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:
$5,000
$6,000
$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:
Deriving temporary change by dividing DTL/DTA value by old tax rate; then
Multiply the temporary change by new tax rate to arrive at new DTL/DTA value an;
Find ΔDTL/ΔDTA by comparing it with original DTL/DTA values.
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! 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.)