Concept Checkers for Income Taxes

[Ernest_Seow]

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

[S2000magician]

@Ernest_Seow

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

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.

[Ernest_Seow]

@Pompey

1st : Depreciation in tax book : 40,000 Per year

Depreciation in financial book : 30,000 Per year

For 2 years:

2nd: Tax expense, Tax book : 32,000

Tax expense, Financial book: 24,000

at the end of year 2, Balance of DTL is 8,000

3rd : Accumulated depreciation till now

Tax book: 80,000

Financial book: 60,000

Difference is 20,000. This multiply by 40% (tax rate) is equal to DTL of 8,000

4th: Adjustment to DTL due to tax increase = 20,000 * 50% = 10,000

We need to credit DTL account an extra 2,000 to reflect this tax change. (cos we already have 8,000 in balance)

Correct me If I’m wrong!

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!

@S2000magician

@Ernest_Seow

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

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 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.)