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Deferred/Income tax question

Hi all,

This question was from the income/deferred tax reading (44) from Schweser QBank,

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) $4,500 $4,500
B) $600 -$200
C) $3,900 $3,900
D) $3,300 $4,100

I know what income tax expense is, but what the heck is incremental income tax expense?

I thought they might be alluding to the +/- from deferred tax liability/asset, but as it turned out, the answer to this question was C, and in the solution all they did was multiply the pretax income by the tax rate (30%)…am I missing something important here or were the question makers smoking some good stuff when they wrote this question?

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There must be something wrong here. Answer B makes more sense to me. Just because we have DTL of 600 the first year and DTA of 200 the second year. DTL increase the income tax (in a sense it is incremental, additional) and DTA decrease the income tax -200

alpenchev,

that’s exactly the answer I put and the reasoning I used, but this was all that was given for solution,

Your answer: B was incorrect. The correct answer was C) $3,900 $3,900

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

I don’t think you should allow the word “incremental” to confuse you. My interpretation is that because they are referring to two consecutive years, there may be an incremental change in income tax expense due to some change in sale, SG&A, etc. (but in this case, there’s none). In corporate finance, they also mention something about “incremental cash flow” which could be interpreted similarly: the amount of cash flow received each consecutive year. Hope that helps…anyone is welcome to confirm.

here is how I calculated it:

Finacial reporting: Tax reporting:
Yr1 depreciation: $2000 $4000
Yr2 depreciation: $2000 $1333.3

Yr1
deferred tax liability = 4000-2000 = $2000 (.30) = 600
Tax payable = 11,000*.30 = 3300
Income tax expense = 3300 + 600 - 0 = 3900

Yr 2
deferred tax asset = 2000 - 1333.3 = 666.7(.3) = 200
Tax payable = 13666.67 * .30 = 4,100
Income tax expense = 4100 + 0 - 200= 3900

Good explanation showtyme. The info about the revenue though: “Revenue will increase by $15,000 per year.” it is ambiguous: how much is the revenue in year one?, if it increases by $15 000 per year, shouldn’t it be $30 000 the second year

Never mind, I forgot we are talking about incremental tax, that should imply the incremental revenue of $15 000