mouse123

Firm 1 has a deferred tax liability and Firm 2 has a deferred tax asset. With respect to the taxes payable for each firm when these deferred tax items reverse, a decrease in the firms’ tax rates will lead to:

Firm 1

Firm 2

A) Lower taxes payable Lower taxes payable

B) Higher taxes payable Lower taxes payable

C) Lower taxes payable Higher taxes payable

---

When the expected tax rate decreases, income will be taxed at a lower rate when a DTL reverses, resulting in lower (cash) taxes payable for Firm 1. In contrast, expenses that will be tax deductible when the DTA reverses will provide less of a benefit when the tax rate is lower, resulting in higher taxes payable for Firm 2.

mouse123

Christophe Inc. is an electronics manufacturing firm. It owns equipment with a tax basis of $800,000 and a carrying value of $600,000 as the result an impairment charge. It also has a tax loss carryforward of $300,000 that is expected to be utilized within the next year or two. The tax rate on these items is 40% but the tax rate is expected to decrease to 35% for the foreseeable future. Which of the following amounts is closest to the net effect of the change in tax rate on the income statement?

A) Increase in deferred tax expense of $5,000.

B) Decrease in deferred tax expense of $5,000.

C) Increase in deferred tax expense of $25,000.

---

The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a deductible temporary difference that leads to a deferred tax asset (DTA) of $80,000 ($200,000 × 40%). The tax loss carryforward of $300,000 also leads to a DTA but for $120,000 ($300,000 × 40%).
The decrease in the tax rate from 40% to 35% will reduce the DTA of the equipment by $10,000 ($200,000 × 5%). It will reduce the DTA of the tax loss carryforward by $15,000 ($300,000 × 5%). In total, the DTA will decrease by $25,000. Therefore, the balancing entry will be to increase deferred tax expense by $25,000.

mouse123

Habel Inc. owns equipment with a tax base of $400,000 and a carrying value of $600,000. Habel also has a tax loss carryforward of $200,000 that is expected to be utilized in the foreseeable future. Deferred tax items on the balance sheet are valued based on a tax rate of 30%. If the tax rate is expected to increase to 35%, the adjustments to the value of deferred tax items will most likely cause Habel’s total liabilities-to-equity ratio to:

A) increase.

B) decrease.

C) remain unchanged.

---

The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a taxable temporary difference that leads to a deferred tax liability of $60,000 ($200,000 × 30%). The tax loss carryforward of $200,000 leads to a deferred tax asset of $60,000 ($200,000 × 30%).
The increase in the tax rate from 30% to 35% will increase both the DTL and the DTA by $10,000 ($200,000 × 5%). Equity is unchanged. Therefore, the total liabilities-to-equity ratio will increase because of the increase in the deferred tax liability.

Kingpin804

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

A) $1,572 $747

B) $1,039 $507

C) $1,572 $507

---

Straight-line depreciation is $12,675 / 5 = $2,535.
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.
At the old tax rate of 41%:
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)
At the new tax rate of 31%:
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)
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).

Kingpin804

If a firm overestimates its warranty expenses, which of the following results is least likely?

A) Income tax expense will be greater than taxes payable.

B) A deferred tax asset will result.

C) A timing difference will result between tax and financial reporting.

---

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.

Kingpin804

An analyst has gathered the following tax information:

	Year 1	Year 2
Pretax Income	$60,000	$60,000
Taxable Income	$50,000	$65,000

The current tax rate is 40%. Assume the tax rate is reduced to 30% and the change is enacted at the beginning of Year 2.In year 1, what are the taxes payable and what is the deferred tax liability?

Taxes Payable

Deferred Tax Liability

A) $24,000 $3,000

B) $20,000 $1,500

C) $20,000 $3,000

---

Taxes Payable = Taxable Income × Current Tax Rate = $50,000 × 40% = $20,000. The taxes payable will be based on the current tax rate of 40%.

Deferred Tax Liability = (Pretax Income − Taxable Income) × 30% = ($60,000 − 50,000) × 30% = $3,000.

SFAS 109 requires adjustments to deferred tax assets and liabilities to reflect the impact of a change in tax rates or tax laws.

---

Total income tax expense for Year 1 is:

A) $23,000.

B) $17,000.

C) $24,000.

---

Total Income Tax Expense = Taxes Payable − Deferred Tax Asset + Deferred Tax Liability = $20,000 − 0 + 3,000 = $23,000.

Kingpin804

Selected information from Kentucky Corp.’s financial statements for the year ended December 31 was as follows (in $ millions):

Property, Plant & Equip.	10		Deferred Tax Liability	0.6
Accumulated Depreciation	(4)

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%):

A) taxes payable will decrease $800,000.

B) deferred tax liability will be eliminated and deferred tax assets will increase $200,000.

C) deferred tax liability will be eliminated and deferred tax assets will increase $1.4 million.

---

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.

Kingpin804

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?

A) $102,000.

B) $90,000.

C) $120,000.

---

According to SFAS 109, Current provision = statutory rate × taxable income
30% = Taxes Payable / $300,000
= 0.30 × $300,000
= $90,000

Kingpin804

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?

A) $1,909.

B) $1,130.

C) $779.

---

Tax payable for year 1 will be $1,130 = [{$7,192 − ($12,676 × 0.35)} × 0.41]

---

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

A) $1,129.

B) $1,909

C) $780.

---

The deferred tax liability for year 1 will be $780.
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)]

Alternative solution:
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.

---

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

A) $1,029.

B) $2,079.

C) $780.

---

The deferred tax liability at the end of year 3 will be $2,079 = ($780 + $780 + $519).
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)]
Alternative solution:
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.

Kingpin804

An analyst gathered the following information about a company:

• Taxable income = $100,000.
• Pretax income = $120,000.
• Current tax rate = 20%.
• Tax rate when the reversal occurs will be 10%.

What is the company's tax expense?

A) $22,000.

B) $24,000.

C) $10,000.

---

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