Question

Question: Novotna Inc.’s only temporary difference at the beginning and end of 2016 is caused by a \(3 million deferred gain for tax purposes for an installment sale of a plant asset, and the related receivable (only one-half of which is classified as a current asset) is due in equal installments in 2017 and 2018. The related deferred tax liability at the beginning of the year is \)1,200,000. In the third quarter of 2016, a new tax rate of 34% is enacted into law and is scheduled to become effective for 2018. Taxable income for 2016 is $5,000,000, and taxable income is expected in all future years.

Instructions

(a) Determine the amount reported as a deferred tax liability at the end of 2016. Indicate proper classification(s).

(b) Prepare the journal entry (if any) necessary to adjust the deferred tax liability when the new tax rate is enacted into law.

(c) Draft the income tax expense portion of the income statement for 2016. Begin with the line “Income before income taxes.” Assume no permanent differences exist.

Short answer

Answer:

1. The amount reported as adeferred tax liability at the end of 2016 is $1,110,000, which is classified as

Current Liability: Deferred tax liability: $600,000

Non-Current liability: Deferred tax liability: $510,000

2.Deferred tax liability is debited and income tax payable is credited by $90,000

3. The net income is $3,090,000

Step-by-step solution

Meaning of Taxable Income

The taxable income means the income which is chargeable to the income tax under the income tax rules.It includes all the taxable income and is reduced by the expenses and deductions.

Calculation of deferred tax liability 

	2017	2018	Total
Future taxable amounts	$1,500,000	$1,500,000	$3,000,000
Tax rate	40%	34%
Deferred tax liability	$600,000	$510,000	$1,110,000

Working note:

Calculation of prior tax rate of 2017

$$\begin{gathered} \mathbf{\text{Incometaxrateof2016=}}\frac{\mathbf{D}\mathbf{e}\mathbf{f}\mathbf{e}\mathbf{r}\mathbf{r}\mathbf{e}\mathbf{d}\mathbf{}\mathbf{t}\mathbf{a}\mathbf{x}\mathbf{}\mathbf{l}\mathbf{i}\mathbf{a}\mathbf{b}\mathbf{i}\mathbf{l}\mathbf{i}\mathbf{t}\mathbf{y}}{\mathbf{T}\mathbf{e}\mathbf{m}\mathbf{p}\mathbf{o}\mathbf{r}\mathbf{a}\mathbf{r}\mathbf{y}\mathbf{}\mathbf{d}\mathbf{i}\mathbf{f}\mathbf{f}\mathbf{e}\mathbf{r}\mathbf{e}\mathbf{n}\mathbf{c}\mathbf{e}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{40}\mathbf{\%} \end{gathered}$$

The classification of deferred tax liability as current or non-current is based on the time when reversal of temporary difference occurs.

$600,000 is treated as a current liability, and $510,000 is treated as a non-current liability.

 Step 3: Journal entry

Date	Particulars	Debit ($)	Credit ($)
	Deferred tax liability	90,000
	Income tax expense		90,000

Showing income statement for 2016

Income statement for 2016
Particulars	Amount ($)	Amount ($)
Income before income tax		$5,000,000
Current income tax expense	$2,000,000
Less: Adjustments due to change in tax rate	$90,000	$1,910,000
Net Income		$3,090,000

Working note:

Calculation of Income tax expense for 2016

$$\begin{gathered} \mathbf{\text{Incometax=Taxableincome×TaxRate}} \\ \mathbf{\text{=\$5,000,000×40\%}} \\ \mathbf{\text{=\$2,000,000}} \end{gathered}$$