FINANCIAL REPORTING AND

ANALYSIS : INVENTORIES,
LONG-LIVED ASSETS,
INCOME TAXES, AND
NON-CURRENT LIABILITIES

INCOME TAXES
Overview —
 Los a Describe the differences between accounting profit and taxable income, and define key terms,
including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and
income tax expense.
 Los b Explain how deferred tax liabilities and assets are created and the factors that determine how a
company's deferred tax liabilities and assets should be treated for the purposes of financial
analysis.
 Los c Calculate the tax base of a company's assets and liabilities.

 Los d Calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax
liabilities, and calculate and interpret the adjustment to the financial statements related to a
change in the income tax rate.
 Los e Evaluate the impact of tax rate changes on a company's financial statements and ratios.
 Los f Distinguish between temporary and permanent differences in pre-tax accounting income and
taxable income.
 Los g Describe the valuation allowance for deferred tax assets” when it is required and what impact
it has on financial statements.
 Los h Explain recognition and measurement of current and deferred tax items;
 Los i Analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and
explain how information included in these disclosures affects a company's financial
statements and financial ratios.
 Los j Identify the key provisions of and differences between income tax accounting under IFRS and
U.S. GAAP.

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 CLASS WORK QUESTIONS
1. Using the straight-line method of depreciation for reporting purposes and accelerated depreciation for tax
purposes would most likely result in a:
A. valuation allowance.
B. deferred tax asset.
C. temporary difference.
2. In early 2009 Sanborn Company must pay the tax authority 37,000 on the income it earned in 2008. This
amount was recorded on the company’s 31 December 2008 financial statements as:
A. taxes payable.
B. income tax expense.
C. a deferred tax liability.
3. Income tax expense reported on a company’s income statement equals taxes payable, plus the net increase
in:
A. deferred tax assets and deferred tax liabilities.
B. deferred tax assets, less the net increase in deferred tax liabilities.
C. deferred tax liabilities, less the net increase in deferred tax assets.
4. Analysts should treat deferred tax liabilities that are expected to reverse as:
A. equity.
B. liabilities.
C. neither liabilities nor equity.
5. Deferred tax liabilities should be treated as equity when:
A. they are not expected to reverse.
B. the timing of tax payments is uncertain.
C. the amount of tax payments is uncertain.
6. When both the timing and amount of tax payments are uncertain, analysts should treat deferred tax
liabilities as:
A. equity.
B. liabilities.
C. neither liabilities nor equity.
7. When accounting standards require recognition of an expense that is not permitted under tax laws, the
result is a:
A. deferred tax liability.
B. temporary difference.
C. permanent difference.
8. When certain expenditures result in tax credits that directly reduce taxes, the company will most
likely record:
A. a deferred tax asset.
B. a deferred tax liability.
C. no deferred tax asset or liability.
9. When accounting standards require an asset to be expensed immediately but tax rules require the item to
be capitalized and amortized, the company will most likely record:
A. a deferred tax asset.
B. a deferred tax liability.
C. no deferred tax asset or liability.

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10. A company incurs a capital expenditure that may be amortized over five years for accounting purposes,
but over four years for tax purposes. The company will most likely record:
A. a deferred tax asset.
B. a deferred tax liability.
C. no deferred tax asset or liability.
11. A company receives advance payments from customers that are immediately taxable but will not be
recognized for accounting purposes until the company fulfills its obligation. The company will most
likely record:
A. a deferred tax asset.
B. a deferred tax liability.
C. no deferred tax asset or liability.
The following information relates to Questions 12–14
Note I
Income Taxes
The components of earnings before income taxes are as follows ($ thousands):
2007 2006 2005
Earnings before income taxes:
United States $ 88,157 $ 75,658 $ 59,973
Foreign 116,704 113,509 94,760
Total $204,861 $189,167 $154,733
The components of the provision for income taxes are as follows ($ thousands):
2007 2006 2005
Income taxes
Current:
Federal $30,632 $22,031 $18,959
Foreign 28,140 27,961 22,263
$58,772 $49,992 $41,222
Deferred:
Federal ($4,752) $5,138 $2,336
Foreign 124 1,730 621
(4,628) 6,868 2,957
Total $54,144 $56,860 $44,179
12. In 2007, the company’s US GAAP income statement recorded a provision for income taxes closest to:
A. $30,632.
B. $54,144.
C. $58,772.
13. The company’s effective tax rate was highest in:
A. 2005.
B. 2006.
C. 2007.
14. Compared to the company’s effective tax rate on US income, its effective tax rate on foreign income was:
A. lower in each year presented.
B. higher in each year presented.

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 C. higher in some periods and lower in others.
15. Zimt AG presents its financial statements in accordance with US GAAP. In 2007, Zimt discloses a
valuation allowance of $1,101 against total deferred tax assets of $19,201. In 2006, Zimt disclosed a
valuation allowance of $1,325 against total deferred tax assets of $17,325. The change in the valuation
allowance most likely indicates that Zimt’s:
A. deferred tax liabilities were reduced in 2007.
B. expectations of future earning power has increased.
C. expectations of future earning power has decreased.
16. Cinnamon, Inc. recorded a total deferred tax asset in 2007 of $12,301, offset by a $12,301 valuation
allowance. Cinnamon most likely:
A. fully utilized the deferred tax asset in 2007.
B. has an equal amount of deferred tax assets and deferred tax liabilities.
C. expects not to earn any taxable income before the deferred tax asset expires.
The following information relates to Questions 17–19
The tax effects of temporary differences that give rise to deferred tax assets and liabilities are as follows
($ thousands):
2007 2006
Deferred tax assets:
Accrued expenses $8,613 $7,927
Tax credit and net operating loss carry forwards 2,288 2,554
LIFO and inventory reserves 5,286 4,327
Other 2,664 2,109
Deferred tax assets 18,851 16,917
Valuation allowance (1,245) (1,360)
Net deferred tax assets $17,606 $15,557
Deferred tax liabilities:
Depreciation and amortization $(27,338) $(29,313)
Compensation and retirement plans (3,831) (8,963)
Other (1,470) (764)
Deferred tax liabilities (32,639) (39,040)
Net deferred tax liability ($15,033) ($23,483)
17. A reduction in the statutory tax rate would most likely benefit the company’s:
A. income statement and balance sheet.
B. income statement but not the balance sheet.
C. balance sheet but not the income statement.
18. If the valuation allowance had been the same in 2007 as it was in 2006, the company would have reported
$115 higher:
A. net income.
B. deferred tax assets.
C. income tax expense.
19. Compared to the provision for income taxes in 2007, the company’s cash tax payments were:
A. lower.
B. higher.
C. the same.

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 The following information relates to Questions 20–22
A company’s provision for income taxes resulted in effective tax rates attributable to loss from continuing
operations before cumulative effect of change in accounting principles that varied from the statutory
federal income tax rate of 34 percent, as summarized in the table below.
Year Ended 30 June 2007 2006 2005
Expected federal income tax expense (benefit) from ($112,000) $768,000 $685,000
continuing operations at 34 percent
Expenses not deductible for income tax purposes 357,000 32,000 51,000

State income taxes, net of federal benefit 132,000 22,000 100,000

Change in valuation allowance for deferred tax assets (150,000) (766,000) (754,000)
Income tax expense $227,000 $56,000 $82,000
20. In 2007, the company’s net income (loss) was closest to:
A. ($217,000).
B. ($329,000).
C. ($556,000).
21. The $357,000 adjustment in 2007 most likely resulted in:
A. an increase in deferred tax assets.
B. an increase in deferred tax liabilities.
C. no change to deferred tax assets and liabilities.
22. Over the three years presented, changes in the valuation allowance for deferred tax assets were most
likely indicative of:
A. decreased prospect for future profitability.
B. increased prospects for future profitability.
C. assets being carried at a higher value than their tax base.
23. Which of the following statements is most accurate? The difference between taxes payable for the period
and the tax expense recognized on the financial statements results from differences:
A. in management control.
B. between basic and diluted earnings.
C. between financial and tax accounting.
24. Which of the following tax definitions is least accurate?
A. Taxable income is income based on the rules of the tax authorities.
B. Taxes payable are the amount due to the government.
C. Pretax income is income tax expense divided by one minus the statutory tax rate.
Use the following data to answer Questions 25 through 31.
 A firm acquires an asset for $120,000 with a 4-year useful life and no salvage value.
 The asset will generate $50,000 of cash flow for all four years.
 The tax rate is 40% each year.
 The firm will depreciate the asset over three years on a straight-line (SL) basis for tax purposes and
over four years on a SL basis for financial reporting purposes.
25. Taxable income in year 1 is:
A. $6,000.
B. $10,000.
C. $20,000.
26. Taxes payable in year 1 are:
A. $4,000.

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 B. $6,000.
C. $8,000.
27. Pretax income in year 4 is:
A. $6,000.
B. $10,000.
C. $20,000.
28. Income tax expense in year 4 is:
A. $4,000.
B. $6,000.
C. $8,000.
29. Taxes payable in year 4 are:
A. $4,000.
B. $6,000.
C. $20,000.
30. At the end of year 2, the firm's balance sheet will report a deferred tax:
A. asset of $4,000.
B. asset of $8,000.
C. liability of $8,000.
31. Suppose tax rates rise during year 2 to 50%. At the end of year 2, the firm's balance sheet will show a
deferred tax liability of:
A. $5,000.
B. $6,000.
C. $10,000.
32. An increase in the tax rate causes the balance sheet value of a deferred tax asset to:
A. decrease.
B. increase.
C. remain unchanged.
33. In its first year of operations, a firm produces taxable income of -$1 0,000. The prevailing tax rate is 40%.
The firm's balance sheet will report a deferred tax:
A. asset of $4,000.
B. asset of $10,000.
C. liability of $4,000.
34. An analyst is comparing a firm to its competitors. The firm has a deferred tax liability that results from
accelerated depreciation for tax purposes. The firm is expected to continue to grow in the foreseeable
future. How should the liability be treated for analysis purposes?
A. It should be treated as equity at its full value.
B. It should be treated as a liability at its full value.
C. The present value should be treated as a liability with the remainder being treated as equity.
35. Which one of the following statements is most accurate? Under the liability method of accounting for
deferred taxes, a decrease in the tax rate at the beginning of the accounting period will:
A. increase taxable income in the current period.
B. increase a deferred tax asset.
C. reduce a deferred tax liability.
36. While reviewing a company, an analyst identifies a permanent difference between taxable income and
pretax income. Which of the following statements most accurately identifies the appropriate financial
statement adjustment?
A. The amount of the tax implications of the difference should be added to the deferred tax liabilities.

