Intermediate Accounting II Chapter 17: Accounting for Income Taxes

Continuing with Example 17.4, assume that Otis Optics collected the $60,000 of installment sales receivable in 2019. This amount is taxable income because it is col-lected in cash. Otis already had recorded book income for installment sales in 2018 along with the related installment sales receivable, so no book income is recognized in the year of cash collection. In addition, Otis recorded $200,000 of regular sales on account dur-ing 2019. Ignore cost of goods sold. Assume no operating expenses in 2019. Determine the difference in the book carrying value and tax basis of the account receivable from the installment sale and compute the deferred tax liability. What is the journal entry to record income taxes for the year?

Once Otis collects the $60,000, both the book basis and tax basis of the related installment sales receivable is zero. Installment Sales Receivable— Book Basis Installment Sales Receiv-able—Tax Basis Difference Tax Rate (%) Deferred Tax Liability Beginning balance $60,000 $0 $60,000 35% $21,000 Change (60,000) 0 (60,000) 35 (21,000) Ending balance $ 0 $0 $ 0 35% $ 0 So, the ending balance of the deferred tax liability is also equal to zero. The deferred tax liabil-ity of $21,000 has fully reversed during the year as illustrated in the t-account that follows. 4 Deferred Tax Liability 21,000 Prior Year-Origination Following Year-Reversal 21,000 0 End of Year We decrease the deferred tax liability for the reversal with a debit of $21,000. When a deferred tax liability reverses, income taxes become currently payable. Therefore, we increase income taxes payable. The computation of income tax expense and income tax payable is presented on the next page.

Otis Optics, Inc. began business in 2018 and billed but did not collect $500,000 in revenue. Assume that Otis did not incur any expenses during the year. This sales transaction is treated identically for both book and income tax purposes. The tax rate is 35%, and Otis will pay any income taxes due in 2019. What journal entries are required to record both the revenues and the related income tax expense in 2018? What accounts and amounts will Otis report on its balance sheet?

Otis Optics reports revenue of $500,000 on its GAAP-based income statement for 2018. The company recognizes income tax expense of $175,000 ($500,000*35%). Otis Optics will also pay income taxes of $175,000 ($500,000*35%) to the government because book income is the same as taxable income. On its 2018 year-end balance sheet, Otis reports an accounts receivable of $500,000 and income taxes payable of $175,000. Because net income increases stockholders' equity, Otis Optics now has equity of $325,000. The jour-nal entries are as follows: Account 2018 Accounts Receivable 500,000 Sales Revenue 500,000 Account December 31, 2018 Income Tax Expense 175,000 Income Taxes Payable 175,000

Otis Optics is an IFRS reporter. The firm earned revenues of $500,000 and incurred warranty expense for book purposes of $110,000. Otis estimates a deferred tax asset of $38,500 because of a basis difference in warranty liabilities. Management has assessed that it is probable that it will not realize 40% of the deferred tax asset. What is the necessary journal entry to record the deferred tax asset? Prepare a simplified 2018 income statement and balance sheet for Otis Optics and compare it with the financial statements from Example 17.8 that do not include a valuation allowance. What is the effective tax rate in the two examples?

Otis's ETR before recording a valuation allowance is 35% ($136,500 / $390,000). Its ETR after recording the valuation allowance increases to 38.9% ($151,900 / 390,000) because of the increase in the tax expense. Without Assess-ing Realizability of Deferred Tax Asset With Assessing Real-izability of Deferred Tax Asset Simplified income statement Sales revenue $500,000 $500,000 Warranty expense (110,000) (110,000) Income before income taxes $390,000 390,000 Income tax expense (136,500) (151,900) Net income $253,500 $ 238,100 Balance sheet Asset: Accounts receivable $500,000 $500,000 Deferred tax asset 38,500 23,100 TOTAL $538,500 $523,100 Liabilities and stockholders' equity Warranty liability $ 110,000 $ 110,000 Income taxes payable 175,000 175,000 Stockholders' equity 253,500 238,100 TOTAL $538,500 $ 523,100

Carryforward

Permits a company to offset the current tax loss against future taxable income, thereby reducing future taxable income and lowering the amount of tax due in the year of the offset.

Piewares, Inc. began business in 2018 and reported sales revenue of $500,000 and expenses of $600,000, resulting in a $100,000 net loss for the current year. Assume that Piewares has not yet received cash for its sales, nor has it paid cash for its expenses incurred during the year. It has no permanent or temporary differences; thus, its taxable loss equals its book loss of $100,000. Because it began business in 2018, the carryback option is not available, so Piewares must carry forward its $100,000 NOL. The tax rate is 35%, and a valu-ation allowance is not required. What is the necessary journal entry to record the impact of the NOL carryforward on the company's financial statements? Prepare a partial 2018 income statement and balance sheet for Piewares.

Piewares records a deferred tax asset of $35,000 ($100,000*35%) and a related income tax benefit of $35,000. The company does not owe any taxes, nor will it record any income taxes payable for the current year.

Refer to information for Piewares, Inc. from Example 17.15. In 2018, the com-pany experienced a $100,000 net operating loss and recorded a deferred tax asset of $35,000 in 2018. Now assume that Piewares decides that it is more likely than not that it will be able to generate only $60,000 of taxable income during the carryforward period. As a result, without generating an additional $40,000 of future taxable income, it will not be able to fully realize the NOL carryforward benefit. What is the journal entry necessary to record the net deferred tax asset in 2018? Prepare a partial income statement and balance sheet for Piewares.

Piewares will report a net deferred tax asset of $21,000 [($100,000- $40,000) * 35%]. The company reports a deferred tax asset of $35,000 ($100,000*35%) and records a valuation allowance of $14,000 ($40,000*35%). Piewares' income tax benefit will decrease by $14,000, and its net deferred tax asset will decrease by $14,000 because of the need for the valuation allowance. The journal entries follow: Account December 31, 2018 Deferred Tax Asset 35,000 Income Tax Benefit 35,000 Account December 31, 2018 Income Tax Benefit 14,000 Valuation Allowance for Deferred Tax Asset 14,000

Deferred tax asset

Represents a future reduction in income taxes payable. That is, more tax is paid today, but the company will experience tax savings at some point in the future.

Deferred tax liability

Represents additional income taxes payable that will be due in future years. In other words, less tax is paid today, but that tax will be paid at some point in the future.

Permanent differences

Result from transactions that are included: 1. In the computation of taxable income but never in book income. 2. In the computation of book income but never in taxable income.

Four possible scenarios that create deferred tax assets or liabilities.

Scenario 1: Tax Basis of Asset Greater Than Book Basis of Asset. A deferred tax asset results when the tax basis of assets is greater than the book basis of assets. For example, consider inventory that a firm writes down for obsolescence under U.S. GAAP but not for tax purposes. If the firm has obsolete inventory, the tax basis of inventory will be higher than the book basis. When the firm eventually sells the inventory at a loss (or disposes of it), it receives a tax benefit because the transaction creates a tax deduction. Thus, until the temporary difference reverses (that is, until it sells or disposes of the inventory), the firm will report a deferred tax asset on its books representing this future tax benefit. Scenario 2: Book Basis of Asset Greater Than Tax Basis of Asset. A deferred tax liability occurs when the book basis of assets is greater than the tax basis of assets. For example, a company typically depreciates fixed assets at a faster rate for tax purposes than it does for book purposes. Thus, in earlier years, the book basis in these assets is greater than the basis under income tax reporting. In future years, tax deductions for depreciation related to these assets will decrease, in turn increasing the company's income tax payment to the government. Scenario 3: Tax Basis of Liability Greater Than Book Basis of Liabil-ity. There is a deferred tax liability when the tax basis of liabilities is greater than their book basis. This scenario is rare because it is far more likely that liabilities are accrued for book purposes before they are paid. When this scenario is found in practice, it involves complex transactions. Scenario 4: Book Basis of Liability Greater Than Tax Basis of Liability. A deferred tax asset is created when the book basis of a liability is greater than the tax basis of the liability. For example, under book reporting, a firm will recognize a warranty expense and record an estimated liability for future warranty costs when it is both estimable and probable. However, the company cannot deduct the estimated warranty cost under tax reporting until the warranty repairs actually take place. Thus, the book basis of the liability is greater than the tax basis. Because the firm has not yet deducted the cost of product repair under warranty, there will be a future tax benefit at the time the deduction occurs. As a result, a company will record a deferred tax asset for the future tax benefit when it records an estimated warranty liability for book purposes. Exhibit 17.3 summarizes these four scenarios.

U.S. GAAP uses a two-step approach, recognition and measurement, to account for uncertain tax positions. In general, accounting under U.S. GAAP is intended to be a "principles-based" meth-odology requiring significant judgment by management, attorneys, and auditors.

