Aq 10

How would the proceeds received from the advance sale of nonrefundable tickets for a theatrical
performance be reported in the seller’s financial statements before the performance?

Unearned revenue for the entire proceeds.
Answer (D) is correct.

Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring a
promised good or service to a customer. The good or service is transferred when the customer obtains
control of that good or service. The entire proceeds therefore should be credited to a contract liability
(deferred or unearned revenue) because the performance obligation will not be satisfied until the
performance has been given even though the tickets are not refundable.
Buc Co. receives deposits from its customers to protect itself against nonpayments for future services.
These deposits should be classified by Buc as
A contract liability.
Answer (A) is correct.

A customer deposit is a contract liability. It is an obligation to transfer goods or services to a customer for
which consideration already has been received from the customer. A contract liability does not qualify for
revenue recognition.
A state requires quarterly sales tax returns to be filed with the sales tax bureau by the 20th day following
the end of the calendar quarter. However, the state further requires that sales taxes collected be remitted
to the sales tax bureau by the 20th day of the month following any month such collections exceed $500.
These payments can be taken as credits on the quarterly sales tax return.
Taft Corp. operates a retail hardware store. All items are sold subject to a 6% state sales tax, which Taft
collects and records as sales revenue. The sales taxes paid by Taft are charged against sales revenue.
Taft pays the sales taxes when they are due.
Following is a monthly summary appearing in Taft’s first quarter sales revenue account:
Debit Credit
January -- $10,600
Februar
y $600 7,420
March -- 9,540
$600 $27,560
In its financial statements for the quarter ended March 31, Taft’s sales revenue and sales taxes payable
would be
Sales Revenue Sales Taxes Payable

$26,000 $960
Answer (B) is correct.

Because this company records both sales revenue and the 6% state sales tax as sales revenue, the
$27,560 in this account is equal to 106% of sales revenue. Sales revenue thus is equal to $26,000
($27,560 ÷ 1.06). The difference of $1,560 ($27,560 – $26,000) is the quarterly sales tax. Given that $600
of this sales tax has previously been remitted, sales tax payable is $960 ($1,560 quarterly sales tax –
$600 previously remitted).
In its Year 4 income statement, Cere Co. reported income before income taxes of $300,000. Cere
estimated that, because of permanent differences, taxable income for Year 4 would be $280,000. During
Year 4, Cere made estimated tax payments of $50,000, which were debited to income tax expense. Cere
is subject to a 30% tax rate. What amount should Cere report as income tax expense?
$84,000
A permanent difference does not result in a change in a deferred tax asset or liability, that is, in a deferred
tax expense or benefit. Thus, total income tax expense equals current income tax expense, which is the
amount of taxes paid or payable for the year. Income taxes payable for Year 4 equal $84,000 ($280,000
taxable income × 30%).
Salvador Co. sold 800,000 electronic can openers in Year 1. Based on past experience, the company
estimated that 10,000 of the 800,000 would prove to be defective and that 60% of these would be
returned for replacement under the company’s standard warranty against manufacturing defects. The cost
to replace an electronic can opener is $6.00.
On January 1, Year 1, the balance in the company’s estimated liability for warranties account was $3,000.
During Year 1, 5,000 electronic can openers were replaced under the warranty. The estimated liability for
warranties reported on December 31, Year 1, should be
$9,000

A standard warranty against manufacturing defects is an assurance-type warranty. This warranty creates
a loss contingency. A liability for warranty costs is recognized on the date the product is sold. At the time
of the sale of each electronic can opener, it is probable that a warranty liability has been incurred and its
amount can be reasonably estimated. Consequently, a warranty expense should be recognized with a
corresponding credit to an estimated liability for warranties account. As indicated below, the 1/1/Year 1
balance in this account is $3,000. It was increased during Year 1 by $36,000 (10,000 estimated defective
can openers × $6 replacement fee × 60% estimated replacement rate). The account should be decreased
by $30,000 (5,000 openers replaced × $6). Thus, the ending balance is $9,000.
Estimated Liability for Warranties
$ 3,0001/1/Year 1
Replacements$30,000 36,000Warranty expense
$ 9,00012/31/Year 1
Lime Co.’s payroll for the month ended January 31, Year 4, is summarized as follows:
Total wages $10,000
Federal income tax

withheld 1,200
All wages paid were subject to FICA. FICA tax rates were 7% each for employee and employer. Lime
remits payroll taxes on the 15th of the following month. In its financial statements for the month ended
January 31, Year 4, what amounts should Lime report as total payroll tax liability and as payroll tax
expense?
Liability Expense
$2,600 $700

The payroll liability is $2,600 ($1,200 federal income tax withheld + $700 employer’s FICA + $700
employees’ FICA). The payroll tax expense consists of the employer’s share of FICA. The employees’
share is considered a withholding, not an expense.
On December 31, Year 1, a publicly traded entity identified a tax position that will result in a $100,000 tax
benefit that qualifies for measurement and should be recognized. The entity has considered the amounts
and possible outcomes of the position being sustained upon examination as follows:
Possible Individual Cumulative

estimated probability probability
outcome of occurring of occurring
$100,000 20% 20%
30,000 35% 55%
10,000 45% 100%
100%
What amount should be recognized as the tax benefit as of December 31, Year 1?
$30,000
Answer (C) is correct.

In measuring a tax position, the entity recognizes the largest benefit that is more than 50% likely to be
realized. Because $30,000 is the largest benefit that is more likely than not to be realized upon settlement
(probability > 50%), the entity recognizes a tax benefit of $30,000.
Milzan Co., which began operations on January 1, Year 2, recognizes revenue from long-term
construction contracts using the input method based on costs incurred in its financial statements and
under the completed-contract method for income tax reporting. Under the completed-contract method,
revenue and gross profit are recognized only upon completion of the project. Income under each method
follows:
Completed- Percentage-
Year Contract of-Completion
Year 2$ -- $300,000
Year 3 400,000 600,000
Year 4 700,000 850,000

There are no other temporary differences. If the applicable tax rate is 25%, Milzan should report in its
balance sheet at December 31, Year 4, a deferred income tax liability of
$162,500
In its financial statements issued through 12/31/Year 4, Milzan has reported $1,750,000 ($300,000 +
$600,000 + $850,000) of income from long-term contracts. In its tax returns for the same period, it has
reported $1,100,000 ($400,000 + $700,000) of income from the same sources. The result is a taxable
temporary difference. Thus, Milzan expects to have future taxable amounts of $650,000 and should
recognize a deferred tax liability of $162,500 ($650,000 × 25% applicable tax rate). NOTE: The
completed-contract method is allowed only in limited circumstances under current federal tax law.
In preparing its December 31, Year 4, financial statements, Irene Corp. must determine the proper
accounting treatment of a $180,000 loss carryforward available to offset future taxable income. There are
no temporary differences. The applicable current and future income tax rate is 30%. Available evidence is
not conclusive as to the future existence of sufficient taxable income to provide for the future realization of
the tax benefit of the $180,000 loss carryforward. However, based on the available evidence, Irene
believes that it is more likely than not that future taxable income will be available to provide for the future
realization of only $100,000 of this loss carryforward. In its Year 4 statement of financial position, Irene
should recognize what amounts?
Deferred Tax Asset Valuation Allowance
$54,000 $24,000

The applicable tax rate should be used to measure a deferred tax asset for an operating loss carryforward
that is available to offset future taxable income. Irene should therefore recognize a $54,000 ($180,000 ×
30%) deferred tax asset. A valuation allowance should be recognized to reduce the deferred tax asset if,
based on the weight of the available evidence, the likelihood is more than 50% that some portion or all of
a deferred tax asset will not be realized. Based on the available evidence, Irene believes that it is more
likely than not that the tax benefit of only $100,000 of the operating loss will be realized. Thus, the
company should recognize a $24,000 valuation allowance to reduce the $54,000 deferred tax asset to
$30,000 ($100,000 × 30%).
According to U.S. GAAP, which of the following items should affect current income tax expense for Year
3?
Change in income tax rate for Year 3.
Current tax expense is the amount of income taxes paid or payable for a year (taxable income × enacted
tax rate).
On July 1, Year 4, Ran County issued realty tax assessments for its fiscal year ended June 30, Year 5.
The assessments are to be paid in two equal installments. On September 1, Year 4, Day Co. purchased a
warehouse in Ran County. The purchase price was reduced by a credit for accrued realty taxes. Day did
not record the entire year’s real estate tax obligation, but instead records tax expenses at the end of each
month by adjusting prepaid real estate taxes or real estate taxes payable, as appropriate. On November
1, Year 4, Day paid the first installment of $12,000 for realty taxes. What amount of this payment should
Day record as a debit to real estate taxes payable?
$8,000

The credit balance in real estate taxes payable at November 1, Year 4, is $8,000. This amount reflects
accrued real estate taxes of $2,000 a month [(2 × $12,000) ÷ 12 months] for 4 months (July through
October). This payable should be debited for $8,000 when the real estate taxes are paid.
A deferred tax asset must be reduced by a valuation allowance if it is

More likely than not that some portion will not be realized.
A deferred tax asset shall be reduced by a valuation allowance if the weight of the available evidence,
both positive and negative, indicates that it is more likely than not (that is, the probability is greater than
50%) that some portion will not be realized. The allowance should suffice to reduce the deferred tax asset
to the amount that is more likely than not to be realized. The effect of a change in the beginning balance
resulting from a new judgment about realizability is an item of income from continuing operations.
Under state law, Boca Co. may reimburse the state directly for actual unemployment claims or it may pay
3% of eligible gross wages. Boca believes that actual unemployment claims will be 2% of eligible gross
wages, and has chosen to reimburse the state. Eligible gross wages are defined as the first $15,000 of
gross wages paid to each employee. Boca had four employees, each of whom earned $20,000 during the
year. What amount should Boca report as accrued liability for unemployment claims in its year-end
balance sheet?
$1,200
Actual unemployment claims equal 2% of eligible gross wages, which are defined as the first $15,000 of
gross wages paid to each employee. Since Boca had four employees, each earning over $15,000 during
the year, the total eligible gross wages for the employees is $60,000 ($15,000 × 4). Boca will have to
reimburse the state $1,200 ($60,000 × 2%). This accrued liability should be reported in Boca’s year-end
balance sheet.
Quinn Co. reported a net deferred tax asset of $9,000 in its December 31, Year 1, balance sheet. For
Year 2, Quinn reported pretax financial statement income of $300,000. Temporary differences of $100,000
resulted in taxable income of $200,000 for Year 2. At December 31, Year 2, Quinn had cumulative taxable
temporary differences of $70,000. Quinn’s effective income tax rate is 30%. In its December 31, Year 2,
income statement, what should Quinn report as deferred income tax expense?
$30,000

Deferred tax expense or benefit is the net change during the year in the entity’s deferred tax liabilities and
assets. Quinn had a net deferred tax asset of $9,000 at the beginning of Year 2 and a net deferred tax
liability of $21,000 ($70,000 × 30%) at the end of Year 2. The net change (a deferred tax expense in this
case) is $30,000 ($9,000 reduction in the deferred tax asset + $21,000 increase in deferred tax liabilities).
Income-tax-basis financial statements differ from those prepared under GAAP because they
Recognize certain revenues and expenses in different reporting periods.

Financial statements prepared under the income tax basis of accounting and financial statements
prepared under GAAP differ when the tax basis of an asset or a liability and its reported amount in the
GAAP-based financial statements are not the same. The result will be taxable or deductible amounts in
future years when the reported amount of the asset is recovered or the liability is settled. Thus, certain
revenues and expenses are recognized in different periods. An example is subscriptions revenue
received in advance, which is recognized in taxable income when received and recognized in financial
income when earned in a later period. Another example is an assurance-type warranty liability, which is
recognized as an expense in financial income when a product is sold and recognized in taxable income
when the expenditures are made in a later period.
Intraperiod income tax allocation arises because
Items included in the determination of taxable income may be presented in different sections of the
financial statements.

To provide a fair presentation, GAAP require that income tax expense for the period be allocated among
continuing operations, discontinued operations, other comprehensive income, and items debited or
credited directly to equity.
In its Year 4 financial statements, Cris Co. reported interest expense of $85,000 in its income statement
and cash paid for interest of $68,000 in its cash flow statement. There was no prepaid interest or interest
capitalization at either the beginning or the end of Year 4. Accrued interest at December 31, Year 3, was
$15,000. What amount should Cris report as accrued interest payable in its December 31, Year 4,
balance sheet?
$32,000

The cash paid for interest was $68,000, including $15,000 of interest paid for Year 3. Consequently,
$53,000 ($68,000 – $15,000) of the cash paid for interest related to Year 4. Interest payable is therefore
$32,000 ($85,000 – $53,000).
For the year ended December 31, Mont Co.’s books showed income of $600,000 before provision for
income tax expense. To compute taxable income for federal income tax purposes, the following items
should be noted:
Income from exempt municipal bonds $ 60,000
Depreciation deducted for tax purposes in excess of
depreciation recorded on the books 120,000
Proceeds received from life insurance on death of officer 100,000
Estimated tax payments 0
Enacted corporate tax rate 30%

Ignoring the alternative minimum tax provisions, what amount should Mont report at December 31 as its
current federal income tax liability?
$96,000

Current income tax expense equals taxable income times the enacted tax rate. Taxable income equals
pretax accounting income adjusted for the items that are treated differently on the tax return and in the
accounting records.
Pretax accounting income $ 600,000
Tax-exempt municipal bond interest (60,000)
Excess of tax depreciation (120,000)
Untaxed life insurance proceeds (100,000)
Taxable income $ 320,000

Current income tax expense is therefore $96,000 ($320,000 × 30%). This amount is also the current
income tax liability because no estimated tax payments have been made.
Dunn Trading Stamp Company records stamp service revenue and provides for the cost of redemptions
in the year stamps are sold to licensees. Dunn’s past experience indicates that only 80% of the stamps
sold to licensees will be redeemed. Dunn’s liability for stamp redemptions was $6 million at December 31,
Year 3. Additional information for Year 4 is as follows:
Stamp service revenue from

stamps sold to licensees $4,000,000
Cost of redemptions
(stamps sold prior to

1/1/Yr 4) 2,750,000
If all the stamps sold in Year 4 were presented for redemption in Year 5, the redemption cost would be
$2,250,000. What amount should Dunn report as a liability for stamp redemptions at December 31,
Year 4?
$5,050,000