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 B. The present value of the amount of the tax implications of the difference should be added to the
deferred tax liabilities.
C. No financial statement adjustment is necessary.
37. An analyst is reviewing a company with a large deferred tax asset on its balance sheet. She has
determined that the firm has had cumulative losses for the last three years and has a large amount of
inventory that can only be sold at sharply reduced prices. Which of the following adjustments should the
analyst make to account for the deferred tax assets?
A. Record a deferred tax liability to offset the effect of the deferred tax asset on the firm's balance sheet.
B. Recognize a valuation allowance to reflect the fact that the deferred tax asset is unlikely to be
realized.
C. Do nothing. The difference between taxable and pretax income that caused the deferred tax asset is
likely to reverse in the future.
38. If the tax base of an asset exceeds the asset's carrying value and a reversal is expected in the future:
A. a deferred tax asset is created.
B. a deferred tax liability is created.
C. neither a deferred tax asset nor a deferred tax liability is created.
39. The author of a new textbook received a $100,000 advance from the publisher this year. $40,000 of
income taxes were paid on the advance when received. The textbook will not be finished until next year.
Determine the tax basis of the advance at the end of this year.
A. $0.
B. $40,000.
C. $100,000.
40. According to IFRS, the deferred tax consequences of revaluing held-for-use equipment upward is reported
on the balance sheet:
A. as an asset.
B. as a liability.
C. in stockholders' equity.
41. KLH Company reported the following:
Gross DTA at the beginning of the year $10,500
Gross DTA at the end of the year $11,250
Valuation allowance at the beginning of the year $2,700
Valuation allowance at the end of the year $3,900
Which of the following statements best describes the expected earnings of the firm? Earnings are expected
to :
A. Increase.
B. decrease.
C. remain relatively stable.

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 SOLUTIONS
1. C is correct. Because the differences between tax and financial accounting will correct over time, the
resulting deferred tax liability, for which the expense was charged to the income statement but the tax
authority has not yet been paid, will be a temporary difference. A valuation allowance would only arise if
there was doubt over the company’s ability to earn sufficient income in the future to require paying the
tax.
2. A is correct. The taxes a company must pay in the immediate future are taxes payable.
3. C is correct. Higher reported tax expense relative to taxes paid will increase the deferred tax liability,
whereas lower reported tax expense relative to taxes paid increases the deferred tax asset.
4. B is correct. If the liability is expected to reverse (and thus require a cash tax payment) the deferred tax
represents a future liability.
5. A is correct. If the liability will not reverse, there will be no required tax payment in the future and the
“liability” should be treated as equity.
6. C is correct. The deferred tax liability should be excluded from both debt and equity when both the
amounts and timing of tax payments resulting from the reversals of temporary differences are uncertain.
7. C is correct. Accounting items that are not deductible for tax purposes will not be reversed and thus
result in permanent differences.
8. C is correct. Tax credits that directly reduce taxes are a permanent difference, and permanent differences
do not give rise to deferred tax.
9. A is correct. The capitalization will result in an asset with a positive tax base and zero carrying value.
The amortization means the difference is temporary. Because there is a temporary difference on an asset
resulting in a higher tax base than carrying value, a deferred tax asset is created.
10. B is correct. The difference is temporary, and the tax base will be lower (because of more rapid
amortization) than the carrying value of the asset. The result will be a deferred tax liability.
11. A is correct. The advances represent a liability for the company. The carrying value of the liability
exceeds the tax base (which is now zero). A deferred tax asset arises when the carrying value of a liability
exceeds its tax base.
12. B is correct. The income tax provision in 2007 was $54,144, consisting of $58,772 in current income
taxes, of which $4,628 were deferred.
13. B is correct. The effective tax rate of 30.1 percent ($56,860/$189,167) was higher than the effective
rates in 2005 and 2007.
14. A is correct. In 2007 the effective tax rate on foreign operations was 24.2 percent [($28,140 +
$124)/$116,704] and the effective US tax rate was [($30,632 − $4,752)/$88,157] = 29.4 percent. In 2006
the effective tax rate on foreign operations was 26.2 percent and the US rate was 35.9 percent. In 2005 the
foreign rate was 24.1 percent and the US rate was 35.5 percent.
15. B is correct. The valuation allowance is taken against deferred tax assets to represent uncertainty that
future taxable income will be sufficient to fully utilize the assets. By decreasing the allowance, Zimt is
signalling greater likelihood that future earnings will be offset by the deferred tax asset.
16. C is correct. The valuation allowance is taken when the company will “more likely than not” fail to earn
sufficient income to offset the deferred tax asset. Because the valuation allowance equals the asset, by
extension the company expects no taxable income prior to the expiration of the deferred tax assets.

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17. A is correct. A lower tax rate would increase net income on the income statement, and because the
company has a net deferred tax liability, the net liability position on the balance sheet would also improve
(be smaller).
18. C is correct. The reduction in the valuation allowance resulted in a corresponding reduction in the
income tax provision.
19. B is correct. The net deferred tax liability was smaller in 2007 than it was in 2006, indicating that in
addition to meeting the tax payments provided for in 2007 the company also paid taxes that had been
deferred in prior periods.
20. C is correct. The income tax provision at the statutory rate of 34 percent is a benefit of $112,000,
suggesting that the pre-tax income was a loss of $112,000/0.34 = ($329,412). The income tax provision
was $227,000. ($329,412) − $227,000 = ($556,412).
21. C is correct. Accounting expenses that are not deductible for tax purposes result in a permanent
difference, and thus do not give rise to deferred taxes.
22. B is correct. Over the three-year period, changes in the valuation allowance reduced cumulative income
taxes by $1,670,000. The reductions to the valuation allowance were a result of the company being “more
likely than not” to earn sufficient taxable income to offset the deferred tax assets.
23. C The difference between taxes payable for the period and the tax expense recognized on the financial
statements results from differences between financial and tax accounting.
24. C Pretax income and income tax expense are not always linked because of temporary and permanent
differences.
25. B Annual depreciation expense for tax purposes is ($120,000 cost - $0 salvage value) /3 years =
$40,000. Taxable income is $50,000 - $40,000 = $10,000.
26. A Taxes payable is taxable income x tax rate = $10,000 x 40% = $4,000. (The $10,000 was calculated in
question #3.)
27. C Annual depreciation expense for financial purposes is ($120,000 cost - $0 salvage value) / 4 years =
$30,000. Pretax income is $50,000 - $30,000 = $20,000.
28. C Because there has been no change in the tax rate, income tax expense is pretax income x tax rate =
$20,000 x 40% = $8,000. (The $20,000 was calculated in question #5.)
29. C Note that the asset was fully depreciated for tax purposes after year 3, so taxable income is $50,000.
Taxes payable for year 4 = taxable income x tax rate = $50,000 x 40% = $20,000.
30. C At the end of year 2, the tax base is $40,000 ($120,000 cost - $80,000 accumulated tax depreciation)
and the carrying value is $60,000 ($120,000 cost - $60,000 accumulated financial depreciation). Since the
carrying value exceeds the tax base, a DTL of $8,000 [($60,000 carrying value - $40,000 tax base) x 40%]
is reported.
31. C The deferred tax liability is now $10,000 [($60,000 carrying value - $40,000 tax base) × 50%].
32. B If tax rates increase, the balance sheet value of a deferred tax asset will also increase.
33. A The tax loss carry forward results in a deferred tax asset equal to the loss multiplied by the tax rate.
34. A The DTL is not expected to reverse in the foreseeable future because a growing firm is expected to
continue to increase its investment in depreciable assets, and accelerated depreciation for tax on the newly
acquired assets delays the reversal of the DTL. The liability should be treated as equity at its full value.
35. C If the tax rate decreases, balance sheet DTL and DTA are both reduced. Taxable income is unaffected.

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36. C No analyst adjustment is needed. If a permanent difference between taxable income and pretax
income is identifiable, the difference will be reflected in the firm's effective tax rate.
37. B A valuation allowance is used to offset deferred tax assets if it is unlikely that those assets will be
realized. Because the company has a history of losses and inventory that is unlikely to generate future
profits, it is unlikely the company will realize its deferred tax assets in full.
38. A If the tax base of an asset exceeds the carrying value, a deferred tax asset is created. Taxable income
will be lower in the future when the reversal occurs.
39. A For revenue received in advance, the tax base is equal to the carrying value minus any amounts that
will not be taxed in the future. Since the advance has already been taxed, $100,000 will not be taxed in the
future. Thus, the textbook advance liability has a tax base of $O ($100,000 carrying value - $100,000
revenue not taxed in the future).
40. C The deferred tax consequences of revaluing an asset upward under IFRS are reported in stockholders'
equity.
41. B The valuation allowance account increased from $2,700 to $3,900. The most likely explanation is the
future earnings are expected to decrease, thereby reducing the value of the DTA.

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 HOME WORK QUESTIONS

1. Which of the following statements is CORRECT? Income tax expense:

A) is the amount of taxes due to the government.

B) is the reported net of deferred tax assets and liabilities.

C) includes taxes payable and deferred income tax expense.

2. Which of the following statements about tax deferrals is NOT correct?
A) A deferred tax liability is expected to result in future cash outflow.

B) Income tax paid can include payments or refunds for other years.

C) Taxes payable are determined by pretax income and the tax rate.
3. The difference between income tax expense and taxes payable is a:
A) deferred income tax expense.

B) deferred tax liability.

C) timing difference.
4. A tax loss carry-forward is best described as the:
A) net taxable loss that can be used to refund paid taxes from the previous year.

B) difference of deferred tax liabilities and deferred tax assets.

C) net taxable loss that can be used to reduce taxable income in the future.
5. If a firm uses accelerated depreciation for tax purposes and straight-line depreciation for financial
reporting, which of the following results is least likely?
A) A permanent difference will result between tax and financial reporting.

