Interpreting income tax disclosures. Exhibit 11.22 presents selected information from the notes to the financial statements of a manufacturer of equipment for farming, construction, and residential uses for the years ending October 31, 2008, 2007, and 2006.

a. Present the journal entry to recognize income tax expense and income taxes payable for the year ended October 31, 2007. Be sure to consider the effect on deferred tax asset and deferred tax liability accounts.

b. Repeat part a for the year ended October 31, 2008.

c. Why do state and local taxes appear as an addition in the tax reconciliation between income taxes at the statutory tax rate and income tax expense?

d. This firm combines the effect of nondeductible costs and other items in its income tax reconciliation. Will nondeductible costs have the effect of increasing or decreasing the effective tax rate? Explain.

e. Explain why a recognized health care liability and a recognized pension liability give rise to deferred tax assets, whereas a recognized prepaid pension asset gives rise to a deferred tax liability.

f. Sales allowances relate to amounts that this firm pays after the time of sale for warranty repairs, rebates, and returned equipment. Why do sales allowances give rise to a deferred tax asset?

g. What is the likely reason that the valuation allowance on deferred tax assets increased continually during the three years?

h. What is the likely explanation for the direction of the change in the deferred tax liability relating to depreciation?

i. This firm leases equipment to its customers, which gives rise to a deferred tax liability. Does this firm likely account for these leases as operating leases or as capital leases for financial reporting? Which method of accounting for these same leases does the firm likely use for taxreporting?

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Income Tax Disclosures EXHIBIT 11.22 (amounts in millions) (Problem 33) 2007 2008 Income Before Income Taxes $2,174 $2,107 Income Tax Expense: $ 736 $ 738 (39) $ 699 Current ... Deferred... Total Income Tax Expense. $ 742 Income Taxes an Income Before Income Taxes at $ 761 $ 737 the Statutory Tax Rate of 35%... State and Local Taxes (net of federal tax benefit) Foreign Tax Rates ..... 22 10 (6) Nondeductible Costs and Other . (49) $ 742 (42) $ 699 Income Tax Expense 2006 October 31: 2008 2007 COMPONENTS OF DEFERRED TAXES Deferred Tax Assets: Health Care Liability .. $ 825 $ 997 $1,017 Sales Allowances 327 324 304 Pension Liability... Tax Loss and Tax Credit Carryforwards.. Other .... 246 250 156 132 93 55 225 362 257 (50) Valuation Allowance (25) $1,864 (1) Total Deferred Tax Assets $1,842 $1,788 Deferred Tax Liabilities: $ 845 S 860 $ 778 Prepaid Pension Asset . Depreciation 214 231 263 Deferred Lease Income.. 144 154 159 Other .... 122 104 96 Tatal Deferred Tax Liabilities. $1,325 $1,341 $1,304