Analysis of Income Taxes- Schweser Notes Book #3, Page #203 Q #10

Hello fellow candidates, I’ve got this question that has been twisting my brains for a while (Schweser Notes Book #3, Page #203 Q #10): A firm acquires an asset for 120,000, 4 year useful life, zero salvage-value, generates 50,000 cash flow for each of the 4 years, tax rate is 40% each year. SL basis depreciation- 3 years for tax-basis and 4 years for financial reporting. Q10: Suppose tax rates rise during year 2 to 50%. What will be the income tax expense in year 2? a)$5000 b)$8000 c)$10000 d)$11000 The correct answer is d)=$11,000…even by reading schweser’s explanations, i still can’t understand why isn’t it c)=$10,000. I’d appreciate help!! :slight_smile: thanks.

Tax: Depreciation expense: (120 - 0) /3 = 40K Financial Statement:Depreciation Expense= (120-0)/4 = 30 K Hence Tax expense Tax statement: Original = (50 - 40)*.4 = 4000 Financial Statement: Original = (50 - 30) * .4 = 8000 So by virtue of this Depreciation expense a DTL of 4K has been created. This was the DTL in year 1. In year 2 – Tax rate went up to 50% So in year 2: we would have a difference of Tax expense = 20 * .5 - 10K Now account for the increase in the tax rate on the DTL of 4 K which becomes 4 * .5 / .4 = 5K Now the delta DTL = 5K (new DTL this year) - 4K already counted last year = 1K add 10K + 1K = 11 K Hope this helps. CP

good job CP

Thanx for taking the time CP, I hope i don’t bother too much by asking this: income tax expense isn’t it by my casual definition “the tax amount we’re supposed to pay according to our Financial Statement”? In other words, after depreciating 30K from 50K in year 2, doesn;t it suffice to multiply 20K by 0.5 (tax rate) = 10K and consider it our income tax expense? what about if we look at it from a different angle: INcome tax expense= Taxes payable + delta (DTL-DTA) where taxes payable in year 2 is 10K*0.5 = 5K + (5K-4K)=6K!!! (which is not even among the answer choices). I’m afraid i haven;t grasped the concept well… any flagrant mistake i’m doing and i’m too blind to see? :slight_smile: Thanks again CP, much appreciated…

In Year 2 Tax Statement: Tax Payable = 5 = (50 - 40) * .5 FStatement: Tax Expense = (50 -30 ) *.5 = 10 So In Year 2 a Delta DTL has been created which = 5 K Therefore Tax Expense Yr 2 = Tax Payable + Delta DTL = 5 + 5 = 10 This works out fine. Now because of the tax rate change – a DTL which was realized in Year 1 and figured in the Year 1 Tax expense calculation = 8 K Year 1 Tax Payable calculation = 4K 8 K = 4 K + 4 K the 4 K of DTL would have to be adjusted for the new tax rate. This is the 1 K additional that is an extra delta DTL. Remember Tax paid in the Year 1 is already with the IRS. Now you deferred the tax to the future by taking an extra depreciation expense. If the tax rate changes - all the DTLs (or for that matter DTAs) that you had created and stowed away on your balance sheet somewhere would have to be paid at the NEW TAX RATE. So IRS wants its extra share of the pie for the DTL / DTA you had taken in a previous year. This is the 1 K additional. Hope I haven’t been too long winded. And further more hope this sticks in my own head. CP Remember: for Year 1 Tax Expense (FS) =

I see…so i gotta make sure to remember the additional delta DTL from the previous year resulting from the tax rate increase…That’s great explanation right there, thanks a lot CP! I’m sure I’ll see you around :slight_smile: