1215

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

A) $2,535 $3,169

B) $2,748 $2,535

C) $4,657 $2,748

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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)

1215

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:

A) decrease by $50,000.

B) increase by $15,000.

C) decrease by $15,000.

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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

1215

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:

A) asset account of $720,000.

B) liability account of $720,000.

C) liability account of $80,000.

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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.

1215

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:

A) a decrease in deferred tax liability and a decrease in tax expense.

B) a decrease in deferred tax liability and an increase in tax expense.

C) an increase in deferred tax liability and an increase in tax expense.

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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.