FAR · Financial reporting · 7 practice questions
Interim Income Taxes: Annual ETR vs. Discrete Items
Apply the estimated annual effective tax rate to year-to-date ordinary income, and recognize discrete tax items in the period they occur. Follow the steps below to separate the two and find year-to-date or current-quarter tax expense.
Try one first
Hint
Separate the tax effect of ordinary income from the tax effect of items that are treated discretely in interim reporting.
Answer C. For interim reporting under U.S. GAAP, income tax on ordinary operations is measured by applying the estimated annual effective tax rate to year-to-date ordinary pretax income (30% of $1,200,000 = $360,000). A settlement of a prior-year tax audit is a discrete item and should be recognized in the interim period in which it occurs, not absorbed into the annual rate. Thus Rexon should report the tax on ordinary income using the 30% annual rate and separately recognize the $90,000 discrete tax benefit in Q2.
Why not A: Incorrect, U.S. GAAP requires a year-to-date approach using the estimated annual effective tax rate for ordinary income in interim statements, and prior-year settlements are recognized when they occur rather than deferred to year-end.
Why not B: This is tempting because interim tax accounting uses an estimated annual rate, but the $90,000 settlement is a discrete prior-year item and should not be merged into the annual effective rate; it must be recognized separately in the period of settlement.
Why not D: Smoothing a discrete prior-year settlement across future quarters is incorrect; discrete tax items are recognized in the interim period in which they occur, not spread ratably.
Step by step
- Identify the reporting period
Rexon has $1,200,000 of ordinary pretax income for the first six months and a reliable 30% estimated annual effective tax rate. The question asks for six-month tax expense, not Q2 alone.
- Separate the discrete item
Rexon's Q2 settlement of a prior-year tax audit creates a $90,000 tax benefit. It is the only discrete item and stays outside the annual rate.
- Compute year-to-date ordinary tax
$1,200,000 × 30% = $360,000. Apply the estimated annual rate to year-to-date ordinary income, not just Q2 income.
- Recognize the settlement benefit
$360,000 − $90,000 = $270,000 of six-month tax expense. Recognize the full benefit in Q2, not over the remaining quarters.
- Isolate the quarter if requested
For Q2 alone, subtract total tax expense already recognized in Q1 from $270,000. For the six-month amount requested here, stop at $270,000.
Key points
- Remember: Current-quarter tax equals total year-to-date tax minus tax already recorded in earlier quarters.
- A revised annual rate applies to all year-to-date ordinary income; record the adjustment now without restating earlier quarters.
- Remeasurement of existing deferred taxes after a tax law change is discrete in the enactment period.
- Keep discontinued operations and their tax effects outside the continuing-operations annual rate.
How the exam traps you
- Apply a revised annual rate only to the current quarter. Recompute year-to-date ordinary tax at the revised rate, then subtract tax already recognized.
- Spread a prior-year settlement benefit through the annual rate. Recognize the full benefit separately in the settlement quarter.
- Report cumulative tax as the current-quarter expense. Subtract tax recognized in earlier quarters only when the question asks for the current quarter.
Question 2
Hint
Separate YTD ordinary continuing operations (use the estimated annual rate and then isolate Q2 by subtracting prior interim tax) from items outside continuing operations (taxed discretely at the stated rate).
Answer D. Apply the 25% estimated annual effective rate to YTD ordinary pretax income: $800,000 × 25% = $200,000. Subtract the $75,000 tax recognized in Q1 to get Q2 tax on ordinary income = $125,000. The discontinued-operations gain is a discrete item taxed at 30% in the period recognized: $100,000 × 30% = $30,000. Total Q2 income tax expense = $125,000 + $30,000 = $155,000.
Why not A: Tempting because it equals the Q2 tax on ordinary continuing operations only (YTD ordinary tax $200,000 less $75,000 recorded in Q1 = $125,000). It is wrong because it omits the tax on the $100,000 discontinued-operations gain, which must be recognized separately in Q2.
