PwC’s tax case studies

Extra Corporation
Suggested solutions

Instructor note
This case assumes that the student holds little or no knowledge about accounting for book-tax
differences. Facts and comments are kept at an “entry level” throughout. You might add the
IFRS aspects as a research module to accompany this case.

You might distribute part 0 of this solution file to the students as a primer on the rules relating
to accounting for income taxes.

You might give some or all of the following items to the students, as a hint or prompt to help in
crafting the solution that is turned in.

I
You will use the completed listing of book-tax differences as a checklist to make certain that
your tax provision computations in part II are complete, so confirm your listing with your
instructor before you move to the next part of the assignment.

Not all of the listed trial balance amounts constitute a book-tax difference. Almost all of the
transactions of a business entity receive identical treatment for book and tax purposes.

II
When determining the current tax payable (“cash tax”) from the trial balance, first compute
state taxable income and tax, as this amount is a federal tax deduction for the year.

Now compute the deferred tax expense. This is the combined state and federal tax rate times
the total temporary differences.

Make certain that you keep your positive/negative signs correct as you compute the addition to
the deferred tax asset account. The largest temporary difference is the add-back to book
income due to changes in the UNICAP balance; this is a temporary increase in tax liabilities.

The tax provision (“tax expense”) is the sum of the current and deferred income tax amounts.

0
The expense for income taxes typically is one of the largest items on the income statement of a business.
Entities make interperiod allocations of the income tax expense because financial accounting and the
taxing system use different rules to accomplish different objectives. 1

Income tax rules are created by a large number of governmental jurisdictions, and financial accounting
rules are created by several different bodies as well. Some observers believe that the book expenses for
income taxes for the year should simply be the “cash tax” amount payable on the income tax returns for
the period, but this approach would ignore the matching principle of financial accounting, under which the
tax expense should be taken in the same accounting period as the income to which it relates.
Furthermore, it often takes longer in time for a client to determine tax payable amounts than is required to
compute book income for reporting purposes.

1
Thor Power Tool, 99 SCt 773 (1979).

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Instead, ASC 740 requires that the book tax expense relate to the income that is reported for the period. If
book income includes taxable or deductible amounts that are recognized in future time periods, a
deferred tax asset and/or liability is created on the balance sheet. This balance sheet approach to the
accounting for income taxes means that an asset or liability is created when a tax amount that relates to
current book income actually is recognized in a future period. The ASC 740 rules assume that all deferred
tax assets and liabilities are realized in full in the future.

Permanent and temporary book-tax differences

The vast majority of items encountered by a business enterprise are treated identically for financial
reporting and tax purposes. But some items receive differing treatment, and they are known as book-tax
differences. Book-tax differences for revenue and expense items are classified as permanent or
temporary.

Permanent differences are book items that never affect the taxable income computation. Permanent
differences affect the effective tax rate of the entity for the period (Pre-Tax Book Income/Tax Expense),
as reported in a footnote to the GAAP financial statements. A permanent difference might arise because:

• The tax law permanently excludes an income item. This reduces the entity’s effective tax rate.
• The tax law disallows a deduction for a book expense item in computing taxable income. This
increases the entity’s effective tax rate.
• The entity operates in a jurisdiction, say the US state of Nevada or the Cayman Islands, which does not
levy an income tax. This reduces the entity’s effective tax rate.

Temporary differences are book items that are recognized on the tax return in future reporting periods.
Temporary differences are summarized and accounted for on the balance sheet as deferred tax assets or
liabilities. This requires that the entity make journal entries to record the income tax expense (also called
the income tax provision) and any deferrals due to book-tax differences.

A book-tax difference that relates to taxable income that will be recognized in the future generally creates
a deferred tax liability. A book-tax difference that relates to a deduction that will be recognized in the
future generally creates a deferred tax asset. Deferred tax accounts are treated as non-current items on
the GAAP balance sheet.

Usually, temporary differences are recorded in one period and then “reverse” in the future, perhaps over a
period of years. Book amounts for future tax benefits are not recorded under financial accounting rules
unless it is more likely than not (> 50 percent probability) that they will occur. 2

Examples of book-tax differences include:

• Municipal bond interest (permanent)

• Bad debt reserves (current temporary, relating to accounts receivable)
• Depreciation computations (non-current temporary, relating to fixed assets)

Many balance sheets include both deferred tax assets and deferred tax liabilities, because these
accounts relate to various transactions and taxing jurisdictions. GAAP rules also discourage the “netting”
of large tax deferral amounts against each other, so that the balance sheet and its footnotes lose
transparency as to operating results that might be important to those who wish to analyze the financial
statements thoroughly.