The liability for stamp redemptions at the beginning of Year 4 is given as $6 million. This liability would be
increased in Year 4 by $2,250,000 if all stamps sold in Year 4 were presented for redemption. However,
because only 80% are expected to be redeemed, the liability should be increased by $1,800,000
($2,250,000 × 80%). The liability was decreased by the $2,750,000 attributable to the costs of
redemptions. Thus, the liability for stamp redemptions at December 31, Year 4, is $5,050,000 ($6,000,000
+ $1,800,000 – $2,750,000).
Lyle, Inc., is preparing its financial statements for the year ended December 31, Year 3. Accounts payable
amounted to $360,000 before any necessary year-end adjustment related to the following:
 At December 31, Year 3, Lyle has a $50,000 debit balance in its accounts payable to Ross, a
supplier, resulting from a $50,000 advance payment for goods to be manufactured to Lyle’s
specifications.
 Checks in the amount of $100,000 were written to vendors and recorded on December 29, Year
3. The checks were mailed on January 5, Year 4.
What amount should Lyle report as accounts payable in its December 31, Year 3, balance sheet?
$510,000

The ending accounts payable balance should include amounts owed as of December 31, Year 3, on trade
payables. Although Lyle wrote checks for $100,000 to various vendors, that amount should still be
included in the accounts payable balance because the company had not surrendered control of the
checks at year end. The advance to the supplier was erroneously recorded as a reduction of (debit to)
accounts payable. This amount should be recorded as a prepaid asset, and accounts payable should be
credited (increased) by $50,000. Thus, accounts payable should be reported as $510,000 ($360,000 +
$50,000 + $100,000).
Zeff Co. prepared the following reconciliation of its pretax financial statement income to taxable income
for the year ended December 31, its first year of operations:
Pretax financial income $160,000
Nontaxable interest received on municipal securities (5,000)
Long-term loss accrual in excess of deductible

amount 10,000
Depreciation in excess of financial statement amount (25,000)
Taxable income $140,000

Zeff’s tax rate for the year is 40%. In its December 31 balance sheet, what should Zeff report as deferred
income tax liability?
$6,000

A deferred income tax liability arises from a taxable temporary difference. The $10,000 long-term loss
accrual (a deductible temporary difference) results in a deferred tax asset. The $25,000 excess
depreciation (a taxable temporary difference) results in a deferred tax liability. These items should be
netted because all deferred tax assets and liabilities should be offset and presented as a single amount.
Accordingly, the net deferred tax liability is $6,000 [($25,000 – $10,000) × 40%].
On a statement of financial position, all of the following should be classified as current liabilities except
Deferred income taxes for differences based on depreciation methods.

On the statement of financial position, deferred tax liabilities and assets are classified as noncurrent
amounts.
At the end of Year 4, the tax effects of Thorn Co.’s temporary differences were as follows:
Deferred
Tax Assets
(Liabilities)
Accelerated tax depreciation $(75,000)
Additional costs in inventory for tax purposes 25,000
$(50,000)
A valuation allowance was not considered necessary. Thorn anticipates that $10,000 of the deferred tax
liability will reverse in Year 5. In Thorn’s December 31, Year 4, balance sheet, what amount should Thorn
report as noncurrent deferred tax liability?
$50,000

In the statement of financial position, deferred tax liabilities and assets are classified as noncurrent
amounts. In addition, deferred tax liabilities and assets and any related valuation allowance are netted
and presented as a single noncurrent amount. Thus, in Thorn’s balance sheet, the deferred tax liability of
$50,000 ($75,000 – $25,000) must be classified as noncurrent.
Hudson Hotel collects 15% in city sales taxes on room rentals, in addition to a $2 per room, per night,
occupancy tax. Sales taxes for each month are due at the end of the following month, and occupancy
taxes are due 15 days after the end of each calendar quarter. On January 3, Year 5, Hudson paid its
November Year 4 sales taxes and its fourth quarter Year 4 occupancy taxes. Additional information
pertaining to Hudson’s operations is
Year 4 Room RentalsRoom Nights
October $100,000 1,100
Novembe
r 110,000 1,200
December 150,000 1,800

What amounts should Hudson report as sales taxes payable and occupancy taxes payable in its
December 31, Year 4, balance sheet?
Occupancy
Sales Tax
Taxes
$39,000
$8,200
Hudson presumably paid its October sales taxes during Year 4, but it did not pay sales taxes for
November and December and occupancy taxes for October, November, and December until Year 5.
Consequently, it should accrue a liability for sales taxes in the amount of $39,000 [($110,000 November
rentals + $150,000 December rentals) × 15%] and a liability for occupancy taxes in the amount of $8,200
[(1,100 + 1,200 + 1,800) room nights × $2].
Lamb Corp. has taxable income of $240,000 and depreciation expense for tax purposes of $50,000
greater than financial reporting purposes. Lamb has a tax rate of 30%, and no other differences exist.
Which of the following entries should Lamb make for deferred taxes?
$15,000 deferred tax liability.

Deferred tax liabilities and assets are recognized for the estimated future tax effects of temporary
differences and carryforwards. A deferred tax liability (asset) arises when the net income for financial
reporting purposes under GAAP is greater (smaller) than that for tax purposes. Because the depreciation
expense for tax purposes is greater than that for financial reporting purposes, Lamb’s net income under
GAAP is greater than taxable income by $50,000. Deferred tax liability is calculated as a future taxable
amount due to temporary differences multiplied by the tax rate. Accordingly, Lamb should record a
deferred tax liability of $15,000 ($50,000 × 30%).
Black Co., organized on January 2, Year 1, had pretax financial statement income of $500,000 and
taxable income of $800,000 for the year ended December 31, Year 1. The only temporary differences are
accrued product warranty costs, which Black expects to pay as follows:
Year 2 $100,000
Year 3 50,000
Year 4 50,000
Year 5 100,000
The enacted income tax rates are 25% for Year 1, 30% for Year 2 through Year 4, and 35% for Year 5.
Future profits will suffice to realize the full tax benefit of the deferred tax asset arising from the accrual of
warranty costs. In its December 31, Year 1, balance sheet, what amount should Black report as a
deferred tax asset?
$95,000

The warranty liability for Year 2 to Year 5 is equal to $300,000. Because warranty costs are not tax
deductible until actually incurred, the tax basis of the warranty liability is $0. Thus, the warranty costs
result in a deductible temporary difference and a deferred tax asset because the amounts will be tax
deductible in the future. The total deferred tax asset to be reported on December 31, Year 1, is $95,000
based on the enacted tax rates in effect when the temporary difference reverses.
Year 2 ($100,000 × 30%) $30,000
Year 3 ($50,000 × 30%) 15,000
Year 4 ($50,000 × 30%) 15,000
Year 5 ($100,000 × 35%) 35,000
Total deferred tax asset $95,000

The issue of whether to record a valuation allowance (a credit) need not be addressed because the
question asks solely for the amount of the deferred tax asset (a debit).
Aneen’s Video Mart sells 1- and 2-year mail order subscriptions for its video-of-the-month business.
Subscriptions are collected in advance and credited to sales. An analysis of the recorded sales activity
revealed the following:
Year 1 Year 2
Sales $420,000 $500,000
Cancellations (20,000) (30,000)

Net sales $400,000 $470,000
Subscriptions expirations:
Year 1 $120,000
Year 2 155,000 $130,000
Year 3 125,000 200,000
Year 4 140,000
$400,000 $470,000
In Aneen’s December 31, Year 2, balance sheet, the balance for unearned subscription revenue should
be
$465,000
An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised
good or service to a customer. The balance for unearned subscription revenue (a contract liability) should
reflect the advance collections for which the performance obligation is not satisfied. Thus, the unexpired
subscriptions as of 12/31/Yr 2 total $465,000 ($125,000 + $200,000 + $140,000), which is the balance for
unearned subscription revenue.
Toddler Care Co. offers three payment plans on its 12-month contracts. Information on the three plans
and the number of children enrolled in each plan for the September 1, Year 1, through August 31, Year 2,
contract year follows:
Monthly
Initial Payment Fees per Number of
Plan per Child Child Children
#1 $500 $ -- 15
#2 200 30 12
#3 -- 50 9
36
Toddler received $9,900 of initial payments on September 1, Year 1, and $3,240 of monthly fees during
the period September 1 through December 31, Year 1. In its December 31, Year 1, balance sheet, what
amount should Toddler report as deferred revenues?
$6,600
Unearned (deferred) revenues (a contract liability) relate to the portion of the contracts for which the
performance obligation has not been satisfied by transfer of promised services. At December 31, Year 1,
deferred revenues should equal $6,600 [$9,900 prepayments received × (8 months ÷ 12 months)].
For its first year of operations, Cable Corp. recorded a $100,000 expense in its tax return that will not be
recorded in its accounting records until next year. There were no other differences between its taxable
and financial statement income. Cable’s effective tax rate for the current year is 45%, but a 40% rate has
already been passed into law for next year. In its year-end balance sheet, what amount should Cable
report as a deferred tax asset (liability)?
$40,000 liability.
A temporary difference is the difference between the tax basis of an asset or liability and its reported
amount in the financial statements that will result in taxable or deductible amounts in future years when
the reported amount of the asset is recovered or the liability is settled. A future taxable amount results
from the recovery of an asset related to any expense or loss that is deductible for tax purposes prior to
being recognized in financial income. An example is a long-term asset that is amortized or depreciated for
tax purposes more quickly than for financial reporting. A deferred tax liability is recognized for a taxable
temporary difference. It is measured using the enacted tax rate(s) expected to be in effect when the
temporary difference is settled. Accordingly, the entity should recognize a deferred tax liability of $40,000
($100,000 expense to be recognized next year × 40% tax rate enacted for next year).
A retail store received cash and issued a gift certificate that is redeemable in merchandise. When the gift
certificate was issued, a
Deferred revenue should be increased.
Revenue should be recognized when (or as) the entity satisfies a performance obligation by transferring a
promised good or service (merchandise) to a customer. The good or service is transferred when the
customer obtains control of that good or service. Consequently, when a gift certificate is issued, the entity
receiving cash should record the issuance as a contract liability (deferred or unearned revenue).
Conch Shell Company sells gift cards, redeemable for merchandise, that expire 1 year after their
issuance. Conch Shell has the following information pertaining to its gift cards sales and redemptions:
Unredeemed at 12/31/Year 1 $150,000
Year 2 sales 500,000
Year 2 redemptions of prior-year sales 50,000
Year 2 redemptions of current-year sales 350,000

Conch Shell’s experience indicates that 10% of gift certificates sold will not be redeemed. In its
December 31, Year 2, balance sheet, what amount should Conch Shell report as deferred revenue?
$100,000
Because the cards expire after 1 year, all revenue from sales prior to Year 2 has been earned. Thus, the
unearned revenue balance for gift card sales at the end of Year 2 relates solely to Year 2 sales. Given
Year 2 sales of $500,000 and redemptions of $350,000, $150,000 of cards are unredeemed at year end.
However, 10% of total cards sold in Year 2 ($500,000 × 10% = $50,000) are not expected to be
redeemed. Accordingly, deferred revenue is $100,000 ($150,000 – $50,000).
During Year 1, Gum Co. introduced a new product carrying a standard 2-year warranty against defects.
The estimated warranty costs related to dollar sales are 2% within 12 months following the sale and 4% in
the second 12 months following the sale. Sales and actual warranty expenditures for the years ended
December 31, Year 1 and Year 2, are as follows:
Actual Warranty
Sales Expenditures
Year 1$150,000 $2,250
Year 2 250,000 7,500
$400,000 $9,750
What amount should Gum report as estimated warranty liability in its December 31, Year 2, balance
sheet?
$14,250

A standard warranty against manufacturing defects is an assurance-type warranty. This warranty
creates a loss contingency. A liability for warranty costs is recognized on the date the product is sold.
Because this product is new, the beginning balance in the estimated warranty liability account at the
beginning of Year 1 is $0. For Year 1, the estimated warranty costs related to dollar sales are 6% (2% +
4%) of sales, or $9,000 ($150,000 × 6%). For Year 2, the estimated warranty costs are $15,000
($250,000 × 6%). These amounts are charged to warranty expense and credited to the estimated
warranty liability account. This liability account is debited for expenditures of $2,250 and $7,500 in Year
1 and Year 2, respectively. Hence, the estimated warranty liability at 12/31/Year 2 is $14,250.
Estimated Liability for Warranties
$ 01/1/Year 2
Year 1 expenditures $2,250 9,000Year 1 expense
Year 2 expenditures $7,500 15,000Year 2 expense
$14,25012/31/Year 2
Hill Corp. began production of a new product. During the first calendar year, 1,000 units of the product
were sold for $1,200 per unit. Each unit had a two-year warranty. Based on warranty costs for similar
products, Hill estimates that warranty costs will average $100 per unit. Hill incurred $12,000 in warranty
costs during the first year and $22,000 in warranty costs during the second year. The company uses the
expense warranty accrual method. What should be the balance in the estimated liability under warranties
account at the end of the first calendar year?
$88,000
A liability for warranty costs is recognized when the related revenue is recognized (i.e., on the day the
product is sold). Even if the warranty covers a period longer than the period in which the product is sold,
the entire liability for the expected warranty costs must be recognized on the day the product is sold.
Thus, in the first calendar year a warranty liability of $100,000 (1,000 units × $100 estimated warranty
cost per unit) was recognized. Actual payments for warranty costs reduce the amount of warranty liability
recognized. Thus, at the end of the first calendar year, the balance of the warranty liability is $88,000
($100,000 warranty liability initially recognized – $12,000 actual warranty costs incurred during the first
year).
Stone Co. began operations in the current year and reported $225,000 in income before income taxes for
the year. Stone’s current year tax depreciation exceeded its book depreciation by $25,000. Stone also
had nondeductible book expenses of $10,000 related to permanent differences. Stone’s tax rate for the
year was 40%, and the enacted rate for subsequent years is 35%. In its December 31 balance sheet,
what amount of deferred income tax liability should Stone report?
$8,750

In measuring a deferred tax liability or asset, the objective is to use the enacted tax rate(s) expected to
apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled
or realized. At 12/31, the only temporary difference is the $25,000 excess of tax depreciation over the
book depreciation. This temporary difference will give rise to a $25,000 taxable amount in subsequent
years. Given the enacted tax rate of 35% applicable after the current year, the total tax consequence
attributable to the taxable temporary difference (the deferred tax liability) is $8,750 ($25,000 × 35%).
The following information pertains to Dash Co.’s utility bills:
Period covered Amount Date paid
April 16 – May
15 $5,000 June 1
May 16 – June 15 $6,000 July 1
June 16 – July 15 $8,000 August 1

What is the amount that Dash should report as a liability in its June 30 balance sheet?
$10,000
Liabilities are existing obligations of a specific entity to transfer assets or provide services to other entities
as a result of previous transactions or events. As of June 30, the unpaid $6,000 covering the period
between May 16 and June 15 is an existing obligation to pay (when it is paid on July 1, the liability is
removed by debiting the liability and crediting cash). The utilities expense accrued between June 16 and
June 30 of $4,000 (half of that covered between June 16 and July 15) also represents an existing
obligation to transfer assets (a $4,000 debit to utilities expense and a $4,000 credit to the liability).
Therefore, Dash should report a liability of $10,000 ($6,000 + $4,000) in its June 30 balance sheet.
At the beginning of the current year, Hayworth Co. sold equipment with a 2-year service warranty for a
single payment of $20,000. The service warranty can be purchased separately by the customer. The fair
value of the equipment was $18,000. Hayworth recorded this transaction with a debit of $20,000 to cash
and a credit of $20,000 to sales revenue. Assuming the proper entry was made for cost of goods sold,
which of the following statements is correct regarding Hayworth’s current-year financial statements?
Net income will be overstated.

A warranty that can be purchased separately by the customer is a service-type warranty. A service-type
warranty is a separate performance obligation in the contract. Thus, a portion of the total transaction price
is allocated to the service-type warranty. At contract inception, the consideration received for the service-
type warranty is accounted for as an advance payment, and a contract liability is recognized. Revenue
from a service-type warranty is recognized over the 2-year service period. Revenue and net income
therefore are overstated in the year of sale.
Which of the following circumstances would result in a deferred tax asset for the current year?
Expenses that are recognized in financial income this year and deductible next year.

An expense recognized in financial income this year and deductible next year results in a future
deductible amount. A deferred tax asset records the deferred tax consequences of deductible temporary
differences and carryforwards (future deductible amounts). It is measured using the enacted tax rate and
enacted tax law.
For calendar Year 1, Clark Corp. reported depreciation of $300,000 in its income statement. On its Year 1
income tax return, Clark reported depreciation of $500,000. Clark’s income statement also included
$50,000 of accrued warranty expense that will be deducted for tax purposes when paid. Applicable
enacted tax rates are 30% for Year 1 and Year 2, and 25% for Year 3 and Year 4. The depreciation
difference and warranty expense will reverse over the next 3 years as follows:
Depreciation Warranty
Difference Expense
Year 2 $ 80,000 $10,000
Year 3 70,000 15,000
Year 4 50,000 25,000

$200,000 $50,000
These were Clark’s only temporary differences. In Clark’s Year 1 income statement, the deferred portion
of its provision for income taxes should be
$41,000

Deferred tax expense or benefit is the net change during the year in the entity’s deferred tax liabilities
and assets. Given that the temporary differences related to the depreciable assets and the warranty
liability arose in Year 1, the deferred tax asset and liability balance sheet position at the beginning of
Year 1 was $0. The scheduled effects of the temporary difference related to the depreciable assets are
taxable amounts of $80,000 in Year 2, $70,000 in Year 3, and $50,000 in Year 4. The scheduled effects
of the temporary difference related to the accrued warranty liability are deductible amounts of $10,000
in Year 2, $15,000 in Year 3, and $25,000 in Year 4. As indicated below, the net taxable amount in each
year equals the excess of the taxable amount over the deductible amount scheduled for that year.
Clark’s tax consequences for each year are equal to the product of the net taxable amount and the
applicable enacted tax rate(s). The total of the tax consequences is the net deferred tax liability position
at December 31, Year 1.
Depreciation Warranty Taxable Enacted Net Tax
Difference Expense Amount Tax Rate Consequences
Year 2$ 80,000 –$10,000 =$70,000 × 30% =$21,000
Year 3 70,000 – 15,000 = 55,000 × 25% = 13,750
Year 4 50,000 – 25,000 = 25,000 × 25% = 6,250
$200,000 $50,000 $41,000
Deferred tax expense is thus $41,000 ($41,000 ending net deferred tax liability – $0 beginning balance).
Cory, Inc., uses the accrual method of accounting for financial reporting purposes and appropriately uses
the installment method of accounting for income tax purposes. Installment income of $250,000 will be
collected in the following years when the applicable enacted tax rates are
Collection Enacted
Year of Income Tax Rates
1 $ 25,000 30%
2 50,000 30%
3 75,000 30%
4 100,000 25%
The installment income is Cory’s only temporary difference. What amount should be included in the
deferred income tax liability in Cory’s December 31, Year 1, balance sheet?
$62,500

At 12/31/Yr 1, the temporary difference related to the installment receivable is equal to $225,000 ($50,000
scheduled to reverse in Year 2, $75,000 in Year 3, and $100,000 in Year 4). The scheduled effects of the
temporary difference result in taxable amounts. As indicated below, multiplying these taxable amounts by
the applicable enacted tax rates determines the tax consequences.
Taxable Enacted Tax
Year Amount Tax Rate Consequences
2 $ 50,000 × 30% =$15,000
3 75,000 × 30% = 22,500
4 100,000 × 25% = 25,000
$62,500
The $62,500 total is equal to the deferred income tax liability that should be included in the 12/31/Yr 1
balance sheet.
On January 1, Glen Co. leased a building to Dix Corp. The lease was properly classified as an operating
lease by Glen for a 10-year term at an annual rental of $50,000. The lease was properly classified as an
operating lease. At the inception of the lease, Glen received $200,000 covering the first 2 years’ rent of
$100,000 and a security deposit of $100,000. This deposit will not be returned to Dix upon expiration of
the lease but will be applied to payment of rent for the last 2 years of the lease. What portions of the
$200,000 should be shown as a current and a long-term liability, respectively, in Glen’s December 31
balance sheet?
Current Liability Long-Term Liability

$50,000 $100,000

Of the $200,000 received at the inception of the lease on 1/1, $50,000 should be recognized as rental
income for the year ended 12/31. At 12/31, the $50,000 attributable to rent for the following year should
be classified as a current liability. Also at 12/31, the $100,000 that is applicable to the last 2 years of the
lease should be classified as a long-term liability.
As a result of differences between depreciation for financial reporting purposes and tax purposes, the
financial reporting basis of Noor Co.’s sole depreciable asset acquired in the current year exceeded its tax
basis by $250,000 at December 31. This difference will reverse in future years. The enacted tax rate is
30% for the current year and 40% for future years. Noor has no other temporary differences. In its
December 31 balance sheet, how should Noor report the deferred tax effect of this difference?
As a liability of $100,000.

The temporary difference arises because the excess of the reported amount of the depreciable asset over
its tax basis will result in taxable amounts in future years when the reported amount is recovered. A
taxable temporary difference results in a deferred tax liability. Because the enacted tax rate for future
years is 40%, the deferred income tax liability is $100,000 ($250,000 × 40%).
Shear, Inc., began operations in Year 1. Included in Shear’s Year 1 financial statements were credit loss
expenses on accounts receivable of $1,400 and profit from an installment sale of $2,600. For tax
purposes, the credit losses will be deducted and the profit from the installment sale will be recognized in
Year 2. The applicable tax rate is 25%. In its Year 1 income statement, what amount should Shear report
as deferred income tax expense?
$300

assets. The deductible temporary difference related to credit loss expense gives rise to a future
deductible amount of $1,400 and a deferred tax asset of $350 ($1,400 × 25% applicable tax rate). The
taxable temporary difference related to the installment sale gives rise to a future taxable amount of $2,600
and a deferred tax liability of $650 ($2,600 × 25% applicable tax rate). Hence, the entity’s deferred tax
asset has increased by $350 ($350 – $0) and its deferred tax liability by $650 ($650 – $0) in the first year
of operations. The net change is $300 ($650 deferred tax liability increase – $350 deferred tax asset
increase), which is the amount of the deferred income tax expense.
Bloy Corp.’s payroll for the pay period ended October 31, Year 4, is summarized as follows:
Amount of Wages
Subject to
Federal
Depart- Income Payroll Taxes
ment Total Tax Unemploy-
Payroll Wages Withheld FICA ment
Factory $ 60,000 $ 7,000 $56,000 $18,000
Sales 22,000 3,000 16,000 2,000
Office 18,000 2,000 8,000 --
$100,000 $12,000 $80,000 $20,000

Assume the following payroll tax rates:
FICA for employer and employee7% each
Unemployment 3%
What amount should Bloy accrue as its share of payroll taxes in its October 31, Year 4, balance sheet?
$6,200
The amount of wages subject to payroll taxes for FICA purposes is $80,000. At a 7% rate, the employer’s
share of FICA taxes equals $5,600 ($80,000 × 7%). Wages subject to unemployment payroll taxes are
$20,000. At a 3% rate, unemployment payroll taxes equal $600 ($20,000 × 3%). Consequently, the total of
payroll taxes is $6,200 ($5,600 + $600). A 7% employee rate also applies to the wages subject to FICA
taxes. This amount ($80,000 × 7% = $5,600) should be withheld from the employee’s wages and remitted
directly to the federal government by the employer, along with the $6,200 in employer payroll taxes. The
employee’s share, however, should be accrued as a withholding tax (an employee payroll deduction) and
not as an employer payroll tax.
Rice Co. salaried employees are paid biweekly. Advances made to employees are paid back by payroll
deductions. Information relating to salaries follows:
12/31/Yr 1 12/31/Yr 2
$24,00
Employee advances 0 $ 36,000
Accrued salaries payable 40,000 ?
Salaries expense during the year 420,000
Salaries paid during the year (gross) 390,000

In Rice’s December 31, Year 2, balance sheet, accrued salaries payable was
$70,000

Accrued salaries payable at the beginning of the year represents salary expense incurred in the preceding
year that was unpaid as of the end of that year. Salaries expense for the current year is recorded as a credit to
salaries payable. Salaries paid during the current year are debited to salaries payable. The beginning balance,
plus the credit, minus the debit is equal to the ending balance indicated below. Employee advances have no
effect on accrued salaries payable. An asset is debited as the advances are made and credited as they are
repaid by the employees.
Salaries Payable
$ 40,00012/31/Yr 1
Salaries paid $390,000 420,000Salaries expense
$ 70,00012/31/Yr 2
For the week ended June 30, Free Co. paid gross wages of $20,000, from which federal income taxes of
$2,500 and FICA were withheld. All wages paid were subject to FICA tax rates of 7% each for employer
and employees. Free makes all payroll-related disbursements from a special payroll checking account.
What amount should Free have deposited in the payroll checking account to cover net payroll and related
payroll taxes for the week ended June 30?
$21,400

At a 7% rate, the employer’s share of FICA taxes on $20,000 in gross wages equals $1,400. A 7%
employee rate also applies to the wages subject to FICA taxes. This $1,400 amount should be withheld
from the employees’ wages and remitted directly to the federal government by the employer along with
the $1,400 in employer payroll taxes. Consequently, the total amount that Free must pay for payroll and
payroll taxes is $21,400 ($20,000 gross wages + $1,400). The employees’ share of FICA taxes, along
with the federal income taxes withheld, should be accrued as withholding taxes (an employee payroll
deduction) and not as employer payroll taxes. Also, the $20,000 of gross wages already includes the
amount of federal income taxes and employee-paid FICA taxes withheld. The employee actually receives
the net amount.
Oak Co. offers a standard 3-year warranty against manufacturing defects on its products. Oak previously
estimated warranty costs to be 2% of sales. Due to a technological advance in production at the
beginning of Year 4, Oak now believes 1% of sales to be a better estimate of warranty costs. Warranty
costs of $80,000 and $96,000 were reported in Year 2 and Year 3, respectively. Sales for Year 4 were
$5 million. What amount should be disclosed in Oak’s Year 4 financial statements as warranty expense?
$50,000
An assurance-type warranty creates a loss contingency. The change affects only Year 4 sales. No change
in the previously recorded estimates is necessary. Thus, the debit to warranty expense is $50,000
($5,000,000 sales × 1%). Estimated liability under warranties is credited for $50,000.
Selected financial information for Windham, Inc., for the year just ended is shown below.
Pretax income $5,000,000
Interest received on municipal bonds 600,000
Gain on the sale of land reported

this
year but not taxable until next year 1,000,000
Tax rate for all years 40%
Beginning balances:
Income taxes payable -0-
Deferred tax liability $50,000
The total income tax expense reported on Windham’s income statement for the year just ended should be
$1,760,000

Taxable income consists of pretax income adjusted for those items that give rise to tax differences.
Taxable income is therefore $3,400,000 ($5,000,000 – $600,000 – $1,000,000), and current tax expense
is $1,360,000 ($3,400,000 × 40%). The interest on municipal bonds is a permanent difference because it
is tax-exempt, i.e., it is recognized in GAAP income but never in taxable income. Permanent differences
have no deferred tax effects. However, the gain on the sale of land is a temporary difference because it is
included in GAAP income this year and is included in taxable income in the future. This temporary
difference gives rise to a future taxable amount, specifically, a $400,000 deferred tax liability ($1,000,000
× 40%). This credit to the deferred tax liability account is balanced by a debit to income tax expense. Total
income tax expense for the year is therefore $1,760,000 ($1,360,000 current portion + $400,000 deferred
portion).
On June 1, Year 2, Archer, Inc. issued a purchase order to Cotton Co. for a new copier machine. The
machine requires one month to produce and is shipped f.o.b. destination on July 1, Year 2, and is
received by Archer on July 15, Year 2. Cotton issues a sales invoice dated July 2, Year 2, for the machine.
As of what date should Archer record a liability for the machine?
July 15, Year 2.

