}\text{value}\text{of}\text{interest}\text{payament}\\ \text{=}\text{\$113,640}\text{+}\text{\$617,727}\\ \text{=}\text{\$731,367}\end{array}$

Step e:

Calculate interest expense.

$\begin{array}{c}\text{Interest expense = Price of bond × Market interest rate × Interest time period}\\ \text{=}\text{\$731,367}\text{×}\text{5\%}\text{×}\frac{\text{1}}{\text{2}}\\ \text{=}\text{\$36,568}\end{array}$ (4)

3.

To determine

To prepare:  Long term liabilities section of balance sheet at December 31, 2016.

Explanation of Solution

The Long term liabilities section of balance sheet at December 31, 2016 is as follows:

C Transportation

Long term liabilities section of Balance Sheet

December 31, 2016                          

Long term Liabilities:
Lease liability – 14 payments of $10,000 due annually on January 1	$73,667
Less: Current portion ($10,000 – 7,367)	($2,633)	$71,034
9% bond payable due on June 30, 2029	$8,00,000
Less: Unamortized discount (balancing figure)	$68,065	$731,935
Deferred income tax liability		$36,000
Total long-term liabilities		$838,969

Conclusion

This problem will provide the basic understanding regarding the calculation of interest expense and income tax expense in case bond and lease. Additionally, it will describe the way of disclosure of interest expense of bond & lease and deferred tax liability in the balance sheet.