B) Income tax expense will be greater than taxes payable.

C) A temporary difference will result between tax and financial reporting.

6. Which of the following best describes valuation allowance? Valuation allowance is a reserve:
A) created when deferred tax assets are greater than deferred tax liabilities.

B) against deferred tax liabilities based on the likelihood that those liabilities will be paid.

C) against deferred tax assets based on the likelihood that those assets will not be realized.
7. If timing differences that give rise to a deferred tax liability are not expected to reverse then the deferred
tax:
A) must be reduced by a valuation allowance.

B) should be considered an asset or liability.

C) should be considered an increase in equity.

8. Which of the following statements regarding deferred taxes is NOT correct?
A) If deferred tax liabilities are not included in equity, debt-to-equity ratio will be reduced.

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 Only those components of deferred tax liabilities that are likely to reverse should be considered a
B)
liability.

C) If deferred taxes are not expected to reverse in the future then they should be classified as equity.
9. When analysing a company's financial leverage, deferred tax liabilities are best classified as:
A) a liability or equity, depending on the company's particular situation.

B) a liability.

C) neither as a liability, nor as equity.

10. For analytical purposes, if a deferred tax liability is expected to not be reversed, it should be treated as
a(n):
A) immaterial amount and ignored.

B) liability.

C) an addition to equity.
11. Which of the following financial ratios is least likely to be affected by classification of deferred taxes as a
liability or equity?
A) Return on equity (ROE).

B) Return on assets (ROA).

C) Debt-to-total assets.
12. For purposes of financial analysis, an analyst should:
A) always consider deferred tax liabilities as stockholder's equity.

B) determine the treatment of deferred tax liabilities on a case-by-case basis.

C) always consider deferred tax liabilities as a liability.

13. At the end of 20X8, Morgan Inc. estimates that $26,000 of warranty repairs will be required in the future
on goods already sold. For tax purposes, warranty expense is not deductible until the work is actually
performed. The firm believes that the warranty work will be required over the next two years. The tax
base of the warranty liability at the end of 20X8 is :
A) $13,000.

B) zero.

C) $26,000.
14. In 20X8, Oil Ltd. received $80,000 cash from a customer for goods that it could not deliver until the next
year and established a liability for unearned revenue. Oil reports under U.S. GAAP, faces a 40% tax rate,
and is located in a tax jurisdiction where unearned revenue is taxed as received. On their balance sheet for
20X8, what change in deferred tax should Oil record as a result of this transaction?
A) A deferred tax liability of $32,000.

B) There is no effect on deferred tax items from this transaction.

C) A deferred tax asset of $32,000.

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15. Alpha Inc. determines that it has $35,000 of accounts receivable outstanding at the end of 20X8. Based on
past experience, it recognizes an allowance for bad debt equal to 10% of its credit sales. The tax base of
Alpha's accounts receivable at the end of 20X8 is closest to:
A) $31,500.

B) $35,000.

C) $3,500.
16. A firm buys an asset with an estimated useful life of five years for $100,000 at the beginning of the year.
The firm will depreciate the asset on a straight-line basis with no salvage value on its financial statements
and will use double declining balance depreciation for tax. The tax basis for this asset at the end of the
first year is closest to :
A) $80,000.

B) $60,000.

C) $40,000.
17. Gini, Inc., has a deferred tax liability on its balance sheet in the amount of $25 million. A change in tax
laws has increased future tax rates for Gini. The impact of this increase in tax rate will be:
A) an increase in deferred tax liability and an increase in tax expense.

B) a decrease in deferred tax liability and a decrease in tax expense.

C) a decrease in deferred tax liability and an increase in tax expense.

18. Corcoran Corp acquired an asset on 1 January 2004, for $500,000. For financial reporting, Corcoran will
depreciate the asset using the straight-line method over a 10-year period with no salvage value. For tax
purposes the asset will be depreciated straight line for five years and Corcoran's effective tax rate is 30%.
Corcoran's deferred tax liability for 2004 will:
A) decrease by $50,000.

B) increase by $15,000.

C) decrease by $15,000.
19. A company purchased a new pizza oven directly from Italy for $12,676. It will work for 5 years and has
no salvage value. The tax rate is 41%, and annual revenues are constant at $7,192. For financial reporting,
the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in
years 1 and 2, and 30% in year 3. For purposes of this exercise ignore all expenses other than
depreciation.
What is the net income and depreciation expense for year one for financial reporting purposes?
Depreciation
Net Income
Expense

A) $2,748 $2,535

B) $2,535 $3,169

C) $4,657 $2,748
20. Kruger Associates uses an accrual basis for financial reporting purposes and cash basis for tax purposes.
Cash collections from customers are $476,000, and accrued revenue is only $376,000. Assume expenses
at 50% in both cases (i.e., $238,000 on cash basis and $188,000 on accrual basis), and a tax rate of 34%.
What is the deferred tax asset or liability? A deferred tax:

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 A) asset of $48,960.

B) asset of $17,000.

C) liability of $17,000.
21. Unit Technologies uses accrual basis for financial reporting purposes and cash accounting for tax
purposes. So far this year, Unit Technologies has recorded $195,000 in revenue for financial reporting
purposes, but, on a cash basis, revenue was only $131,000. Assume expenses at 50 percent in both cases
(i.e., $ 97,500 on accrual basis and $ 65,500 on cash basis), and a tax rate of 34%. What is the deferred tax
liability or asset? A deferred tax:
A) liability of $10,880.

B) liability of $16,320.

C) asset of $10,880.
22. This year, Green Horizon has recorded $390,000 in revenue for financial reporting purposes, but, on a
cash basis, revenue was only $262,000. Assume expenses at 50% in both cases (i.e., $195,000 on accrual
basis and $131,000 on cash basis), and a tax rate of 34%. What is the deferred tax liability or asset? A
deferred tax:
A) liability of $21,760.

B) liability of $16,320.

C) asset of $21,760.
23. Camphor Associates uses accrual basis for financial reporting purposes and cash basis for tax purposes.
Cash collections from customers is $238,000, and accrued revenue is only $188,000. Assume expenses at
50% in both cases (i.e., $119,000 on cash basis and $94,000 on accrual basis), and a tax rate of 34%.
What is the deferred tax asset/liability in this case? A deferred tax:
A) asset of $8,500.

B) asset of $48,960.

C) liability of $8,500.
24. A firm purchased a piece of equipment for $6,000 with the following information provided:
 Revenue will increase by $15,000 per year.
 The equipment has a 3-year life expectancy and no salvage value.
 The firm's tax rate is 30%.
 Straight-line depreciation is used for financial reporting and double declining balance is used for tax
purposes.
Calculate the incremental income tax expense for financial reporting for years 1 and 2.
Year 1 Year 2

A) $3,300 $4,100

B) $600 -$200

C) $3,900 $3,900
25. A firm purchased a piece of equipment for $6,000 with the following information provided:
 Revenue will increase by $15,000 per year.
 The equipment has a 3-year life expectancy and no salvage value.
 The firm's tax rate is 30%.

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  Straight-line depreciation is used for financial reporting and double declining is used for tax purposes.
What will the firm report for deferred taxes on the balance sheet for years 1 and 2?
Year 1 Year 2

A) $600 $400

B) $3,900 $3,900

C) $3,300 $4,100
26. Laser Tech has net temporary differences between tax and book income resulting in a deferred tax liability
of $30.6 million. According to U.S. GAAP, an increase in the tax rate would have what impact on
deferred taxes and net income, respectively:
Deferred Taxes Net Income

A) Increase No effect

B) No effect Decrease

C) Increase Decrease
27.
Year ending 31 December: 2002 2003 2004
Income Statement:
Revenues after all expenses other than depreciation $200 $300 $400
Depreciation expense 50 50 50
Income before income taxes $150 $250 $350

Tax return:
Taxable income before depreciation expense $200 $300 $400
Depreciation expense 75 50 25
Taxable income $125 $250 $375
Assume an income tax rate of 40% and zero deferred tax liability on 31 December 2001.
The deferred tax liability to be shown in the 31 December 2003, balance sheet and the 31 December 2004
balance sheet, is:
2003 2004

A) $0 $10

B) $25 $20

C) $10 $0
28. A dance club purchased new sound equipment for $25,352. It will work for 5 years and has no salvage
value. Their tax rate is 41%, and their annual revenues are constant at $14,384. For financial reporting, the
straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in years
1 and 2 and 30% in Year 3. For purposes of this exercise ignore all expenses other than depreciation.
Assume that the tax rate changes for years 4 and 5 from 41% to 31%. What will be the deferred tax
liability as of the end of year three?
A) $3,144.

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 B) $1,039.

C) $2,948.
29. Because the tax rate changes for years 4 and 5 from 41% to 31%, net income will have to be adjusted for
financial reporting purposes in year three. What is the amount of this adjustment?
A) $1,030.

B) $1,014.

C) $747.
30. Indata Company sold a specially manufactured item for $5,000,000 on December 31, 20X6. The item was
sold on an instalment sale basis, with $1,000,000 paid on the date of the sale and $4,000,000 to be paid in
four annual instalments of $1,000,000 plus interest at the market rate of 6%. Indata's tax rate is 40% and
its costs to construct the item were $2,500,000. Indata recognizes the entire amount of the sale as income
on the date the sale is made for accounting purposes, but not until cash is received for tax purposes.
On its balance sheet dated December 31, 20X6, Indata will, as a result of the transaction described above,
increase its deferred tax:
A) asset by $800,000.

B) liability by $800,000.

C) liability by $200,000.
31. The Puchalski Company reported the following:
Year 1 Year 2 Year 3 Year 4
Income before taxes $1,000 $1,000 $900 $800
Taxable income $800 $900 $900 $1,000
Puchalski has no deferred tax asset or liability prior to Year 1. If the tax rate is 40%, what is the amount of
the deferred tax asset or liability reported at the end of Year 3?
A) Asset of $120.

B) Liability of $120.

C) Asset of $80.
32. Graphics, Inc. has a deferred tax asset of $4,000,000 on its books. As of December 31, it became more
likely than not that $2,000,000 of the asset's value may never be realized because of the uncertainty of
future income. Graphics, Inc. should:
A) reduce the asset by establishing a valuation allowance of $2,000,000 against the asset.

B) not make any adjustments until it is certain that the tax benefits will not be realized.

C) reverse the asset account permanently by $2,000,000.

33. An analyst gathered the following information about a company:
 Taxable income = $100,000.
 Pretax income = $120,000.
 Current tax rate = 20%.
 Tax rate when the reversal occurs will be 10%.
What is the company's tax expense?
A) $24,000.

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 B) $10,000.

C) $22,000.
34. A company purchased a new pizza oven directly from Italy for $12,676. It will work for 5 years and has
no salvage value. The tax rate is 41%, and annual revenues are constant at $7,192. For financial reporting,
the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35% in
years 1 and 2, and 30% in year 3. For purposes of this exercise ignore all expenses other than
depreciation.
What is the tax payable for year one?
A) $1,130.

B) $1,909.

C) $779.
35. What is the deferred tax liability as of the end of year one?
A) $780.

B) $1,129.

C) $1,909
36. What is the deferred tax liability as of the end of year three?
A) $2,079.

B) $1,029.

C) $780.
37. For the year ended 31 December 2004, Pick Co's pretax financial statement income was $400,000 and its
taxable income was $300,000. The difference is due to the following:
Interest on tax-exempt municipal bonds $140,000
Premium expense on key person life insurance $(40,000)
Total $100,000
Pick's statutory income tax rate is 30 percent. In its 2004 income statement, what amount should Pick
report as current provision for tax payable?
A) $102,000.

B) $90,000.

C) $120,000.
38. Selected information from Kentucky Corp.'s financial statements for the year ended December 31 was as
follows (in $ millions):
Property, Plant & Equip. 10 Deferred Tax Liability 0.6
Accumulated Depreciation (4)
The balances were all associated with a single asset. The asset was permanently impaired and has a
present value of future cash flows of $4 million. After Kentucky writes down the asset, Kentucky's tax
accounts will be affected as follows (the tax rate is 40%):
A) taxes payable will decrease $800,000.

B) deferred tax liability will be eliminated and deferred tax assets will increase $200,000.

C) deferred tax liability will be eliminated and deferred tax assets will increase $1.4 million.

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39. The Puchalski Company reported the following:
Year 1 Year 2 Year 3 Year 4
Income before taxes $1,000 $1,000 $900 $800
Taxable income $800 $900 $900 $1,000
The differences between income before taxes and taxable income are the result of using accelerated
depreciation for tax purposes on an asset purchased in Year 1. Puchalski had no deferred tax liability prior
to Year 1. If the tax rate is 40%, what is the amount of the deferred tax liability reported at the end of Year
4?
A) $120.

B) $40.

C) $80.
40. An analyst has gathered the following tax information:
Year 1 Year 2
Pretax Income $60,000 $60,000
Taxable Income $50,000 $65,000
The current tax rate is 40%. Assume the tax rate is reduced to 30% and the change is enacted at the
beginning of Year 2.
In year 1, what are the taxes payable and what is the deferred tax liability?
Deferred Tax
Taxes Payable
Liability

A) $24,000 $3,000

B) $20,000 $1,500

C) $20,000 $3,000
41. Total income tax expense for Year 1 is:
A) $17,000.

B) $23,000.

C) $24,000.
42. If a firm overestimates its warranty expenses, which of the following results is least likely?
A) A deferred tax asset will result.

B) A timing difference will result between tax and financial reporting.

C) Income tax expense will be greater than taxes payable.

43. A company purchases a new pizza oven for $12,675. It will work for 5 years and have no salvage value.
The company will depreciate the oven over 5 years using the straight-line method for financial reporting,
and over 3 years for tax reporting. If the tax rate for years 4 and 5 changes from 41% to 31%, the deferred
tax liability as of the end of year 3 is closest to:
A) $2,080

B) $1,570

C) $1,040

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44. Given the following data regarding two firms under different scenarios, determine the amount of any
deferred tax liability or asset.
Firm 1:
Tax Reporting Financial Reporting
Revenue $500,000 Revenue $500,000
Depreciation $100,000 Depreciation $50,000
Taxable income $400,000 Pretax income $450,000
Taxes payable $160,000 Tax expense $180,000
Net income $240,000 Net income $270,000
Firm 2:
Tax Reporting Financial Reporting
Revenue $500,000 Revenue $500,000
Warranty expense $0 Warranty expense $10,000
Taxable income $500,000 Pretax income $490,000
Taxes payable $200,000 Tax expense $196,000
Net income $300,000 Net income $294,000
Firm 1 Deferred Tax: Firm 2 Deferred Tax:

A) $20,000 Liability $4,000 Asset

B) $30,000 Asset $6,000 Asset

C) $20,000 Asset $6,000 Liability

45. Habel Inc. owns equipment with a tax base of $400,000 and a carrying value of $600,000. Habel also has
a tax loss carryforward of $200,000 that is expected to be utilized in the foreseeable future. Deferred tax
items on the balance sheet are valued based on a tax rate of 30%. If the tax rate is expected to increase to
35%, the adjustments to the value of deferred tax items will most likely cause Habel's total liabilities-to-
equity ratio to:
A) decrease.

B) remain unchanged.

C) increase.
46. Christophe Inc. is an electronics manufacturing firm. It owns equipment with a tax basis of $800,000 and
a carrying value of $600,000 as the result an impairment charge. It also has a tax loss carryforward of
$300,000 that is expected to be utilized within the next year or two. The tax rate on these items is 40% but
the tax rate is expected to decrease to 35% for the foreseeable future. Which of the following amounts is
closest to the net effect of the change in tax rate on the income statement?
A) Increase in deferred tax expense of $5,000.

B) Decrease in deferred tax expense of $5,000.

C) Increase in deferred tax expense of $25,000.

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47. Firm 1 has a deferred tax liability and Firm 2 has a deferred tax asset. With respect to the taxes payable
for each firm when these deferred tax items reverse, a decrease in the firms' tax rates will lead to:
Firm 1 Firm 2

A) Lower taxes payable Lower taxes payable

B) Higher taxes payable Lower taxes payable

C) Lower taxes payable Higher taxes payable

48. Enduring Corp. operates in a country where net income from sales of goods are taxed at 40%, net gains
from sales of investments are taxed at 20%, and net gains from sales of used equipment are exempt from
tax. Instalment sale revenues are taxed upon receipt.
For the year ended December 31, 2004, Enduring recorded the following before taxes were considered:
 Net income from the sale of goods was $2,000,000, half was received in 2004 and half will be
received in 2005.
 Net gains from the sale of investments were $4,000,000, of which 25% was received in 2004 and the
balance will be received in the 3 following years.
 Net gains from the sale of equipment were $1,000,000, of which 50% was received in 2004 and 50%
in 2005.
On its financial statements for the year ended December 31, 2004, Enduring should apply an effective tax
rate of:
A) 22.86% and increase its deferred tax liability by $1,000,000.

B) 22.86% and increase its deferred tax asset by $1,000,000.

C) 26.67% and increase its deferred tax liability by $1,000,000.

49. Which of the following statements about deferred taxes is least accurate? Deferred taxes:
A) arise primarily due to differences between GAAP and IRS code.

B) can relate to either permanent or temporary differences.

C) may never œreverse in the case of companies that are growing.

50. Which of the following statements regarding differences in taxable and pretax income is CORRECT?
Differences in taxable and pretax income that:
A) increase or reduce the effective tax rate are called temporary differences.

B) result in deferred taxes are called temporary differences.

C) are not reversed for five or more years are called permanent differences.
51. Permanent differences between taxable and pretax income:
A) are considered as changes in the effective tax rate.

B) are reported on both tax returns and financial statements.

C) can be deferred in some cases.

52. Deferred tax liabilities may result from:
A) pretax income greater than taxable income due to temporary differences.

B) pretax income less than taxable income due to temporary differences.

C) pretax income greater than taxable income due to permanent differences.

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53. Which of the following situations will most likely require a company to record a valuation allowance on
its balance sheet?
To report depreciation, a firm uses the double-declining balance method for tax purposes and the
A)
straight-line method for financial reporting purposes.

A firm is unlikely to have future taxable income that would enable it to take advantage of
B)
deferred tax assets.

C) A firm has differences between taxable and pretax income that are never expected to reverse.
54. Which of the following statements best justifies analyst scrutiny of valuation allowances?
If differences in taxable and pretax incomes are never expected to reverse, a company's equity
A)
may be understated.

B) Changes in valuation allowances can be used to manage reported net income.

Increases in valuation allowances may be a signal that management expects earnings to improve
C)
in the future.
55. Which of the following statements best describes the impact of a valuation allowance on the financial
statements? A valuation allowance:
A) reduces reported income, reduces assets, and reduces equity.

B) reduces reported income, increases liabilities, and reduces equity.

C) increases reported income, reduces assets, and reduces equity.

56. Luigi Medici, a level II candidate for the CFA charter, was asked to assist in the analysis of the effective
tax rate for Monster Software Inc. The following comments were left with Medici by his superior, Greg
Becker.
1. The analyst should estimate expected changes in the effective tax rate based solely on the provided
reconciliation, without regard to any additional input from the management of the company.
2. The analysis of trends and forecasting should include all continuous items.
3. The analysis of trends and forecasting should include all sporadic items.
4. The forecast should include expected changes in legislation related to corporate taxation.
Becker is:
A) correct in regard to statements 2 and 4.

B) incorrect in regard to statements 2 and 3.

C) correct in regard to statements 3 and 4.