FOB destination means title and risk of loss pass to the buyer when the seller makes a proper tender of
delivery of the goods at the destination. Thus, the title for the new copier machine and risk of loss passed
to Archer only on July 15, Year 2, when the copier machine was received. Accordingly, the liability for the
machine should be recorded only on July 15, Year 2.
Acme Co.’s accounts payable balance at December 31 was $850,000 before necessary year-end
adjustments, if any, related to the following information:
 At December 31, Acme has a $50,000 debit balance in its accounts payable resulting from a
payment to a supplier for goods to be manufactured to Acme’s specifications.
 Goods shipped FOB destination on December 20 were received and recorded by Acme on
January 2. The invoice cost was $45,000.
In its December 31 balance sheet, what amount should Acme report as accounts payable?
$900,000
The payment to a supplier for goods to be manufactured to specifications should have been recorded by
a debit to a prepaid asset, not accounts payable. Accordingly, accounts payable should be $900,000
($850,000 + $50,000 error correction). The goods shipped FOB destination were not received until
January 2, so they were appropriately excluded from accounts payable at year end. When the shipping
term is FOB destination, the buyer records inventory and a payable when the goods are tendered at the
destination (when title and risk of loss pass).
Orlean Co., a cash-basis taxpayer, prepares accrual-basis financial statements. In its current-year
balance sheet, Orlean’s deferred income tax liabilities increased compared with those reported for the
prior year. Assume that, for tax purposes, expenditures are deducted when actually paid. Which of the
following changes would cause this increase in deferred income tax liabilities?
I. An increase in prepaid insurance

II. An increase in rent receivable
III. An increase in warranty obligations
I and II only.

An increase in prepaid insurance signifies the recognition of a deduction on the tax return of a cash-basis
taxpayer but not in the accrual-basis financial statements. The result is a temporary difference giving rise
to taxable amounts in future years when the reported amount of the asset is recovered. An increase in
rent receivable involves recognition of revenue in the accrual-basis financial statements but not in the tax
return of a cash-basis taxpayer. This temporary difference also will result in future taxable amounts when
the asset is recovered. A deferred tax liability records the tax consequences of taxable temporary
differences. Hence, these transactions increase deferred tax liabilities. An increase in warranty obligations
is a noncash expense recognized in accrual-basis financial statements but not on a modified-cash-basis
tax return. The result is a deductible temporary difference and an increase in a deferred tax asset.
Lucas Company computed the following deferred tax balances for the 2 most recent years. Deferred tax
assets are considered fully realizable.
Year 1 Year 2
Deferred tax assets $9,000$17,000
Deferred tax liabilities13,000 23,000
If Lucas calculates taxable income of $1,000,000 for Year 2 and is taxed at an enacted income tax rate of
40%, how much income tax expense will be reported on Lucas’s income statement for Year 2?
$402,000

assets. It is aggregated with the current tax expense or benefit to determine total income tax expense for
the year. The amount of income taxes payable (current tax expense) is $400,000 ($1,000,000 × 40%).
The deferred tax assets increased by $8,000 ($17,000 – $9,000) and the deferred tax liabilities increased
by $10,000 ($23,000 – $13,000). Thus, Lucas’ income tax expense for Year 2 is $402,000 ($400,000
current tax expense – $8,000 increase in the deferred tax assets + $10,000 increase in the deferred tax
liabilities).
Lind Co.’s salaries expense of $10,000 is paid every other Friday for the 10 workdays then ending. Lind’s
employees do not work on Saturdays and Sundays. The last payroll was paid on June 18. On
Wednesday, June 30, the month-end balance in the salaries expense account before accruals was
$14,000. What amount should Lind report as salaries expense in its income statement for the month
ended June 30?
$22,000
The salaries expense per day is $1,000 ($10,000 per pay period ÷ 10 days per period). Given that
June 18 was a payday (a Friday), June 4 also was a payday (a Friday). Accordingly, June has 22
workdays (June 1-4 + June 7-11 + June 14-18 + June 21-25 + June 28-30). Salaries expense for June is
therefore $22,000 (22 days × $1,000).
A liability that represents the accumulated difference between the income tax expense reported on the
firm’s books and the income tax actually paid is
Deferred taxes.
Deferred tax liabilities arise when temporary differences in book and taxable income result in future
taxable amounts. Deferred tax assets arise when temporary differences in book and taxable income result
in future deductible amounts.
Regal Department Store sells gift certificates, redeemable for merchandise, that expire 1 year after their
issuance. Regal has the following information pertaining to its gift certificates sales and redemptions:
Unredeemed at 12/31/Year 1 $ 75,000
Year 2 sales 250,000
Year 2 redemptions of prior-year sales 25,000
Year 2 redemptions of current-year sales 175,000

Regal’s experience indicates that 10% of gift certificates sold will not be redeemed. In its December 31,
Year 2, balance sheet, what amount should Regal report as unearned revenue?
$50,000

promised good or service (merchandise) to a customer. The good or service is transferred when the
customer obtains control of that good or service. Because the certificates expire after 1 year, all revenue
from sales prior to Year 2 is recognized because no performance obligation remains to be satisfied. Thus,
the unearned revenue (contract liability) balance for gift certificate sales at the end of Year 2 relates solely
to Year 2 sales. Given Year 2 sales of $250,000 and redemptions of $175,000, $75,000 of certificates are
unredeemed at year end. However, 10% of total certificates sold in Year 2 ($250,000 × 10% = $25,000)
are not expected to be redeemed. Accordingly, unearned revenue is $50,000 ($75,000 – $25,000).
Ram Corp. prepared the following reconciliation of income per books with income per tax return for the
year ended December 31, Year 1:
Book income before income taxes $750,000
Add temporary difference:
Construction contract revenue that will
reverse in Year 2 100,000
Deduct temporary difference:
Depreciation expense that will reverse in
equal amounts in each of the next 4 years (400,000)

Ram’s effective income tax rate is 34% for Year 1. What amount should Ram report in its Year 1 income
statement as the current provision for income taxes?
$153,000

Current income tax expense or benefit is equal to taxable income multiplied by the effective income tax
rate. Thus, Ram should report $153,000 ($450,000 × 34%) as the current provision for income taxes.
Delect Co. provides repair services for the AZ195 TV set. Customers prepay the fee on the standard 1-
year service contract. The Year 1 and Year 2 contracts were identical, and the number of contracts
outstanding was substantially the same at the end of each year. However, Delect’s December 31, Year 2,
deferred revenue balance on unperformed service contracts was significantly less than the balance at
December 31, Year 1. Which of the following situations might account for this reduction in the deferred
revenue balance?
Most Year 2 contracts were signed earlier in the calendar year than were the Year 1 contracts.

control of that good or service. Service contract revenue should be recognized over time as the services
are provided. An appropriate measure of the entity’s progress to complete satisfaction of the performance
obligation also must be selected. Service contract fees are not recognized until the services are provided
and the performance obligation is satisfied. Thus, the fees collected in advance should be reported as
unearned (deferred) revenue (a contract liability) in the liability section of the balance sheet until the
services are provided. The earlier a service contract is signed, the longer the time to provide the service
and satisfy the performance obligation. Thus, if most contracts outstanding on December 31, Year 2, were
signed earlier in the period than those outstanding a year earlier, the deferred revenue balance should
have decreased.
Which of the following is usually associated with payables classified as accounts payable?
Periodic Payment of Interest Secured by Collateral
No No

Accounts payable, commonly termed trade accounts payable, are liabilities reflecting the obligations to
sellers that are incurred when an entity purchases inventory, supplies, or services on credit. Accounts
payable should be recorded at their settlement value. Short-term liabilities, such as accounts payable, do
not usually provide for a periodic payment of interest unless the accounts are not settled when due or
payable. They also are usually not secured by collateral.
West Corp. leased a building and received the $36,000 annual rental payment on June 15, Year 4. The
lease was classified as an operating lease. The beginning of the lease was July 1, Year 4. Rental income
is taxable when received. West’s tax rates are 30% for Year 4 and 40% thereafter. West had no other
permanent or temporary differences. West determined that no valuation allowance was needed. What
amount of deferred tax asset should West report in its December 31, Year 4, balance sheet?
$7,200

The $36,000 rental payment is taxable in full when received in Year 4, but only $18,000 [$36,000 × (6 ÷
12)] should be recognized in financial accounting income for the year. The result is a deductible
temporary difference (deferred tax asset) arising from the difference between the tax basis ($0) of the
liability for unearned rent and its reported amount in the year-end balance sheet ($36,000 – $18,000 =
$18,000). The income tax payable for Year 4 based on the rental payment is $10,800 ($36,000 × 30% tax
rate for Year 4), the deferred tax asset is $7,200 ($18,000 future deductible amount × 40% enacted tax
rate applicable after Year 4 when the asset will be realized), and the income tax expense is $3,600
($10,800 current tax expense – $7,200 deferred tax benefit). The deferred tax benefit equals the net
change during the year in the entity’s deferred tax liabilities and assets ($7,200 deferred tax asset
recognized in Year 4 – $0).
Sable Co., organized on January 2, Year 1, had pretax accounting income of $300,000 and taxable
income of $800,000 for the year ended December 31, Year 1. Sable expected to maintain this level of
taxable income in future years. The only temporary difference is for accrued product warranty costs
expected to be paid as follows:
Year 2$100,000
Year 3 150,000
Year 4 150,000
Year 5 100,000
The applicable enacted income tax rate is 30%. In Sable’s December 31, Year 1, balance sheet, the
deferred income tax asset and related valuation allowance should be

$150,000 $0

Sable should report an accrued product warranty liability of $500,000. The result is a deductible
temporary difference of $500,000 because the liability will be settled and related amounts will be tax
deductible when the warranty costs are incurred. A deferred tax asset should be measured for deductible
temporary differences using the applicable tax rate. Hence, Sable should record a $150,000 ($500,000 ×
30%) deferred tax asset. A valuation allowance should be used to reduce a deferred tax asset if, based on
the weight of the available evidence, it is more likely than not that some portion will not be realized. In this
case, Sable had taxable income of $800,000 for Year 1 and expects to maintain that level of taxable
income in future years. The positive evidence therefore indicates that sufficient taxable income will be
available for the future realization of the tax benefit of the existing deductible temporary differences. Given
no negative evidence, a valuation allowance is not necessary.
On December 2, Huff Corp. received a condemnation award of $450,000 as compensation for the forced
sale of land purchased 5 years earlier for $300,000. The gain was not reported as taxable income on its
income tax return for the year ended December 31 because Huff elected to replace the land within the
allowed replacement period for at least $450,000. Huff has an income tax rate of 25% for the current year,
and the enacted rate is 30% for subsequent years. There were no other temporary differences. In its
December 31 balance sheet, Huff should report a deferred income tax liability of
$45,000

The $150,000 gain was not taxable, but the tax basis of the asset is reduced by the amount of the
unrecognized gain. Consequently, when the reported amount of the asset is recovered, a taxable amount
of $150,000 will result. The related deferred tax liability is $45,000 ($150,000 × 30% enacted rate for
subsequent years).
Under state law, Acme may pay 3% of eligible gross wages or it may reimburse the state directly for
actual unemployment claims. Acme believes that actual unemployment claims will be 2% of eligible gross
wages and has chosen to reimburse the state. Eligible gross wages are defined as the first $10,000 of
gross wages paid to each employee. Acme had five employees, each of whom earned $20,000 during
Year 4. In its December 31, Year 4, balance sheet, what amount should Acme report as accrued liability
for unemployment claims?
$1,000

A contingent liability should be accrued when it is probable that a liability has been incurred and the
amount can be reasonably estimated. Thus, Acme should accrue a liability for $1,000 [(5 employees ×
$10,000) eligible wages × 2%].
Temporary differences arise when expenses are deductible for tax purposes
After They Are Recognized in Financial Income Before They Are Recognized in Financial Income
Yes Yes
A temporary difference exists when (1) the reported amount of an asset or liability in the financial
statements differs from the tax basis of that asset or liability, and (2) the difference will result in taxable or
deductible amounts in future years when the asset is recovered or the liability is settled at its reported
amount. A temporary difference may also exist although it cannot be identified with a specific asset or
liability recognized for financial reporting purposes. Temporary differences most commonly arise when
either expenses or revenues are recognized for tax purposes either earlier or later than in the
determination of financial income.
Zeff Co. prepared the following reconciliation of its pretax financial statement income to taxable income
for the year ended December 31, its first year of operations:
Pretax financial income $160,000
Nontaxable interest received on municipal securities (5,000)
Long-term loss accrual in excess of deductible

amount 10,000
Depreciation in excess of financial statement amount (25,000)

Zeff’s tax rate for the year is 40%. In its income statement, what amount should Zeff report as income tax
expense -- current portion?
$56,000
Pretax financial income is adjusted for permanent and temporary differences to arrive at the current
taxable income. The current portion of income tax expense equals income taxes paid or payable as
determined by applying enacted tax law. Thus, the current portion of income tax expense equals $56,000
($140,000 × 40%).
For the year ended December 31, Tyre Co. reported pretax financial statement income of $750,000. Its
taxable income was $650,000. The difference is due to accelerated depreciation for income tax purposes.
Tyre’s effective income tax rate is 30%, and Tyre made estimated tax payments during the year of
$90,000. What amount should Tyre report as current income tax expense for the year?
$195,000

Current income tax expense equals taxable income for the year times the applicable enacted rate, or
$195,000 ($650,000 × 30%).
On April 1, Ash Corp. began offering a new product for sale under a 1-year assurance-type warranty. Of
the 5,000 units in inventory at April 1, 3,000 had been sold by June 30. Based on its experience with
similar products, Ash estimated that the average warranty cost per unit sold would be $8. Actual warranty
costs incurred from April 1 through June 30 were $7,000. At June 30, what amount should Ash report as
estimated warranty liability?
$17,000

An assurance-type warranty creates a loss contingency. A liability for warranty costs is recognized on the
date the product is sold. If 3,000 units were sold at an estimated $8 per unit warranty cost, the total
credits to the liability account equaled $24,000 (3,000 × $8). Given that actual warranty costs of $7,000
were debited to the account, the ending balance must have been $17,000 ($24,000 – $7,000).
During Year 3, Rex Co. introduced a new product carrying a 2-year warranty against defects. The
estimated warranty costs related to dollar sales are 2% within 12 months following sale and 4% in the
second 12 months following sale. Sales and actual warranty expenditures for the years ended
December 31, Year 3 and Year 4, are as follows:
Actual Warranty
Sales Expenditures
Year 3$ 600,000 $ 9,000
Year 4 1,000,000 30,000
$1,600,000 $39,000
At December 31, Year 4, Rex should report an estimated warranty liability of
$57,000

An assurance-type warranty creates a loss contingency. Because this product is new, the beginning
balance in the estimated warranty liability account at the beginning of Year 3 is $0. For Year 3, the
estimated warranty costs related to dollar sales are 6% (2% + 4%) of sales or $36,000 ($600,000 ×
6%). For Year 4, the estimated warranty costs are $60,000 ($1,000,000 sales × 6%). These amounts
are charged to warranty expense and credited to the estimated warranty liability account. This liability
account is debited for expenditures of $9,000 and $30,000 in Year 3 and Year 4, respectively. Thus, the
estimated warranty liability at 12/31/Yr 4 is $57,000.
Estimated Warranty Liability
$ 0 1/1/Yr 3
Year 3 expenditures $ 9,000 36,000 Year 3 expense
Year 4 expenditures 30,000 60,000 Year 4 expense
$57,000 12/31/Yr 4
Fay Corp. pays its outside salespersons fixed monthly salaries and commissions on net sales. Sales
commissions are computed and paid on a monthly basis (in the month following the month of sale), and
the fixed salaries are treated as advances against commissions. However, if the fixed salaries for
salespersons exceed their sales commissions earned for a month, such excess is not charged back to
them. Pertinent data for the month of March for the three salespersons are as follows:
Fixed Commission
Salesperso
n Salary Net Sales Rate
A $10,000 $ 200,000 4%
B 14,000 400,000 6%
C 18,000 600,000 6%
Totals $42,000 $1,200,000

What amount should Fay accrue for sales commissions payable at March 31?
$28,000

No sales commissions will be payable to salesperson A whose fixed salary ($10,000) exceeds
commissions on net sales ($200,000 × 4% = $8,000). The accrued payable to B is $10,000 [($400,000 ×
6%) – $14,000]. The accrued payable to C is $18,000 [($600,000 × 6%) – $18,000]. Hence, the total
accrual is $28,000.
Miro Co. began business on January 2, Year 1. Miro used the double-declining balance method of
depreciation for financial statement purposes for its building and the straight-line method for income
taxes. On January 16, Year 3, Miro elected to switch to the straight-line method for both financial
statement and tax purposes. The building cost $240,000 in Year 1, which has an estimated useful life of
15 years and no salvage value. Information related to the building is as follows:
Double-declining Straight-line
Yearbalance depreciationdepreciation
1 $30,000 $16,000
2 20,000 16,000
Miro’s tax rate is 40%.
Which of the following statements is correct?
Miro’s deferred tax asset should be reduced by $554 in Year 3.

