CFA Practice Question

CFA Practice Question

Western Seals reports depreciation on a straight-line basis while it accounts for warranty repairs on an estimated defects basis. In the just-ended fiscal year, it has purchased a large oil seal machine at a cost of $15 million; it has a salvage value of $500,000 after seven years. Tax rules allow use of the double declining depreciation method over five years and Western takes advantage of this rule to reduce taxes in the early years. Its actual warranty expense was $430,000 for the year but its estimated warranty expenses are 1% on sales of $150 million. Which of the following statements regarding deferred taxes is CORRECT? Western is in the 35% marginal tax bracket.
A. Deferred tax liability of $1,000,500
B. Deferred tax asset of $2,858,571
C. Deferred tax liability of $1,375,000; Deferred tax asset of $374,500
Explanation: DDB depreciation = 15,000,000 x (2/5) = 6,000,000
Straight-line depreciation = (15,000,000 - 500,000) / 7 = 2,071,429
Differences in taxes under the two depreciation amounts = 0.35 x (6,000,000 - 2,071,429) = 1,375,000
This is a deferred tax liability, since reported income is greater than taxable income due to lower straight-line depreciation.

Estimated warranty expense for reporting purposes = 0.01 x 150,000,000 = 1,500,000
Actual warranty expense for tax purposes = 430,000
Difference in taxes under the two warranty expenses = 0.35 x (1,500,000 - 430,000) = 374,500
This is a deferred tax asset, since the reported income is lower than taxable income.

Deferred tax assets and liabilities are shown separately, as their timing and source of reversal is different.

User Contributed Comments 9

User Comment
danlan We should use the tax rate 0.35
george2006 A is wrong because these two are of different reversal nature and should be kept at two different line items on asset and liability sides.
hannovanwyk 1.5minutes...sure
Xocrevilo Note that as long as you can recognise that both a DTA and DTL have been created, then you only need to calculate one of them to answer the question, which should save time.
cong It can be done in a minute if you know what you are doing. The gist of the question: If reported income is greater than taxable income (less tax is payable than required by tax authority), you should create a deferred tax liability. If reported income is less than taxable income (more tax has been paied in actuality than required by tax authority), then you should create a deferred tax asset account.
dipu617 Are they really gonna put this type of question in real exam??!!! Good luck to me.......
jj122 Why doesn't the double declining method have a salvage value ?
MXXL @jj122. Under The Double Declining Method, the depreciation rate is applied to the carrying amount (Net Book Value)
Lambo83 Got it right with a guess but would have calculated the correct answer had I not missed the DDB was for 5 years not 7 years. There is so much info in these questions to absorb in 1 minute. Then have say 30 seconds (on average) to answer. Crazy
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