Step 1: Recognition: To account for uncertain tax positions, the company first determines whether it should recognize any benefits from its tax position. To do so, it must decide if it is more likely than not that it will sustain the tax position after examination by the taxing authority, assuming that the taxing authority has full knowledge of all relevant information. In concrete terms, after the taxing authority examines all available evidence (both positive and negative), the company must determine whether there is slightly more than a 50% chance that it will sustain the tax position. If the company expects that it will sustain the position, it can recognize a benefit and measure the tax benefit as determined in Step 2. Step 2: Measurement: If a tax position meets the more-likely-than-not threshold, the company measures the amount of tax benefit to be recognized in the financial statements. The tax benefit is the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. This measurement system is based on cumulative probability computations without considering the time value of money. In other words, a tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50% likely to be realized.

Book Income

The amount of income that a company reports in its financial statements

Taxable Income

The amount of income that a company reports on its tax return.

Otis Optics reported sales on account of $500,000 in 2018 and no permanent differences. The company also recorded an estimated product warranty liability and the related warranty expense of $110,000 for book purposes. There were no additional expenses in 2018. Under tax law, Otis cannot deduct the estimated warranty expense and does not create a tax liability for these amounts until it actually provides the services by repairing the product. Ignore cost of goods sold. Assume no operating expenses dur-ing the year. The company's tax rate is 35%. What is Otis's income tax expense and income taxes payable? Show the difference between the book carrying value and the tax basis of the warranty liability. In addition, compute the deferred tax asset. What journal entries are required for the year to record the revenues, warranty expense, and the related income tax?

The book basis of the firm's liabilities is greater than the tax basis because Otis does not create a liability for the warranty for tax purposes until the product is actually repaired. From Exhibit 17.3, we know that when the book basis of a liability is greater than its tax basis, the company will report a deferred tax asset. We compute the deferred tax asset as follows: Book (U.S. GAAP) Ta x Difference Warranty liability $110,000 $0 $110,000 Tax rate *35% Deferred tax asset $ 38,500

Otis Optics, Inc. began business during 2018 and billed but did not collect $500,000 in revenue. Otis Optics also sold $60,000 of merchandise on installment sales. None of the installment sales is collected during the current year. Installment sales are considered revenue and installment sales receivable for book purposes but not for tax purposes. Otis will recognize revenue on installment sales for tax purposes only when it collects cash. Ignore cost of goods sold. Assume no operating expenses during the year. Assume also that the company did not incur any expenses during the year. In addition, Otis did not report any permanent differences. The company's tax rate is 35%. What is Otis's income tax expense and income taxes pay-able? Show the difference in the book carrying value and the tax basis of the receivable from installment sales and compute the deferred tax liability. What journal entries are required for the year to record both the revenues and the related income tax?

The book carrying value of the installment sales receivable is $60,000 greater than the tax basis of zero. The tax basis is zero because the installment sale is not recorded as revenue or receivable for tax purposes. Exhibit 17.3 indicates that when the book basis of an asset is greater than its tax basis, the company reports a deferred tax liability. The deferred tax liability is the difference on the basis of the asset times the statutory tax rate. Thus, we compute the deferred tax liability as follows:

Differences Resulting in Book Income Being Less Than Taxable Income

. Fines and penalties: Fines and penalties are reported as expenses on the income statement but are not tax deductible. 2. Certain meals and entertainment expenses: Meals and entertainment costs are reported as expenses on the income statement but are not fully tax deductible. 3. Life insurance premiums paid for key officers or employees: Officers' life insurance is an expense subtracted on the income statement, but this cost cannot be deducted for tax purposes. 4. Expenses incurred in securing tax-exempt income: These expenses are subtracted from earnings on the income statement but are not deductible for tax purposes

Differences Resulting in Book Income Being Greater Than Taxable Income

1. Municipal interest income: Tax-free interest is reported on the financial statements as income, but it is not taxable. 2. Dividend received deduction: Corporations can deduct all or a portion of inter-corporate dividends received for tax purposes. However, all of the dividends received are reported as income on the financial statements. 3. Life insurance death proceeds for key officers or employees: Officers' life insurance proceeds received are reported as income on the financial statements but are not taxable. 4. Domestic production activities deduction: This is a tax deduction that provides incentives for businesses to produce most of their goods or services in the U.S., but it is not recognized as an expense on the financial statements

Valuation Allowance

A contra-asset to the deferred tax asset account on the balance sheet. Thus, the company reports a net deferred tax asset on its balance sheet measured as the deferred tax asset net of the valuation allowance.

