Given the following data regarding two firms under different scenarios, determine the amount of any deferred tax liability or asset.
Firm 1:
Tax Reporting
Financial Reporting
Revenue
$500,000
Revenue
$500,000
Depreciation
$100,000
Depreciation
$50,000
Taxable income
$400,000
Pretax income
$450,000
Taxes payable
$160,000
Tax expense
$180,000
Net income
$240,000
Net income
$270,000
Firm 2:
Tax Reporting
Financial Reporting
Revenue
$500,000
Revenue
$500,000
Warranty expense
$0
Warranty expense
$10,000
Taxable income
$500,000
Pretax income
$490,000
Taxes payable
$200,000
Tax expense
$196,000
Net income
$300,000
Net income
$294,000
| Firm 1 Deferred Tax: | Firm 2 Deferred Tax: |
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A deferred tax liability and asset is created when an income or expense item is treated differently on financial statements than it is on the company’s tax returns.
A deferred tax liability is when that difference results in greater tax expense on the financial statements than taxes payable on the tax return.
The deferred tax liability for firm 1 = $180,000 tax expense - $160,000 taxes payable = $20,000
A deferred tax asset is when that difference results in lower taxes payable on the financial statements than on the tax return.
The deferred tax asset for firm 2 = $200,000 taxes payable - $196,000 tax expense = $4,000
A company purchased a new pizza oven directly from Italy for $12,675. It will work for 5 years and has no salvage value. The tax rate is 41%, and annual revenues are constant at $7,192. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years 1 and 2, and 30% in year 3. For purposes of this exercise ignore all expenses other than depreciation.
Assume the tax rate for years 4 and 5 changed from 41% to 31%. What will be the deferred tax liability as of the end of year 3 and the resulting adjustment to net income in year 3 for financial reporting purposes due to the change in the tax rate?
| Deferred Tax Liability | Net Income |
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Straight-line depreciation is $12,675 / 5 = $2,535. At the old tax rate of 41%: At the new tax rate of 31%: The deferred tax liability will decrease by $507 = ($2,079 ? $1,572) due to the new lower tax rate. An adjustment of $507 in tax expense will result in increase in net income by the same amount $507. Another way of answering this question is as follows: The deferred tax liability is the cost of the oven multiplied by the difference in the amount of depreciation at the end of year 3 between accelerated depreciation (100%) and straight line (60%) depreciation methods multiplied by the tax rate ((12,675 × 0.4) × 0.31 = $1,572). The change in net income due to the change in tax rates is the cost of the oven multiplied by the difference in the amount of depreciation at the end of year 3 multiplied by the difference in tax rates (12,675 × 0.4 × (0.41 ? 0.31) = 507).
Financial statement income is $7,192 ? $2,535 = $4,657.
Accelerated depreciation is $12,675(0.35) = $4,436 in years 1 and 2 and $12,675(0.3) = $3,803 in year 3.
Taxable income is $7,192 ? $4,436 = $2,756 in years 1 and 2 and $7,192 ? $3,803 = $3,389 in year 3.
Deferred Tax liability for year 1 = $779.41 [($4,657 ? $2,756)(0.41)]
Deferred Tax liability for year 2 = $779.41 [($4,657 ? $2,756)(0.41)]
Deferred Tax liability for year 3 = $519.88 [($4,657 ? $3,389)(0.41)]
Deferred tax liability at the end of year 3, before the change in tax rate, is $2,079 = ($779.41 + $779.41 + $519.88)
Deferred Tax liability for year 1 = $589.31 [($4,657 ? $2,756)(0.31)]
Deferred Tax liability for year 2 = $589.31 [($4,657 ? $2,756)(0.31)]
Deferred Tax liability for year 3 = $393.08 [($4,657 ? $3,389)(0.31)]
Deferred tax liability at the end of year 3, after the change in tax rate, will be $1,572 = ($589.31 + $589.31 + $393.08)
Laser Tech has net temporary differences between tax and book income resulting in a deferred tax liability of $30.6 million. According to U.S. GAAP, an increase in the tax rate would have what impact on deferred taxes and net income, respectively:
| Deferred Taxes | Net Income |
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If tax rates rise then deferred tax liabilities will also rise. The increase in deferred tax liabilities will increase the current tax expense, and if expenses are increasing the net income will decrease.
