Sherrod, Inc., reported pretax accounting income of $62 million for 2016. The fo

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Question

Sherrod, Inc., reported pretax accounting income of $62 million for 2016. The following information relates to differences between pretax accounting income and taxable income:

a. Income from installment sales of properties included in pretax accounting income in 2016 exceeded that reported for tax purposes by $7 million. The installment receivable account at year-end had a balance of $8 million (representing portions of 2015 and 2016 installment sales), expected to be collected equally in 2017 and 2018.

b. Sherrod was assessed a penalty of $4 million by the Environmental Protection Agency for violation of a federal law in 2016. The fine is to be paid in equal amounts in 2016 and 2017.

c. Sherrod rents its operating facilities but owns one asset acquired in 2015 at a cost of $44 million. Depreciation is reported by the straight-line method assuming a four-year useful life. On the tax return, deductions for depreciation will be more than straight-line depreciation the first two years but less than straight-line depreciation the next two years ($ in millions):

Income Statement : $11 (2015-2018)

Tax Return : $14 (2015), $20 (2016), $6 (2017), $4 (2018)

Difference : (3)2015, (9) 2016, 5 for 2017, 7 for 2018

d. Warranty expense of $5 million is reported in 2016. For tax purposes, the expense is deducted when costs are incurred, $3 million in 2016. At December 31, 2016, the warranty liability was $3 million (after adjusting entries). The balance was $1 million at the end of 2015.

e. In 2016, Sherrod accrued an expense and related liability for estimated paid future absences of $14 million relating to the company’s new paid vacation program. Future compensation will be deductible on the tax return when actually paid during the next two years ($8 million in 2017; $6 million in 2018).

f. During 2015, accounting income included an estimated loss of $2 million from having accrued a loss contingency. The loss is paid in 2016 at which time it is tax deductible.

Balances in the deferred tax asset and deferred tax liability accounts at January 1, 2016, were $1.2 million and $1.6 million, respectively. The enacted tax rate is 40% each year.

Required:

1. Determine the amounts necessary to record income taxes for 2016 and prepare the appropriate journal entry. (If no entry is required for an event, select "No journal entry required" in the first account field. Enter your answers in millions rounded to 1 decimal place (i.e., 5,500,000 should be entered as 5.5))

Record the journal entry for 2016 income tax?

Explanation / Answer

Permanent Difference and Temporary Difference

Temporary (or timing) differences between book income versus taxable income are due to items of revenue or expense that are recognized in one period for taxes, but in a different period for the books. Book recognition can come before or after tax recognition. These revenue and expense items cause a timing difference between the two incomes, but over the "long run", they cause no difference between the two incomes. This is why they are temporary. When the difference first arises, it is called "an originating timing difference". When it later reverses it is called "a reversing timing difference".

Permanent differences are differences that never reverse. That is, they are items of book (or tax) revenue or expense in one period, but they are never items of tax (or book) revenue or expense. They are either nontaxable revenues (book revenues that are nontaxable) or nondeductible expenses (book expenses that are nondeductible).

Here accounting income is more to taxable income

So we need to create the deferred tax liability

Deferred tax Liability = $ 7 * 40% = $ 2.8 Million

Journal Entry

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Profit and Loss - Dr

2.8

To Deferred Tax Liability

2.8

(Being Deferred tax liability created on

installment sale of properties of $ 7 million)

b. Sherrod was assessed a penalty of $4 million by the Environmental Protection Agency for violation of a federal law in 2016. The fine is to be paid in equal amounts in 2016 and 2017.

It is a Permanent Difference so No Journal entry required for this adjustment

Income Statement : $11 (2015-2018)

Tax Return : $14 (2015), $20 (2016), $6 (2017), $4 (2018)

Difference : (3)2015, (9) 2016, 5 for 2017, 7 for 2018

It is a timing difference

For the year 2016 difference between Income statement and tax return for depreciation

Difference = 11-20 = 9

Here accounting income is more to taxable income

So we need to create the deferred tax liability

Deferred tax Liability = $ 9 * 40% = $ 3.6 Million

Journal Entry

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Profit and Loss - Dr

3.6

To Deferred Tax Liability

3.6

(Being Deferred tax liability created on

Depreciation difference of $ 9 Million)

Here the difference of warranty expenses allowed as per accounting and tax return

= 5-3 = $ 2 Million

Here accounting income is less as compared to taxable income

So we need to create the deferred tax asset for difference

Deferred tax Asset = $ 2 * 40% = $ 0.8 Million

Journal Entry

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Deferred Tax Asset - Dr

0.8

To Profit and Loss

0.8

(Being Deferred tax asset created on

warranty expenses of $ 2 million)

Here accrued expenses of $ 14 Million not allowed in the year 2016 under Tax return

So here taxable income is more as compared to accounting income

So we need to create the deferred tax asset for difference

Deferred tax Asset = $ 14 * 40% = $ 5.6 Million

Journal Entry

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Deferred Tax Asset - Dr

5.6

To Profit and Loss

5.6

(Being Deferred tax asset created on

Accrued expenses of $ 14 million)

f. During 2015, accounting income included an estimated loss of $2 million from having accrued a loss contingency. The loss is paid in 2016 at which time it is tax deductible.

Here the Loss is paid in 2016 and it is allowed under tax return during the year 2016

It is a reversal of Deferred tax asset

Deferred tax asset = $ 2 million * 40% = 0.8

Journal entry for reversal of deferred tax asset

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Profit and Loss - Dr

0.8

To Deferred Tax Asset

0.8

(Being Deferred tax asset reversed on

loss of $ 2 million)

Journal entry for Income tax for 2016

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Current Tax (62*40%)

24.8

Deferred Tax Asset (0.8+5.6-0.8)

5.6

To Profit and Loss

To Deferred Tax Liability (2.8+3.6)

6.4

(Being Income tax Recorded for the year 2016.)

Date

Accounting Particulars

Debit

Credit

31st Dec 2016

Profit and Loss - Dr

2.8

To Deferred Tax Liability

2.8

(Being Deferred tax liability created on

installment sale of properties of $ 7 million)

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Sherrod, Inc., reported pretax accounting income of $62 million for 2016. The fo

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