Question

First Bank has some question as to the tax-free nature of $5 million of governmental bonds held in its investment portfolio. This amount is excluded from First Bank's taxable income of $95 million. Management has determined that there is a 75% chance that the tax-free status of this entire amount of interest can't withstand scrutiny of taxing authorities. Assuming a 25% tax rate, what amount of income tax expense should the bank report? Note: Enter your answer in millions rounded to 2 decimal place (i.e., i.e., 5,500,000 should be entered as 5.50 ).

Answer 1

First Bank should report an income tax expense of $24.69 million, considering the contingency that $5 million of government bond interest might be taxed due to scrutiny, at a 75% likelihood and a 25% tax rate.

Step-by-step explanation:

The student is questioning the proper accounting treatment for government bonds held by First Bank that potentially could lose their tax-free status. Since there is a 75% chance that the $5 million of bond interest will not maintain its tax-exempt status and might be subjected to a 25% tax rate, the bank must prepare for this contingency in its financial statements.

To calculate the income tax expense that should be reported by the bank, we apply the probability factor to the potential tax effect:

• Potential tax = 25% of $5 million = $1.25 million
• Contingent tax expense = 75% chance of $1.25 million = $0.9375 million

Add the contingent tax expense to the tax on the bank's taxable income:

• Tax on taxable income = 25% of $95 million = $23.75 million
• Total income tax expense = $23.75 million + $0.9375 million = $24.6875 million

Rounded to two decimal places, the income tax expense the bank should report is $24.69 million.