The difference between the tax basis and the carrying amount of a depreciable asset is a temporary
difference. This temporary difference will result in future deductible amounts after Year 2 because more
depreciation was recognized in Year 1 and Year 2 for financial-statement purposes than for tax purposes.
Thus, after Year 2, the tax basis of the building was $208,000 ($240,000 – $16,000 – $16,000), and its
carrying amount was $190,000 ($240,000 – $30,000 – $20,000), a difference of $18,000. The result was
a deferred tax asset of $7,200 ($18,000 future deductible amount × 40% tax rate). However, Miro
changed to the straight-line depreciation method for tax and financial statements purposes at the
beginning of Year 3. A change in a method of depreciation is accounted for prospectively as a change in
estimate because the change in principle is inseparable from the change in estimate. Hence, Miro will
recognize $190,000 of depreciation in its financial statements for the remainder of the building’s estimated
useful life (13 years, starting in Year 3). During the same period, Miro will deduct $208,000 on its tax
return (assuming sufficient taxable income). Miro’s depreciation expense for Year 3 is $14,615 ($190,000
÷ 13 years). The excess tax deduction (assuming sufficient taxable income) is $1,385 ($16,000 –
$14,615), so the reduction in the deferred tax asset is $554 ($1,385 × 40%).
Barnel Corp. owns and manages 19 apartment complexes. On signing a lease, each tenant must pay the
first and last months’ rent and a $500 refundable security deposit. The security deposits are rarely
refunded in total because cleaning costs of $150 per apartment are almost always deducted. About 30%
of the time, the tenants are also charged for damages to the apartment, which typically cost $100 to
repair. If a 1-year lease is signed on a $900 per month apartment, what amount would Barnel report as
refundable security deposit?
$500

The refundable security deposit is a liability. It involves a probable future sacrifice of economic benefits
arising from a current obligation of a particular entity to transfer assets or provide services to another
entity in the future as a result of a past transaction. The reported amount of the liability for the refundable
security deposit ($500) is the probable future sacrifice of economic benefits. It may be in the form of (1) a
$500 refund or (2) the sum of an estimated $320 refund, $150 of cleaning costs, and $30 of damages.
In its first 4 years of operations, Alder, Inc.’s depreciation for income tax purposes exceeded its
depreciation for financial statement purposes. This temporary difference was expected to reverse over the
next 3 years. Alder had no other temporary differences. Alder’s balance sheet for its fourth year of
operation should include
A noncurrent deferred tax liability only.

Because of differences between the financial and tax reporting of depreciation, the financial reporting
basis of Alder’s depreciable assets exceeded their tax basis. The result is a temporary difference. Based
on the assumption that amounts related to the future recovery of the depreciable assets recorded for
financial reporting purposes will exceed their remaining tax basis, the excess will be taxable when the
assets are recovered. Thus, the recovery of the reported amounts of these assets will give rise to taxable
amounts. The deferred tax consequences of taxable amounts are recognized as deferred tax liabilities.
Deferred taxes are classified as noncurrent amounts.
In its Year 3 income statement, Noll Corp. reported depreciation of $400,000. Noll reported depreciation of
$550,000 on its Year 3 income tax return. The difference in depreciation is the only temporary difference,
and it will reverse equally over the next 3 years. Assume that the enacted income tax rates are 35% for
Year 3, 30% for Year 4, and 25% for Year 5 and Year 6. What amount should be included in the deferred
income tax liability in Noll’s December 31, Year 3, balance sheet?
$40,000
At 12/31/Year 3, the only temporary difference is the $150,000 ($550,000 – $400,000) excess of
the tax depreciation over the book depreciation. This temporary difference will give rise to a
$50,000 taxable amount in each of the years Year 4 through Year 6. Given the enacted tax rates
of 30% in Year 4 and 25% in Year 5 and Year 6, the total tax consequences are $40,000, which is
the balance that should be reported in the deferred income tax liability at year end.
Taxable Enacted Tax
Year Amount Tax Rates Consequences
4 $50,000 × 30% = $15,000
5 50,000 × 25% = 12,500
6 50,000 × 25% = 12,500
$40,000
An entity receives an advance payment for special order goods that are to be manufactured and delivered
within 6 months. The advance payment should be reported in the company’s balance sheet as a
Current liability.

The contract liability for the advance payment is classified in the balance sheet as current. It is an
obligation that will be either liquidated using current assets or replaced by another current liability. The
advance is for special order goods that are to be manufactured and delivered within 6 months. Thus, the
obligation will be liquidated using current assets, and the advance payment should be reported as a
current liability.
Long-term obligations that are or will become callable by the creditor because of the debtor’s violation of
a provision of the debt agreement at the balance sheet date should be classified as
Current liabilities unless the creditor has waived the right to demand repayment for more than 1 year from
the balance sheet date.

A current liability is an obligation that will be either liquidated using a current asset or replaced by another
current liability. Current liabilities also include (1) obligations that by their terms are or will be due on
demand within 1 year (or the operating cycle, if longer), and (2) obligations that are or will be callable by
the creditor within 1 year because of a violation of a debt covenant. An exception exists, however, if the
creditor has waived or subsequently lost the right to demand repayment for more than 1 year (or the
operating cycle, if longer) from the balance sheet date.
Harrison Corporation entered into a 3-year construction contract. Revenue is recognized over time using
the input method based on costs incurred for financial income and the completed contract method for
taxable income. Under the completed-contract method, revenue and gross profit are recognized only
upon completion of the project. Harrison expected the project to be profitable throughout the construction
period. The effect on Harrison’s financial statements for the third year of this contract would be a(n)
Decrease in the deferred tax liability account.

For the first two years of the contract, Harrison reports more revenue for financial reporting purposes than
for tax purposes, giving rise to a deferred tax liability. Upon completion of the contract, Harrison reports all
the revenue on its tax return, thereby decreasing the deferred tax liability.
Current liabilities include which of the following items?
I. Obligations due on demand within 1 year

II. Obligations callable at any time by the creditor
III. Obligations that will be replaced by other current liabilities
I and III only.
A current liability is an obligation that will be either liquidated using current assets or replaced by another
current liability. Current liabilities also include (1) obligations that, by their terms, are or will be due on
demand within 1 year (or the operating cycle if longer), and (2) obligations that are or will be callable by
the creditor within 1 year because of a violation of a debt covenant.
Grey operates as a retail fabric seller. Some customers pick out rolls of fabric and place deposits with
Grey to set the rolls aside for future delivery. Grey records the cash receipts on these transactions as
layaway plan sales. However, title to the fabric passes to the customer only when the full sales price is
received by Grey. The average gross margin on the fabric is 75% of sales. The following pertinent data
were taken from Grey’s December 31 unadjusted trial balance:
Regular sales $2,500,000
Layaway plan sales $1,000,000
Deposits from
customers $0
An analysis of the layaway plan sales revealed that $600,000 was received in full payment for fabric
delivered to customers during the year. In Grey’s December 31 balance sheet, deposits from customers
will be
$400,000
Title to the goods does not pass and the goods are not delivered until payment is made in full. Thus, Grey
has not satisfied a performance obligation by transferring promised goods to customers related to
layaway plan sales not yet fully paid. Grey therefore should recognize a contract liability for deposits from
customers of $400,000 ($1,000,000 layaway plan sales – $600,000 fully paid layaway plan sales).
When accounting for income taxes, a temporary difference occurs in which of the following scenarios?
An item is included in the calculation of net income in one year and in taxable income in a different year.
A temporary difference results when the GAAP basis and the tax basis of an asset or liability differ. The
effect is that a taxable or deductible amount will occur in future years when the asset is recovered or the
liability is settled. But some temporary differences are not related to an asset or liability for financial
reporting. Thus, temporary differences occur when revenues or gains, or expenses or losses, are used to
calculate net income under GAAP in a year before or after being used to calculate taxable income
Rein, Inc., reported deferred tax assets and deferred tax liabilities at the end of both Year 3 and Year 4.
For the year ended in Year 4, Rein should report deferred income tax expense or benefit equal to the
Sum of the net changes in deferred tax assets and deferred tax liabilities.
assets.
A retail store sold gift certificates that are redeemable in merchandise. The gift certificates lapse one year
after they are issued. How would the deferred revenue account be affected by each of the following?
Redemptionof Certificates Lapse ofCertificates
Decrease Decrease

When the gift certificates are sold, the retail store records deferred revenue (a contract liability). When the
certificates are redeemed or lapse, the store reclassifies deferred revenue as revenue because no
performance obligation remains to be satisfied. Thus, the redemption and lapse of certificates decrease
deferred revenue.
On December 31, Year 4, special insurance costs, incurred but unpaid, were not recorded. If these
insurance costs were related to work-in-process at year end, what is the effect of the omission on accrued
liabilities and retained earnings in the December 31, Year 4, balance sheet?
Accrued
Retained Earnings
Liabilities
No effect
Understated

Special insurance costs related to work-in-process should be debited to work-in-process and credited to
accrued liabilities. The effect of their omission is to understate assets and accrued liabilities. Retained
earnings will be unaffected until the goods are sold and the costs are recognized as part of the cost of
goods sold in the determination of net income.
East Corp. manufactures stereo systems that carry a 2-year warranty against defects. Based on past
experience, warranty costs are estimated at 4% of sales for the warranty period. During the year, stereo
system sales totaled $3 million, and warranty costs of $67,500 were incurred. In its income statement for
the year ended December 31, East should report warranty expense of
$120,000

An assurance-type warranty creates a loss contingency. A liability for warranty costs is recognized on the
date the product is sold. Warranty expense equals 4% of sales for the period, or $120,000 ($3,000,000 ×
4%).
Which of the following statements is correct regarding valuation allowances in accounting for income
taxes?
The effect of a change in the opening balance of a valuation allowance that results from a change of
circumstances ordinarily is included in income from operations.

A valuation allowance reduces a deferred tax asset. It is recognized if it is more likely than not (probability
> 50%) that some portion of the tax benefit of the asset will not be realized. At a subsequent reporting
date, a new judgment based on facts, circumstances, and information at the reporting date may require a
change in a valuation allowance. This revision ordinarily is an item of income from continuing operations.
Leer Corp.’s pretax income for the current year is $100,000. The temporary differences between amounts
reported in the financial statements and the tax return are as follows:
 Depreciation in the financial statements was $8,000 more than tax depreciation.
 The equity method of accounting resulted in financial statement income of $35,000.
 A $25,000 dividend was received from an equity-method investee during the year, which is
eligible for the 80% dividends received deduction (DRD).
Leer’s effective income tax rate is 30%. In its income statement, Leer should report a current provision for
income taxes of
$23,400

Current tax expense is the amount of income taxes paid or payable for a year as determined by applying
the provisions of the enacted tax law to the taxable income for that year. Pretax accounting income is
given as $100,000. Financial statement depreciation exceeds tax depreciation by $8,000. Accounting
income includes $35,000 of income determined in accordance with the equity method, but taxable income
includes only $5,000 of this amount [$25,000 dividend received – ($25,000 × 80%) dividends received
deduction]. The reconciliation of pretax accounting income to taxable income is as follows:
Pretax accounting income $100,000
Excess of
fin. stmt. depreciation 8,000
Untaxed equity method income (35,000)
Taxable portion of dividend:
Dividend received $ 25,000
Dividends received deduction
($25,000 × 80%) (20,000) 5,000

Accordingly, the current provision for income taxes is $23,400 ($78,000 × 30%).
Among the items reported on Cord, Inc.’s income statement for the year ended December 31 were the
following:
Compensation expense for a stock option plan $50,000
Insurance premium on the life of an officer
(Cord is the owner and beneficiary.) 25,000

Neither is deductible for tax purposes. Temporary differences amount to
$0
Expenses for compensation expense for a stock option plan and payment of a premium for life insurance
covering a key executive are recognized in the financial statements but are not deductible under the
provisions of the federal tax code. Because neither will result in taxable or deductible amounts in future
years, they are permanent, not temporary differences.
Winn Co. sells subscriptions to a specialized directory that is published semiannually and shipped to
subscribers on April 15 and October 15. Subscriptions received after the March 31 and September 30
cutoff dates are held for the next publication. Cash from subscribers is received evenly during the year
and is credited to deferred revenues from subscriptions. Data relating to Year 2 are as follows:
Deferred revenues from subscriptions,
balance 12/31/Year 1 $ 750,000
Cash receipts from subscribers 3,600,000

In its December 31, Year 2, balance sheet, Winn should report deferred revenues from subscriptions of
$900,000
The deferred revenues (a contract liability) from subscriptions account records subscription fees received
for which the performance obligation has not been satisfied by transfer of promised goods to customers.
The balance in this account in the December 31, Year 2, balance sheet should reflect the subscription
fees received after the September 30 cutoff date. Because cash from subscribers is received evenly
during the year, $900,000 [$3,600,000 × (3 months ÷ 12 months)] should be reported as deferred
revenues from subscriptions.
Taft Corp. uses the equity method to account for its 25% investment in Flame, Inc. During the year, Taft
received dividends of $30,000 from Flame and recorded $180,000 as its equity in the earnings of Flame.
All the undistributed earnings of Flame will be distributed as dividends in future periods. The dividends
received from Flame are eligible for the 80% dividends received deduction. There are no other temporary
differences. Enacted income tax rates are 30% for the current year and thereafter. In its December 31
balance sheet, what amount should Taft report for deferred income tax liability?
$9,000

The deferred tax liability constitutes the “deferred tax consequences attributable to taxable temporary
differences. A deferred tax liability is measured using the applicable enacted tax rate and provisions of the
enacted tax law.” Taft’s recognition of $180,000 of equity-based earnings creates a temporary difference
that will result in taxable amounts in future periods when dividends are distributed. The deferred tax
liability arising from this temporary difference is measured using the 30% enacted tax rate and the
dividends received deduction. Accordingly, given that all the undistributed earnings will be distributed, a
deferred tax liability of $9,000 [($180,000 equity – $30,000 dividends received) × 20% not deductible ×
30% tax rate applicable after the current year] should be reported.
The relationship between income tax currently payable and income tax expense is that income tax
currently payable
May differ from income tax expense.

