cash basis for tax reporting

An analyst gathered the following data for Alice Company. Alice Company reported a pretax income of $400,000 in its income statement for the period ended 31 December 2002 . Included in its pretax income are: (1) interest received on tax-free municipal bonds $50,000 and (2) rent expense of $20,000. (Only $10,000 was paid in cash for rent during 2002). Alice follows cash basis for tax reporting. Assume a tax rate of 40%. What is the income tax expense that Alice should report on its income statement for the year ended 31 December 2002? A) $132,000. B) $144,000. C) $140,000. D) $160,000. Your answer: B was incorrect. The correct answer was C) $140,000. $400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000 -------------------------------------------------- If cash basis is used for tax reporting, shouldn’t we have added to net income that 10,000 of rent expense because it wasn’t paid out in cash? And then consequently my answer was 400,000 - 50,000 + 10,000 = 360,000 x 40% = $144,000 Why does the fact that cash basis is used for tax reporting have no effect on this problem?

I think the point here is not “cash” but the interest being tax exempt.

but why do I leave rent expense alone at $20,000, when only 10,000 cash was paid?

it’s irrelevant information to make you go nuts.

well mission accomplished on making me go nuts so I guess my next question is how does a cash basis affect tax reporting? cash basis isn’t in the index of the cfai books.

any takers on this?

I’m now also confused. The cash basis doesn’t make a lot of sense to me, since then the whole tax reporting should be made on a cash basis and you would need more information. otherwise you might be right to also adjust the “cash”-icnome by the non-cash charge.

yeah, it seems to me that cash basis would affect revenue and expense recognition…which led me to my first answer…but I don’t know we might have beat this one dead.

This is a very tricky question, they key being like on many other CFAI questions to read it very carefully… The question does not ask for Taxes Payable or income tax paid… It asks what the “income tax expense on the income statement” should be… Hence throwing the cash basis information out the window… Income tax expense = Taxes payable + deferred tax expenses… In this case netting out the $10000 in rent that is a DTL…

remember guys tax expense = tax payable+DTL-DTA 400000-50000 which is the permanent diffrence= 350000. for tax reporting we use cash basis so Taxable income will be lower than pretax income. So, Taxable we 150000-10000 becuase we only got 10000 in cash= 140000*.4= 136000 this the taxes payable. However. we do have a temporary diffrence betweem income tax and taxble income of 10000 that is included in pretax income= since pretax in higher than taxable income, the diffrence must be DTL. so, 10000*.4= 4000 back to the formula" tax expense= tax payable 136000 + DTL 4000- DTA ( no DTA)= 140000

I find it much simpler to realize that the additional rent information will be a DTL right off the bat and hence to ignore the information (automatically adding it back into the interest expense)… Though ssdnola’s method is exactly correct and would be required if a DTA was thrown into the mix as well.

Wait a sec, isn’t income tax expense (on your financial statements) just equal to pretax income * tax rate? I’m confused now

No, income tax expense is used calculating the EFF rate. This section is driving me nuts!!!

I recently got my CA, and as far as I know the reason why the rent expense is not deducted is because tax does allow for normal accruals to be used when determining income tax expense. The rent would not actually create a temporary difference as it would be deductible for tax purposes and accounting purposes. Tax usually does use the “cash basis”, but the act does allow normal accruals, I can’t remember the exact section in the act that states this. Good luck on your exam