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2. An analyst has correctly recognized the nature of a deferred tax liability under U.S.GAAP when he states that: A. A permanent difference arises from undistributed earnings of an affiliate. B. A temporary difference arises due to interest received from an investment in tax-exempt municipal bonds. C. A temporary difference results from the use of straight-line depreciation for book purposes and an accelerated method for tax purposes.

Ans: C This situation creates a temporary difference between pretax (book) income and taxable income which results in the recognition of a deferred tax liability in the early years of an asset’s useful life. A is incorrect. Undistributed earnings of an affiliate generally result in deferred tax liabilities when the investment is accounted for under the equity method. Under the equity method, the investor company reports its share of the net earnings of the affiliate (investee) for financial reporting (book) purposes, but is taxed on earnings only when they are paid (distributed as dividends. This results in a temporary difference between pretax (book) income and taxable income. B is incorrect. The interest received from an investment in tax-exempt municipal bonds results in a permanent difference that does not reverse.