Hi guys
Sorry but I need your help with this question.
A dance club purchased new sound equipment for $25,352. The useful life is 5 years and has no salvage value.
Their tax rate is 41%, and their annual revenues are constant at $14,384.
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.
Assume that the tax rate changes for years 4 and 5 from 41% to 31%.
What will be the deferred tax liability as of the end of year three
My method which didn’t yield me the right ans is as follows:
Y1 Y2 Y3 Y4 Y5 Tax base 16478.8 10711.22 7497.854 Carrying Value 20281.6 15211.2 10140.8 5070.4 0 Difference -3802.8 -4499.98 -2642.95 Tax rate 41% 41% 41% DTL -1559.148 -1844.99 -1083.61
Thus, from my working, I get a cumulative DTL of -1083.61 at the end of year 3.
The tax rate only changes in year 4 and 5. So why is the solution given as
Straight-line depreciation = $25,352 / 5 = $5,070. Income using straight-line depreciation = $14,384 − $5,070 = $9,314. Accelerated depreciation (years 1 and 2) = 0.35($25,352) = $8,873. Income (years 1 and 2) = $14,384 − $8,873 = $5,511. Accelerated depreciation (year 3) = 0.3($25,352) = $7,606. Income (year 3) = $14,384 − $7,606 = $6,778.
Deferred tax liability at the end of year three, after the change in the expected tax rate, will be $3,144:
DTL for year 1 = $1,178.93 = [($9,314 − $5,511)(0.31)]. DTL for year 2 = $1,178.93 = [($9,314 − $5,511)(0.31)]. DTL for year 3 = $786.16 = [($9,314 − $6,778)(0.31)] $1,178.93 + $1,178.93 + $786.16 = $3,144
WHY IS THE NEW TAX RATE USED TO CALCULATE DTL AT THE END OF YEAR 3 when TAX RATE ONLY CHANGES IN YEAR 4???
Thanks so much guys!