[Jasminekoko]

NINJA Question –

I don’t understand why we don’t reverse the DTA account as it is used up in X2 to get the total income tax expense to 360,000? Can someone please help? Thank you so much.

Mobe Co. reported the following operating income (loss) for its first three years of operations:

20X0 $ 300,000

20X1 (700,000)

20X2 1,200,000

For each year, there were no deferred income taxes, and Mobe’s effective income tax rate was 30%. In its 20X1 income tax return, Mobe elected to carry back the maximum amount of loss possible. In 20X1, Mobe was unsure that it would earn any future taxable income, thus requiring a valuation allowance to write down the deferred tax asset to zero until it is used next year. In its 20X2 income statement, what amount should Mobe report as total income tax expense?

A.

$120,000

B.

$150,000

C.

$240,000

Incorrect D.

$360,000

You answered D. The correct answer is C.

20X1 loss after carryback to 20X0:

= ($700,000) – $300,000

= ($400,000)

20X2 income after carryforward of remainder of 20X1 loss:

= $1,200,000 – $400,000

= $800,000

20X2 income tax expense:

= ($800,000 x 0.30)

= $240,000

[excel monkey]

The devil's in the details with this one. Since Mobe was unsure of future earnings and had to book a valuation allowance in 20X1, they had to expense the remaining 120,000 in 20X1. When they earned income in 20X2, the first thing they did was reverse the valuation allowance, reducing their income tax expense by 120,000. Journal entries really helped with this one.

20X0

To record income taxes for 20X0

dr. Income tax expense…………………………………………..90,000 (300,000*.30)

cr. Income taxes payable………………………………………………….90,000

20X1

To record income taxes for 20X1

dr. Income tax receivable………………………………………..90,000 (to book tax refund)

dr. Deferred tax asset…………………………………………..120,000 ((700,000-300,000)*.30)

cr. Income tax benefit……………………………………………………….210,000 (700,000*.30)

To record necessary valuation allowance

dr. Income tax expense…………………………………………120,000

cr. Valuation allowance……………………………………………………..120,000

In its 20X1 income statement, Mobe would report total Income tax benefit of 90,000 (210,000 benefit – 120,000 expense)

20X2

To reverse the previous valuation allowance

dr. Valuation Allowance…………………………………………120,000

cr. Income tax benefit………………………………………………………120,000

To record income taxes for 20X2

dr. income tax expense………………………………………….360,000

cr. Deferred tax asset……………………………………………………….120,000

cr. Income taxes payable………………………………………………….240,000

In its 20X2 income statement, Mobe would report total Income tax expense of 240,000 (360,000 expense – 120,000 benefit). The 120,000 was originally expensed in X1, when future earnings were uncertain and a valuation allowance was required. If Mobe reported them again in X2, they would be double counted.

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[Jasminekoko]

Hi excel monkey,

Really appreciate your detailed response. One thing I'm not sure is why we reverse the deferred tax asset in year 2 JE. So if the NOL carry forward of $400,000 is used up in year 2, we should reverse the DTA as :

Dr. Income tax expense

Cr. DTA

and if it is not going to be realized as in year 1, we use the valuation allowance to write it down? I'm still a bit blurry on this DTA reversal. Can you please clarify.

Thank you so much.

[Author]

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