2
ASC 740-10.

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Tax provision v tax payable

The tax payable (sometimes called cash tax) is the amount determined on the entity’s current-year tax
returns. This amount is calculated under the taxing rules of the various jurisdictions in which the business
operates. For most entities, these include taxes imposed by governments such as the US federal, one or
more US states, other countries, and states/provinces/etc. within the other countries. Tax payable
generally is computed relative to taxable income, and then certain tax credits and carryovers are allowed.

A tax provision (tax expense) is the amount used on financial accounting records to reduce book income.
The financial accounting rules of the US and other countries are used to summarize the entity’s current-
year results on its financial statements. The tax expense can be seen as the tax payable amount adjusted
for current-year tax deferrals relating to both taxable and deductible items.

GAAP provisions concerning tax deferrals are found chiefly in ASC 450 and ASC 740. Under the rules of
the International Financial Reporting Standards (IFRS), IAS 12 (2012) uses many of the same rules and
concepts as have been developed in GAAP. IFRS rules use a probable profits test regarding deferred tax
assets, in place of the GAAP more likely than not requirement.

For instance, some discussion about the proper accounting for income taxes asserts that tax deferrals are
not legally enforceable assets or liabilities of the entity, i.e., their recognition depends fully upon future
events, such that they are not balance sheet items similar to others included in the balance sheet.
Examples of seemingly-contingent subsequent events include the recognition of taxable income in future
tax years, so that a loss or credit carryforward can be used, or the fulfilling of statutory requirements to
avoid the pay-back of a tax credit, say because the required number of jobs were created by the entity
under the terms of the credit as granted by the taxing jurisdiction.

Applicable tax rates

Deferred tax accounts on the balance sheet are not discounted to their present values. The ASC 740
rules require that computations of the tax deferrals apply the tax rates that are scheduled to be in effect in
the future years when the temporary differences are expected to reverse.

Other than the reduction of corporate tax rates from 35% to 21% effective January 1, 2018, in the US,
only rarely are schedules of future tax rate changes enacted by Congress. This means that current rates
usually are expected to be used in the future, although expected income and loss amounts might push
the entity into higher or lower rates on a progressive tax rate schedule. A zero rate, though, never should
be used in constructing the tax deferral amounts.

If tax rates do change between the dates of the tax deferral and its recognition, the balance sheet
accounts are adjusted when the legislative change occurs.

Valuation allowance

A deferred tax asset is created when, say, the entity generates a tax net operating loss that it carries
forward to future years. The deferred tax asset, though, might be offset by a balance sheet contra-asset
account known as a valuation allowance. This book-only allowance is derived when the entity’s
management applies its professional judgment to determine that it is more likely than not (> 50 percent
probability) that some portion of the deferred tax asset never will be recognized on the income statements
of the business.

For instance, if taxable income projections are so low as to call into question whether an NOL
carryforward actually will be used, the entity creates a valuation allowance against the deferred tax asset.
Management can take into account its various tax planning strategies, e.g., to accelerate taxable income
into the period of the NOL carryforward, in constructing the valuation allowance.

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Summary of the steps

ASC 740 rules summarize the procedures used to construct a full accounting for the entity’s current and
deferred income tax expense.

Identify the types and amounts of permanent and temporary

book-tax differences that relate to current-year book income

For taxable temporary differences, use the applicable current

and future tax rates to determine any deferred tax liability

For deductible temporary differences, use the applicable

current and future tax rates to determine any deferred tax
asset

If it is more likely than not that some or all of a deferred tax

asset will not be realized, measure and apply a valuation
allowance to offset the asset

Track specific deferred tax assets and liabilities over their life
cycle and adjust them on future financial statements due to
changes in management expectations, tax planning
techniques, tax rates, and tax laws

Example

Trucco Limited has one book-tax difference to report. It uses accelerated tax depreciation for its operating
equipment, classified as a long-term asset on the balance sheet. This year, Trucco is subject to a blended
26 percent income tax rate. Its pre-tax book income totals $75, and the excess of tax over book
depreciation is $15.

Here is the journal entry to record the deferred tax liability relating to the depreciation.

Income Tax Expense (.26 x $75) 19.5

Income Tax Payable [.26 x ($75 – 15)] 15.6

Deferred Tax Liability – Non-Current 3.9

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Here is the presentation of the deferral on Trucco’s income statement.

Pre-Tax Book Income $75

Income Tax Expense

Current $15.6

Deferred 3.9 (19.5)

Financial Accounting Net Income $55.5

Example

Fallert Limited generated a tax net operating loss (NOL) this year of $35. It is subject to a 30 percent
blended income tax rate. Because NOLs can no longer be carried back, all NOLs must be carried
forward. The $35 NOL is carried forward to future tax years, to offset positive taxable income recognized
then.

