# Taxable Income

Intel Research reported earnings before taxes of \$500,000 on December 31, 20X1. The following two items were included in the computation of 20X1 earnings before taxes: · Interest income of \$75,000, which was received on tax-exempt municipal bonds owned. · Warranty expense on products sold equaling \$25,000. The warranty expense is not deductible for tax purposes in 20X1. However, it is expected that the warranty expense will be deductible for tax purposes in 20X2 and 20X3. If the tax rate in 20X1 was 40% and the tax rate is expected to be 35% in both 20X2 and 20X3, what is Intel Research’s taxable income in 20X1? a. \$450,000 b. \$425,000 c. \$525,000 d. \$550,000 - Dinesh S

500 - 75 + 25 = 450 Choice A -75 bcos Interest expense was not tax exempt +25 bcos warranty expense was incurred.

you are correct cpk!! I just don’t understand this… When they say that 500K is the Earning before Taxes and say that it includes 75K muni-interest and 25K warranty. Now when we move to Tax Reporting, we need to subtract the 75K muni-interest as that is tax-free, so I understand till 500 - 75 = 425 (my answer was B). Could you elaborate a bit more on why the 25K warranty expense was added back to the income, when they already said in the question that It was already included in the 500K amount, aren’t we double counting the warranty expenses?? - Dinesh S

You add it back because the question says it is not tax deductible. The 500k income includes the deduction for the warranty expense, but it is not tax deductible, so you have to add it back. Warranty expenses will be deducted from income on financial statements as soon as they are sold., however for tax reporting you cannot deduct it until actual expenditures have been made.

and to add to the misery see this… Tennessee Tuxedo Corporation reported pretax income of \$720,000 for the current year, which included warranty expense of \$80,000. For tax purposes warranty costs are not deductible until incurred. Actual warranty expenditures totaled \$48,000. The tax rate is 30%. a. \$206,400 b. \$216,000 c. \$225,600 d. \$230,400 I did a ‘A’ for this since 720K already contains 80K in it but now the real warranty expenses were 48K, so we need to subtract the complete estimated amount of 80K from 720K and add back the read expenses amount on the warranty i.e 48K so answer should be [720K - 80K + 48K] * 0.30, right?? I am seriously missing something big here… - Dinesh S

No dinesh exactly the opposite you add back what was deducted but not deductible, that is the 80k the you substract what is allowable to be deducted, the actual incurred 48k (720+80-48)*0.3 ans C

Should be 720+80-48 C You need to understand the difference between pretax income (on financial statements) and taxable income (tax reporting). I think I will confuse you more if I try to explain it, so just look it over

Pre tax income = 720K (Income statement). Incl 80 K warranty expense. (this was not included in the Income statement). so if we go over to the Tax statement – Taxable Income = 720 + 80. Actual warranty expense = 48K So Tax Payable would be on 800 - 48 = 752K @ 30% = 225.6 K – Choice C

Actuallly CPK, I think 80k warranty expense will be included on the income statement, but it cannot be included on the tax statement. Thats why you add it back.

thanks LongonCFA…

it’s deducted in income statement not deducted in tax statement. longoncfa is right

florinpop Wrote: ------------------------------------------------------- > No dinesh exactly the opposite > you add back what was deducted but not deductible, > that is the 80k > the you substract what is allowable to be > deducted, the actual incurred 48k > (720+80-48)*0.3 ans C you mean to say, when they say that the Pretax income was 720K, the complete warrenty expense (80K) was already subtracted to get to this amount… so is it safe so say that [X - 80K = 720K]?? and that’s the reason why when calculating income on the tax reporting side, we add back the 80K and subtract only what was really spent on warrents??? help me out of this… - Dinesh S

exactly you got it

for taxable income you add back all the nondeductible expenses and deduct only what is deductible

LongOnCFA Wrote: ------------------------------------------------------- > You add it back because the question says it is > not tax deductible. The 500k income includes the > deduction for the warranty expense, but it is not > tax deductible, so you have to add it back. > > Warranty expenses will be deducted from income on > financial statements as soon as they are sold., > however for tax reporting you cannot deduct it > until actual expenditures have been made. Ok, now I get this … Earning before taxes (on FR side) = 500K Intel Research got to this figure by including the tax-free muni-interest of 75K and subtracting the warrent expenses of 25K … [X + 75K - 25K], but then they came to know that munis are tax exempt so they subtracted 75K, and also it was declared that warrenty expense will not be tax deductibe for 2001 (but they already deducted 25K initially), so now they add back 25K. hence 500 - 75K + 25K is the answer. Is my understanding correct? - Dinesh S

yes. the first calculation is financial statement and the other one is on the tax statement

Thanks florinpop, I am clear on this now… and will nail the question in the exam. Actually I read the (Schweser - reading 44) notes twice and my understanding was the other way round. Thanks guys, the forum truely rockz!! - Dinesh S