The following facts apply to The Nelson Music Co., for the calendar year ended D

Question

The following facts apply to The Nelson Music Co., for the calendar year ended December 31, 2004:

The company purchased new equipment at the beginning of 2004, at a cost $140,000. For accounting purposes, straight-line depreciation was used, assuming an eight-year useful life. For tax purposes, accelerated cost recovery of $31,000 was allowed.

Estimated warranty expenses of $8,400 did not qualify as a tax deduction because actual out-of-pocket expenditures related to repairs and replacements had not been made.

Pre-tax income on the income statement was 99,800.

On July 1, 2002, Nelson acquired all of the common stock of the Jennings Corporation at a cost 0f $675,000. The fair value of Jennings’ net assets at that date was $555,000. The tax law permits amortization of goodwill over a period of 15 years. Nelson wrote off $21,000 of goodwill in 2004 as unrealizable.

Nelson paid $19,000 in foreign import duties on inventory that was purchased in Grand Fenwick, with no carryforward of the difference. The import-duty deduction was $14,000.

The company earned $4,500 in interest on tax-exempt bonds (issued by a federal development agency) that was not taxable in 2004.

Prepare a schedule supporting the computation of taxable income for the year 2004.

                                                                              The Nelson Music Co.

                                                               Schedule for the Computation of Earnings

                                                                              Subject to Income Tax

                                                                  For the Year Ended December 31, 2004

Earnings before taxes                                                                                          $ 99,800

Permanent differences:

       Difference between tax limitations on import

             duties and actual import duties paid                  $   5,000

       Tax-exempt interest                                                   (4,500)                               500                             

                                                                                                                       $ 100,300

Temporary differences:

        Excess of depreciation permitted for tax

             purposes over that computed per GAAP             $ (13,500)

        Warranty liability not deductible until actual

             warranty costs are paid                                            8,400

        Excess of goodwill write-off over goodwill

             amortization permitted by tax laws                          13,200                             8,100

Earnings subject to income tax, per tax return                                                        $ 108,400

Explanation / Answer

Earnings before taxes = Pre-tax income on the income statement = $99,800

Difference between tax limitation on import duties and actual import duties paid = Payment of foreign import duties – Import-duty deduction = 19,000 – 14,000 = $5,000

Tax-exempt interest = Interest on tax-exempt bonds = $4,500

Excess of depreciation = (Straight-line depreciation of equipment) – (Accelerated cost recovery) = (Cost of equipment/Life years) - $31,000 = ($140,000/8) - $31,000 = $17,500 - $31,000 = ($13,500)

Warranty liability = Estimated warranty expenses = $8,400

Excess of goodwill = Goodwill actually written off - Amortized goodwill = 21,000 - {(675,000 – 555,000)/15 years} = $13,000

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