Why not B: Tempting because a candidate might apply the 25% estimated rate to both ordinary income and the discontinued gain (Q2 ordinary tax $125,000 + 25% × $100,000 = $150,000). It is wrong because the discontinued-operations gain is taxed at 30% per the facts, so its tax is $30,000 (not $25,000).
Why not C: Tempting because it equals total year-to-date tax on ordinary income plus tax on the discontinued gain ($200,000 + $30,000 = $230,000). It is wrong for the Q2 expense because $75,000 of tax was already recorded in Q1; the question asks only for Q2 tax expense.
Question 3
Hint
Separate the tax effect of ordinary income from the tax effect of a one-time event caused by an enacted law change.
Answer B. Under ASC 740, the effect of a change in tax law or tax rate on existing deferred tax balances is recognized in the interim period that includes the enactment date and treated as a discrete item. Separately, tax on ordinary year-to-date income is measured using the estimated annual effective tax rate, updated for current expectations and applied on a year-to-date basis. Therefore Maren should recognize the remeasurement as a discrete Q2 item and use the updated annual ETR for ordinary income.
Why not A: This confuses ordinary interim annualization with a discrete enacted-law remeasurement. The remeasurement from a tax law change is recognized immediately as a discrete item in the interim period of enactment, not smoothed into the annual ETR and spread ratably.
Why not C: Deferred taxes relate to future reversals, but a change in tax law requires immediate remeasurement of existing deferred tax balances in the interim period of enactment; waiting until year-end is not permitted for the remeasurement effect.
Why not D: While recognizing the remeasurement in Q2 is correct, interim reporting still requires allocation of tax on ordinary income using an updated estimated annual effective tax rate applied to year-to-date ordinary income; switching to a single-quarter actual rate for subsequent periods is not the required approach.
Question 4
Hint
Compute the interim tax on continuing ordinary operations on a year-to-date basis, then back out what was already recognized in Q1. Keep the discontinued operation out of that annual effective tax rate calculation.
Answer B. Compute interim tax on continuing ordinary operations by applying the revised estimated annual effective tax rate to year-to-date ordinary income and then true up for tax recognized in prior interim periods. Year-to-date continuing ordinary income is $200,000 (400,000 − 200,000); at 30% that yields $60,000 of year-to-date tax. Because $100,000 was already recognized in Q1, Q2 should reflect a $40,000 tax benefit for continuing operations. The discontinued-operation tax effect is recognized and presented separately with the discontinued operation (the $25,000 tax benefit).
Why not A: This applies the revised rate to the Q2 continuing loss only (200,000 × 30% = 60,000) instead of using the year-to-date basis and then trueing up for tax already recognized in Q1, so it overstates the Q2 continuing-operations benefit.
Why not C: A positive year-to-date ordinary income does not eliminate the interim tax calculation; the company must recompute year-to-date tax using the revised annual effective tax rate and compare that to tax already recorded, which here produces a $40,000 benefit in Q2 continuing operations.
Why not D: This incorrectly mixes discontinued operations with continuing-operations tax calculation. Under interim-tax rules, the discontinued-operation tax effect is recognized discretely and presented with the discontinued operation, so combining them into continuing operations is incorrect.
Question 5
Hint
Separate tax on ordinary income from tax on discrete items, and calculate the ordinary-income piece on a year-to-date basis.
Answer D. Compute year-to-date ordinary-income tax using the current estimated annual rate: YTD ordinary pretax income = $600,000 + $600,000 = $1,200,000; tax = $1,200,000 × 30% = $360,000. Add the discrete tax on the equipment gain of $25,000 for a YTD total of $385,000. Subtract the $168,000 already recognized in Q1 to get Q2 income tax expense = $217,000.
