Question

The asset-liability approach for recording deferred income taxes is an integral part of generally accepted accounting principles.

Instructions (a) Indicate whether each of the following independent situations should be treated as a temporary difference or as a permanent difference, and explain why. (1) Estimated warranty costs (covering a 3-year warranty) are expensed for financial reporting purposes at the time of sale but deducted for income tax purposes when paid. (2) Depreciation for book and income tax purposes differs because of different bases of carrying the related property, which was acquired in a trade-in. The different bases are a result of different rules used for book and tax purposes to compute the basis of property acquired in a trade-in. (3) A company properly uses the equity method to account for its 30% investment in another company. The investee pays dividends that are about 10% of its annual earnings. (4) A company reports a gain on an involuntary conversion of a nonmonetary asset to a monetary asset. The company elects to replace the property within the statutory period using the total proceeds so the gain is not reported on the current year’s tax return.

Short answer

Dividends are the type of payment earned by an investor against the shares purchased or money invested in the form of equity shares in an organization. It is paid out of the organization'stotal profits.

Step-by-step solution

(1) Temporary difference

The amount of estimated warranty costs for three years (total) will eventually decrease the organization's pretax financial income. On the other hand, it will also reduce the total taxable income. It is regarded as a future deductible amount and will increase the amount of deferred tax assets.

(2) Temporary difference

The variation in the amounts of tax basis and the book basis while computing the income tax expense will decrease the taxable amount because of the depreciation on the value of an asset.

(3) Temporary difference and permanent difference

The share of earnings by an investor will be added to the amount of pretax financial income of an organization in which 80% of the amount will be listed under the permanent difference and 10% of the earnings (out of 20% of dividends) will be reported under the temporary difference. It is because of the distributions made by the investor for 10% of the earnings.

(4) Temporary difference

As per the rule prescribed by IFRS, if an organization incurs any gain due to an involuntary conversion into the qualitative value of assets, it must be recognized during the conversion period. The difference in the amounts of replacement cost and the carrying value of assets will lead to additional taxable income.