57. Friend Gopal and his wife, Padmaboti, are the founders and current owners of the Riverview Restaurant
and Lounge. They retired several years ago from the day-to-day management, however, turning it over to
a nephew, Sahrukh Shah. Shah has run the restaurant very profitably, but recent redevelopment of the
downtown riverfront area has brought new competition to the Riverview. Gopal's 25 year old grandson,
Jeff Patel, thinks the restaurant can leap ahead of the competition and attract a hipper crowd by turning the
lounge into a nightclub.
Patel wants to incorporate a new business and lease the restaurant lounge for his nightclub, the Red
Monkey. Patel has consulted a contractor who says he can do the renovations for $25,352,000. Patel
estimates that the new sound system and Decor would be usable for five years before fashions changed
enough that it would have to be replaced, at which point it would have no salvage value.
Patel assures his grandfather and uncle that he could generate $14,384,000 in revenue every year once the
renovations are complete. For their parts, Gopal and Shah are understandably leery of turning over the
financial future of the family business to a 25 year old who wants to open a club. Since the new club
would face the same 41% tax rate that the restaurant faces, Gopal and Shah are not sure that the cash flow

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 from the club would be sufficient to cover the rapid depreciation of the fashionable Decor. The fact that
Patel also expects them to fund the new company for him doesn't help. They say no.
Patel returns to his uncle and grandfather armed with financial projections. Patel shows his hoped-for
business partners that, if they use the straight-line method in reporting the club's results, the Red Monkey
will report $5,495,024 in after-tax income (ignoring expenses other than depreciation) in the first year.
Gopal counters that straight-line depreciation is irrelevant because for tax purposes the depreciation
schedule will be accelerated to 35% per year in each of the first two years and 30% in the third year.
Gopal points out that after-tax income for the club in the first year will be only $3,251,372 on a tax basis
(again ignoring expenses other than depreciation).
Shah joins Gopal in his objections, adding that the accelerated depreciation schedule used for tax purposes
will result in a substantial deferred tax liability, reaching approximately $4,158,000 by the end of year
three. Patel replies that the deferred tax liability is merely an accounting entry and the Red Monkey will
never have to pay any of it since the club will reinvest in up-to-date Decor in five years when the current
renovations are out of fashion.
Patel adds that a change in the tax law to cut tax rates from 41% to 31% is likely in year three, and if that
happens the deferred tax liability at the end of the third year will decline to $2.948 million. Gopal agrees
about the likelihood of a tax cut, saying that such a cut in tax rates would add $1.014 million to the Red
Monkey's reported net income in year three.
Gopal and Shah agree to fund the nightclub if the tax cut passes.
What would be the Red Monkey's projected tax payable (in millions) in year one?
A) $1.909.

B) $2.259.

C) $0.779.
58. Regarding Patel's and Gopal's statements about the Red Monkey's after-tax income in the first year, which
is CORRECT ?
Patel Gopal

A) Correct Correct

B) Incorrect Correct

C) Correct Incorrect
59. Which statement about an analyst's treatment of deferred tax assets and liabilities is most accurate?
A) Deferred tax assets that are unlikely to be reversed should be added to equity.

Deferred tax liabilities that are unlikely to reverse should be treated as equity, without
B)
discounting.

Deferred tax liabilities are unlikely to reverse should be discounted to present value and treated
C)
as liabilities.
60. Regarding Patel's and Shah's statements about the Red Monkey's deferred tax liability, which is
CORRECT ?
Patel Shah

A) Correct Correct

B) Incorrect Incorrect

C) Incorrect Correct

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61. Regarding Patel's and Gopal's statements about the effect of a tax cut from 41% to 31% in year three on
Red Monkey, which is CORRECT ?
Patel Gopal

A) Incorrect Correct

B) Incorrect Incorrect

C) Correct Correct
62. When analyzing a firm's reconciliation between its effective tax rate and the statutory tax rate, which of
the following is least likely a potential cause for the difference between the effective rate and the
statutory rate ?
A) Differential tax treatment between capital gains and operating income.

B) Deferred taxes provided on the reinvested earnings of unconsolidated domestic affiliates.

Use of accelerated depreciation for tax purposes and straight-line depreciation for reporting
C)
purposes.
63. All of the following factors complicate the comparability of effective tax rates across firms EXCEPT:
A) changes in the statutory tax rate.

B) comparisons over relatively short time horizons.

C) volatility in the effective tax rate over the comparison period.

64. Differences between the effective tax rate and the statutory rate arise due to all of the following
EXCEPT :
A) non-deductible expenses.

B) tax credits.

C) deductible expenses.
65. While evaluating the financial statements of Omega, Inc., the analyst observes that the effective tax rate
is 7% less than the statutory rate. The source of this difference is determined to be a tax holiday on a
manufacturing plant located in South Africa. This item is most likely to be:
sporadic in nature, and the analyst should try to identify the termination date and determine if
A)
taxes will be payable at that time.

sporadic in nature, but the effect is typically neutralized by higher home country taxes on the
B)
repatriated profits.

C) continuous in nature, so the termination date is not relevant.

66. An analyst gathered the following information about a company:
 Pretax income = $10,000.
 Taxes payable = $2,500.
 Deferred taxes = $500.
 Tax expense = $3,000.
What is the firm's reported effective tax rate?
A) 30%.

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 B) 25%.

C) 5%.
67.
Year: 2002 2003 2004
Income Statement:
Revenues after all expenses other than depreciation $200 $300 $400
Depreciation expense 50 50 50
Income before income taxes $150 $250 $350

Tax return:
Taxable income before depreciation expense $200 $300 $400
Depreciation expense 75 50 25
Taxable income $125 $250 $375
Assume an income tax rate of 40%.
The company's income tax expense for 2002 is:
A) $60.

B) $50.

C) $0.
68. A firm purchased a piece of equipment for $6,000 with the following information provided:
 Revenue will be $15,000 per year.
 The equipment has a 3-year life expectancy and no salvage value.
 The firm's tax rate is 30%.
 Straight-line depreciation is used for financial reporting and double declining is used for tax purposes.
Calculate taxes payable for years 1 and 2.
Year 1 Year 2

A) 3,300 4,100

B) 600 -200

C) 3,900 3,900
69. Under U.S. GAAP, which of the following statements regarding the disclosure of deferred taxes in a
company's balance sheet is most accurate ?
A) There should be a combined disclosure of all deferred tax assets and liablities.

Current deferred tax liability, current deferred tax asset, noncurrent deferred tax liability and
B)
noncurrent deferred tax asset are each disclosed separately.

Current deferred tax liability and noncurrent deferred tax asset are netted, resulting in the
C)
disclosure of a net noncurrent deferred tax liability or asset.
70. A tax rate that has been substantively enacted is used to determine the balance sheet values of deferred
tax assets and deferred tax liabilities under:
A) U.S. GAAP only.

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 B) IFRS only.

C) both IFRS and U.S. GAAP.

71. Under IFRS, deferred tax assets and deferred tax liabilities are classified on the balance sheet as:
A) current items.

B) noncurrent items.

C) either current or noncurrent items.

72. An increase in DTL most likely results in a(n):
A. Decrease in income tax expense.
B. Increase in current assets.
C. Decrease in shareholders’ equity
73. A decrease in the valuation allowance most likely results in a(n):
A. Increase in total assets.
B. Decrease in shareholders’ equity.
C. Increase in income tax expense.
74. A company reports DTA of $300 million and DTL of $200 million on its balance sheet for the year
ended December 2009. Tax rates from 2010 onward are brought down from 40% to 30%. In response to
this change in tax rates, the decrease in the company’s shareholders’ equity is closest to:
A. $25 million.
B. $10 million.
C. $75 million.
75. Taxable temporary differences would most likely arise when:
A. The carrying amount of a liability exceeds its tax base.
B. The carrying amount of an asset exceeds its tax base.
C. The carrying amount of an asset is less than its tax base.
76. Deductible temporary differences least likely arise when:
A. The carrying amount of a liability is less than its tax base.
B. The carrying amount of an asset is less than its tax base.
C. The tax base of a liability is less than its carrying amount.
Use the following information to answer Questions 77 to 83:
ABC Company uses the straight-line method of depreciation on its financial statements to write off a
piece of equipment that it purchased for $10,000. The asset has an estimated salvage value of zero and a
useful life of 4 years. On the tax return it writes off the asset over 2 years with zero salvage value. The
company is taxed at 30%.
77. The difference between the amount of depreciation recognized on the income statement and on the tax
return will result in a:
A. Permanent difference.
B. Deferred tax liability.
C. Deferred tax asset.
78. The carrying value of the asset on the balance sheet for Year 2 is closest to:
A. $7,500
B. $5,000
C. $2,500
79. The tax base of the asset as of the end of Year 2 is closest to:
A. $7,500
B. $5,000
C. Zero
80. The amount of DTL/DTA recognized on the balance sheet for Year 2 is closest to:
A. $2,000 DTA.
B. $1,500 DTL.
C. $1,500 DTA.

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81. The change in DTL over Year 3 is closest to:
A. $750 increase.
B. $750 decrease.
C. $500 increase.
82. The change in DTL over Year 4 is closest to:
A. $750 increase.
B. $750 decrease.
C. $500 increase.
83. For Year 3, which of the following statements is most likely?
A. Income tax expense will be greater than taxes payable by $750.
B. Income tax expense will be lower than taxes payable by $750.
C. Income tax expense will be greater than taxes payable by $500.
84. A company had recognized a valuation allowance against a significant portion of its deferred tax assets.
If the company now believes that its future profitability is set to rise it will most likely result in a(n):
A. Increase in the valuation allowance.
B. Increase in deferred tax assets.
C. Decrease in deferred tax liabilities.
85. A company incurred $1 million in research and development costs. All of these were expensed for
financial reporting, but for tax purposes these costs will be written off over 2 years. Which of the
following statements is most likely at the end of Year 1?
A. The tax base of the asset exceeds the carrying value by $500,000 at the end of Year 1.
B. This is an example of a permanent difference.
C. The tax base of the asset is lower than its carrying value by $500,000 at the end of Year 1.
86. Deferred tax liabilities should be treated as equity when:
A. They are caused by permanent differences.
B. They are not expected to reverse.
C. The amount of tax payments is uncertain.
87. On the financial statements, a company recognizes the entire amount of an expense in the year it was
incurred. However, for tax purposes the expense is capitalized and written-off over 3 years. This will
most likely result in:
A. A deferred tax asset.
B. A deferred tax liability.
C. Neither a deferred tax asset nor a deferred tax liability.
88. A company received cash in Year 1 for rent revenue that will be recognized on its financial statements
in Year 2. However, tax authorities tax the revenue upon receipt of cash. This will most likely result in:
A. A deferred tax asset.
B. A deferred tax liability.
C. Neither a deferred tax asset nor a deferred tax liability.
89. Accounting standards allow ABC Company to recognize interest income on its financial statements.
However ABC is not allowed to recognize such items on its tax return. This will most likely result in:
A. A deferred tax asset.
B. A deferred tax liability.
C. Neither a deferred tax asset nor a deferred tax liability.
90. Tax credits that directly reduce taxes are most likely classified as:
A. Deferred tax assets.
B. Deferred tax liabilities.
C. Permanent differences.
91. ABC Company reports the following amounts on its 2009 income statement and balance sheet:
Net income after tax: $25 million
Total assets: $400 million
Total liabilities: $300 million
Deferred tax assets: $35 million
Deferred tax liabilities: $45 million
A reduction in the statutory tax rate will most likely:
A. Benefit the income statement and have no effect on the balance sheet.

