honeycfa

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) $600 $400

B) $3,900 $3,900

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

honeycfa

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 balance is used for tax purposes.

Calculate the incremental income tax expense for financial reporting for years 1 and 2.

Year 1

Year 2

A) $3,300 $4,100

B) $600 -$200

C) $3,900 $3,900

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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

honeycfa

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

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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).