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.

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

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

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