[Iron_Victory]

My materials were not entirely clear on this point. So my question is when using the equity method to report on an investment how do we calculate deferred income taxes?

So lets say that A owns 40% of B and accounts for it using the equity method. During the year B reports net income of $100,000 and declares dividends of $20,000. A has a tax rate of 30% what impact does this have on the tax expense for A?

So the current tax expense is not too difficult. We have dividends of $8,000 (20,000 x .4) and we have a dividend-received deduction of 80% so we take 8,000 x (1-.8) = 1,600 taxable portion of the dividends. 1,600 x .3 (tax rate) = 480

Journal entry as follows

Income tax expense – current 480

Income tax payable – current (or cash) 480

Now comes the tricky part. A still has $32,000 ((100,000 x .40)- 8,000 dividends) of net income from the investment in B. My materials just say that this is a deferred amount at a 20% rate or (32,000 x .2 = 6,400) then we would take the 6,400 x .30 (tax rate) = 1920 deferred tax liability.

Now my understanding is 20% is 1 – .8( the DRD) but why is the net income of the investment deferred at 20% taxable portion? why is this figure not 32,000 x .30 or 9,600 deferred tax liability?

AUD - (74),78
BEC - 85
FAR - 86
REG - 84

[Anonymous]

From my understanding:

The DRD is a permanent difference, so you have to include it into the calculation of the deferred tax liability since it will never reverse.

[Anonymous]

From my understanding:

The DRD is a permanent difference, so you have to include it into the calculation of the deferred tax liability since it will never reverse.

[Iron_Victory]

I found the answer to this so I thought I would share if anyone else was having trouble wrapping their minds around this one.

The material just was bad at explaining the earnings in the investment was $40,000 less dividends of $8,000 leaving us a net of $32,000 to be distributed in future years. Since future cash distributions from the investment come in the form of dividends on which we get a 80% dividends received deduction, the 20% remainder is used for the deferred tax calculation using the deferred tax rate.

I'm pretty sure this is one of those topics that you might see 1 or 2 questions on the actual exam and quite possibly zero. It just made me kinda mad that the study material explained it so poorly.

AUD - (74),78
BEC - 85
FAR - 86
REG - 84

[Iron_Victory]

I found the answer to this so I thought I would share if anyone else was having trouble wrapping their minds around this one.

The material just was bad at explaining the earnings in the investment was $40,000 less dividends of $8,000 leaving us a net of $32,000 to be distributed in future years. Since future cash distributions from the investment come in the form of dividends on which we get a 80% dividends received deduction, the 20% remainder is used for the deferred tax calculation using the deferred tax rate.

I'm pretty sure this is one of those topics that you might see 1 or 2 questions on the actual exam and quite possibly zero. It just made me kinda mad that the study material explained it so poorly.

AUD - (74),78
BEC - 85
FAR - 86
REG - 84

[Anonymous]

I believe equity method only applies for book not tax

So percent of income from investee is a temp difference

As are dividends, which are taxed as income but are not income under equity method

[Anonymous]

I believe equity method only applies for book not tax

So percent of income from investee is a temp difference

As are dividends, which are taxed as income but are not income under equity method

[Anonymous]

And yea drd is a permanent difference

[Anonymous]

And yea drd is a permanent difference

[Anonymous]

But permanent difference should not affect deferred taxes

Deferred tax liability only arises due to temp difference

[Anonymous]

But permanent difference should not affect deferred taxes

Deferred tax liability only arises due to temp difference

[Iron_Victory]

Right so for tax purposes we don't recognized the income from the investment in B. We only recognize the dividends as income which we do not do for book purposes. Since we get a DRD of 80% we pay tax on 20% of the dividends. Since we assume future earnings(or this is given to us in the problem) will be distributed as dividends that is where we have a future tax liability (income to be taxed in future periods). The formula would then be this

Undistributed earnings = (Net income of investee x ownership %) – (dividends of investee x ownership %)

Undistributed earnings x (1-DRD %) x Tax Rate = Deferred Income tax liability for equity method investments

I suppose if the earnings were not planning on being distributed, and they would say this in the problem?, then there would be no deferred tax liability.

Two things about the example problem were throwing me off. 1) the horrible explanation and 2) That the deferred tax liability base amount and the DRD were the same number (6,400), by coincidence or by design, which got confusing.

AUD - (74),78
BEC - 85
FAR - 86
REG - 84

[Iron_Victory]

Right so for tax purposes we don't recognized the income from the investment in B. We only recognize the dividends as income which we do not do for book purposes. Since we get a DRD of 80% we pay tax on 20% of the dividends. Since we assume future earnings(or this is given to us in the problem) will be distributed as dividends that is where we have a future tax liability (income to be taxed in future periods). The formula would then be this

Undistributed earnings = (Net income of investee x ownership %) – (dividends of investee x ownership %)

Undistributed earnings x (1-DRD %) x Tax Rate = Deferred Income tax liability for equity method investments

I suppose if the earnings were not planning on being distributed, and they would say this in the problem?, then there would be no deferred tax liability.

Two things about the example problem were throwing me off. 1) the horrible explanation and 2) That the deferred tax liability base amount and the DRD were the same number (6,400), by coincidence or by design, which got confusing.

AUD - (74),78
BEC - 85
FAR - 86
REG - 84

[Anonymous]

I'm struggling with how the DRD (dividend received deduction) gets factored in here:

Taft Corp. uses the equity method to account for its 25% investment in Flame, Inc. During 20X1, Taft received dividends of $30,000 from Flame and recorded $180,000 as its equity in the earnings of Flame. Additional information follows:

•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 20X1 and thereafter.

In its December 31, 20X1, balance sheet, what amount should Taft report for deferred income tax liability?

A. $9,000

B. $10,800

C. $45,000

D. $54,000

Correct answer: A

Explanation:

The recognized but as yet unreceived income will generate a future tax consequence, a future tax liability. However, dividends received by a corporation are eligible for a dividends-received deduction, and thus only a smaller taxable amount (multiplied by the tax rate) will eventually be paid.

Taft's recorded equity in Flame earnings $180,000
Less dividends received in 20X1 30,000
Equals temporary difference before dividend deduction 150,000
Less dividends received deduction (80% x $150,000) 120,000
Equals net amount of temporary difference $ 30,000
Times tax rate x 30%
Deferred income tax liability $ 9,000

[Author]

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