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 B. Benefit the income statement and improve the balance sheet.
C. Weaken the income statement and improve the balance sheet.
92. Over the past 3 years, ABC Company has reported a steady increase in its valuation allowance. This
trend most likely suggests that:
A. The company’s future profitability prospects have diminished.
B. The company’s future profitability prospects have improved.
C. The company’s shareholders’ equity has risen.
93. Given a statutory tax rate of 35%, ABC Company records taxable income of $450,000 on its 2009 tax
return. It also reports an increase in net deferred tax liabilities amounting to $50,000. ABC’s income tax
expense for 2009 is closest to:
A. $207,500
B. $107,500
C. $500,000
94. Which of the following will most likely result in a deferred tax liability?
A. Higher expenses are charged in the income statement compared to the tax return.
B. Pretax profit is higher than taxable income.
C. An asset’s tax base is higher than its carrying value.
95. Which of the following will least likely result in a deferred tax asset?
A. Taxable income is higher than pretax profit.
B. Taxes payable are greater than income tax expense.
C. An asset’s tax base is lower than its carrying value.

Use the following information to answer Questions 96 to 102:

Wood Manufacturers acquires an asset for $280,000. The asset has a useful life of 4 years and an estimated
salvage value of $20,000. It is expected to generate $150,000 of cash flow each year over its useful life. Wood
will depreciate the asset using the double-declining balance method for tax purposes, but for financial
reporting purposes, it will depreciate the asset on a straight-line basis. The company’s tax rate is 40%.

96. Taxable income in Year 1 is closest to:

A. $85,000
B. $10,000
C. $34,000
97. Pre-tax income in Year 2 is closest to:
A. $65,000
B. $80,000
C. $85,000
98. Income tax expense in Year 3 is closest to:
A. $46,000
B. $34,000
C. $32,000
99. Taxes payable in Year 4 are closest to:
A. $54,000
B. $34,000
C. $46,000
100. Which of the following statements is most accurate?
The company will report:
A. Higher depreciation expense on the tax return than on the financial statements over the 4 years.
B. Lower taxes payable on the tax return than on the financial statements over the 4 years.

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 C. Lower profit after tax on the tax return than on the financial statements in the early years.
101. In Year 1, the company will most likely report a:
A. Deferred tax liability of $30,000.
B. Deferred tax liability of $75,000.
C. Deferred tax asset of $140,000.
102. In Year 4, the company will most likely report a:
A. Deferred tax asset of $50,000.
B. Deferred tax liability of $65,000.
C. Deferred tax liability of $0.

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 SOLUTIONS
1. Answer : C
Income tax expense is defined as expense resulting from current period pretax income. It includes taxes
payable and deferred income tax expense. Taxes payable are the amount of taxes due the government.
2. Answer : C
Taxes payable are the taxes due to the government and are determined by taxable income and the tax rate.
Note that pretax income is income before tax expense and is used for financial reporting. Taxable income
is the income based upon IRS rules that determines taxes due and is used for tax reporting.
3. Answer : A
Taxes payable is defined as the taxes due to the government as determined by taxable income and the tax
rate, while income tax expense is the amount actually recognized on the income statement. Deferred
income tax expense is defined as the difference in income tax expense and taxes payable. Each individual
deferred item is expected to be paid (or recovered) in future years.
4. Answer : C
A tax loss carry forward is the net taxable loss that can be used to reduce taxable income in the future.
5. Answer : A
A permanent difference between tax and financial reporting is a difference that is expected to not reverse
itself. Under normal circumstances, the effects of the different depreciation methods will reverse.
6. Answer : C
Valuation allowance is a reserve against deferred tax assets based on the likelihood that those assets will
not be realized. Deferred tax assets reflect the difference in tax expense and taxes payable that are
expected to be recovered from future operations.
7. Answer : C
If deferred tax liabilities are expected to reverse in the future, then they should be classified as liabilities.
If, however, they are not expected to reverse in the future, then they should be classified as equity.
8. Answer : A
When deferred tax liabilities are included in equity, it will reduce the debt-to-equity ratio (by increasing
the denominator), in some cases considerably.
9. Answer : A
Depends on the "performance" of the timing difference.
10. Answer : C
If deferred tax liabilities are expected to never reverse, they should be treated as equity for analytical
purposes. This situation usually arises because of growth in capital expenditures.
11. Answer : B
The ROA will not be affected by the classification of the deferred taxes. The total assets will remain the
same regardless of whether the deferred taxes are classified as a liability or equity.
12. Answer : B
For financial analysis, an analyst must decide on the appropriate treatment of deferred taxes on a case-by-
case basis. These can be classified as liabilities or stockholder's equity, depending on various factors.
Sometimes, deferred taxes are just ignored altogether.
13. Answer : B
The carrying value of the warranty liability is $26,000 (the same amount is recorded as a liability on the
balance sheet and as an expense on the income statement). The tax base is equal to the carrying value less
any amounts deductible in the future. Therefore, the tax base is $0 ($26,000 − $26,000) since the warranty
expense will be deductible when the work is performed next year.
14. Answer : C
Oil has paid tax on the $80,000 revenue in 20X8, but has not recorded the revenue on it for financial
statement purposes. This results in a temporary difference of $32,000, which is a deferred tax asset. The

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 tax asset will be realized when the company recognizes the revenue on its financial statements in the
subsequent period.
15. Answer : B
For tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless.
Therefore, the tax base is $35,000 since no bad debt expense has been deducted on the tax return. Note
that the carrying value would be $31,500 since bad debt expense is reflected on the income statement.
16. Answer : B
For tax, the asset's basis is reduced by the DDB depreciation (2/5 × 100,000 = 40,000) from $100,000 to
$60,000.
17. Answer : A
An increase in tax rates will increase future deferred tax liability, and the impact of the increase in liability
will be reflected in the income statement of the year in which the tax rate change is effected.
18. Answer : B
Straight-line depreciation per financial reports = 500,000 / 10 = $50,000
Tax depreciation = 500,000 / 5 = $100,000
Temporary difference = 100,000 − 50,000 = $50,000
Deferred tax liability will increase by $50,000 × 30% = $15,000
19. Answer : A
Net income in year 1 for financial reporting purposes will be $2,748 = [($7,192 − $2,535)(1 − 0.41)]
The annual depreciation expense on financial statements will be $2,535 = ($12,676 / 5 years)
20. Answer : B
Since taxable income ($238,000) exceeds pretax income ($188,000), Kruger will have a deferred tax asset
of $17,000 [($238,000 − $188,000)(0.34)].
21. Answer : A
Since pretax income ($97,500) exceeds the taxable income ($65,500), United Technologies will have a
deferred tax liability of $10,880 = [( $97,500 − $65,500)(0.34)]
22. Answer : A
Since pretax income ($195,000) exceeds the taxable income ($131,000), Green Horizon will have a
deferred tax liability of $21,760 [($195,000 − $131,000)(0.34)].
23. Answer : A
Since taxable income ($119,000) exceeds pretax income ($94,000), Camphor will have a deferred tax
asset of $8,500 = [($119,000 − $94,000)(0.34)].
24. Answer : C
Using SL:
Yr. 1 Yr. 2
Revenue 15,000 15,000
Dep. 2,000 2,000
Pretax income 13,000 13,000
Tax Expense 3,900 3,900
25. Answer : A
Using DDB:
Yr. 1 Yr. 2
Revenue 15,000 15,000
Dep. 4,000 1,333
Taxable Inc 11,000 13,667
Taxes Pay 3,300 4,100

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 Using SL:
Yr. 1 Yr. 2
Revenue 15,000 15,000
Dep. 2,000 2,000
Pretax Inc 13,000 13,000
Tax Exp 3,900 3,900
Deferred taxes year 1 = 3,900 “ 3,300 = 600
Deferred taxes year 2 = 3,900 “ 4,100 + previously deferred taxes = -200 + 600 = 400
26. Answer : C
If tax rates rise then deferred tax liabilities will also rise. The increase in deferred tax liabilities will
increase the current tax expense, and if expenses are increasing the net income will decrease.
27. Answer : C
First, for 2003, remember that the deferred tax liability (DTL) is cumulative so, it includes the balance
from prior years, (assume 2002 in this example since we have no other information).
DTL cumulative = (tax return depreciation “ financial statement depreciation) — tax rate + DTL from
previous year
 DTL for 2002: (75 “ 50) — 0.4 + 0 = 10
 DTL for 2003: (50 “ 50) — 0.4 + 10 = 10
 DTL for 2004: (25 “ 50) — 0.4 + 10 = 0
28. Answer : A
Straight-line depreciation = $25,352 / 5 = $5,070. Income using straight-line depreciation = $14,384 −
$5,070 = $9,314. Accelerated depreciation (years 1 and 2) = 0.35($25,352) = $8,873. Income (years 1 and
2) = $14,384 − $8,873 = $5,511. Accelerated depreciation (year 3) = 0.3($25,352) = $7,606. Income (year
3) = $14,384 − $7,606 = $6,778.
Deferred tax liability at the end of year three, after the change in the expected tax rate, will be $3,144:
DTL for year 1 = $1,178.93 = [($9,314 − $5,511)(0.31)].
DTL for year 2 = $1,178.93 = [($9,314 − $5,511)(0.31)].
DTL for year 3 = $786.16 = [($9,314 − $6,778)(0.31)]
$1,178.93 + $1,178.93 + $786.16 = $3,144
29. Answer : B
The deferred tax liability will decrease by $1,014 = ($4,158 − $3,144) due to the new lower tax rate. An
adjustment of $1,014 in tax expense will result in an increase in net income by the same amount of
$1,014.
Deferred tax liability at the end of year 3 with tax rate of 41% = $4,158.
Deferred tax liability at the end of year 3 with tax rate of 31% = $3,144.
30. Answer : B
Accounting profit from the instalment sale was $5,000,000 - $2,500,000 = $2,500,000. Income tax
expense is calculated based on 40% of accounting profit, so tax expense from the transaction is
$2,500,000 — 0.40 = $1,000,000. Revenue reported on the tax form is $1,000,000 and the year's costs for
tax purposes are $2,500,000 — ($1,000,000 / $5,000,000) = $500,000. Income taxes payable, as of
December 31, 2006, were ($1,000,000 “ $500,000) — 0.40 = $200,000. The excess of income tax expense
over income taxes payable is a deferred tax liability of $1,000,000 - $200,000 = $800,000.
31. Answer : B
Year 1 Year 2 Year 3
Income tax expense $400 $400 $360
Taxes paid $320 $360 $360
Deferred tax liability $80 $120 $120