Tax consequences are an event’s effects on income taxes. Income taxes currently payable for a particular
year usually include the tax consequences of most of the events recognized in the financial statements for
that same year. However, certain significant exceptions exist. As a result, the tax consequences of some
transactions or events may be recognized in income taxes currently payable or refundable in a year
different from that in which their financial-statement effects are recognized. Moreover, some transactions
or events may have tax consequences or financial-statement effects but never both. Because of these
differences, income taxes currently payable may differ from (exceed or be less than) income tax expense.
The accounting for these differences is known as interperiod tax allocation.
A customer is considering buying a television set with a retail price of $2,000. The customer asks the
store manager if the store will consider paying the sales tax so that the total cash payment is $2,000. The
sales tax is 8%. The store manager agrees to accept $2,000 cash. What should the accountant credit in
this transaction?
Sales Sales tax payable

$1,852 $148

Sales taxes are paid by the buyer but are collected and remitted by the seller. Sales tax is calculated as a
percentage of the purchase price paid by the buyer. The total payment of $2,000 includes both (1) the
purchase price of the television set (the sales recognized by the store) and (2) 8% sales tax on the
purchase price of the television set (sales tax payable account). Thus, the following journal entry is
recorded by the accountant: cash is debited for $2,000, sales account is credited for the net-of-tax
amount paid for the television set of $1,852 ($2,000 ÷ 108%), and sales tax payable is credited for $148
($1,852 × 8%).
During the current year, Casual Wear Co. had total retail sales of $800,000 and collected a 5% state
sales tax on all sales. At the end of the prior year, Casual Wear had $4,500 in sales taxes that had not
been remitted to the state authorities. During the current year, Casual Wear remitted $39,500 in state
sales tax. What amount should be recorded in Casual Wear’s current-year financial statements?
$5,000 in sales tax payable.

During the current year, $40,000 ($800,000 × 5%) of state sales taxes were collected. The year-end
amount of sales tax payable is $5,000 ($4,500 beginning balance of sales tax payable + $40,000 sales
taxes collected during the year – $39,500 sales taxes remitted during the year).
Ross Co. pays all salaried employees on a Monday for the 5-day workweek ended the previous Friday.
The last payroll recorded for the year ended December 31, Year 4, was for the week ended December 25,
Year 4. The payroll for the week ended January 1, Year 5, included regular weekly salaries of $80,000
and vacation pay of $25,000 for vacation time earned in Year 4 not taken by December 31, Year 4. Ross
had accrued a liability of $20,000 for vacation pay at December 31, Year 3. In its December 31, Year 4,
balance sheet, what amount should Ross report as accrued salary and vacation pay?
$89,000

The salary accrual at December 31, Year 4, was for a 4-day period (December 28-31). Thus, the accrued
salary (amount earned in Year 4 but not paid until Year 5) should be $64,000 [$80,000 in salaries for a 5-
day week × (4 days ÷ 5 days)]. Vacation pay ($25,000) for time earned but not taken in Year 4 was not
paid until Year 5. Hence, $25,000, not $20,000, should have been accrued at year end. The total accrual
is $89,000 ($64,000 + $25,000).
On December 31, Year 4, Deal, Inc., failed to accrue the December Year 4 sales salaries that were
payable on January 6, Year 5. What is the effect of the failure to accrue sales salaries on working capital
and cash flows from operating activities in Deal’s Year 4 financial statements?
Working Capital Cash Flows from Operating Activities

Overstated No effect
The effect is to overstate working capital (Current assets – Current liabilities) because of the failure to
accrue a current liability by a debit to salaries expense and a credit to salaries payable. The error has no
effect on cash flows because an accrual does not involve a cash payment or receipt.
Kamchatka sells a durable good on January 1, Year 1, and the customer is automatically given a 1-year
standard warranty against manufacturing defects. The customer also buys an extended warranty
package, extending the coverage for an additional 2 years to the end of Year 3. At the time of the original
sale, the company expects warranty costs to be incurred evenly over the life of the warranty contracts.
The customer has only one warranty claim during the 3-year period, and the claim occurs during Year 2.
The company will recognize revenue from the sale of the extended warranty
In Years 2 and 3.

Because the extended warranty was purchased separately, it is classified as a service-type warranty.
Revenue from a service-type warranty is recognized over the coverage period. Because warranty costs
are expected to be incurred evenly over the life of the warranty contracts, the revenue should be
recognized on the straight-line basis over the life of the extended warranty contract.
In its first year of operations, Aviator Corp. took a deduction of $20,000 on its tax return. Its effective tax
rate was 35%, resulting in a tax benefit of $7,000. Aviator believes that it is more likely than not that this
deduction will be sustained based on its technical merits. However, Aviator prefers not to litigate the
matter and would accept a settlement offer. Aviator has considered the amounts and probabilities of the
possible estimated outcomes as follows:
Possible Estimate OutcomeIndividual Probability of Occurring %Cumulative Probability of Occurring
$7,000 35 35
5,500 25 60
3,000 25 85
1,500 15 100
What is the amount of tax benefit Aviator Corp. should recognize in its financial statements?
$5,500

An entity recognizes in its financial statements the largest benefit that is more than 50% likely to be
realized upon settlement. Because $5,500 is the largest amount of benefit that has a greater than 50%
likelihood of being realized, Aviator recognizes a tax benefit of $5,500 in its financial statements.
On the first day of each month, Bell Mortgage Co. receives from Kent Corp. an escrow deposit of $2,500
for real estate taxes. Bell records the $2,500 in an escrow account. Kent’s Year 2 real estate tax is
$28,000, payable in equal installments on the first day of each calendar quarter. On December 31, Year 1,
the balance in the escrow account was $3,000. On September 30, Year 2, what amount should Bell show
as an escrow liability to Kent?
$4,500

Through the first three quarters, Kent’s deposits were $22,500 ($2,500 × 9 months), and the tax payments
totaled $21,000 [3 × ($28,000 ÷ 4 quarters)]. Consequently, the escrow balance should be $4,500 ($3,000
beginning balance + $22,500 – $21,000).
Rabb Co. records its purchases at gross amounts but wishes to change to recording purchases net of
purchase discounts. Discounts available on purchases recorded from October 1, Year 3, to September
30, Year 4, totaled $2,000. Of this amount, $200 is still available in the accounts payable balance. The
balances in Rabb’s accounts as of and for the year ended September 30, Year 4, before conversion are
Purchases $100,000
Purchase discounts
taken 800
Accounts payable 30,000

What is Rabb’s accounts payable balance as of September 30, Year 4, after the conversion?
$29,800

The gross method records purchases and accounts payable without regard to purchase discounts
available, for example, cash discounts for early payment. The net method records purchases and
accounts payable at the cash (discounted) price. If the accounts payable balance at the gross amount is
$30,000 and $200 of discounts are available, the accounts payable balance at the net amount must be
$29,800.
In Year 2, Ajax, Inc., reported taxable income of $400,000 and pretax financial statement income of
$300,000. The difference resulted from $60,000 of nondeductible premiums on Ajax’s officers’ life
insurance and $40,000 of rental income received in advance. Rental income is taxable when received.
Ajax’s effective tax rate is 30%. In its Year 2 income statement, what amount should Ajax report as
income tax expense -- current portion?
$120,000

Current income tax expense or benefit is the amount of taxes paid or payable (or refundable) for the year
based on enacted tax law applied to taxable income (or excess of deductions over revenues). Thus,
current income tax expense is $120,000 ($400,000 × 30%).
Fern Co. has net income, before taxes, of $200,000, including $20,000 interest revenue from municipal
bonds and $10,000 paid for officers’ life insurance premiums where the company is the beneficiary. The
tax rate for the current year is 30%. What is Fern’s effective tax rate?
28.5%

The municipal bond revenue (nontaxable) and key-person life insurance premiums (an expense that is
nondeductible) are permanent differences. Thus, pretax income is adjusted to eliminate both items.
Pretax accounting
income $200,000
Municipal bond income (20,000)
Life insurance premiums 10,000

Assuming no temporary differences and deferred taxes, total income tax expense is $57,000 ($190,000
× 30%). Accordingly, the effective tax rate is 28.5% ($57,000 income tax expense ÷ $200,000 pretax net
income).
Hut Co. has temporary taxable differences that will reverse during the next year and add to taxable
income. These differences relate to noncurrent assets. Deferred income taxes based on these temporary
differences should be classified in Hut’s balance sheet as a
Noncurrent liability.
Future taxable amounts reflecting the difference between the tax basis and the reported amount of the
assets will result when the reported amount is recovered. Accordingly, Hut must recognize a deferred tax
liability to record the tax consequences of these temporary differences. Deferred taxes are classified as
noncurrent amounts.
Black Co., organized on January 2, Year 1, had pretax accounting income of $500,000 and taxable
income of $800,000 for the year ended December 31, Year 1. Black expected to maintain this level of
taxable income in future years. The only temporary difference is for accrued product warranty costs,
expected to be paid as follows:
Year 2 $100,000
Year 3 50,000
Year 4 50,000
Year 5 100,000
The applicable enacted income tax rate is 30%. In Black’s December 31, Year 1, balance sheet, the
deferred income tax asset and related valuation allowance should be

$90,000 $0
Black should report an accrued product warranty liability of $300,000. The result is a deductible temporary
difference of $300,000 because the liability will be settled and related amounts will be tax deductible when
the warranty costs are incurred. A deferred tax asset should be measured for deductible temporary
differences using the applicable tax rate. Hence, Black should record a $90,000 ($300,000 × 30%)
deferred tax asset. A valuation allowance should be used to reduce a deferred tax asset if, based on the
weight of the available evidence, it is more likely than not that some portion will not be realized. In this
case, Black had taxable income of $800,000 for Year 1 and expects to maintain that level of taxable
income in future years. The positive evidence therefore indicates that sufficient taxable income will be
available for the future realization of the tax benefit of the existing deductible temporary differences. Given
no negative evidence, a valuation allowance is not necessary.
Scott Corp. received cash of $20,000 that was included in revenues in its Year 1 financial statements, of
which $12,000 will not be taxable until Year 2. Scott’s enacted tax rate is 30% for Year 1, and 25% for
Year 2. What amount should Scott report in its Year 1 balance sheet for deferred income tax liability?
$3,000
This transaction gives rise to a taxable temporary difference. The resulting deferred tax liability should be
measured using the enacted rate expected to apply to taxable income in the period in which the deferred
tax liability is expected to be settled. Hence, the deferred tax liability is $3,000 ($12,000 taxable amounts
× 25% rate applicable in Year 2).
Black Corp.’s accounts payable at December 31, Year 1, totaled $900,000 before any necessary year-end
adjustments relating to the following transactions:
 On December 27, Year 1, Black wrote and recorded checks to creditors totaling $400,000,
causing an overdraft of $100,000 in Black’s bank account at December 31, Year 1. The checks
were mailed on January 10, Year 2.
 On December 28, Year 1, Black purchased and received goods for $153,061, terms 2/10, n/30.
Black records purchases and accounts payable at net amounts. The invoice was recorded and
paid January 3, Year 2.
 Goods shipped FOB destination on December 20, Year 1, from a vendor to Black were received
January 2, Year 2. The invoice cost was $65,000.
At December 31, Year 1, what amount should Black report as total accounts payable?
$1,450,000

The $400,000 debit to accounts payable for the checks recorded on December 27 should be reversed.
Black did not surrender control of the checks until they were mailed during the following year (January
10). The goods received prior to year-end on December 28 should be recorded by a debit to purchases
and a credit to accounts payable in Year 1. They were erroneously recorded in Year 2 when the invoice
was paid. Because the company records purchases and accounts payable at net amounts, the Year 1
accounts payable should be increased by $150,000 [$153,061 – ($153,061 × 2%)]. When goods are
shipped FOB destination, title does not pass until they are received. Accordingly, the goods shipped on
December 20 should not be recorded in purchases and accounts payable until January 2 and no
adjustment is necessary for them. Accounts payable thus should be reported as $1,450,000 ($900,000 +
$400,000 + $150,000).
In June Year 1, Northan Retailers sold refundable merchandise coupons. Northan received $10 for each
coupon redeemable from July 1 to December 31, Year 1, for merchandise with a retail price of $11. At
June 30, Year 1, how should Northan report these coupon transactions?
Unearned revenues at the cash received amount.

