[Level 1] Revision Phase with SAPP

[ FRA - Income Taxes] - Buoi 5

Income taxes 

DTA-DTL

Example  :

1. Firm 1 has a deferred tax liability and Firm 2 has a deferred tax asset. If the tax rate decreases, the balance sheet values of
these deferred tax items will:
     Firm 1                                    Firm 2
  A. increase.                              decrease.
  B. increase.                              increase.
  C. decrease.                            decrease.

Explanation : C
A decrease in the future tax rate decreases the balance sheet value of either a deferred tax liability or a deferred tax asset.


2. Enduring Corp. operates in a country where net income from sales of goods are taxed at 40%, net gains from sales of investments are taxed at 20%, and net gains from sales of used equipment are exempt from tax. Installment sale revenues are taxed upon receipt. For the year ended December 31, 2004, Enduring recorded the following before taxes were considered:
-   Net income from the sale of goods was $2,000,000, half was received in 2004 and half will be received in 2005.
-   Net gains from the sale of investments were $4,000,000, of which 25% was received in 2004 and the balance will be
received in the 3 following years.
-   Net gains from the sale of equipment were $1,000,000, of which 50% was received in 2004 and 50% in 2005. On its financial statements for the year ended December 31, 2004, Enduring should apply an effective tax rate of: 

 A.   22.86% and increase its deferred tax asset by $1,000,000.
 B.   26.67% and increase its deferred tax liability by $1,000,000.
 C.   22.86% and increase its deferred tax liability by $1,000,000.

Explanation : C
Total taxes eventually due on 2004 activities were (($2,000,000 × 0.40) + ($4,000,000 × 0.20) =) $1,600,000. Permanentdifferences are adjusted in the effective tax rate, which is ($1,600,000 / $7,000,000 =) 22.86%. Of the $1,600,000 taxes due,(($2,000,000 × 0.50 × 0.40) + ($4,000,000 × 0.25 × 0.20) =) $600,000 were paid in 2004 and $1,000,000 ($1,600,000 − $600,000) is added to deferred tax liability.


3. Christophe Inc. is an electronics manufacturing firm. It owns equipment with a tax basis of $800,000 and a carrying value of $600,000 as the result an impairment charge. It also has a tax loss carryforward of $300,000 that is expected to be utilized within the next year or two. The tax rate on these items is 40% but the tax rate will decrease to 35%. Which of the following is closest to the effect on the income statement of the change in tax rate?
 A.  Decrease income tax expense by $5,000.
 B.  Increase income tax expense by $5,000.
 C.  Increase income tax expense by $25,000.


Explanation
The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a deductible temporary difference that leads to a deferred tax asset (DTA) of $80,000 ($200,000 × 40%). The tax loss carryforward of $300,000 also leads to a DTA but for $120,000 ($300,000 × 40%). The decrease in the tax rate from 40% to 35% will reduce the DTA of the equipment by $10,000 ($200,000 × 5%). It will reduce the DTA of the tax loss carryforward by $15,000 ($300,000 × 5%). In total, the DTA will decrease by $25,000. The decrease in the value of the DTA will increase income tax expense by $25,000 in the period when DTA is decreased.


4. An analyst gathered the following information about a company:
Pretax income = $10,000.
Taxes payable = $2,500.
Deferred taxes = $500.
Tax expense = $3,000.
What is the firm's reported effective tax rate?
  A. 30%.
  B. 25%.
  C. 5%.


Explanation
Reported effective tax rate = Income tax expense / pretax income = $3,000 / $10,000 = 30%.


5. Graphics, Inc. has a deferred tax asset of $4,000,000 on its books. As of December 31, it became more likely than not that $2,000,000 of the asset's value may never be realized because of the uncertainty of future income. Graphics, Inc. should:
 A.  not make any adjustments until it is certain that the tax benefits will not be realized.
 B.  reverse the asset account permanently by $2,000,000.
 C.  reduce the asset by establishing a valuation allowance of $2,000,000 against the asset.


Explanation : C

If it becomes more likely than not that deferred tax assets will not be fully realized, a valuation allowance that reduces the asset and also reduces income from continuing operations should be established.


6. Year:                                                                                      2002          2003         2004
Income Statement:
Revenues after all expenses other than depreciation            $200          $300         $400
Depreciation expense                                                                 50             50             50
Income before income taxes                                                   $150          $250        $350
Tax return:
Taxable income before depreciation expense                         $200          $300        $400
Depreciation expense                                                                  75              50            25
Taxable income                                                                        $125          $250        $375
Assume an income tax rate of 40%.
The company's income tax expense for 2002 is:
 A.  $50.
 B.  $60.
 C   $0.


Explanation : B
Effective tax rate = Income tax expense / pretax income
Income tax expense = Effective tax rate × pretax income
= $150 x (0.40) = $60


7. A company purchases a new pizza oven for $12,675. It will work for 5 years and have no salvage value. The company will depreciate the oven over 5 years using the straight-line method for financial reporting, and over 3 years for tax reporting. If the tax rate for years 4 and 5 changes from 41% to 31%, the deferred tax liability as of the end of year 3 is closest to:
 A.  $2,080
 B.  $1,040
 C.  $1,570


Explanation : C 
At the end of year 3, the oven has a tax base of zero (it has been fully depreciated for tax reporting) and a carrying value on the balance sheet of $12,675 - 3(0.2)($12,675) = $5,070. The deferred tax liability, valued at the 31% tax rate that will apply when the temporary difference reverses, is ($5,070 - $0)(0.31) = $1,571.70.


