Question: Lyon Company had pretax earnings of $150M in its first year of operation. Pretax income included:
$25M of interest income from tax-free municipal bonds
-$35M of accrued warranty expense that is not yet deductible
-$15M of deductible depreciation expense that is not yet accrued
At a tax rate of 40%, Lyon’s income taxes payable are?
Answer: $58 M
Could someone talk me through how you arrive at this. It makes sense to me that you would deduct the $25 tax free muni’s. And I guess it makes sense that you would deduct the $15M depreciation expense because it says that it is deductible (although the not yet accrued part confuses me…wouldn’t it not even be included in pretax earnings if it wasn’t accrued?)…but where I really get lost is adding back the $35M warranty expense.
The question says Pre tax income includes it…so why are you adding it again?
So your starting point is the reported earnings of $150M.
the $25M of interest income from the munis is included in $150M of earnings but it is not subject to taxation, hence you deduct that portion of the income before computing taxes payable:
Subtotal: $125M ($150M - $25M)
the $35M warranty expense is accrued, i.e. it has been included as an expense in the computation of the $150M of earnings. Seeing as it is not tax deductible yet, you must reverse the deduction when attempting to arrive at taxable income:
Subtotal: $160M ($125M + $35M)
the $15M of depreciation expense is not yet accrued, i.e. it has not been included as an exense in the computation of the $150M of earning. However, from a tax persepctive it is a deductible expense, so you should deduct it before calculating taxes payable: