A dance club purchased new sound equipment for $25,352. It will work for 5 years and has no salvage value. Their tax rate is 41% , and their annual revenues are constant at $14,384. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years 1 and 2 and 30% in Year 3. For purposes of this exercise ignore all expenses other than depreciation. Assume that the tax rate changes for years 4 and 5 from 41% to 31%. What will be the deferred tax liability as of the end of year three? A) $3,144. B) $1,039. C) $2,948. ANSWER: Straight-line depreciation = $25,352 / 5 = $5,070. Income using straight-line depreciation = $14,384 − $5,070 = $9,314. Accelerated depreciation (years 1 and 2) = 0.35($25,352) = $8,873. Income (years 1 and 2) = $14,384 − $8,873 = $5,511. Accelerated depreciation (year 3) = 0.3($25,352) = $7,606. Income (year 3) = $14,384 − $7,606 = $6,778. Deferred tax liability at the end of year three, after the change in the expected tax rate, will be $3,144: DTL for year 1 = $1,178.93 = [($9,314 − $5,511)(0.31)]. DTL for year 2 = $1,178.93 = [($9,314 − $5,511)( 0.31 )]. DTL for year 3 = $786.16 = [($9,314 − $6,778)(0.31)] $1,178.93 + $1,178.93 + $786.16 = $3,144 ------------------------------------------------------------------------- My question is: Why do they apply the tax rate of 31% which is the tax rate for year 4 and year 5? The question ask to find DTL as of the end of year three, so I think tax rate 41% should be used. Where am I wrong? Thanks.
Its just an accounting rule I believe. For US GAAP, as long as the tax law is passed completely, use the new rate to adjust and calculate DTA/DTLs. For IFRS, if the tax rate change is very likely to pass (some technical language was used, but I cannot remeber), then use new rate to adjust, etc.
Hope this helps.
Thanks for your answer.
I haven’t read or learned about this, perhaps because I read Schweser and nowhere it mentions this.
I found that there are many things that Schweser doesn’t cover in details.
Ya, I did not recall learning this in Schweser’s texts, but ran across it in a couple qbank questions.
As a general rule, you can just take the overall b/t difference (as opposed to doing it year by year) and multiply it by the tax rate to find the DTA/DTL; makes the calculations a little easier. Also, as an accounting major, if you are good with journal entries, breaking these sort of tax decisions down into JE’s make them extremely simple.
GL with this section. It is sort of confusing as to why it is weighted so heavily considering how flawed our financial reporting is (see our financial institutions).
Thanks.
At a more basic level, the question is written in a way to lead you to believe that year 3 is over and that year’s taxes are paid.
After year 3, you will have a DTL balance. The next time you will pay any taxes where that balance is in effect the rate will be 31%, so you must revalue your outstanding balance using the new rate.
In the above example… they have given a retrospective effect by using 31% directly whereas in schweser they will calculate @41% and then take into account the difference if it was @31%