Here is the journal entry to account for the current-year Fallert NOL. The debit is a balance sheet items
and the credit shows up on the income statement as an offset to the book net operating loss. The loss to
Fallert is really only $24.5 ($35 – 10.5), because of the tax benefits (current and future tax savings in
cash) from the NOL.

Deferred Tax Asset, NOL 10.5

Income Tax Benefit, NOL carryforward 10.5

Now assume that management projects that there will be positive operating income during the tax NOL
carryforward period sufficient only to use up to forty percent of the carryforward, several years from now.
A valuation allowance is created to reduce the deferred tax asset accordingly. The journal entry as
revised for this additional information is:

Deferred Tax Asset, NOL 10.5

Income Tax Benefit, forty percent of NOL carryforward 4.2

Valuation Allowance to Reduce Deferred Tax Asset to 6.3

Realizable Value – NOL Carryforward

The Fallert balance sheet is affected by the receivable, deferred tax asset, and valuation allowance. The
income tax benefit to reduce the $35 operating loss on the income statement is now only $4.2. Combined
with the valuation allowance, the deferred tax asset nets to $4.2, the tax benefit that is more likely than
not to be realized.

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Other financial reporting for taxes

The footnotes to the financial statements report the entity’s effective tax rate that falls on current book
income, often separately for US federal, US state/local, and international taxing jurisdictions. Some detail
is required to be disclosed as to the specific temporary book-tax differences that lead to the balance
sheet amounts. Other footnotes, e.g., relating to accounting methods and policies, the use of stock
options, and pension obligations, also include some information about the entity’s income tax positions.

In addition, a “rate reconciliation” is used to explain why the entity’s effective rate of income tax for the
period (Pre-tax Book Income/Tax Provision) is greater or less than its expected combined federal,
state/local, and international statutory tax rate. The rate reconciliation provides some detail concerning
the permanent book-tax differences that the entity employed for the reporting period, e.g., concerning the
non-taxable portion of dividend income received. It further might disclose the tax benefit resulting from the
entity’s use of reduced tax rates available through a treaty with another country.

Changes in the tax deferral accounts also are reflected in the entity’s statement of cash flows, usually
classified with continuing operating activities. 3 For instance, an increase in the deferred tax liability
account relating to the current-year tax provision generally is a positive amount in the cash flow
statement. This entry also should include adjustments to the deferrals that are caused by pertinent tax
rate and tax law changes.4

The income statement also discloses the entity’s obligations for other taxes, e.g., sales, property, excise,
and payroll taxes incurred. Book-tax differences from these items are rare, except as they might relate to
audit adjustments, and to governmental challenges over whether there is a need for the taxpayer to pay
taxes at all (these often are known as nexus or permanent establishment issues). But those obligations
are reported under the general GAAP rules for measuring contingent liabilities, 5 not ASC 740, which
relates only to income tax expenses and obligations.

Ethical considerations

Tax deferral accounts, and especially those relating to changes in the valuation allowances, turn to a
great extent on subjective decisions and projections that are made by management. Thus, some
observers maintain that there is an opportunity for the tax accounts to be used to “manage the income” of
the entity to meet or beat the expectations of analysts or the markets. The valuation allowance rules
require that a more-likely-than-not standard be met as to anticipated future events before the allowance is
adjusted. Documentation should be generous and contemporaneous in providing a rationale for the
changes in the valuation allowance.

Conceivably, changes to the valuation allowance are assessed and measured every reporting quarter for
the business. If an income-smoothing strategy is being executed and the business is profitable, one might
expect that the tax deferral valuation allowances would increase. But proper unbiased documentation
could be available to back up such an increase in the allowance as correct.

3
ASC 230.
4
ASC 740, ¶45.
5
ASC 450.

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Summary

Here is a summary of the most commonly encountered book-tax differences for entities that report using
GAAP rules, and the tax law reference as to the source of the chief pertinent tax rules.