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32. Answer : A
If it becomes more likely than not that deferred tax assets will not be fully realized, a valuation allowance
that reduces the asset and also reduces income from continuing operations should be established.
33. Answer : C
Deferred tax liability = (120,000 − 100,000) — 0.1 = 2,000
Tax expense = current tax rate — taxable income + deferred tax liability
0.2 — 100,000 + 2,000 = 22,000
34. Answer : A
Tax payable for year 1 will be $1,130 = [{$7,192 − ($12,676 × 0.35)} × 0.41]
35. Answer : A
The deferred tax liability for year 1 will be $780.
Pretax Income = $4,657 = ( $7,192 − $2,535)
Taxable Income = $2,755 = ($7,192 − $4,437)
Deferred Tax liability = $780 = [($4,657 − $2,755)(0.41)]
Alternative solution: The difference in depreciation at the end of year one is $12,676 × (0.35 − 0.20) =
$1901.
Deferred tax liability = difference in depreciation × tax rate = $1901 × 0.41 = $780.
36. Answer : A
The deferred tax liability at the end of year 3 will be $2,079 = ($780 + $780 + $519).
Pretax Income = $4,657( $7,192 − $2,535)
Taxable Income = $3,389[$7,192 − ($12,676 × 0.30)]
Deferred Tax liability for year 3 = $519[($4,657 − $3,389)(0.41)]
Deferred Tax liability for year 1 = $780[($4,657 − $2,755)(0.41)]
Deferred Tax liability for year 2 = $780[($4,657 − $2,755)(0.41)]
Alternative solution :
For tax purposes the machine is 100% depreciated out at the end of year three, while for GAAP it is only
60% depreciated.
The difference in depreciation is $12,676 × (1.00 − 0.60) = $5070.
Deferred tax liability = difference in depreciation × tax rate = $5070 × 0.41 = $2079.
37. Answer : B
According to SFAS 109, Current provision = statutory rate × taxable income
30% = Taxes Payable / $300,000
= 0.30 × $300,000
= $90,000
38. Answer : B
A permanently impaired asset must be written down to the present value of its future cash flows. The
asset's carrying value of ($10 − $4 =) $6 million must be reduced by $2 million to $4 million. An impaired
value write-down reduces net income for accounting purposes, but not for tax purposes until the asset is
sold or disposed of, so taxes payable do not decrease. At a 40% tax rate, the eventual write down for tax
purposes of $2 million will cause $800,000 of changes in deferred tax items. The $600,000 deferred tax
liability associated with this asset is eliminated and a deferred tax asset of $200,000 is established.
39. Answer : B
Year 1 Year 2 Year 3 Year 4
Income tax expense $400 $400 $360 $320
Taxes paid $320 $360 $360 $400
Deferred tax liability $80 $120 $120 $40
40. Answer : C
Taxes Payable = Taxable Income — Current Tax Rate = $50,000 — 40% = $20,000. The taxes payable
will be based on the current tax rate of 40%. Deferred Tax Liability = (Pretax Income − Taxable Income)

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 — 30% = ($60,000 − 50,000) — 30% = $3,000. SFAS 109 requires adjustments to deferred tax assets and
liabilities to reflect the impact of a change in tax rates or tax laws.
41. Answer : B
Total Income Tax Expense = Taxes Payable − Deferred Tax Asset + Deferred Tax Liability = $20,000 − 0
+ 3,000 = $23,000.
42. Answer : C
Income tax expense will be less than taxes payable because the firm can only recognize warranty expense
as they occur. Thus, if the warranty expenses are overestimated on the financial statements income tax
expense will be less that taxes payable.
43. Answer : B
At the end of year 3, the oven has a tax base of zero (it has been fully depreciated for tax reporting) and a
carrying value on the balance sheet of $12,675 “ 3(0.2)($12,675) = $5,070. The deferred tax liability,
valued at the 31% tax rate that will apply when the temporary difference reverses, is ($5,070 “ $0)(0.31) =
$1,571.70.
44. Answer : A
A deferred tax liability and asset is created when an income or expense item is treated differently on
financial statements than it is on the company's tax returns. A deferred tax liability is when that difference
results in greater tax expense on the financial statements than taxes payable on the tax return.
The deferred tax liability for firm 1 = $180,000 tax expense - $160,000 taxes payable = $20,000
A deferred tax asset is when that difference results in lower taxes payable on the financial statements than
on the tax return.
The deferred tax asset for firm 2 = $200,000 taxes payable - $196,000 tax expense = $4,000
45. Answer : C
The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a
taxable temporary difference that leads to a deferred tax liability of $60,000 ($200,000 — 30%). The tax
loss carry forward of $200,000 leads to a deferred tax asset of $60,000 ($200,000 — 30%).
The increase in the tax rate from 30% to 35% will increase both the DTL and the DTA by $10,000
($200,000 — 5%). Equity is unchanged. Therefore, the total liabilities-to-equity ratio will increase
because of the increase in the deferred tax liability.
46. Answer : C
The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a
deductible temporary difference that leads to a deferred tax asset (DTA) of $80,000 ($200,000 × 40%).
The tax loss carry forward of $300,000 also leads to a DTA but for $120,000 ($300,000 × 40%).
The decrease in the tax rate from 40% to 35% will reduce the DTA of the equipment by $10,000
($200,000 × 5%). It will reduce the DTA of the tax loss carry forward by $15,000 ($300,000 × 5%). In
total, the DTA will decrease by $25,000. Therefore, the balancing entry will be to increase deferred tax
expense by $25,000.
47. Answer : C
When the expected tax rate decreases, income will be taxed at a lower rate when a DTL reverses, resulting
in lower (cash) taxes payable for Firm 1. In contrast, expenses that will be tax deductible when the DTA
reverses will provide less of a benefit when the tax rate is lower, resulting in higher taxes payable for Firm
2.
48. Answer : A
Total taxes eventually due on 2004 activities were (($2,000,000 × 0.40) + ($4,000,000 × 0.20) =)
$1,600,000. Permanent differences are adjusted in the effective tax rate, which is ($1,600,000 /
$7,000,000 =) 22.86%. Of the $1,600,000 taxes due, (($2,000,000 × 0.50 × 0.40) + ($4,000,000 × 0.25 ×
0.20) =) $600,000 were paid in 2004 and $1,000,000 ($1,600,000 − $600,000) is added to deferred tax
liability.
49. Answer : B
Permanent difference will not result in deferred taxes since they are not expected to reverse in the future.

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50. Answer : B
The permanent differences are never reversed, while there is no time limit on temporary differences to
reverse. Permanent differences never result in tax deferrals; temporary differences always result in
deferred tax assets or liabilities.
51. Answer : A
The permanent differences are never deferred but are considered increases or decreases in the effective tax
rate. If the only difference between the taxable and pretax incomes were a permanent difference, then tax
expense would simply be taxes payable.
52. Answer : A
Deferred tax liabilities result from temporary differences that cause pretax income and income tax
expense (on the income statement) to be greater than taxable income and taxes due (on the firm's tax
form). Temporary differences that cause pretax income to be less than taxable income are recognized as
deferred tax assets. Permanent differences do not result in deferred tax items; instead they cause the
effective tax rate to differ from the statutory tax rate.
53. Answer : B
A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood
that the deferred tax assets will never be realized. If a firm is unlikely to have future taxable income, it
would be unlikely to ever use its deferred tax assets, and therefore must record a valuation allowance.
54. Answer : B
A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood
that the deferred tax assets will never be realized. Changes in the valuation allowance have a direct impact
on reported income. Because management has discretion with regard to the amount and timing of a
valuation allowance, changes in the valuation allowance give management significant opportunity to
manage earnings.
55. Answer : A
A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood
that the deferred tax assets will never be realized. The establishment of a valuation allowance reduces
reported income, offsets (reduces) assets, and reduces equity.
56. Answer : A
The correct statements are 2 and 4. Statement 1 is incorrect because the analysis of the effective tax rate
typically requires that the analyst, at a minimum, use the information in the management analysis and
discussion (MD&A). Furthermore, it is recommended that the analyst seek additional information from
the management if needed. Statement 3 is incorrect because, by definition, sporadic items are not repeated
and are difficult to predict. Therefore they will complicate trend analysis and forecasting.
57. Answer : B
On a tax basis, first-year depreciation will be ($25.352 million × 0.35) = $8,873,200.
Pre-tax income will be ($14,384,000 “ $8,873,200) = $5,510,800.
At a 41% tax rate, tax payable in year one would be ($5,510,800 × 0.41) = $2.259 million.
58. Answer : A
If the Red Monkey uses straight-line depreciation in its reported results, the annual depreciation expense
on financial statements will be ($25.352 million / 5 years) = $5,070,400 per year. Pre-tax income
(ignoring depreciation) will be ($14,384,000 revenue − $5,070,400 depreciation) = $9,313,600. At a 41%
tax rate, reported income each year will equal ((1 “ 0.41) — $9,313,600) = $5,495,024, ignoring expenses
other than depreciation. Patel's statement is correct.
On a tax basis, first-year depreciation will be ($25.352 million — 0.35) = $8,873,200 and pre-tax income
will be ($14,384,000 “ $8,873,200) = $5,510,800, again ignoring expenses other than depreciation. At a
41% tax rate, the after-tax income of the Red Monkey will be [(1 “ 0.41) — $5,510,800] = $3,251,372.
Gopal's statement is also correct.
59. Answer : B
Deferred tax assets that are unlikely to be reversed should be subtracted from equity, not added to it.
Deferred tax liabilities should be discounted to present value and treated as liabilities if they are likely,