Examples of uncertain tax positions include:

A decision not to file a tax return • A shift of income across jurisdictions • A decision to exclude potentially taxable income from a tax return • A choice to treat a transaction as tax-exempt To illustrate, consider a company that takes an aggressive tax position on its U.S. federal tax return to reduce income tax payable by $100,000. It is possible that the Internal Revenue Service will ultimately require the company to pay at least some of this amount in the future. How much of the $100,000 should the company record as a tax liability from the uncertain tax position, and how much should it record as a tax benefit? 18 The tax benefit is simply the reduction in the reported tax expense and liability as the result of the uncertain tax position.

Net Operating Loss (NOL)

A net loss for tax purposes that occurs when tax-deductible expenses exceed taxable revenues.

Income Tax Benefit

A reduction of income tax expense and thus increases income. Although temporary differences do not cause the ETR to differ from the statutory rate, a change in the assessment of deferred tax assets' realizability result in a change in the ETR. For example, Luby's Inc., the restaurant operator, increased its valuation allowance by $6.9 million in 2016, lowering its ETR by 128.3%.

Installment Sale

A transaction in which the sales price is paid in two or more installments over two or more years. If the sale meets certain requirements, a taxpayer can postpone reporting such income until future years by paying tax each year only on the proceeds received that year.

Carryback

Allows a company to offset the current tax loss against prior years' taxable income and claim a refund for taxes previously paid on the amount offset.

Balance Sheet Approach

Also referred to as the asset and liability method, focuses on the differences between book carrying values and tax bases of a firm's assets and liabilities.

Uncertain Tax Positions

Are positions for which the tax authorities may disallow a deduction in whole or in part.

Backus Inc. reported a loss of $500,000 in 2018. The company reported taxable income of $125,000 in 2016 and $230,000 in 2017. It has no permanent or temporary differ-ences, and its tax rate is 35%. What is the necessary journal entry for 2018? Backus reported taxable income of $250,000 in 2019. What is the necessary journal entry for 2019?

Backus first carries back the loss to 2016, the earliest possible year in which it can apply the loss, and then to 2017. Backus reported taxable income of $125,000 in 2016, so the company can carry back that amount to 2016. It reported taxable income of $230,000 in 2017, so it carries back that amount also. Thus, the total carryback is $355,000, leaving $145,000 available as a carryforward. Description 2016 2017 Year of the Loss 2018 Taxable income (loss) $ 125,000 $ 230,000 $(500,000) Carryback (125,000) (230,000) (355,000) Carryforward $(145,000 AT THE END: The journal entry is as follows: Account December 31, 2019 Income Tax Expense 87,500 Income Tax Payable 36,750 Deferred Tax Asset 50,750

Continuing Example 17.6, assume that Otis Optics made actual warranty repairs at a total cost of $110,000 in 2019. The company also reported $300,000 in sales revenue on account and did not incur any additional expenses for the year. The company is subject to a 35% income tax rate and does not report any permanent differences. Ignore cost of goods sold. Show the difference in the book and tax bases of the warranty liability and compute the deferred tax asset. What journal entries are required to record this year's sales and the income tax provision for the year?

Because Otis satisfied the warranty liability by making the actual product repairs, both the book and tax basis of the liability is zero. As a result, Otis can remove the deferred tax asset associated with this temporary difference (i.e., the book-tax difference reverses) AT THE END: Account December 31, 2019 Income Tax Expense 105,000 Deferred Tax Asset 38,500 Income Taxes Payable 66,500 Otis pays $66,500 in tax rather than the income tax expense of $105,000 recorded on the income statement because it had paid the difference of $38,500 in the prior year. The taxes paid in the prior year provided future economic benefit and were recorded as a deferred tax asset (i.e., Otis deferred realization of the benefit of the asset until the year it actually made the warranty repair).

More on Example 17.4

Example 17.4 provided an analysis of the initial creation of a deferred tax liability account. When a deferred tax account is created and continues to increase, we say that it originates. What account-ing is required when Otis collects the installment sales receivable and the temporary difference reverses? In general, a temporary difference reverses when a company either: 1. Has to pay the taxes it previously recorded as a deferred tax liability or 2. Receives the benefits of reduced taxes originally reported as a deferred tax asset. The reversal reduces the deferred tax account in both cases. To illustrate, Example 17.5 presents the reversal of the deferred tax liability created by Otis Optics in Example 17.4

In Example 17.1 where book and taxable income are the same, the ETR is 35% ($175,000 / $500,000). In Example 17.2 where there is a permanent difference, the ETR is lower—specifically, 32.4% ($175,000 / $540,000). The company, Otis Optics, received tax-free income, so its tax rate on total income is lower than the 35% statutory income tax rate. U.S. GAAP requires companies to reconcile the federal statutory income tax rate to the effective tax rate shown in either percentages of book income, dollars, or both. The required reconciliation for Example 17.2 follows.

Exhibit 17.2 illustrates the required reconciliation of a 35% statutory tax rate to 21.1%, 16.8%, and 19.3% effective tax rate for Google in fiscal 2014, 2015, and 2016, respectively. Its parent company is Alphabet Inc. Google provided the reconciliation of percentages from the statutory rate to its effective tax rate. Foreign tax rate differentials and federal research credits are permanent differences that reduce Google's tax rate.

More on Example 17.3

In Example 17.3, in Year 1 the book basis of the equipment is $75,000 and the tax basis is $60,000. The $15,000 difference between the book basis and tax basis of the equipment represents $15,000 less in current-year taxable income for the company and less tax currently payable. There is $15,000 less taxable income because more depreciation is deducted for tax purposes resulting in the lower tax basis relative to book. However, at the future point when the equipment is fully depreciated, the company will pay taxes on this $15,000 both for book and tax purposes. At a 35% tax rate, there is an additional $5,250 in future taxes payable ($15,000*35%). In effect, the company will owe this $5,250 tax, but it does not need to pay it at this time. Temporary differences create either deferred tax liabilities or deferred tax assets. The $5,250 tax liability from Example 17.3 is an example of a deferred tax liability.

Effective Tax Rate

Income Tax Expense / Pretax Income / Book Income before taxes

Lawson Enterprises experienced an NOL of $567,000 in 2018. The company reported taxable income of $434,000 in 2016 and $327,000 in 2017. The tax rate for all years is 40%. Lawson elects to carryback the NOL. What is the necessary journal entry to record the NOL carryback in the year of the loss? Prepare a partial income statement for the year of the loss.

Lawson Enterprises first carries back the loss to 2016, the earliest possible year to which the loss can be applied. If any of the loss remains, the company can carry back that amount to 2017. Lawson reported taxable income of $434,000 in 2016, so the company can carry back that amount to 2016. The remaining NOL of $133,000 ($567,000-$434,000) is a carryback to 2017. Therefore, Lawson has sufficient taxable income in the 2 years before the year of the NOL to carry back the entire amount of the NOL.

In 2018, several customers at Maydew Restaurants, Inc. presented with cases of food poisoning and subsequently sued Maydew. Maydew reported a $5 million contingent liability on its December 31, 2018, financial statements. The tax rate for 2018 is 35%. However, the enacted tax rates for 2019, 2020, 2021, and thereafter are 34%, 32%, and 30%, respectively. What amount should Maydew record for the deferred tax asset related to the contingency?

Maydew needs to record a deferred tax asset computed as the book-tax basis differ-ence in the contingent liability times the tax rate that will be in effect at the time of the reversal. The problem is that this deferred tax asset won't reverse until Maydew settles the case or the case works its way through the court system. If we assume that the case will not be resolved until after 2021, the deferred tax asset will be measured at $1.5 million ($5 million*30%). However, if we believe that the case will be resolved in 2019, the deferred tax asset will be measured at $1.7 million ($5 million*34%).

Temporary Differences

Occur when the book treatment and the tax treatment for a given transaction are different in a given year but will be the same over the life of the firm.

Hush Sound Systems, Inc. took an aggressive tax position on its current-year tax return. The taxing jurisdictions have challenged the deduction claimed in prior years upon examining the returns of other firms in the industry. Hush reported $600,000 in taxable income after the $500,000 deduction in question. In other words, the company earned $1,100,000 in taxable income before the $500,000 deduction. Hush is subject to a 34% tax rate and has no book-tax differences. Based on a careful analysis, management believes that it is more likely than not that the position will be sustained upon examination. Therefore, the potential tax benefit will be rec-ognized. The company will assess the following probabilities corresponding to possible tax deduction outcomes in order to measure the potential tax benefit: Possible Estimated Outcome (i.e., amount allowed as a tax deduction) Individual Probability of Occurring (%) $500,000 5% 380,000 30 300,000 25 210,000 15 190,000 25 What journal entry is required to record the current year's income tax expense, income tax payable, and tax liability for the uncertain tax position?

