deferred tax question

hi there, the following question is from the schweser practice exams book #1, exam3, AM session. A has sold a luxury oassenger boat from its inventory on dec-31 for $2m. it is estimated that A will incur $0.1m in warranty expenses over the 5y warranty period. A’s tax rate is 35%. to account for tax implications of the warranty obligation prior to incurring warranty expenses, A should: a. record DTA $30,000 b. record DTL $30,000 c. make no entry until actual warranty expenses are incurred => correct answer is a. actually i think the DTL should be lower. the tax base is zero. the CV of the warranty liability for reporting purposes should accrue over the life of warranty period, right? that means in t=1 CV_rep is $100,000/5=$20,000. thus in the first year the difference of the tax base/CV of the warranty liability is 20,000, multiplied by the tax rate of 30%, this yields a DTL of $6,000. please help me out :smiley:

You say it is a DTL in your explanation. Did you mean to say DTA? A warranty results in DTA since the books recognize that expense when estimated, but for tax purposes it is not recognized until actually incurred. Thus taxes payable income>pretax income ==> higher tax payment, which is expected to reverse. As for the actual amount, I’m a bit confused on that as well, though I don’t agree with your explanation. I wouldve expected there to be a DTA of 35,000. For tax purposes reported income would be 2,000,000 On the books, income would be 2,000,000-100,000 = 1,900,000 Difference = 100,000 DTA = 100,000 *.35 = 35,000

omg what is the problem with me? ;D yes i mean DTA and the tax rate is 30% not 35%, i contradicted myself twice in a single post :confused: the way i memorised the tax thing is as follows: compare tax base & carrying value if assets are compared (tax base - CV) > 0 --> DTA (tax base - CV) < 0 --> DTL if liabilities are compared (a warranty liability in our case) (tax base - CV) > 0 --> DTL (tax base - CV) < 0 --> DTA i see your reasoning, going over the difference in incomes… but you would not recognise the WHOLE warranty expense in one year, but you would spread them over the warranty period. income on TR 2m income on PL 1.98m difference .02m * 0.30 = 6,000 DTA

If the tax rate is 30%, then yes the answer is DTA of 30,000. You would recognize the entire warranty expense. That is consistent with accrual basis accounting, record warranty expense at the time of sale.

you’re right… according to the matching principle the associated expenses have to follow the revenues for which they have been incurred… realisation already completed, so, fully deduct warranty expense… thanks