Just when I think I've got it... (DTA/DTL)

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chibwack

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From Qbank:
An analyst gathered the following data for Alice Company.
  • Alice Company reported a pretax income of $400,000 in its income statement for the period ended December 31, 2002.
  • Included in its pretax income are: (1) interest received on tax-free municipal bonds $50,000 and (2) rent expense of $20,000. (Only $10,000 was paid in cash for rent during 2002).
  • Alice follows cash basis for tax reporting.
  • Assume a tax rate of 40%.
Based on the information provided, which of the following is most accurate with respect to deferred tax during 2002? Deferred tax:
A)
liability will increase by $4,000.
B)
will remain unchanged.
C)
asset will increase by $4,000.
The correct answer was C) asset will increase by $4,000.
Since only $10,000 of the rent expense will be allowed per tax returns, a deferred tax asset of $4,000 will result ($10,000 × 40%).
What I don’t understand is why it’s an asset created? From reading the question it sounds like they’re paying an actual tax bill of 4000, but writing down the full 8000 tax bill on their reporting. This would imply a future cash outflow, therefore a DTL…?
 
Income = 400,000
Tax free = -50,000
Adjusted = 350,000
add back rent expenses = 370,000
Taxable Income (For tax return purpose) = 370,000 - 10,000 = 360,000 (since alice is using cash basis for tax)
Pre tax Income (For financial statement purpose) = 370,000 - 20,000 = 350,000 (since alice is using accruals for financial reporting)
Tax Payable (For tax return purpose) = 360,000 * 40% = 144,000
Income tax expense (For financial statement purpose) = 350,000 * 40% = 140,000
Tax payable > Income Tax expense by $4,000 therefore a DTA should be created for $4,000
 
chibwack wrote:
What I don’t understand is why it’s an asset created? From reading the question it sounds like they’re paying an actual tax bill of 4000, but writing down the full 8000 tax bill on their reporting. This would imply a future cash outflow, therefore a DTL…?
Click to expand...
This exact same question was asked some time back also. I’m just gonna answer the conceptual part of this question.
Since cash basis is followed, $10000 rent is disallowed. Your income goes up by $10k and hence you end up paying MORE tax than you normally would.
Extra payment made –> May be compared to Prepaid Expense –> Deferred Tax Asset
 
Ahh, ok I think I’m getting it. So we take off 20k for reporting purposes, but only 10k for IRS purposes. I had just left out the inverse nature of the deduction to taxable income.
So the higher rent expense for reporting purposes decreases pretax income by more than for tax purposes, creating a larger taxes payable than reported tax expense, therefore DTA. Got it.
 
To keep it simple i like to think in this way.
As per the question the company follows cash basis for tax calculations so they will account for only cash expenses while preparing tax accounts so in our question the company will take 10,000 as expense in tax reporting in place of 20,000 taken for financial reporting and as we are taking less expense in tax reporting, the net income will be higher in tax reporting the tax on net income will be higher as well in tax reporting.
so what’s happening is company will be paying higher tax than what it should have paid so its an asset or DTA to the tune of 10,000*0.40 = 4,000.
i hope it makes any sense to you.
 
As discovering explained, you can look at it based on carrying value versus tax base or you can look a it through net income. You expense 20 000 based on financial accounting, however, tax authorities recognize taxes based on cash basis. 10 000 has been paid in cash and is taxable. Since only 10 000 is taxable but you expensed 20 000, you NI based on tax reporting will be higher than your NI based on financial accounting. Since your NI based on tax accounting is higher, you will actually have a higher tax expense. If you tax expenses are higher for tax reporting than for financial accounting reporting, you have a DTA because you paid too much taxes. I tend to often look at DTA and DTL based on Net income rather than carrying versus tax base. but again, ut depends on the context and the question. Sometimes it might be more useful to look at it based on carrying amount vs tax base rather than using net income.
 
this question should win an award for the most asked questions on this site
 
Don’t even worry about it. You might get one or two questions on this topic if at all. Understand the basics and move on.
 
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