1215

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:

A) not make any adjustments until it is certain that the tax benefits will not be realized.

B) reverse the asset account permanently by $2,000,000.

C) reduce the asset by establishing a valuation allowance of $2,000,000 against the asset.

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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.

1215

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?

A) $2,259.

B) $779.

C) $1,909.

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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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What is the deferred tax liability as of the end of year one?

A) $1,909.

B) $1,129.

C) $1,559.

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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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What is the deferred tax liability as of the end of year three?

A) $780.

B) $4,158.

C) $1,029.

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The deferred tax liability at the end of year 3 will be $4,158 ($1,559 + $1,559 + $1,040).
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 1 = $1,559 = [($9,314 ? $5,511)(0.41)].
Deferred Tax liability for year 2 = $1,559 = [($9,314 ? $5,511)(0.41)].

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1215

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:

A) liability by $800,000.

B) asset by $800,000.

C) liability by $200,000.

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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.

1215

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?

A) $140,000.

B) $160,000.

C) $132,000.

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$400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000

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Based on the information provided, which of the following is most accurate with respect to deferred tax during 2002? Deferred tax:

A) liability will increase by $4,000.

B) asset will increase by $4,000.

C) will remain unchanged.

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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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All else equal, when a company issues bonds at a premium, the debt/equity ratio will show:

A) an increasing trend over the life of the bond.

B) a decreasing trend over the life of the bond.

C) stable trend over the life of the bond.

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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.

1215

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?

A) $3,144.

B) $1,039.

C) $2,948.

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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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Because the tax rate changes for years 4 and 5 from 41% to 31%, net income will have to be adjusted for financial reporting purposes in year three. What is the amount of this adjustment?

A) $1,030.

B) $747.

C) $1,014.

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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.

1215

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

A) $0 $10

B) $25 $20

C) $10 $0

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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

• DTL for 2002: (75 – 50) × 0.4 + 0 = 10
• DTL for 2003: (50 – 50) × 0.4 + 10 = 10
• DTL for 2004: (25 – 50) × 0.4 + 10 = 0

1215

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:

A) asset of $8,500.

B) asset of $48,960.

C) liability of $8,500.

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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)].

1215

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:

A) liability of $21,760.

B) liability of $16,320.

C) asset of $21,760.

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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)].

1215

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:

A) liability of $16,320.

B) liability of $10,880.

C) asset of $10,880.

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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)]

1215

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:

A) asset of $17,000.

B) asset of $48,960.

C) liability of $17,000.

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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)].