A firm purchased a piece of equipment for $6,000 with the following information provided:
What will the firm report for deferred taxes on the balance sheet for years 1 and 2?
| Year 1 | Year 2 |
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Using DDB: Using SL: Deferred taxes year 1 = 3,900 – 3,300 = 600 Deferred taxes year 2 = 3,900 – 4,100 + previously deferred taxes = -200 + 600 = 400
Yr. 1
Yr. 2
Revenue
15,000
15,000
Dep.
4,000
1,333
Taxable Inc
11,000
13,667
Taxes Pay
3,300
4,100
Yr. 1
Yr. 2
Revenue
15,000
15,000
Dep.
2,000
2,000
Pretax Inc
13,000
13,000
Tax Exp
3,900
3,900
A firm purchased a piece of equipment for $6,000 with the following information provided:
Calculate the incremental income tax expense for financial reporting for years 1 and 2.
| Year 1 | Year 2 |
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Using SL:
Yr. 1
Yr. 2
Revenue
15,000
15,000
Dep.
2,000
2,000
Pretax income
13,000
13,000
Tax Expense
3,900
3,900
If a firm overestimates its warranty expenses, which of the following results is least likely?
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Income tax expense will be less than taxes payable because the firm can only recognize warranty expense as they occur. Thus, if the warranty expenses are overestimated on the financial statements income tax expense will be less that taxes payable.
Selected information from Kentucky Corp.’s financial statements for the year ended December 31 was as follows (in $ millions):
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Property, Plant & Equip. |
10 |
Deferred Tax Liability |
0.6 | |
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Accumulated Depreciation |
(4) |
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The balances were all associated with a single asset. The asset was permanently impaired and has a present value of future cash flows of $4 million. After Kentucky writes down the asset, Kentucky’s tax accounts will be affected as follows (the tax rate is 40%):
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A permanently impaired asset must be written down to the present value of its future cash flows. The asset’s carrying value of ($10 ? $4 =) $6 million must be reduced by $2 million to $4 million. An impaired value write-down reduces net income for accounting purposes, but not for tax purposes until the asset is sold or disposed of, so taxes payable do not decrease. At a 40% tax rate, the eventual writedown for tax purposes of $2 million will cause $800,000 of changes in deferred tax items. The $600,000 deferred tax liability associated with this asset is eliminated and a deferred tax asset of $200,000 is established.
For the year ended 31 December 2004, Pick Co's pretax financial statement income was $400,000 and its taxable income was $300,000. The difference is due to the following:
Interest on tax-exempt municipal bonds $140,000 Premium expense on key person life insurance $(40,000) Total $100,000
Pick's statutory income tax rate is 30 percent. In its 2004 income statement, what amount should Pick report as current provision for tax payable?
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According to SFAS 109, Current provision = statutory rate × taxable income 30% = Taxes Payable / $300,000 = 0.30 × $300,000 = $90,000
A company purchased a new pizza oven directly from Italy for $12,676. It will work for 5 years and has no salvage value. The tax rate is 41%, and annual revenues are constant at $7,192. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years 1 and 2, and 30% in year 3. For purposes of this exercise ignore all expenses other than depreciation.
What is the tax payable for year one?
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Tax payable for year 1 will be $1,130 = [{$7,192 ? ($12,676 × 0.35)} × 0.41]
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The deferred tax liability for year 1 will be $780. Alternative solution:
Pretax Income = $4,657 = ( $7,192 ? $2,535)
Taxable Income = $2,755 = ($7,192 ? $4,437)
Deferred Tax liability = $780 = [($4,657 ? $2,755)(0.41)]
The difference in depreciation at the end of year one is $12,676 × (0.35 ? 0.20) = $1901.
