Income Tax question.

CFA Level I FRA
#1

Hi everyone, and S2000(!!!)

FInancial statements for 2009.

2009 taxable income = $5,000

Deferrered tax asset year end 2008 = 2000

Deferred tax liability year end 2008 = 1000

2009 temp difference creating DTL = 600

2009 temp difference creating DTA = 200

In 2009, the tax rate increases from 35% to 50%, pickets income tax expense for 2009 is closest to?

A) 2300

B) 2500

C) 2700

Below is the answer. When taxes increase, wouldnt you think think the taxable income would go up? Can someone please try to make this question make sense? And is there a easier way to solve?

Thanks!

20X9 taxes payable = 0.5 × 5000 = $2,500

20X9 deferred tax asset increase = 0.5 × 200 = $100

20X9 deferred tax liability increase = 0.5 × 600 = $300

adjustment of deferred tax asset = (0.5 / 0.35) × 2000 – 2000 = $857 (increase in tax rate makes DTA more valuable)

adjustment of deferred tax liability = (0.5 / 0.35) × 1000 – 1000 = $429

Income tax expense = taxes payable + ΔDTL – ΔDTA = 2,500 + (300 + 429) – (100 + 857) = $2,272.

#2

Like… why do you multiple everything by .5, instead of .15 (differnece of tax rates?)

#3

Um . . . hi.

Taxes can go up because you have more taxable income, and they can go up because tax rates increase. However, it appears that you’re confusing a couple of ideas: income taxes payable (which comes from the income tax return) and income tax expense, which comes from the income statement. They’re related, but they’re not the same. One can go up while the other goes down, for example.

The formula relating them – income tax expense = taxes payable + ΔDTL – ΔDTA – is about as easy as it gets (though it’s a little easier to do this with T-accounts than to have to remember whether you add or subtract ΔDTL and ΔDTA). Taxes payable is easy: you get that from your tax return, and they’ll give you that on the exam (or, as here, give you the taxable income and the rate; it’s trivial). The only (slightly) tricky parts are ΔDTL and ΔDTA. There are two things that will cause you DTL and DTA to change:

  1. You had some temporary differences this year that created DTLs or DTAs
  2. You had previous DTLs or DTAs, and the tax rate changed this year

Number 1 is straightforward: multiply the temporary difference by this year’s tax rate. In this example, those were:

20X9 deferred tax asset increase = 0.5 × 200 = $100

20X9 deferred tax liability increase = 0.5 × 600 = $300

Number 2 takes a bit of thought (but just a bit): we have to determine the amount of the temporary change that led to the existing DTL or DTA, then multiply that temporary change by the current tax rate to get the revised DTL or DTA. The steps are:

  1. Divide the existing DTL or DTA by the previous (old) tax rate; this gives you the amount of the temporary change that created the DTL or DTA.
  2. Multiply the amount of the temporary change by the current (new) tax rate; this gives you the new, revised DTL or DTA. This goes on the balance sheet.
  3. Subtract the existing DTL or DTA from the new DTL or DTA to get the change: ΔDTL or ΔDTA.

In this example, they combined these three steps into a single formula:

adjustment of deferred tax asset = (0.5 / 0.35) × 2000 – 2000 = $857

adjustment of deferred tax liability = (0.5 / 0.35) × 1000 – 1000 = $429

You can multiply by the difference in the rates, but you still have to divide by the old rate: dividing by the old rate gets you to the temporary difference (step 1); multiplying by the difference in the rates gets you to the difference between the old DTL or DTA and the new DTL or DTA (steps 2 and 3, combined).

#4

This is great… Just need to keep reviewing step No. 2.

If i pass… expect me to send you a thank you package.