Question

Bikram Yoga Natick pays taxes on a cash basis so annual membership fees received during the year are included in determining their Taxable Income. However, for financial reporting purposes, they are only treated as revenue as time passes and the memberships are expiring. This creates a temporary timing difference which causes Taxable Income to be greater than Income Before Taxes in years when the Deferred Revenue increases; 2013 was such a year.

What will the entry be in 2013 to record this difference?

1. Credit the deferred tax liability account
2. Debit the deferred tax liability account
3. Credit the deferred tax asset account
4. Debit the deferred tax asset account

Answer 1

For Bikram Yoga Natick, the difference in revenue recognition methods between tax and financial reporting creates a deferred tax liability which is recognized by crediting the deferred tax liability account in 2013.

Step-by-step explanation:

For Bikram Yoga Natick, and entities that use cash basis for tax and accrual basis for financial reporting, differences between taxable income and income before taxes due to timing of revenue recognition can create either a deferred tax asset or deferred tax liability. Since the prepaid annual membership fees are recognized as income for tax purposes when received, but recognized over time as they are earned for financial reporting purposes, this creates a future taxable amount when the membership is actually being used. This is a temporary difference that will reverse in the future when the revenue is recognized for tax purposes.

In 2013, the situation described led to a deferred tax liability because taxable income is higher than the income reported for financial reporting purposes. The appropriate journal entry would be to credit the deferred tax liability account to recognize the future tax obligation.

The answer to the question, therefore, is 1. Credit the deferred tax liability account.