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

Land:            
   Proceeds $3,000,000
   Book Value  
      Cost      500,000
         Gain on Sale $2,500,000
   Permanent Difference  
      Half of gain ($2,500,000 x 50%) $1,250,000
   
Building:  
   Proceeds $5,000,000
   Book Value  
      Cost$4,000,000 
      Accumulated amortization 1,800,000 2,200,000
         Gain on Sale $2,800,000
   Permanent Difference  
      Half of gain (Proceeds less cost)  
         ($5,000,000 - $4,000,000) x 50%    $500,000
   
Accounting gain included in income:  
   Land $2,500,000
   Building  2,800,000
  $5,300,000
   
Taxable Capital Gain  
   Land $1,250,000
   Building     500,000
  $1,750,000
   
Recapture on sale of building: The lesser of proceeds and cost, less UCC.  
   Proceeds: $5,000,000
   Cost: $4,000,000
   UCC: $2,827,000
   Recapture: $1,173,000
   
Recapture is fully taxable.  

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 basis0
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$170,80000
2005 Building$3,327,000$4,800,000$(1,473,000)$(589,200)$170,800$(760,000)
Development Costs0$1,000,000$(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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