Problem:
Nelson, Inc. purchased machinery at the beginning of 2005 for $90,000. Management used the straight-line method to depreciate the cost for financial reporting purposes and the sum of the years' digits method to depreciate the cost for tax purposes. The life of the machinery was estimated to be two years, and the salvage value was estimated at zero. Revenues less expenses other than depreciation expense and amortization of goodwill equaled $500,000 for 2005 and 2006. Nelson pays income tax at a rate of 20% of taxable income. The amortization of goodwill equaled $500,000 for 2005 and 2006.
Required:
1. Compute the taxable income and the financial reporting income ( before taxes) for the years 2005 and 2006.
2. What are the permanent and timing differences? Give an example of each for Nelson, Inc.
3. Complete the following table on your answer to requirement 1.
Ending balance ending balance in
Year Tax Liability Tax expense Deferred Income Taxes
2005
2006
4. Assume that the tax rate was changed by the federal government to 30% at the beginning of 2006. Compute the following.
Increase/decrease in deferred income taxes
Income tax liability for 2006
Income tax expense for 2006