### 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.