Concept Checkers for Income Taxes

Dear all,

I have a question pertaining to computation of DTL.

Presented below is one of the question under Income Tax’s concept checkers (for Schweser Notes):

  • A firm acquires an asset for $120,000 with a 4-year useful life and no salvage value.
  • The asset will generate $50,000 of cash flow for all four years.
  • The tax rate is 40% each year.
  • The firm will depreciate the asset over three years on a SL basis for tax purposes and over four years on a SL basis for financial reporting purposes.

Question: Suppose tax rates rise during year 2 to 50%. At the end of year 2, the firm’s balance sheet will show a deferred tax liability of:

  1. $5,000
  2. $6,000
  3. $10,000

Why the answer is C and not A? I read from somewhere that we can utilize current DTL/DTA values to compute new DTL/DTA values when tax rate changes simply by:

  1. Deriving temporary change by dividing DTL/DTA value by old tax rate; then
  2. Multiply the temporary change by new tax rate to arrive at new DTL/DTA value an;
  3. Find ΔDTL/ΔDTA by comparing it with original DTL/DTA values.

Taking the above as example:

Initial DTL = 40%(Tax Base - Carrying Value) = 40%($80K - $90K) = $4K

After tax rate increases to 50%,

New DTL = [(4,000)/0.4]*0.5= $5K

Am I missing out something?

Thanks,

Ernest

You’ve done your calculation as of the end of year one; the question asked for the calculation as of the end of year _ two _: the numbers should be _ $40K _ and _ $60K _ respectively.

Thanks pompey! Yeah, the temporary differences will increase through the years as long as there are differences in depreciation expenses under both reporting (everything being equal). I did not manage to obtain the answer initially as I only concentrate on yearly temporary difference incremental instead of the total amount.; and hence a value of 5,000 instead of 10,000. Alright, confusion cleared! Thanks!

Thanks S2000magician, that is indeed helpful! :slight_smile: Tax change will affect previous temporary differences and hence must be adjusted as these amount will be reversed in the future (qualify the definition for DTAs/DTLs.)