The first step is to determine whether management can report any benefit from this tax position. If they cannot recognize any tax benefit—that is, if the $500,000 tax deduction is not recognized—taxable income is $1,100,000 ($600,000+500,000). If none of the deduc-tion is recognized, the company debits income tax expense for $374,000 ($1,100,000*34%) and credits income tax payable for the same amount. However, because it is more likely than not that the position will be sustained upon examination, the company is allowed to recognize some amount of benefit. In other words, Hush will not be required to record the full $374,000 of income tax expense.

Statutory Tax Rate

The legally imposed tax rate.

Tax Contingency

Uncertain tax positions can result in the company reporting a tax-related liability as these on its balance sheet.

Use the same information from Example 17.19 but assume that Hush Sound Sys-tems, Inc., reports using IFRS. Determine the income tax liability that Hush should recognize in its financial statements under IFRS

Under IFRS, Hush Sound Systems needs to recognize the amount expected to be paid. However, there is no specific guidance on determining the amount to be recognized. Assuming a 34% income tax rate, the total possible liability related to this tax deduction is $170,000 ($500,000 * 34%). Because it is likely Hush would settle for less than the full amount of the entire position, it should recognize some amount of contingent liability less than $170,000. The exact amount of the liability to be recognized is highly subjective and requires further analysis to determine with certainty.

Whitewater Rafts, Inc. reported a net deferred tax asset balance of $137,000 result-ing from an estimated warranty expense accrual for book purposes. The total book-tax differ-ence related to the bases of the estimated warranty liability is $391,429. The enacted statutory tax rate related to this balance changed from 35% to 30%, effective immediately. What journal entry does Whitewater Rafts need to make to adjust for this change in tax rates?

Whitewater Rafts computed the current deferred asset balance of $137,000 at a 35% tax rate. The adjusted deferred tax asset balance from the change in tax rate is $117,429 ($391,429*30%). Because tax rates decreased, the future tax deductions taken are less valuable. Consequently, Whitewater Rafts will reduce its deferred tax asset balance by $19,571 ($137,000-$117,429). 14 The deferred tax asset is now expected to provide less future benefit, thereby increasing income tax expense and the effective tax rate, as reflected in the following journal entry:

Consider Otis Optics from Example 17.6. Otis recorded $500,000 in sales rev-enue in 2018. The company is subject to a 35% tax rate. Otis recorded a deferred tax asset of $38,500 in 2018 because of a $110,000 basis difference in warranty liabilities ($110,000*35%). Based on its assessment of all positive and negative evidence associ-ated with this deferred tax asset, management has assessed that it is more likely than not that it will not realize 40% of the deferred tax asset. Ignore cost of goods sold. What are the necessary journal entries to record the deferred tax asset and valuation allowance? Prepare a partial 2018 income statement and balance sheet for Otis Optics and compare it with the financial statements from Example 17.6 that do not include a valuation allowance. What is the effective tax rate in the two examples? Provide the footnote reconciliation of the federal statutory income tax rate to the effective tax rate in both dollars and percentages, incorporating the use of the valuation allowance

Without Valuation Allowance With Valuation Allowance Partial Income Statement Sales Revenue $500,000 $500,000 Warranty Expense (110,000) (110,000) Income before Income Taxes 390,000 390,000 Income Tax Expense (136,500) (151,900) Net Income $253,500 $238,100 Effective Tax Rate 35% 38.9% Partial Balance Sheet Assets: Accounts Receivable $500,000 $500,000 Deferred Tax Asset—Net of Valuation Allowance 38,500 23,100 TOTAL $538,500 $523,100 Liabilities and Stockholders' Equity: Warranty Liability $ 110,000 $ 110,000 Income Taxes Payable 175,000 175,000 Stockholders' Equity 253,500 238,100 TOTAL $538,500 $523,100 The ETR before recording a valuation allowance is 35% ($136,500 / $390,000). The effective tax rate after recording the valuation allowance increases to 38.9% ($151,900 / 390,000). The higher ETR is a result of the increase in income tax expense caused by the use of a valuation allowance. The required footnote reconciliation after recognizing the valuation allowance follows. Description Dollars Percentage Income tax at the statutory tax rate $136,500* 35.0% Increase in the valuation allowance 15,400 3.9%** Tax at the effective rate $151,900 38.9%*** * $390,000*35% ** $15,400 / $390,000 *** $151,900 / $390,000