Question

Explorers Auto Parts, Inc. reported pretax accounting (GAAP) income of $200,000 in 2019. Included in this amount is $100,000 of warranty expense.

IRS rules say that warranty expenses cannot be used to reduce taxable income until they are paid. $0 of warranty expense was paid in 2019.

The 2019 tax rate was 25%.

Required:

[1] Prepare the journal entry necessary to record Explorers' 2019 taxes.

[2] Due to COVID-19, there is uncertainty regarding whether Explorers Auto will be able to utilize the tax asset created in 2019 (i.e., the company does not anticipate generating significant taxable income for the next several years). It estimates that it will not be able to use 20% of the deferred tax asset (DTA) recorded in [1] above. Record the entry necessary in 2020 to establish an appropriate valuation allowance.

Answer 1

1) Calculation of Deferred Tax Asset

Since the amount of warranty expense will be available for deduction from future taxable income of the company, hence we will create a deferred tax asset in this case.

Amount of Deferred Tax Asset = Amount * Tax Rate

Amount of Deferred Tax Asset = 100000 * 25%= 25000

Actual Tax Liability will be 200000+100000= 300000*25%= 75000

Journal Entry to record the same will be:

Deferred Tax Asset Dr 25000 (Dr.)

Tax Expense Dr 50000 (Dr.)

To Income Tax Payable 75000 (Cr.)

2. Calculation of valuation allowance

Amount of Allowance= 25000* 20%= 5000

Entry to be passed in books

Valuation Allowance Dr 5000 (Dr.)

To Deferred Tax Asset 5000 (Cr.)