Deferred tax liability = difference in depreciation × tax rate = $1901 × 0.41 = $780.
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The deferred tax liability at the end of year 3 will be $2,079 = ($780 + $780 + $519). Alternative solution:
Pretax Income = $4,657( $7,192 ? $2,535)
Taxable Income = $3,389[$7,192 ? ($12,676 × 0.30)]
Deferred Tax liability for year 3 = $519[($4,657 ? $3,389)(0.41)]
Deferred Tax liability for year 1 = $780[($4,657 ? $2,755)(0.41)]
Deferred Tax liability for year 2 = $780[($4,657 ? $2,755)(0.41)]
For tax purposes the machine is 100% depreciated out at the end of year three, while for GAAP it is only 60% depreciated.
The difference in depreciation is $12,676 × (1.00 ? 0.60) = $5070.
Deferred tax liability = difference in depreciation × tax rate = $5070 × 0.41 = $2079.
An analyst gathered the following information about a company:
What is the company's tax expense?
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Deferred tax liability = (120,000 ? 100,000) × 0.1 = 2,000 Tax expense = current tax rate × taxable income + deferred tax liability 0.2 × 100,000 + 2,000 = 22,000
Graphics, Inc. has a deferred tax asset of $4,000,000 on its books. As of December 31, it became more likely than not that $2,000,000 of the asset’s value may never be realized because of the uncertainty of future income. Graphics, Inc. should:
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If it becomes more likely than not that deferred tax assets will not be fully realized, a valuation allowance that reduces the asset and also reduces income from continuing operations should be established.
A dance club purchased new sound equipment for $25,352. It will work for 5 years and has no salvage value. Their tax rate is 41%, and their annual revenues are constant at $14,384. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years 1 and 2 and 30% in Year 3. For purposes of this exercise ignore all expenses other than depreciation.
What is the tax payable for year one?
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Tax payable for year one will be $2,259 = [{$14,384 ? ($25,352 × 0.35)} × 0.41].
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The deferred tax liability for year 1 will be $780.
Pretax Income = $9,314 ( $14,384 ? $5,070).
Taxable Income = $5,511 ($14,384 ? $8,873).
Deferred Tax liability = $1,559 [($9,314 ? $5,511)(0.41)].
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The deferred tax liability at the end of year 3 will be $4,158 ($1,559 + $1,559 + $1,040). Deferred Tax liability for year 1 = $1,559 = [($9,314 ? $5,511)(0.41)].
Pretax Income = $9,314 = ( $14,384 ? $5,070).
Taxable Income = $6,778 = [$14,384 ? ($25,352 × 0.30)].
Deferred Tax liability for year 3 = $1,040 = [($9,314 ? $6,778)(0.41)].
Deferred Tax liability for year 2 = $1,559 = [($9,314 ? $5,511)(0.41)].
Indata Company sold a specially manufactured item for $5,000,000 on December 31, 20X6. The item was sold on an installment sale basis, with $1,000,000 paid on the date of the sale and $4,000,000 to be paid in four annual installments of $1,000,000 plus interest at the market rate of 6%. Indata’s tax rate is 40% and its costs to construct the item were $2,500,000. Indata recognizes the entire amount of the sale as income on the date the sale is made for accounting purposes, but not until cash is received for tax purposes.
On its balance sheet dated December 31, 20X6, Indata will, as a result of the transaction described above, increase its deferred tax:
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Accounting profit from the installment sale was $5,000,000 - $2,500,000 = $2,500,000. Income tax expense is calculated based on 40% of accounting profit, so tax expense from the transaction is $2,500,000 × 0.40 = $1,000,000. Revenue reported on the tax form is $1,000,000 and the year's costs for tax purposes are $2,500,000 × ($1,000,000 / $5,000,000) = $500,000. Income taxes payable, as of December 31, 2006, were ($1,000,000 – $500,000) × 0.40 = $200,000. The excess of income tax expense over income taxes payable is a deferred tax liability of $1,000,000 - $200,000 = $800,000.
