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

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

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) $24,000.

B) $22,000.

C) $10,000.

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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

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

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.

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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.

1215

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) $120,000.

C) $90,000.

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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

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 tax payable for year one?

A) $1,909.

B) $1,130.

C) $779.

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

A) $780.

B) $1,129.

C) $1,909

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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.

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

A) $1,029.

B) $780.

C) $2,079.

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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.

1215

A firm purchased a piece of equipment for $6,000 with the following information provided:

• Revenue will increase by $15,000 per year.
• The equipment has a 3-year life expectancy and no salvage value.
• The firm's tax rate is 30%.
• Straight-line depreciation is used for financial reporting and double declining is used for tax purposes.

What will the firm report for deferred taxes on the balance sheet for years 1 and 2?

Year 1

Year 2

A) $3,900 $3,900

B) $600 $400

C) $3,300 $4,100

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Using DDB:

	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

Using SL:

	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

Deferred taxes year 1 = 3,900 – 3,300 = 600

Deferred taxes year 2 = 3,900 – 4,100 + previously deferred taxes = -200 + 600 = 400