8. Deferred tax liabilities may result from:
 A.  pretax income greater than taxable income due to permanent differences.
 B.  pretax income greater than taxable income due to temporary differences.
 C.  pretax income less than taxable income due to temporary differences.


Explanation : B
Deferred tax liabilities result from temporary differences that cause pretax income and income tax expense (on the income statement) to be greater than taxable income and taxes due (on the firm's tax form). Temporary differences that cause pretax income to be less than taxable income are recognized as deferred tax assets. Permanent differences do not result in deferred tax items; instead they cause the effective tax rate to differ from the statutory tax rate.


9. A firm purchased a piece of equipment for $6,000 with the following information provided:

-  Revenue will increase by $15,000 per year.

-  The equipment has a 3-year life expectancy and no salvage value.

-  The firm's tax rate is 30%.

-  Straight-line depreciation is used for financial reporting and double declining is used for tax purposes. 

What will the firm report for deferred taxes on the balance sheet for years 1 and 2?

         Year 1                 Year 2

  A.    $3,900                $3,900

  B.    $600                     $400

  C.    $3,300                $4,100

Explanation : B

Using DDB:

                        Yr. 1                    Yr. 2

Revenue        15,000                15,000

Dep.                4,000                  1,333

Taxable Inc     11,000                13,667

Taxes Pay         3,300                 4,100

Using SL:

                         Yr. 1                     Yr. 2

Revenue          15,000                15,000

Dep.                   2,000                  2,000

Pretax Inc         13,000                13,000

Tax Exp              3,900                  3,900

Deferred taxes year 1 = 3,900 - 3,300 = 600

Deferred taxes year 2 = 3,900 - 4,100 + previously deferred taxes = -200 + 600 = 400


10. Corcoran Corp acquired an asset on 1 January 2004, for $500,000. For financial reporting, Corcoran will depreciate the asset using the straight-line method over a 10-year period with no salvage value. For tax purposes the asset will be depreciated straight line for five years and Corcoran's effective tax rate is 30%. Corcoran's deferred tax  liability for 2004 will:
 A.  increase by $15,000.
 B.  decrease by $50,000.
 C.  decrease by $15,000.


Explanation : A
Straight-line depreciation per financial reports = 500,000 / 10 = $50,000
Tax depreciation = 500,000 / 5 = $100,000
Temporary difference = 100,000 − 50,000 = $50,000
Deferred tax liability will increase by $50,000 × 30% = $15,000


11. A health care company purchased a new MRI machine on 1/1/X3. At year-end the company recorded straight-line depreciation expense of $75,000 for book purposes and accelerated depreciation expense of $94,000 for tax purposes. Management estimates warranty expense related to corrective eye surgeries performed in 20X3 to be $250,000. Actual warranty expenses of $100,000 were incurred in 20X3 related to surgeries performed in 20X2. The company's tax rate for the current year was 35%, but a tax rate of 37% has been enacted into law and will apply in future periods. Assuming these are the only relevant entries for deferred taxes, the company's recorded changes in deferred tax assets and liabilities on 12/31/X3 are closest to:
         DTA                       DTL
 A.  $55,500                   $7,030
 B.  $55,500                   $6,650
 C.  $52,500                   $6,650


Explanation : A
DTL = (tax depreciation - financial statement depreciation) × future tax rate
= ($94,000 - $75,000) × 37% = $7,030.
DTA = (estimated warranty expense − actual warranty expense) × future tax rate
= ($250,000 − $100,000) × 37% = $55,500.


12. Nespa, Inc., has a deferred tax liability on its balance sheet in the amount of $25 million. A change in tax laws has increased
future tax rates for Nespa. The impact of this increase in tax rate will be:
 A.  a decrease in deferred tax liability and an increase in tax expense.
 B.  an increase in deferred tax liability and an increase in tax expense.
 C.  a decrease in deferred tax liability and a decrease in tax expense.


Explanation : B
An increase in tax rates will increase future deferred tax liability, and the impact of the increase in liability will be reflected in the income statement of the year in which the tax rate change is effected.


13. A company purchased a new pizza oven for $12,676. It will work for 5 years and has no salvage value. The tax rate is 41%, and
annual revenues are constant at $7,192. For financial reporting, the straight-line depreciation method is used, but for tax
purposes depreciation is 35% of original cost in years 1 and 2 and the remaining 30% in Year 3. For this question ignore all
expenses other than depreciation.
What is the deferred tax liability as of the end of year one?
 A.  $780.
 B.  $1,909.
 C.  $1,129.


Explanation : A
Pretax Income = $7,192 − $2,535 = $4,657
Taxable Income = $7,192 − $4,437 = $2,755
Deferred Tax liability = ($4,657 − $2,755)(0.41) = $780.
Alternative solution:
Difference in depreciation at the end of year one is $12,676 × (0.35 − 0.20) = $1,901
Deferred tax liability = difference in depreciation × tax rate = $1,901 × 0.41 = $780.