deferred tax asset

CFA Level I
#1

Can anyone please explain this?

An analyst gathered the following data for Alice Company.

  • Alice Company reported a pretax income of $400,000 in its income statement for the period ended December 31, 2002.
  • Included in its pretax income are: (1) interest received on tax-free municipal bonds $50,000 and (2) rent expense of $20,000. (Only $10,000 was paid in cash for rent during 2002).
  • Alice follows cash basis for tax reporting.
  • Assume a tax rate of 40%.

What is the income tax expense that Alice should report on its income statement for the year ended December 31, 2002?

A) $160,000. B) $140,000. C) $132,000.

Answer is B 140,000. They included the rent $20,000

$400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000 $400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000

Based on the information provided, which of the following is most accurate with respect to deferred tax during 2002? Deferred tax: A) liability will increase by $4,000.

B) will remain unchanged.

C) asset will increase by $4,000

The answer is C and below the solution is:

Since only $10,000 of the rent expense will be allowed per tax returns, a deferred tax asset of $4,000 will result ($10,000 × 40%).

$400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000

#2

The first one is pretty straightforward i think. Pretax Income is 400,000. Since this already includes a tax exempt income of 50,000 from the municipal bonds, it implies that Alice company will only pay the 40% tax rate on the rest of his income which in this case will be 400,000 - 50,000 = 350,000. The rent expense is part of operating expense and it’s not tax exempt.

For the second question,

There are two things you should look at here. The Taxable Income and the Pretax Income. The Pre tax Income is reported on the income statement on the basis of accural accounting and under accural accounting rental expense can be reported regardless of when actual cash is paid.

Here’s where it becomes tricky.

Let’s assume that Mr Alice actually made a revnue of 100,000 dollars.

Following from the case given, he reported 20,000 as rent expense in his Income statement, the amount of his pretax income will then be 80,000.

Let’s assume that no other cost is involved and Mr alice has a corporate tax rate of 40% then his tax expense during that period will be 32,000 dollars.

But the government says, “hey, i don’t give an a*** about your accural accounting”…You’ve only actually paid 10,000 dollars as an expense for your rent not 20,000. So your taxable income should be 90,000. If your taxable income is 90,000, and you have a 40% tax rate, then I am collecting 36,000 from you in taxes.

Given that Mr Alice intends to only pay 32,000 in taxes as per his income statement and the government has bullied him into paying 36,000, then the government “owes” him 4,000 dollars. This amount can be seen as a deferred tax asset.

#3

thanks!

Can you tell me where i went wrong with my logic of this:

since Alice follows cash basis for tax reporting…this would mean that she only gets taxed on for what she paid for in cash…therefore what the guv will be taxing her on is as follows:

$400,000 – 50,000 (tax-free) - 10,000 (rent for which she did not paid for in cash during this period) = 340,000

Taxable income: 340,000 (this includes the $10,000 rent this year that she paid in cash)

taxable payable= 340,000 (.4)= 136,000

since income tax expense > taxable income by $4,000 therefore a DTL should be created for $4,000.

#4

You haven’t actually calculated your Income tax expense, how did you manage to compare it with tax payable?

Here’s how i will break this down

Income = 400,000

Tax free = -50,000

Adjusted = 350,000

Taxable Income (For tax return purpose) = 350,000 - 10,000 = 340,000 (since alice is using cash basis for tax)

Pre tax Income (For financial statement purpose) = 350,000 - 20,000 = 330,000 (since alice is using accruals for financial reporting)

Tax Payable (For tax return purpose) = 340,000 * 40% = 136,000

Income tax expense (For financial statement purpose) = 330,000 * 40% = 132,000

Tax payable > Income Tax expense by $4,000 therefore a DTA should be created for $4,000

#5

This is exactly why i posted this question to begin with. This is a 2-part question in the Qbank, the 1st part of this question is asking you for the income tax expense (I reposted the question below for you) it gives you the income tax expense as $140,000 in their solution.

I’m with you with $132,000, but I got it wrong when i picked C

What is the income tax expense that Alice should report on its income statement for the year ended December 31, 2002?

A) $160,000. B) $140,000. C) $132,000.

Answer is B 140,000

$400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000 $400,000 – 50,000 = $350,000. $350,000 × 40% = $140,000

#6

I actually got a different answer for this question… below is my logic

400,000 Income

Subtract $50,000 in non taxable income

Because the 20,000 expense has already been subtracted to calculate the 400,000 pretax income. You would need to add back the non cash portion as this will not be taxed.

So I got $400,000 - $50,000 + $10,000 = $360,000

360,000 x 0.4 = $144,000

My answer is also incorrect, but I’m not sure why exactly…

The 400,000 already includes the 20,000 expense but only half of that can be used to deduct tax as it was paid in that period. The other half cannot be used and must be added back to calculate taxable income.

#7

Oh snap! my bad. I forgot the rent expense has already been deducted in arriving at the 400k figure.

Here’s how i have done this again.

Income = 400,000

Tax free = -50,000

Adjusted = 350,000

add back rent expenses = 370,000

Taxable Income (For tax return purpose) = 370,000 - 10,000 = 360,000 (since alice is using cash basis for tax)

Pre tax Income (For financial statement purpose) = 370,000 - 20,000 = 350,000 (since alice is using accruals for financial reporting)

Tax Payable (For tax return purpose) = 360,000 * 40% = 144,000

Income tax expense (For financial statement purpose) = 350,000 * 40% = 140,000

Tax payable > Income Tax expense by $4,000 therefore a DTA should be created for $4,000

I think the reason for the confusion is the rent expense bit. The initial amount given is already net of rental expense. So to make the figure useful for both tax and financial statement, we must add back the rent expense to get a clearer picture.

But you will see, that in the second question, regardless of what the initial income is, as long as you are using the same Income figure for both tax and financial reporting, your conclusion should remain the same. Regardless of what your income may be, if your financial statement claims you have more expenses (20,000) than what the government thinks you have (10,000) then you will always end up with a deferred tax asset of the difference (20,000-10,000)*40% = 4,000.