Current and Deferred Tax With Uncertain Tax Position
Cedarbrook Inc. reports pre-tax book income of $2,400,000 for 20X5. Its book-tax differences are: municipal bond interest of $60,000; life insurance proceeds on a key executive of $150,000; warranty expense accrued of $90,000, of which $30,000 was paid in 20X5; tax depreciation of $400,000 versus book depreciation of $250,000; bad debt expense of $50,000 and write-offs of $35,000; and a $200,000 fine for an environmental violation. Cedarbrook also holds trading securities with a $120,000 unrealized gain; the gain is taxable only when the securities are sold. The enacted tax rate is 30% for 20X5 and 25% for later years. At 1 January 20X5, the deferred tax liability was $45,000 and the deferred tax asset was $18,000, both measured at 30%. Management concludes it is more likely than not that 80% of the deferred tax asset will be realized. In 20X4, Cedarbrook claimed a $300,000 research credit that is under audit; counsel believes it is probable that $100,000 will be disallowed and that there is a 30% chance a 20% penalty will be assessed. The allowance for bad debts had a zero opening balance.
1. Compute taxable income, current tax expense, and the deferred tax balances at 31 December 20X5. Show the valuation allowance and total tax expense.
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Start with pre-tax book income $2,400,000. Adjust for permanent differences: subtract municipal interest $60,000 and life insurance proceeds $150,000; add the fine $200,000. Adjust for temporary differences: warranty add $60,000 ($90,000 accrued less $30,000 paid); bad debts add $15,000 ($50,000 expense less $35,000 write-offs); depreciation subtract $150,000 ($400,000 tax less $250,000 book); unrealized gain subtract $120,000. Taxable income = $2,400,000 - $60,000 - $150,000 + $200,000 + $60,000 + $15,000 - $150,000 - $120,000 = $2,195,000. Current tax = 30% × $2,195,000 = $658,500.
Deferred balances at 25%: warranty deductible difference $60,000 → DTA $15,000; bad debt allowance $15,000 → DTA $3,750; depreciation taxable difference $150,000 → DTL $37,500; unrealized gain taxable difference $120,000 → DTL $30,000. Total DTA $18,750; valuation allowance 20% = $3,750; net DTA $15,000. Net DTL = $67,500 - $15,000 = $52,500.
Beginning net DTL = $45,000 - $18,000 = $27,000. Deferred tax expense = $52,500 - $27,000 = $25,500. Total tax expense = $658,500 + $25,500 = $684,000. The beginning balances were at 30%; remeasurement to 25% is included in the $25,500.
2. How should the uncertain tax position and the possible penalty be accounted for? Prepare the journal entry.
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A tax position is recognized only if it is more likely than not to be sustained on examination. For the portion that is not expected to be sustained, recognize a liability. Counsel believes it is probable that $100,000 will be disallowed, so Cedarbrook should recognize a $100,000 uncertain tax liability and charge income tax expense. If the credit was already claimed in the 20X4 return, the liability reduces the benefit previously recognized; it does not reduce 20X5 current tax payable.
Entry: debit income tax expense $100,000; credit uncertain tax liability $100,000.
The possible penalty is 20% of $100,000 = $20,000, but the probability of assessment is only 30%. A 30% chance is not probable, so do not accrue the penalty; disclose the contingency. The expected value of $6,000 is not recognized because the recognition threshold is not met. If the penalty were probable and reasonably estimable, accrue it as part of the tax expense or as a separate penalty liability depending on presentation policy.
3. Compute the effective tax rate and explain why it differs from the 30% statutory rate.
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Effective tax rate = $684,000 / $2,400,000 = 28.5%.
The difference from 30% arises from three sources. First, permanent differences: municipal interest and life insurance proceeds are nontaxable, reducing tax expense by 30% × ($60,000 + $150,000) = $63,000; the environmental fine is nondeductible, increasing tax expense by 30% × $200,000 = $60,000. Net permanent effect is a $3,000 reduction.
Second, temporary differences are measured at the 25% future rate rather than the 30% current rate. The current tax effect of reversals occurs at 30%, while ending deferred balances are at 25%, producing a net reduction. Third, the valuation allowance of $3,750 increases tax expense because only 80% of the gross DTA is expected to be realized. The combination of the rate change, the valuation allowance, and the permanent differences produces the 28.5% rate. The rate is not a substitute for the detailed current and deferred computation.