CFA Practice Question

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CFA Practice Question

Gifford Co. began operations in 2011 and had an effective tax rate of 30%. Congress enacted new legislation that would increase the company's tax rate to 35% beginning in 2012 and thereafter. Gifford had book income before income taxes of $100,000 for 2011, with tax depreciation exceeding book depreciation by $5,000. What amount of income tax expense will Gifford recognize for 2011?

A. $30,250
B. $30,000
C. $28,500
Correct Answer: A

Compute tax expense in two parts in the year an increase is enacted. Tax expense for book income is $30,000 ($100,000 * 30%). Tax expense increases $250 for the rate change on the deferred liability ($5,000 * 5%), for a total tax expense of $30,250.

User Contributed Comments 21

User Comment
kalps I do not understand why the tax expense increases becos the higher depreciation will reuslt in lower income for the firm - i am very confused with this answer.
robkaz kalps: Income tax expense is based on book income, not taxable income. So higher tax depreciation did not matter. I myself missed this question because I did not consider tax rate change. Your comments help me to understand explanation. Thanks.
gjwhite tax expense = (taxes payable)+(.35)(current deferred tax liab) -(.35)(current deferred tax assets). Now, taxes payable =(.30)(100k-5k) because tax depreciation was 5k more than financial reporting deprecn. current deferred tax assets=0, and current deferred tax liab.= 5k. so, we have tax expense=(.3)(95k)+(.35)5k)=$30,250.
danlan Same as 0.3*100k+(0.35-0.3)5k=30250
HiBunty Should not this come in 2012 than in 2011.
aggabad Shouldn't it be B because a tax changes in 2012
(100-5)*.3+ 5*.3=30
gth763s Tax changes should happen in 2012.
o123 Tax Expense = Tax Payable + kDTL - kDTA [k=change]
Without Rate change: 30,000 = 28500 + 1500
With Rate Change: x = 28500 + 1750
x = 30,250
Nightsurfer Taxes payable reflects today's rate (30%) while the calculation of the deferred liability is done at tomorrow's rate (35%). Income tax expense is the combination of these (payable + liability).
thud Following Nightsurfer's post, 100,000*0.3 (taxes payable) + 5,000*0.35 (DTL) = 31,750. This is what I thought, but apparently is wrong. Why do we only take into account the 5% difference in taxes regarding DTL? Isn't what matters the fact that we still have to pay 0.35% over 5,000, which is total deferred liabilities?
thekapila gjwhite is perfectly right....
tax rate will go on DTL or DTA but will remain same for income tax reporting as long as its not in effective.
Tomcat82 Thud, you're double counting the DTL. at the 20% tax rate and at the 30% tax rate.
alallstar Thud, Your way works, but Taxes payable would be 95,000*.30, not 100,000 * .30
You get 28,500 + 1,750 = 30,250
cfaajay As per accounting rule the tax should be .3*100000 = 30000, whereas as per tax code it should be .3* ( 100000 + book dep - book dep -5000 )= 28500
Deferred tax asset will be 30000 -28500= 1500
now as tax rate has changed so new tax rate of .35 will be applied to deferred tax liability hence 1500*.35/.3= 1750
total tax expense will be 28500 + 1750=30250
hope this helps.
gill15 Thanks CFAajay....thats a good explanation...
gill15 CFAajay...sweet but its a DTL = 30 0000 - 28500 = 1500
gill15 Actually there's an easier way. But CFAjay works as well

We know tax expense using the old tax rate = .3 * 10000 = 30 000
Now the tax rate has increased so there MUST be an increase in tax expense. We know Taxable income is 95000 and EBT = 100000. Difference between the two is the Expense.

Increase in Expense = 50000*(0.05) = 250
Old tax expense = EBT * .3 = 30000
So tax expense = 30250
johntan1979 Just to confirm: Tax rate changes only affects deferred taxes, not the income? Seems that the 5% rate increase is only applied towards the $5,000. Is that because this is for 2011? And my follow-up question is, for 2012, what is the calculation if income is the same? $100K * 35%?
Shaan23 CFAajay did it best. Main thing to understand. DTA/DTL and Income tax expense is affected by change rate. Taxes payable not affected.

Taxes payable = .3*95000 = 28500
DTL = .35 * 5000 = 1750
Income tax X = 28500 + 1750 = 30250
dbedford On the books you made it as though you paid for $100k @ 30%. You actually only paid 30% on $95k to the IRS so that leaves the $5k difference. The following year you will make that up when rates are at 35% but on the books you already account for the $5k @ 30% since it was part of your $100k you have to account for the extra 5% you will still owe on it so on the books you show a DTL of $5k x .05 the missing 5%
X212250 Really don't have to do any calcs here:

Tax Depreciation > Book Depreciation; means there will be a DTL; you will pay then taxes than what is booked; 30,000 is the effective rate and the DTL rate change increases what will be booked. Only option over effective rate is $30,250.
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