Revenue should be recognized when (or as) the related performance obligation is satisfied (e.g., when
the coupons lapse or are redeemed). An unearned revenue (a contract liability) should be credited at the
time of sale for the amount received.
Bake Co.’s trial balance included the following at December 31, Year 1:
Accounts payable $ 80,000
Bonds payable, due Year 2 300,000
Discount on bonds payable 15,000
Deferred income tax liability 25,000

The deferred income tax liability is not related to an asset for financial accounting purposes and is
expected to reverse in Year 2. What amount should be included in the current liability section of Bake’s
December 31, Year 1, balance sheet?
$365,000

Accounts payable (trade accounts payable) are liabilities that meet the definition of current liabilities. They
are short-term credit arrangements (e.g., 30 to 60 days) that are “obligations whose liquidation is
reasonably expected to require the use of current assets, or the creation of other current liabilities.” Bonds
payable, which are reported net of the discount (a direct deduction from the face amount), are current
liabilities if they are due within 1 year. Deferred taxes are classified as noncurrent amounts.
Consequently, the amount of current liabilities is $365,000 ($80,000 A/P + $285,000 carrying amount of
bonds payable).
Ajax Corp. has an effective tax rate of 30%. On January 1, Year 1, Ajax purchased equipment for
$100,000. The equipment has a useful life of 10 years. What amount of current tax benefit will Ajax realize
during Year 1 by using the 150% declining balance method of depreciation for tax purposes instead of the
straight-line method?
$1,500
The straight-line rate is 10% ($100,000 ÷ 10 years). Assuming no salvage value, straight-line depreciation
is $10,000 ($100,000 × 10%). Declining-balance depreciation at 150% of the straight-line rate is $15,000
[$100,000 × (10% × 150%)]. Consequently, depreciation expense is $10,000, the tax deduction is
$15,000, and the realized current tax benefit of using the 150% declining balance method of depreciation
for tax purposes instead of the straight-line method is $1,500 [($15,000 – $10,000) × 30% tax rate].
A company reported the following financial information:

Taxable income for current year $120,000
Deferred income tax liability, beginning of year 50,000
Deferred income tax liability, end of year 55,000
Deferred income tax asset, beginning of year 10,000
Deferred income tax asset, end of year 16,000
Current and future years’ tax rate 35%

The current year’s income tax expense is what amount?
$41,000

Income tax expense is the sum of the current component and the deferred component. The current tax
expense is $42,000 ($120,000 taxable income × 35% tax rate). The deferred tax expense or benefit is the
net change during the year in an entity’s deferred tax amount. The deferred income tax liability increased
$5,000 ($55,000 – $50,000), resulting in a $5,000 increase in income tax expense (deferred). The
deferred income tax asset increased $6,000 ($16,000 – $10,000), resulting in a $6,000 decrease in
income tax expense (deferred). Therefore, the current year’s income tax expense is $41,000 ($42,000 +
$5,000 – $6,000).
Because Jab Co. uses different methods to depreciate equipment for financial statement and income tax
purposes, Jab has temporary differences that will reverse during the next year and add to taxable income.
Deferred income taxes that are based on these temporary differences should be classified in Jab’s
balance sheet as a
Noncurrent liability.
These temporary differences arise from use of an accelerated depreciation method for tax purposes.
Future taxable amounts reflecting the difference between the tax basis and the reported amount of the
asset will result when the reported amount is recovered. Accordingly, Jab must recognize a deferred tax
liability to record the tax consequences of these temporary differences. Deferred taxes are classified as
noncurrent amounts.
Lion Co.’s income statement for its first year of operations shows pretax income of $6,000,000. In
addition, the following differences existed between Lion’s tax return and records:
Tax Accounting
Return Records
Credit loss expense $220,000 $250,000
Depreciation expense 860,000 570,000
Tax-exempt interest revenue -- 50,000

Lion’s current year tax rate is 30% and the enacted rate for future years is 40%. What amount should Lion
report as deferred tax expense in its income statement for the year?
$104,000

assets. In the first year of operations, no previous deferred tax liability or asset exists. Furthermore, the
tax-exempt interest revenue is a permanent difference and does not result in a deferred tax liability or
asset. However, the following deferred tax amounts must be recognized: (1) a taxable temporary
difference for an excess of tax depreciation over accounting depreciation ($860,000 – $570,000 =
$290,000) and (2) a deductible temporary difference for the excess of credit loss expense over the
corresponding tax deduction ($250,000 – $220,000 = $30,000). These differences result in the recognition
of a deferred tax liability of $116,000 ($290,000 taxable temporary difference × 40% future rate) and a
deferred tax asset of $12,000 ($30,000 deductible temporary difference × 40% future tax rate). Thus, the
deferred tax expense is $104,000 [($116,000 deferred tax liability – $0) – ($12,000 deferred tax asset –
$0)].
Vadis Co. sells appliances that include a standard 3-year assurance-type warranty. Service calls under
the warranty are performed by an independent mechanic under a contract with Vadis. Based on
experience, warranty costs are estimated at $30 for each machine sold. When should Vadis recognize
these warranty costs?
When the machines are sold.
An assurance-type warranty creates a loss contingency. Under the accrual method, a provision for
warranty costs is made when the related revenue is recognized.
Hemple Co. maintains escrow accounts for various mortgage companies. Hemple collects the receipts
and pays the bills on behalf of the customers. Hemple holds the escrow monies in interest-bearing
accounts. They charge a 10% maintenance fee to the customers based on interest earned. Hemple
reported the following account data:
Escrow liability beginning of year $ 500,000
Escrow receipts during the year 1,200,000
Real estate taxes paid during the year 1,450,000
Interest earned during the year 40,000

What amount represents the escrow liability balance on Hemple’s books?
$286,000
All escrow receipts collected by Hemple on behalf of its customers represent liabilities. As such, escrow
receipts during the year ($1,200,000) must be added to the beginning escrow liability account ($500,000)
to arrive at a balance of $1,700,000. Hemple decreases this liability by the amount of taxes paid during
the year on behalf of its customers ($1,700,000 – $1,450,000 = $250,000). Hemple must then increase
this liability by the amount of interest earned by the escrow monies, less the 10% maintenance fee. This
is a net increase of $36,000 [$40,000 interest earned – ($40,000 × 10% fee)]. Thus, the ending escrow
liability balance on Hemple’s books is $286,000 ($250,000 + $36,000).
During December of Year 1, Nile Co. incurred special insurance costs but did not record these costs until
payment was made during the following year. These insurance costs related to inventory that had been
sold by December 31, Year 1. What is the effect of the omission on Nile’s accrued liabilities and retained
earnings at December 31, Year 1?
Accrued Retained Earnings

Liabilities Overstated
Understated
A liability must be recognized when (1) an item meets the definition of a liability (probable future sacrifice
of economic benefits arising from a current obligation of the entity as a result of a past event or
transaction), (2) it is measurable, and (3) the information about it is relevant and reliable. These criteria
were met in Year 1 with respect to the insurance obligation. The insurance is a cost of inventory and
theoretically should be accounted for as a product cost. Thus, the entry in Year 1 should have been to
debit inventory and credit a liability. The omission of this entry understated accrued liabilities. Given that
the related inventory was sold in Year 1, it also overstated net income and retained earnings by
understating cost of goods sold. Moreover, the same effects would occur if the insurance costs were
chargeable to expense as a period cost.
On March 31, Dallas Co. received an advance payment of 60% of the sales price for special order goods
to be manufactured and delivered within 5 months. At the same time, Dallas subcontracted for production
of the special order goods at a price equal to 40% of the main contract price. What liabilities should be
reported in Dallas’s March 31 balance sheet?
Deferred Revenues Payables to Subcontractor

60% of main contract price None

The 60% advance payment is a deferred revenue (a contract liability) because it is an obligation to
transfer goods to a customer for which consideration already has been received from the customer. The
agreement with the subcontractor does not create a liability because the entity has no performance
obligation to transfer goods or provide services. That obligation will not arise until the subcontractor has
performed.
Pine Corp.’s books showed pretax income of $800,000 for the year ended December 31. In the
computation of federal income taxes, the following data were considered:
Gain on an involuntary conversion
(Pine has elected to replace the property within the statutory period using the total
proceeds.) $350,000
Depreciation deducted for tax purposes in excess of depreciation deducted for book purposes 50,000
Federal estimated tax payments 70,000
Enacted federal tax rates 30%

What amount should Pine report as its current federal income tax liability on its December 31 balance
sheet?
$50,000
Current income tax expense equals taxable income times the enacted tax rate. Taxable income equals
pretax accounting income adjusted for the items that are treated differently on the tax return and in the
accounting records.
Pretax accounting income $ 800,000
Untaxed gain on involuntary conversion (350,000)
Excess of tax depreciation (50,000)
Enacted tax rate × 30%
Current tax expense $ 120,000

Because $70,000 has already been paid to the federal government in the form of estimated tax payments,
the current federal income tax liability is $50,000 ($120,000 current income tax expense – $70,000
estimated tax payments).
Under current generally accepted accounting principles, which approach is used to determine income tax
expense?
Asset-and-liability approach.
The asset-and-liability approach accrues liabilities or assets (taxes payable or refundable) for the current
year. It also recognizes deferred tax amounts for the future tax consequences of events previously
recognized in the financial statements or tax returns. These liabilities and assets recognize the effects of
temporary differences measured using the tax rate(s) expected to apply when the liabilities and assets
are expected to be settled or realized. Accordingly, deferred tax expense (benefit) is determined by the
change during the period in the deferred tax assets and liabilities. Income tax expense (benefit) is the
sum of current tax expense (benefit), that is, the amount paid or payable, and the deferred tax expense
(benefit).
Which of the following should be disclosed in an entity’s financial statements related to deferred taxes?
I. The types and amounts of existing temporary differences.

II. The types and amounts of existing permanent differences.
III. The nature and amount of each type of operating loss and tax credit carryforward.
I and III only.

A public entity discloses the tax effects of each type of temporary difference and carryforward resulting in
a significant deferred tax amount. A nonpublic entity makes the same disclosures but may omit the tax
effects. Other required disclosures include the amounts and expiration dates of operating loss and tax
credit carryforwards for tax purposes. No disclosure is required about the types and amounts of existing
permanent differences.
Dunne Co. sells equipment service contracts that cover a 2-year period. The sales price of each contract
is $600. Dunne’s past experience is that, of the total dollars spent for repairs on service contracts, 40% is
incurred evenly during the first contract year and 60% evenly during the second contract year. Dunne sold
1,000 contracts evenly throughout the year. In its December 31 balance sheet, what amount should
Dunne report as deferred service contract revenue?
$480,000

control of that good or service. Service contract revenue should be recognized over time as the services
are provided. An appropriate measure of the entity’s progress to complete satisfaction of the performance
obligation also must be selected. Assuming that services are provided in proportion to the incurrence of
expenses, 40% of revenue should be recognized in the first year of a service contract. Given that
expenses are incurred evenly throughout the year, revenue also will be recognized evenly. Moreover,
given that Dunne sold 1,000 contracts evenly throughout the year, total revenue will be $600,000 (1,000
contracts × $600), and the average contract must have been sold at mid-year. Thus, the elapsed time of
the average contract must be half a year, and revenue recognized for the year must equal $120,000
($600,000 total revenue × 40% × .5 year). Deferred revenue (a contract liability) at year end will equal
$480,000 ($600,000 – $120,000).
At the end of Year 1, Ritzcar Co. failed to accrue sales commissions earned during Year 1 but paid in
Year 2. The error was not repeated in Year 2. What was the effect of this error on Year 1 ending working
capital and on the Year 2 ending retained earnings balance?
Year 1 Ending Working Capital Year 2 Ending Retained Earnings

Overstated No effect

The Year 1 ending working capital (current assets – current liabilities) is overstated because the error
understates current liabilities. The Year 2 ending retained earnings balance is unaffected because it is a
cumulative amount. Whether the sales commission expense is recognized in Year 1 when it should have
been accrued or in Year 2 when it was paid affects the net income amounts for Year 1 and Year 2 but not
Year 2 ending retained earnings.
Brass Co. reported income before income tax expense of $60,000 for Year 2. Brass had no permanent or
temporary differences for tax purposes. Brass has an effective tax rate of 30% and a $40,000 net
operating loss carryforward from Year 1. What is the maximum income tax benefit that Brass can realize
from the loss carryforward for Year 2?
$12,000
The $60,000 reported income from Year 2 can absorb the entire $40,000 loss carryforward from Year 1.
Thus, the tax benefit is $12,000 ($40,000 × 30% tax rate).
Pane Co. had the following borrowings on its books at the end of the current year:
$100,000, 12% interest rate, borrowed 5 years ago on September 30; interest payable March 31 and
September 30.
$75,000, 10% interest rate, borrowed 2 years ago on July 1; interest paid April 1, July 1, October 1, and
January 1.
$200,000, noninterest bearing note, borrowed July 1 of current year, due January 2 of next year;
proceeds $178,000.
What amount should Pane report as interest payable in its December 31 balance sheet?
$4,875
Accrued expenses meet recognition criteria in the current period but have not been paid as of year end.
The amount of interest payable that should be reported by Pane in its December 31 balance sheet is
$4,875 [$100,000 × 12% × (3 ÷ 12) + $75,000 × 10% × (3 ÷ 12)].
Which of the following does not result in recognition of a deferred tax asset?
Receipt of municipal bond interest.
Municipal bond interest is nontaxable, so it results in a permanent, not a temporary, difference. A
permanent difference is an event that is recognized either in pretax financial income or in taxable income
but never in the other. It does not result in a deferred tax asset or liability. Examples of items recognized
in pretax financial income but not in taxable income are municipal bond interest, premiums paid by a
beneficiary entity on insurance policies for its key executives, and the proceeds from such policies.
Examples of items recognized in taxable income but not in financial income are the dividends received
deduction and percentage depletion.
On May 1, Year 1, Marno County issued property tax assessments for the fiscal year ended June 30,
Year 2. The first of two equal installments was due on November 1, Year 1. On September 1, Year 1, Dyur
Co. purchased a 4-year-old factory in Marno subject to an allowance for accrued taxes. Dyur did not
record the entire year’s property tax obligation, but instead records tax expenses at the end of each
month by adjusting prepaid property taxes or property taxes payable, as appropriate. The recording of the
November 1, Year 1, payment by Dyur should have been allocated between an increase in prepaid
property taxes and a decrease in property taxes payable in which of the following percentages?
Percentage Allocated to Increase in Prepaid Property Taxes Decrease in Property Taxes Payable
33 1/3% 66 2/3%

The property tax assessment relates to the 12-month period from 7/1/Yr 1 through 6/30/Yr 2. The first of
two equal installments, however, was due on November 1, Year 1, after only 4 months of the tax period
had elapsed. Consequently, the initial payment representing 6 months of property taxes should be
allocated between decrease in taxes payable and increase in prepaid taxes in the ratios of 4 months to 6
months and 2 months to 6 months, or 66 2/3% to 33 1/3%.
Which of the following statements is correct regarding deferred revenues recorded by a company that
provides services to customers?
Deferred revenue is a liability until the service has been performed.
A deposit or other advance (a deferred revenue) is a contract liability. It does not qualify for revenue
recognition until the performance obligation is satisfied by transfer of the promised good or service to a
customer.
On September 15, Year 4, the county in which Spirit Company operates enacted changes in the county’s
tax law. These changes are to become effective on January 1, Year 5. They will have a material effect on
the deferred tax amounts that Spirit reported. In which of the following interim and annual financial
statements issued by Spirit should the effect of the changes in tax law initially be reported?
The interim financial statements for the 3-month period ending September 30, Year 4.
When a change in the tax law or rates occurs, the effect of the change on a deferred tax liability or asset
is recognized as an adjustment in the period that includes the enactment date of the change. The
adjustment is allocated to income from continuing operations in the first financial statements issued for
the period that includes the enactment date.
On September 30, World Co. borrowed $1,000,000 on a 9% note payable. World paid the first of four
quarterly payments of $264,200 when due on December 30. In its December 31 balance sheet, what
amount should World report as note payable?
$758,300