An analyst gathered the following data for Alice Company.
Alice Company reported a pretax income of $400,000 in its income statement for the period ended December 31, 2002.
Included in its pretax income are: (1) interest received on tax-free municipal bonds $50,000 and (2) rent expense of $20,000. (Only $10,000 was paid in cash for rent during 2002).
Alice follows cash basis for tax reporting.
Assume a tax rate of 40%.
What is the income tax expense that Alice should report on its income statement for the year ended December 31, 2002?
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$400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000
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Since only $10,000 of the rent expense will be allowed per tax returns, a deferred tax asset of $4,000 will result ($10,000 × 40%).
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Net book value of debt decreases from amortization of the premium, while stockholders’ equity increases (due to increasing earnings). This decreases debt/equity ratio over the life of the bond.
A dance club purchased new sound equipment for $25,352. It will work for 5 years and has no salvage value. Their tax rate is 41%, and their annual revenues are constant at $14,384. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years 1 and 2 and 30% in Year 3. For purposes of this exercise ignore all expenses other than depreciation.
Assume that the tax rate changes for years 4 and 5 from 41% to 31%. What will be the deferred tax liability as of the end of year three?
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Straight-line depreciation = $25,352 / 5 = $5,070. Income using straight-line depreciation = $14,384 ? $5,070 = $9,314. Accelerated depreciation (years 1 and 2) = 0.35($25,352) = $8,873. Income (years 1 and 2) = $14,384 ? $8,873 = $5,511. Accelerated depreciation (year 3) = 0.3($25,352) = $7,606. Income (year 3) = $14,384 ? $7,606 = $6,778.
Deferred tax liability at the end of year three, after the change in the expected tax rate, will be $3,144:
DTL for year 1 = $1,178.93 = [($9,314 ? $5,511)(0.31)].
DTL for year 2 = $1,178.93 = [($9,314 ? $5,511)(0.31)].
DTL for year 3 = $786.16 = [($9,314 ? $6,778)(0.31)]
$1,178.93 + $1,178.93 + $786.16 = $3,144
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The deferred tax liability will decrease by $1,014 = ($4,158 ? $3,144) due to the new lower tax rate. An adjustment of $1,014 in tax expense will result in an increase in net income by the same amount of $1,014.
Deferred tax liability at the end of year 3 with tax rate of 41% = $4,158.
Deferred tax liability at the end of year 3 with tax rate of 31% = $3,144.
| Year ending 31 December: | 2002 | 2003 | 2004 | |
| Income Statement: | ||||
| Revenues after all expenses other than depreciation | $200 | $300 | $400 | |
| Depreciation expense | 50 | 50 | 50 | |
| Income before income taxes | $150 | $250 | $350 | |
| Tax return: | ||||
| Taxable income before depreciation expense | $200 | $300 | $400 | |
| Depreciation expense | 75 | 50 | 25 | |
| Taxable income | $125 | $250 | $375 | |
Assume an income tax rate of 40% and zero deferred tax liability on 31 December 2001.
The deferred tax liability to be shown in the 31 December 2003, balance sheet and the 31 December 2004 balance sheet, is:
| 2003 | 2004 |
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First, for 2003, remember that the deferred tax liability (DTL) is cumulative so, it includes the balance from prior years, (assume 2002 in this example since we have no other information). DTL cumulative = (tax return depreciation – financial statement depreciation) × tax rate + DTL from previous year
Camphor Associates uses accrual basis for financial reporting purposes and cash basis for tax purposes. Cash collections from customers is $238,000, and accrued revenue is only $188,000. Assume expenses at 50% in both cases (i.e., $119,000 on cash basis and $94,000 on accrual basis), and a tax rate of 34%. What is the deferred tax asset/liability in this case? A deferred tax:
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Since taxable income ($119,000) exceeds pretax income ($94,000), Camphor will have a deferred tax asset of $8,500 = [($119,000 ? $94,000)(0.34)].