General tax General book IRC section

Item Type treatment treatment reference

Depreciation Temporary Various accelerated Straight line, or 167,168, others

methods some acceleration

Muni Bond Interest Permanent Exclude Include 103

Dividends Received Permanent Exclude 50, 65, or 100 Include 243,245,246

percent

Meals Permanent Deduct 50 percent Expense 100% 274

Entertainment Permanent Nondeductible Expense 100% 274

Net Capital Loss Temporary Only to offset capital Subtract as incurred 1211
gains

Federal Income Tax Permanent Do not deduct Expense 275

State/Local Income Temporary Deduct Expense per 164

Tax provision amount

Bad Debts Temporary Deduct per specific Expense using 166

write-off allowance

Excessive Permanent Deduction limited to Expense 162

Compensation $1M if publicly traded

Qualified Plans Temporary Deduct per actuary, Expense 404, others

with 8 ½ month grace
period

Political Permanent Do not deduct Expense 162

Contributions, Most
Lobbying
Expenditures

UNICAP Costs re Temporary Capitalize into Usually expense 263A

Cost of Goods Sold inventory

Inventory Reserves Temporary Reserves not allowed Reserves allowed 471

LIFO Reserves Temporary Reserves not allowed Reserves allowed 472

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 General tax General book IRC section
Item Type treatment treatment reference

Self-Insurance Temporary Reserves not allowed Reserves allowed 461

Reserves

Warranty Reserves Temporary Reserves not allowed Reserves allowed 461

Accrued Vacation Temporary Deduct as paid, with 2 Reserves allowed 404

and Bonus ½ month grace period

Organization Costs Temporary Amortize over 180 Expense as incurred 248

months; one-year rule;
may deduct up to
$5,000 currently

Gain/Loss on Asset Temporary Reflect tax basis Reflect book cost 168,1245
Sale

Installment Sale Temporary Recognize gross profit Realize in year of 453, others
Gain over collection period sale

Gifts to Charity Temporary Deduct payment Expense 170

made within taxable
year, within income
limits, carryforward
excess

Prepaid Rent Temporary Include as received Realize as earned 451

Income

Goodwill, Temporary Amortize over 15 Expense per 197

purchased years impairment of value

Covenants not to Temporary Amortize over 15 Expense over 197

Compete years contract term

Software Developed Temporary Immediate deduction Amortize over useful 162,167

(through 2021), or 3 life
year amortization

Premiums Paid, Permanent Do not deduct Expense 264

Key Employee Life
Insurance

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 General tax General book IRC section
Item Type treatment treatment reference

Cash Surrender Permanent Exclude Include 101

Value Increase, Key
Employee Life
Insurance

Proceeds Received, Permanent Exclude Include 101

Key Employee Life
Insurance

Expenditures for Temporary Deduct as paid Expense as work is 41,174

R&D (through 2021), carried out
harmonize with credit

Luxury box, club Permanent Do not deduct Expense 274

dues

Futures and Temporary Include mark-to- Include as earned 1256

Options market amount at
year-end

References

Hoffman, et al, Southwest Federal Taxation: Corporations, 2018 ed, chapter 14 (Cengage).

No book-tax
Item difference Permanent Temporary

Advertising Costs 

Bad Debts 

Depreciation 

Fines, Penalties, Lobbying 

Expenditures

Legal and Accounting Fees 

Meals 

Salaries, Wages, Benefits 

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 No book-tax
Item difference Permanent Temporary

Tax NOL Carryforward 

Taxes Paid 

UNICAP adjustment 

Utilities Paid 

Vacation Accruals 

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 II
Extra Corporation
Trial balance to tax provision ($M)

Temporary Book- Permanent Book-

Item Amount Tax Differences Tax Differences

Pre-tax book profits, per

Trial Balance $ 555

Book-tax differences, Current tax payable

Unicap 190 $ 190 from case facts
NOL carryforward (75) (75) from case facts
Bad debts 30 30
Depreciation (35) (35)
Fines, penalties, lobbying 60 $ 60
Meals 30 30
Vacation accruals 50 50
State taxable income $ 805
State tax payable (40) 5%
Federal taxable income $ 765
Federal tax payable $ 161 21%
Current tax payable, total $ 201 A

Deferred tax expense

Total temporary differences $ 160

state income tax
Times combined state and is a federal tax
federal income tax rate 24.95% deduction
Addition to net deferred tax
asset, rounded $ 40 B
Tax provision $ 161 A+B

Proof
Book income $ 555 C
Net permanent differences 90 D
Income subject to tax $ 645 C+D
Combined tax rate 24.95%
Tax provision $ 161

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 III
Now we can construct the journal entry for our results. Some amounts are rounded.

Income Tax Expense 161

Deferred Tax Asset 67
Income Tax Payable 201
Deferred Tax Liability 27

To record income tax expenses and deferrals for the year

Notes

Deferred Tax Asset

Unicap adjustment 190
Disallowed vacation allowance 50
Disallowed bad debt allowance 30 270
Combined federal and state tax rate 24.95%
This year's change to the account 67

Deferred Tax Liability

NOL carryover used this year 75
Cost recovery differences 35 110
Combined federal and state tax rate 24.95%
This year's change to the account 27

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Thank you

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