Question

A firm acquires an asset for $120,000 at the beginning of year 1. The asset will generate $50,000 of revenues in each year. For financial reporting purposes, the asset will be depreciated straight line to zero over four years. For tax purposes, it will be depreciated straight line to zero over three years. Assume the firm has no other expenses apart from depreciation expense. The tax rate is 40%. Use this information to answer Questions (7) - (12).

At the end of year 2 (two), the firm’s balance sheet will report a:

A) deferred tax asset of $4,000 B) deferred tax asset of $8,000. C) deferred tax liability of $4,000. D) deferred tax liability of $8,000.

Answer 1

A firm acquires an asset for $120,000 at the beginning of year 1. The asset will generate $50,000 of revenues in each year. For financial reporting purposes, the asset will be depreciated straight line to zero over four years. For tax purposes, it will be depreciated straight line to zero over three years. Assume the firm has no other expenses apart from depreciation expense. The tax rate is 40%. Use this information to answer Questions (7) - (12).

At the end of year 2 (two), the firm’s balance sheet will report a:

Ans: D) deferred tax liability of $8,000.

Calculation

Actually this deferred tax liability is occur due to temporary timing difference in the recording transaction on book purpose and tax purpose.

Here I prove this answer through preparing the statements

For this purpose I prepared first 2 year statement of income for financial purpose to find the tax expenses that should payable according to standard

Revenue	50000	50000
- Depreciation exp (straight line over 4 years for book purpose) 120000 / 4 = 30000	30000	30000
Pretax income	20000	20000
Tax expenses @ 40%( based on book)	8000	8000

Next I prepare taxable income and tax payable statement for tax purpose according to tax rule

Revenue	50000	50000
- Depreciation exp (straight line over 3 years for tax purpose) 120000 / 3 = 40000	40000	40000
Pretax income	10000	10000
Tax expenses @ 40%( based on book)	4000	4000

>> in the first year the firm should pay $ 8000 as tax expense according to financial book, However the firm only paid tax payable $ 4000 according to tax regulate authority.But the difference is should pay by the firm in the following year. The remaining is transferred to a liability account called deferred tax liability account ( future tax payable ) In the end there is $ 4000 in the deferred liability account

>> in the second year also the same are occur. Tax expenses according to book $ 8000. However the tax payable according tax authority is $ 4000.

There is also a liability for future tax of $ 4000 ( 8000 - 4000 ). it will transfer to deferred liability account at the end of 2nd year.

So in the deferred liability account has total off $ 8000 as credit balance in the account.

It also prove using journal entry

1st year end journal entry for tax expenses

Dr Tax expenses ( according to book )       $ 8000

  Cr Tax payable (according to tax authority ) $ 4000

  Cr deferred tax liability account( residual)   $ 4000

2nd year tax journal entry

Dr Tax expenses ( according to book )       $ 8000

  Cr Tax payable (according to tax authority ) $ 4000

  Cr deferred tax liability account( residual)   $ 4000

Deferred Tax liability account

	1st year end Transferred       4000 2nd year end                  4000
	total at end of 2nd year 8000

* In this case the difference are coming from temporary timing differences

temporary timing differences

which occur when revenue or expenses are recorded in different periods for book purpose compired to tax purpose.

Deferred tax liabilty :

DTL means , we deffering to the future periods. that is the settlement or the payment of the tax in the future period