This interest-bearing 1-year note with four quarterly payments is a current liability because it is expected
to be liquidated using current assets. Each payment of $264,200 consists of interest and principal. Only
the principal component reduces the liability. The interest component equals $22,500 [$1,000,000 face
amount × 9% × (1 ÷ 4 quarters)]. Thus, the principal is reduced by $241,700 ($264,200 payment –
$22,500 interest). The note payable is reported as $758,300 ($1,000,000 carrying amount – $241,700
principal reduction) at year end.
At the end of its first year in business, Pebbles Corporation reported pretax financial statement income of
$50,000. Included in pretax income were $10,000 of revenue from installment sales and depreciation
expense of $12,000. On the tax return, $5,000 of installment sales revenue was reported, and
depreciation expense of $16,000 was deducted. The income tax rate was 40%. Pebbles reports
installment sales receivables as current assets. On its year-end statement of financial position, how
should Pebbles report deferred tax amounts?
$3,600 as a noncurrent liability.
Temporary differences arise when the GAAP basis and the tax basis of an item of income or expense
differ. Of the installment sales, all $10,000 was recognized for financial reporting, but only $5,000 was
recognized for tax purposes, producing a temporary difference of $5,000. Because this amount will be
recognized later for tax purposes than for financial reporting, it is a deferred tax liability in the amount of
$2,000 ($5,000 × 40%). The depreciation expense also will result in a deferred tax liability. More expense
was recognized for tax purposes than for GAAP reporting ($16,000 – $12,000 = $4,000). Thus, a deferred
tax liability of $1,600 ($4,000 × 40%) results. In the statement of financial position, deferred tax liabilities
and assets are classified as noncurrent amounts. Thus, a noncurrent deferred tax liability of $3,600 is
recognized by Pebbles.
Which of the following statements is a primary objective of accounting for income taxes?
To recognize the amount of deferred tax liabilities and deferred tax assets reported for future tax
consequences.

The objectives of accounting for income taxes are to recognize (1) the amount of taxes currently payable
or refundable and (2) the deferred tax liabilities and assets for the future tax consequences of events that
have been recognized in the financial statements or tax returns.
Marr Co. sells its products in reusable containers. The customer is charged a deposit for each container
delivered and receives a refund for each container returned within 2 years after the year of delivery. Marr
accounts for the containers not returned within the time limit as being retired by sale at the deposit
amount. The information for Year 4 is as follows:
Container deposits at December 31, Year 3, from deliveries in
Year 2 $150,000
Year 3 430,000 $580,000
Deposits for containers delivered in Year 4 $780,000

Deposits for containers returned in Year 4 from deliveries in
Year 2 $ 90,000
Year 3 250,000
Year 4 286,000 $626,000
In Marr’s December 31, Year 4, balance sheet, the liability for deposits on returnable containers should be
$674,000

At the beginning of Year 4, the contract liability for deposits on returnable containers is given as $580,000.
This liability is increased by the $780,000 attributable to containers delivered in Year 4. The liability is
decreased by the $626,000 attributable to containers returned in Year 4. Moreover, the 2-year refund
period for Year 2 deliveries has expired. Accordingly, the liability should also be decreased for $60,000
($150,000 – $90,000) worth of containers deemed to be retired. As indicated below, the liability for
returnable containers at December 31, Year 4, is $674,000.
Deposits on Returnable Containers

$580,000 12/31/Yr 3
Containers returned $626,000 780,000 Year 4 Containers delivered
Year 2 retired 60,000
$674,000 12/31/Yr 4
Wall Co. sells a product under a standard 2-year warranty against manufacturing defects. The estimated
cost of warranty repairs is 2% of net sales. During Wall’s first 2 years in business, it made the following
sales and incurred the following warranty repair costs:
Year 1
Total sales $250,000
Total repair costs incurred 4,500
Year 2
Total sales $300,000
Total repair costs incurred 5,000
What amount should Wall report as warranty expense for Year 2?
$6,000

A standard warranty against manufacturing defects is an assurance-type warranty. This warranty creates
a loss contingency. A liability for warranty costs is recognized on the date the product is sold. Warranty
expense equals 2% of sales. In Year 2, warranty expense is $6,000 ($300,000 × 2%). A payable (or cash)
is credited for actual costs incurred of $5,000, and a warranty liability is credited for $1,000.
Robb Company requires advance payments with special orders from customers for machinery
constructed to their specifications. Information for the current year is as follows:
Customer advances -- balance 1/1 $295,000
Advances received with orders during the year 460,000
Advances applied to orders shipped during the year 410,000
Advances applicable to orders canceled during the

year 125,000
At December 31, what amount should Robb report as a current liability for customer deposits?
$220,000

The contract liability for advance payments is current because the obligation will be satisfied using current
assets (goods manufactured to customer’s specifications). Robb Company designates this account as
customer advances. When orders are shipped or when orders are canceled, they should be recorded as
decreases in the customer advances balance. As indicated below, the amount that should be reported at
year end as the current liability for customer deposits is $220,000.
Customer Advances
$295,0001/1
Orders shipped$410,000 460,000Received
Canceled 125,000
$220,00012/31
At the end of the accounting period, which of the following costs should be accrued?
Liability for Federal Unemployment Taxes Wages Earned but Unpaid

Yes Yes

An accrued cost may also be referred to as an accrued liability, an accrued payable, or an accrued
expense. When an item is accrued, it is recognized before any cash payments are made. Consequently,
liabilities for federal unemployment taxes and wages earned but unpaid should be accrued in real
(balance sheet) accounts. The corresponding expenses should be charged to nominal (income
statement) accounts.
Cado Co.’s payroll for the month ended January 31 is summarized as follows:
Total wages $100,000
Amount of wages subject to payroll taxes:
FICA 80,000
Unemployment 20,000
Payroll tax rates:
FICA for employer and employee 7% each

Unemployment 3%
In its January 31 balance sheet, what amount should Cado accrue as its share of payroll taxes?
$6,200

The amount of wages subject to payroll taxes for FICA purposes is $80,000. At a 7% rate, the employer’s
share of FICA taxes equals $5,600 ($80,000 × 7%). Wages subject to unemployment payroll taxes are
$20,000. At a 3% rate, unemployment payroll taxes equal $600 ($20,000 × 3%). Consequently, the total of
payroll taxes is $6,200 ($5,600 + $600). A 7% employee rate also applies to the wages subject to FICA
taxes. This amount ($80,000 × 7% = $5,600) should be withheld from the employee’s wages and remitted
directly to the federal government by the employer, along with the $6,200 in employee payroll taxes. The
employee’s share, however, should be accrued as a withholding tax and not as an employer payroll tax.
On its December 31, Year 2, balance sheet, Shin Co. had income taxes payable of $13,000 and a current
deferred tax asset of $20,000 before determining the need for a valuation account. Shin had reported a
current deferred tax asset of $15,000 at December 31, Year 1. No estimated tax payments were made
during Year 2. At December 31, Year 2, Shin determined that it was more likely than not that 10% of the
deferred tax asset would not be realized. In its Year 2 income statement, what amount should Shin report
as total income tax expense?
$10,000

Deferred tax expense or benefit is the net change during the year in the entity’s deferred tax liabilities and assets. It
is added to the current tax expense or benefit to determine total income tax expense for the year. The amount of
income taxes payable (current tax expense) is given as $13,000. The deferred tax asset increased by $5,000, but
$2,000 ($20,000 × 10%) was determined to be an appropriate credit to an allowance account. Total income tax
expense for Year 2 can thus be calculated as follows:
Income tax payable $13,000
Increase in deferred tax asset (5,000)
Increase in valuation
allowance 2,000
Total income tax expense $10,000
Dana Co.’s officers’ compensation expense account had a balance of $490,000 at December 31, Year 1,
before any appropriate year-end adjustment relating to the following:
 No salary accrual was made for the week of December 25-31, Year 1. Officers’ salaries for this
period totaled $18,000 and were paid on January 5, Year 2.
 Bonuses to officers for Year 1 were paid on January 31, Year 2, in the total amount of $175,000.
The adjusted balance for officers’ compensation expense for the year ended December 31, Year 1, should
be
$683,000

The officers’ compensation expense account should include the entire compensation expense incurred in
Year 1. Accordingly, it should include the $490,000 previously recorded in the account, the $18,000 of
accrued salaries, and the $175,000 of accrued bonuses. The adjusted balance should therefore be
$683,000 ($490,000 + $18,000 + $175,000).
A deferred tax liability may result from which of the following items?
Depreciation of tangible assets.

Deferred tax liabilities result when expenses or losses are deductible for tax purposes before they are
recognized under GAAP. Depreciation of tangible assets may give rise to a deferred tax liability due to the
differences in accelerated tax depreciation and straight-line GAAP depreciation.
An automobile dealer sells service contracts. The contracts stipulate that the dealer will perform specific
repairs on covered vehicles. The contracts vary in length from 12 to 36 months. Do the following increase
when service contracts are sold?
Deferred RevenueService Revenue

Yes No

Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring a
promised good or service to a customer. Thus, revenue is not recognized until the agreed services have
been provided or the contracts expire. Consequently, deferred revenue (as contract liability) is credited
(increased) at the date of sale of a service contract, but revenue is not.
A tax rate other than the current tax rate may be used to calculate the deferred income tax amount on the
statement of financial position if a(n)
Future tax rate has been enacted into law.

A tax rate other than the current tax rate may be used to calculate the deferred income tax amount on the
statement of financial position if a future tax rate has been enacted into law.
Kent Co., a division of National Realty, Inc., maintains escrow accounts and pays real estate taxes for
National’s mortgage customers. Escrow funds are kept in interest-bearing accounts. Interest, less a 10%
service fee, is credited to the mortgagee’s account and used to reduce future escrow payments.
Additional information follows:
Escrow accounts liability, 1/1 $ 700,000
Escrow payments received during the

year 1,580,000
Real estate taxes paid during the year 1,720,000
Interest on escrow funds during the year 50,000

What amount should Kent report as escrow accounts liability in its December 31 balance sheet?
$605,000

The liability at the beginning of the year was $700,000. Escrow payments of $1,580,000 were credited
and taxes paid of $1,720,000 were debited to the account during the year. Furthermore, interest of
$45,000 [$50,000 – ($50,000 × 10%) service fee] was credited. Thus, the year-end balance was $605,000
($700,000 + $1,580,000 – $1,720,000 + $45,000).
Black Co. requires advance payments with special orders for machinery constructed to customer
specifications. These advances are nonrefundable. Information for Year 2 is as follows:
Customer advances -- balance 12/31/Yr 1 $118,000

Advances received with orders in Year 2 184,000
Advances applied to orders shipped in Year 2 164,000
Advances applicable to orders canceled in Year 2 50,000
In Black’s December 31, Year 2, balance sheet, what amount should be reported as a current liability for
advances from customers?
$88,000
The amount of $88,000 ($118,000 beginning balance + $184,000 advances received – $164,000
advances credited to revenue after shipment of orders – $50,000 for canceled orders) should be reported
as a contract liability. It is current because the performance obligation will be satisfied using current
assets (goods constructed to customer specifications). The advances applicable to canceled orders are
not refundable because no performance obligation remains to be satisfied.
Ryan Co. sells major household appliance service contracts for cash. The service contracts are for a 1-
year, 2-year, or 3-year period. Cash receipts from contracts are credited to unearned service contract
revenues. This account had a balance of $720,000 at December 31, Year 1, before year-end adjustment.
Service contract costs are charged as incurred to the service contract expense account, which had a
balance of $180,000 at December 31, Year 1. Outstanding service contracts at December 31, Year 1,
expire as follows:
During Year 2 -$150,000
During Year 3 - 225,000
During Year 4 - 100,000

What amount should be reported as unearned service contract revenues in Ryan’s December 31, Year 1,
balance sheet?
$475,000

Revenue is recognized when (or as) a performance obligation is satisfied. Thus, the amount to be
reported as unearned service contract revenues (a contract liability) equals the $475,000 ($150,000 +
$225,000 + $100,000) of service contracts outstanding at December 31, Year 1.

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How would the proceeds received from the advance sale of nonrefundable tickets for a theatrical

performance be reported in the seller’s financial statements before the performance?

Answer (D) is correct.

Answer (A) is correct.

Sales Revenue Sales Taxes Payable

Answer (B) is correct.

Answer (A) is correct.

Total wages $10,000

Federal income tax

Answer (B) is correct.

Possible Individual Cumulative

$100,000 20% 20%

30,000 35% 55%

10,000 45% 100%

Answer (C) is correct.

Year Contract of-Completion

Year 3 400,000 600,000

Year 4 700,000 850,000

Answer (B) is correct.

Answer (C) is correct.

A deferred tax asset must be reduced by a valuation allowance if it is

Answer (B) is correct.

Recognize certain revenues and expenses in different reporting periods.

Answer (C) is correct.

Intraperiod income tax allocation arises because

Answer (D) is correct.

Answer (D) is correct.

Income from exempt municipal bonds $ 60,000

Depreciation deducted for tax purposes in excess of

depreciation recorded on the books 120,000

Proceeds received from life insurance on death of officer 100,000

Estimated tax payments 0

Enacted corporate tax rate 30%

Answer (B) is correct.

Pretax accounting income $ 600,000

Tax-exempt municipal bond interest (60,000)

Excess of tax depreciation (120,000)

Untaxed life insurance proceeds (100,000)

Taxable income $ 320,000

Stamp service revenue from

(stamps sold prior to

Answer (C) is correct.

Answer (A) is correct.

Pretax financial income $160,000

Nontaxable interest received on municipal securities (5,000)

Long-term loss accrual in excess of deductible

Depreciation in excess of financial statement amount (25,000)

Taxable income $140,000

Answer (D) is correct.

Deferred income taxes for differences based on depreciation methods.

Answer (B) is correct.

Accelerated tax depreciation $(75,000)

Additional costs in inventory for tax purposes 25,000

Answer (D) is correct.

Year 4 Room RentalsRoom Nights

October $100,000 1,100

December 150,000 1,800

$15,000 deferred tax liability.

Answer (B) is correct.

Answer (D) is correct.

Year 2 ($100,000 × 30%) $30,000

Year 3 ($50,000 × 30%) 15,000

Year 4 ($50,000 × 30%) 15,000