FRA: Dealing with Tax Adjustments - is this a trick question or a glitch?

I bumped into this questions while practicing:

Equipment Price: 25,352

Years: 5 (no salvage value)

Tax Rate: 41%

Fin Reporting Depreciation: Straight Line (5,070)

Tax Depreciation: Accelerated to 35% in years 1 and 2 and 30% in year 3 (8,873, 8,873 and 7,606)

Annual Revenues: 14,384

Question:

  1. assuming tax changes for years 4 and 5 from 41% to 31%. what’s the DTL as of the end of Year 3?

a. 1,039

b. 3,144 - correct answer

c. 2,948

Solution:

DTL year 1: 1,178 = [9,314 - 5511)(.31)]

DTL year 2: 1,178 = [9,314 - 5511)(.31)]

DTL year 3: 786.16 = [9,314 - 6.778)(.31)]

Sum = 3,144

My question is why was the tax reduced from Years 1-3 when the question clearly stated that the rate will change starting year 4? I never got the correct answer because I used the initial tax rate. Am I missing something here?

you restate the entire DTL due to the tax rate …

so you never need to use the 41% tax rate at all.

Another way of saying the same problem contents -> if they had told you cumulative DTL at the end of year 3 using the 41% tax rate was 4158 - and now asked you to calculate the new DTL

you would have done

4158 / 0.41 * 0.31 = 3144 …

“If the tax rate changes, then under the asset-liability (or balance sheet) method, all deferred tax assets and liabilities must be revaluated using the new tax rate that is expected to be in place at the time of the reversal.

So, when they say tax rate will change by the 4th year, you have to take the 31% as the one that will be in force when the reversal takes place. Notice that it’s from the 4th year onwards that the reversal of the DTL will take place.

Got hunged with the question as well…

Thanks for the clarity.

Great, I missed that one during my review. or that Schweser did not touch on that one becuase the closest LOS I could rememeber related to that is finding the adjustment value between the initial and the new tax rate.

Thanks guys!