This year, Blue Horizon has recorded $390,000 in revenue for financial reporting purposes, but, on a cash basis, revenue was only $262,000. Assume expenses at 50% in both cases (i.e., $195,000 on accrual basis and $131,000 on cash basis), and a tax rate of 34%. What is the deferred tax liability or asset? A deferred tax:
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Since pretax income ($195,000) exceeds the taxable income ($131,000), Blue Horizon will have a deferred tax liability of $21,760 [($195,000 ? $131,000)(0.34)].
Unit Technologies uses accrual basis for financial reporting purposes and cash accounting for tax purposes. So far this year, Unit Technologies has recorded $195,000 in revenue for financial reporting purposes, but, on a cash basis, revenue was only $131,000. Assume expenses at 50 percent in both cases (i.e., $ 97,500 on accrual basis and $ 65,500 on cash basis), and a tax rate of 34%. What is the deferred tax liability or asset? A deferred tax:
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Since pretax income ($97,500) exceeds the taxable income ($65,500), United Technologies will have a deferred tax liability of $10,880 = [( $97,500 ? $65,500)(0.34)]
Kruger Associates uses an accrual basis for financial reporting purposes and cash basis for tax purposes. Cash collections from customers are $476,000, and accrued revenue is only $376,000. Assume expenses at 50% in both cases (i.e., $238,000 on cash basis and $188,000 on accrual basis), and a tax rate of 34%. What is the deferred tax asset or liability? A deferred tax:
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Since taxable income ($238,000) exceeds pretax income ($188,000), Kruger will have a deferred tax asset of $17,000 [($238,000 ? $188,000)(0.34)].
A company purchased a new pizza oven directly from Italy for $12,676. It will work for 5 years and has no salvage value. The tax rate is 41%, and annual revenues are constant at $7,192. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years 1 and 2, and 30% in year 3. For purposes of this exercise ignore all expenses other than depreciation.
What is the net income and depreciation expense for year one for financial reporting purposes?
| Net Income | Depreciation Expense |
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Net income in year 1 for financial reporting purposes will be $2,748 = [($7,192 ? $2,535)(1 ? 0.41)] The annual depreciation expense on financial statements will be $2,535 = ($12,676 / 5 years)
Corcoran Corp acquired an asset on 1 January 2004, for $500,000. For financial reporting, Corcoran will depreciate the asset using the straight-line method over a 10-year period with no salvage value. For tax purposes the asset will be depreciated straight line for five years and Corcoran’s effective tax rate is 30%. Corcoran’s deferred tax liability for 2004 will:
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Straight-line depreciation per financial reports = 500,000 / 10 = $50,000 Tax depreciation = 500,000 / 5 = $100,000 Temporary difference = 100,000 ? 50,000 = $50,000 Deferred tax liability will increase by $50,000 × 30% = $15,000
On its financial statements for the year ended December 31, Jackson, Inc. listed $2,000,000 in post retirement benefits expense. Jackson, Inc. contributed $200,000 of the expense to its retirement plan during the year. Tax law recognizes cash contributions to a pension account as tax deductible, but not expense accruals. Jackson’s tax rate is 40%.
For the year ended December 31, Jackson, Inc. should show, based on the above, an increase in its deferred tax:
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Jackson’s post-retirement benefits expense will decrease income tax expense by $2,000,000 × 0.40 = $800,000. The cash contribution will decrease income taxes payable by $200,000 × 0.40 = $80,000. Because taxes payable will exceed income tax expense, the difference of $800,000 ? $80,000 = $720,000 is an increase in the deferred tax asset account.
Nespa, Inc., has a deferred tax liability on its balance sheet in the amount of $25 million. A change in tax laws has increased future tax rates for Nespa. The impact of this increase in tax rate will be:
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An increase in tax rates will increase future deferred tax liability, and the impact of the increase in liability will be reflected in the income statement of the year in which the tax rate change is effected.
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