Chapter 18, Problem 7P

Deferred Tax Liability: Depreciation At the beginning of 2019, its first year of operations, Cooke Company purchased an asset for $100,000. This asset has an 8-year economic life with no residual value, and it is being depreciated by the straight-line method for financial reporting purposes. For tax purposes, however, the asset is being depreciated using the MACRS (200%, 5-year life) method.

During 2019, Cooke reported pretax financial income of $51,500 and taxable income of $44,000. The depreciation temporary difference caused the difference between the two income amounts. The tax rate in 2019 was 30%, and no change in the tax rate had been enacted for future years.

Required:

1. 1. Prepare a schedule that shows for each year, 2019 through 2026, (a) MACRS depreciation, (b) straight line depreciation, (c) the annual depreciation temporary difference, and (d) the accumulated temporary difference at the end of each year.
2. 2. Prepare a schedule that computes for each year, 2019 through 2026, (a) the ending deferred tax liability and (h) the change in the deferred tax liability.
3. 3. Prepare Cooke’s income tax journal entry at the end of 2019.
4. 4. Next Level Explain what happens to the balance of the deferred tax liability at the end of 2019 through 2026.

To determine

Prepare a schedule that shows MACRS depreciation from 2019 through 2026.

Explanation of Solution

Prepare a schedule that shows MACRS depreciation from 2019 through 2026:

Year	MACRS Depreciation rate	MACRS Depreciation (Tax purpose)
	(1)	$\left(2\right)=\left(1\right)\times \$100,000$
2019	20%	$20,000
2020	32%	$32,000
2021	19.20%	$19,200
2022	11.52%	$11,520
2023	11.52%	$11,520
2024	5.76%	$5,760
2025	0%	$0
2026	0%	$0

Table (1)

To determine

Prepare a schedule that shows straight line depreciation from 2019 through 2026.

Explanation of Solution

Straight-line Depreciation: Under the straight-line method of depreciation, the same amount of depreciation is allocated every year over the estimated useful life of an asset. The formula to calculate the depreciation cost of the asset using the residual value is shown as below:

$\text{Depreciation cost = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}$

Prepare a schedule that shows straight line depreciation from 2019 through 2026.

Given, the cost of the asset is $100,000 and the estimated useful life is 8 years. So, the straight line depreciation is $12,500 $\left(\frac{\$100,000}{8\text{ years}}\right)$ for each year.

Year	Straight line Depreciation    (Financial reporting  purpose)
2019	$12,500
2020	$12,500
2021	$12,500
2022	$12,500
2023	$12,500
2024	$12,500
2025	$12,500
2026	$12,500

Table (2)

To determine

Prepare a schedule that shows the annual depreciation temporary difference from 2019 through 2026.

Explanation of Solution

Temporary Difference: Temporary difference refers to the difference of one income recognized by the tax rules and accounting rules of a company in different periods. Consequently 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 known as temporary difference.

Prepare a schedule that shows the annual depreciation temporary difference from 2019 through 2026:

Year	MACRS Depreciation rate	Straight line Depreciation    (Financial reporting  purpose)	Temporary difference of annual depreciation
2019	20%	$12,500	$7,500
2020	32%	$12,500	$19,500
2021	19.20%	$12,500	$6,700
2022	11.52%	$12,500	($980)
2023	11.52%	$12,500	($980)
2024	5.76%	$12,500	($6,740)
2025	0%	$12,500	($12,500)
2026	0%	$12,500	($12,500)

Table (3)

To determine

Prepare a schedule that shows the accumulated temporary difference from 2019 through 2026.

Explanation of Solution

Prepare a schedule that shows the accumulated temporary difference from 2019 through 2026:

Year	Temporary difference of annual depreciation	Accumulated Temporary difference
2019	$7,500	$7,500
2020	$19,500	$27,000
2021	$6,700	$33,700
2022	($980)	$32,720
2023	($980)	$31,740
2024	($6,740)	$25,000
2025	($12,500)	$12,500
2026	($12,500)	$0

Table (4)

Note: The temporary difference is computed in Table (3) of requirement 1 (c).

To determine

Prepare a schedule that calculates the ending deferred tax liability from 2019 through 2026.

Explanation of Solution

Deferred tax liability: Deferred tax liability is created, if the tax obligation (income tax payable) is deferred temporarily due to differences in reporting revenue or expense at different time periods on the income statement (financial reporting) and on tax return (tax reporting).

Prepare a schedule that calculates the ending deferred tax liability from 2019 through 2026:

Year	Accumulated Temporary difference	Tax rate	Ending deferred tax liability
2019	$7,500	30%	$2,250
2020	$27,000	30%	$8,100
2021	$33,700	30%	$10,110
2022	$32,720	30%	$9,816
2023	$31,740	30%	$9,522
2024	$25,000	30%	$7,500
2025	$12,500	30%	$3,750
2026	$0	30%	$0

Table (5)

Note: The accumulated temporary difference is computed in requirement 1 (d).

To determine

Prepare a schedule that calculates the changes in deferred tax liability from 2019 through 2026.

Explanation of Solution

Prepare a schedule that calculates the changes in deferred tax liability from 2019 through 2026:

Year	Ending deferred tax liability	Beginning deferred tax liability	Change in deferred tax liability
2019	$2,250	$0	2,250
2020	$8,100	$2,250	5,850
2021	$10,110	$8,100	2,010
2022	$9,816	$10,110	(294)
2023	$9,522	$9,816	(294)
2024	$7,500	$9,522	(2,022)
2025	$3,750	$7,500	(3,750)
2026	$0	$3,750	(3,750)

Table (6)

Note: The ending deferred tax liability is computed in requirement 2 (a) and the ending deferred tax liability of 2019 is the beginning deferred tax liability for 2020 and so on

To determine

Record the income tax journal entry at the end of 2019 for Company C.

Explanation of Solution

Record the income tax journal entry at the end of 2019 for Company C.

Date	Account title and Explanation	Post ref.	Amount
			Debit	Credit
2019
December 31	Income tax expense (1)		$15,450
	Income tax payable (2)			$13,200
	Deferred tax liability			$2,250
	(To record the income tax payable )

Table (7)

• Income tax expense is an expense that decreases the stockholder’s equity and it is increased. Thus, it is debited.
• Income tax Payable is a liability and it is increased. Thus, it is credited.
• Deferred tax liability is a liability and it is increased. Thus, it is credited.

Working note 1: Determine the income tax expense:

$\begin{array}{c}\text{Income tax expense}=\text{Income tax payable}+\text{Deferred tax liability}\\ \text{=\$13,200}+\$2,250\\ \text{=\$15,450}\end{array}$

Working note 2: Determine the income tax payable:

Given, the taxable income is $44,000 and the tax rate is 30%.

$\begin{array}{c}\text{Income tax payable}=\text{Taxable income}\times \text{Corporate tax rate}\\ \text{=\$44,000}\times \text{30\%}\\ \text{=\$13,200}\end{array}$

Note: The deferred tax liability is $2,250 for year 2019 as computed in Table (6).

To determine

Elaborate the effects of the balance of deferred tax liability from 2019 through 2026.

Explanation of Solution

As per table (5), the balance of the deferred tax liability account increases (originates) at the end of 2019 from $2,250 to $10,110 in 2021 , and then declines (reverses) at the end of 2022 through 2026, which reduces to zero at the end of 2026.