Why not A: This treats Q2 as if the original 28% rate applied to Q2 ordinary income and then adds the discrete tax: ($600,000 × 28% = $168,000) + $25,000 = $193,000. That's incorrect because interim tax on ordinary income must be recomputed on a cumulative year-to-date basis using the current estimated annual effective tax rate.
Why not B: This applies the updated 30% rate to Q2 only and then adds the discrete tax: ($600,000 × 30% = $180,000) + $25,000 = $205,000. That incorrectly treats Q2 as a standalone quarter instead of recomputing year-to-date ordinary-income tax and subtracting previously recorded interim tax.
Why not C: This is the correct total tax expense for the six months ended June 30 ($360,000 ordinary + $25,000 discrete = $385,000), not the incremental tax expense attributable to Q2 alone.
Question 6
Hint
Compute the tax on year-to-date ordinary income first, then convert that to the current quarter amount, and only after that consider the discrete item.
Answer C. Apply the annual estimated effective tax rate to year-to-date ordinary pretax income: 3,200,000 × 24% = 768,000 (YTD tax on ordinary income). Subtract tax already recognized for Q1 (600,000 × 24% = 144,000) to get Q2 ordinary tax: 768,000 − 144,000 = 624,000. The $96,000 prior-year audit settlement is a discrete tax benefit recognized in Q2, reducing Q2 tax expense to 624,000 − 96,000 = 528,000.
Why not A: This subtracts the discrete benefit from the year-to-date tax (768,000 − 96,000 = 672,000) producing a net YTD figure, not the current-quarter expense. It fails to remove the tax already recognized in Q1 when isolating Q2 expense.
Why not B: This equals the Q2 ordinary tax calculated by annualizing the rate and removing Q1 tax (768,000 − 144,000 = 624,000) but ignores the $96,000 discrete prior-year tax benefit that must be recognized entirely in Q2, which reduces Q2 expense to 528,000.
Why not D: This is the year-to-date tax on ordinary income (3,200,000 × 24%) rather than the tax expense for Q2 alone, and it also ignores the discrete $96,000 benefit recognized in Q2.
Question 7
Hint
For interim income taxes, start with year-to-date ordinary income rather than the current quarter alone, and then ask whether any item is treated discretely.
Answer D. Compute year-to-date tax on ordinary income: $1,400,000 × 30% = $420,000. Include the $90,000 discrete tax benefit in Q2, so year-to-date tax expense after discrete items is $420,000 − $90,000 = $330,000. Subtract the $150,000 recognized in Q1 to get Q2 tax expense: $330,000 − $150,000 = $180,000.
Why not A: This is the year-to-date tax expense after the discrete benefit ($420,000 − $90,000 = $330,000) but fails to convert the year-to-date figure into the current-quarter amount by subtracting the tax already recognized in Q1.
Why not B: This result arises if a candidate treats the $90,000 uncertain tax benefit as discrete (correct) but incorrectly applies the 30% rate only to Q2 ordinary income and then nets the discrete benefit, rather than using the year-to-date catch-up approach required for interim tax expense.
Why not C: This reflects applying the revised 30% rate to Q2 ordinary income only (Q2 pretax = $800,000; $800,000 × 30% = $240,000) and ignoring the discrete $90,000 tax benefit. Under interim rules, you must compute year-to-date tax on ordinary income and then recognize discrete items separately.
Common questions
How do you calculate the estimated annual effective tax rate?
Divide estimated full-year tax expense on ordinary income by estimated full-year ordinary pretax income. Apply that rate to year-to-date ordinary income from continuing operations.
What happens when the estimated annual effective tax rate changes?
Recompute year-to-date ordinary tax using the revised rate. Record the difference from previously recognized tax in the current quarter; do not restate earlier quarters.
Which items are discrete in an interim tax provision?
Prior-year tax settlements and remeasurement of existing deferred taxes caused by enacted tax law changes are discrete. An unusual gain identified as discrete is also taxed separately in the period it occurs.
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