I use the HP12C…
Is this question answer incorrect? Why does the answer use .31%, when the tax rate does not change until year 4 and 5? The first part of the question asks for the DTL at the end of year three.
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?
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
Because the tax rate changes for years 4 and 5 from 41% to 31%, net income will have to be adjusted for financial reporting purposes in year three. What is the amount of this adjustment?
The deferred tax liability will decrease by $1,014 = ($4,158 − $3,144) due to the new lower tax rate. An adjustment of $1,014 in tax expense will result in an increase in net income by the same amount of $1,014. Deferred tax liability at the end of year 3 with tax rate of 41% = $4,158. Deferred tax liability at the end of year 3 with tax rate of 31% = $3,144.