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 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

1215

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

A) A deferred tax asset will result.

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

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

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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.

1215

Laser Tech has net temporary differences between tax and book income resulting in a deferred tax liability of $30.6 million. According to U.S. GAAP, an increase in the tax rate would have what impact on deferred taxes and net income, respectively:

Deferred Taxes

Net Income

A) Increase Decrease

B) Increase No effect

C) No effect Decrease

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If tax rates rise then deferred tax liabilities will also rise.  The increase in deferred tax liabilities will increase the current tax expense, and if expenses are increasing the net income will decrease.

1215

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 $507

B) $1,572 $747

C) $1,039 $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).