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 not unlikely, to reverse. If the deferred tax liability is unlikely to reverse, the difference between the
reported value and present value is added to equity.
60. Answer : C
Although it is true that the Red Monkey will be renovating the Decor frequently, it will not be investing
in Decor as rapidly as it depreciates it for tax purposes. In years four and five, the Red Monkey will
have no depreciation for tax purposes but will still be depreciating the renovations on its books, and in
those years its deferred tax liabilities will become due. Deferred tax liabilities are generally deferred
indefinitely only if a company invests consistently. Patel's statement is incorrect.
In order to calculate the total deferred tax liability for year three, we can calculate the deferred tax
charge in years one, two, and three and then add them.
Pre-tax income for the Red Monkey for reporting purposes every year equals ($14,384,000 revenue −
$5,070,400 straight-line depreciation) = $9,313,600.
For tax purposes, pre-tax income in years one and two equals $14,384,000 revenue “ ($25,352,000 —
0.35) = $8,873,200 depreciation, or $5,510,800 in net income per year. Thus the deferred tax charge in
years one and two equals the difference in income of ($9,313,600 reported income − $5,510,800 taxable
income) = $3,802,800 at a 41% tax rate, or ($3,802,800 — 0.41) = $1,559,148.
For tax purposes, pre-tax income in year three equals $14,384,000 revenue “ ($25,352,000 — 0.30) =
$7,605,600 depreciation, or $6,778,400 in net income. Thus the deferred tax charge for year three
equals the difference in income of ($9,314,000 reported income − $6,778,400 taxable income) =
$2,535,600 at a 41% tax rate, or ($2,535,600 — 0.41) = $1,039,596.
Thus the total deferred tax liability at the end of year 3 equals ($1.559 million + $1.559 million +
$1.040 million) = $4.158 million. Shah's statement is correct.
Alternately, we could do this more quickly by recognizing that, in year three, the renovations will be
completely depreciated for tax purposes, so that taxable depreciation will have reached their full cost,
$25,352,000. We also can calculate that, because the renovations are being depreciated on a straight-line
basis over five years, by year three Red Monkey will have depreciated (3 years charged / 5-year asset
life) = 60% of their total cost on its books. Thus, the deferred tax liability in year three will be based on
the [($25,352,000)— (1 “ 0.60)] = $10.141 million in cost not yet depreciated. At a 41% tax rate, the
deferred taxes on the cost not yet depreciated will equal ($10.141 million — 0.41) = $4.158 million.
Note that calculating a deferred tax liability directly is often much faster than doing it year by year.
61. Answer : A
Using the information we calculated in question 4, we can recalculate the deferred tax liability for years
one, two, and three using the lower tax rate:
Deferred tax liability for years one and two equals [($9.314 − $5.511) — 0.31] = $1.179 million.
Deferred tax liability for year three equals ($9.314 − $6.778) — 0.31 = $0.786 million. Thus the
deferred tax liability on Red Monkey's balance sheet at the end of year three, after the change in tax
rate, will be ($1.179 million + $1.179 million + $0.786 million) = $3.144 million. Alternately, we can
calculate the deferred tax liability for year three directly as ($10.141 million — 0.31) = $3.144 million.
Using either approach, Patel's statement is incorrect.
We calculated in question 4 that the deferred tax liability in year three will equal $4.158 million. Thus,
Red Monkey's deferred tax liability will decrease by ($4.158 − $3.144) = $1.014 million due to the new
lower tax rate. Thus, Red Monkey will have to make an adjustment of $1.014 million in tax expense in
year three, which will result in an increase in net income of $1.014 million. Gopal's statement is correct.
62. Answer : C
Potential reasons for a difference between a firm's statutory and effective tax rates include tax credits,
differential tax treatment between capital gains and operating income, and deferred tax provisions on
reinvested earnings of unconsolidated domestic affiliates. The difference in depreciation schedules for
tax and reporting purposes affects the level of deferred taxes but not the tax rate at which they are
calculated.
63. Answer : A
Comparability decreases when the comparison period is relatively short (e.g. quarters vs. years), with
the presence of volatility in the effective tax rate over the comparison period, and operations in different
tax jurisdictions.

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64. Answer : C
Permanent tax differences such as tax credits, non-deductible expenses, and tax differences between
capital gains and operating income give rise to differences in the effective and statutory tax rates.
65. Answer : A
As the name suggests, a tax holiday is usually a temporary exemption from having to pay taxes in some
tax jurisdiction. Because of the temporary nature, the key issue for the analyst is to determine when the
holiday will terminate, and how the termination will affect taxes payable in the future.
66. Answer : A
Reported effective tax rate = Income tax expense / pretax income
= $3,000 / $10,000
= 30%
67. Answer : A
Effective tax rate = Income tax expense / pretax income
Income tax expense = Effective tax rate × pretax income
= $150(0.40)
= $60
68. Answer : A
Using DDB:
Yr. 1 Yr. 2
Revenue 15,000 15,000
Depreciation 4,000 1,333
Taxable Income 11,000 13,667
Taxes Payable 3,300 4,100
An asset with a 3-year life would have a straight line depreciation rate of 0.3333 per year. Using DDB
the depreciation rate is twice this amount or 0.66667. $2,000 is the amount of depreciation left on the
equipment in year 2 ($6,000 − $4,000). Therefore, the amount of depreciation in the 2nd year is
(0.66667)(2,000) = $1,333
69. Answer : B
Under U.S. GAAP, deferred tax assets and liabilities are classified as current or noncurrent, based on
the underlying asset or liability. Under IFRS, deferred tax items are classified as noncurrent.
70. Answer : B
Under IFRS, a tax rate that has been enacted or substantively enacted is used to measure deferred tax
items. Under U.S. GAAP, only a tax rate that has actually been enacted can be used.
71. Answer : B
Under IFRS, deferred tax assets and liabilities are classified as noncurrent. Under U.S. GAAP, deferred
tax items may be current or noncurrent, depending on how the underlying asset or liability is classified.
72. Answer: C
ITE = TP + Change in DTL – Change in DTA
An increase in DTL increases ITE and results in lower net income and retained earnings.
73. Answer: A
A decrease in the valuation allowance implies that the company’s DTA (assets) are increasing. An
increase in DTA reduces ITE and increases retained earnings (equity).
74. Answer: A
The company’s DTA and DTL will fall by 25% as a result of the decrease in tax rates. On a net basis, its
net assets and shareholders’ equity will fall by (300 million − 200 million) × 25% = $25m.
75. Answer: B
Taxable temporary differences or deferred tax liabilities arise when the carrying amount of an asset is
greater than its tax base or when the carrying amount of a liability is less than its tax base.

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76. Answer: A
Deductible temporary differences or deferred tax assets arise when the tax base of an asset exceeds its
carrying value or when the tax base of a liability is less than its carrying value. When the carrying
amount of a liability is less than its tax base, a deferred tax liability arises.
77. Answer: B
Higher depreciation expense is being recognized on the tax return and this difference in expense
recognition across the income statement and the tax return is expected to reverse in the future.
Therefore, a deferred tax liability will be created.
78. Answer: B
The carrying value of the asset on the financial statements at the end of Year 2 is calculated as:
Historical cost of the asset – Accumulated depreciation charged on the income statement = 10,000 –
5,000 = $5,000
79. Answer: C
The tax base of the asset at the end of Year 2 is calculated as:
Historical cost of the asset – Accumulated depreciation charged on the tax return = 10,000 – 10,000 =
$0
80. Answer: B
DTL at the end of Year 2 are calculated as:
(Carrying value of asset – Tax base) × Tax rate = 5,000 × 0.3 = $1,500
81. Answer: B
In Year 3, taxes payable exceed income tax expense by 2,500 × 0.3 = $750. Therefore, DTL in Year 3
will fall by $750. The temporary difference starts to reverse in Year 3.
82. Answer: B
In Year 4, taxes payable exceed income tax expense by 2,500 × 0.3 = $750. Therefore, DTL in Year 4
falls by $750. The temporary difference entirely reversed in Year 4 and the DTL balance sheet value
falls to zero.
83. Answer: B
In Year 3, taxes payable exceed income tax expense by 2,500 × 0.3 = $750.
84. Answer: B
An increase in the likelihood that deferred tax assets will be eventually recognized against the
company’s future profits will result in a decrease in the valuation allowance and an increase in deferred
tax assets.
85. Answer: A
The tax base of the asset exceeds the carrying value by $500,000 at the end of Year 1.
The expenses have entirely been written off on the income statement (carrying value equals zero) while
only half of the expense has been recognized on the tax return in Year 1 (tax base equals $500,000).
86. Answer: B
Deferred tax liabilities should be treated as equity when the temporary differences that caused them to
arise are not expected to reverse.
87. Answer: A
The carrying value of the asset will be lower than its tax base. Therefore, a deferred tax asset will arise.
88. Answer: A
The carrying value of the liability will be greater than its tax base. Therefore, a deferred tax asset will
arise.
89. Answer: C
When certain income or expense items are not allowed by tax legislation, permanent differences arise.
90. Answer: C
Tax credits that directly reduce taxes are examples of permanent differences.

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91. Answer: B
A reduction in the statutory tax rate will increase net profit after tax on the income statement. Further, it
will reduce net deferred tax liabilities and result in an increase in net assets (equity).
92. Answer: A
An increase in the valuation allowance suggests that ABC no longer feels that it will have sufficient
taxable income to offset the deferred tax assets.
Taxes Payable = 0.35 × 450,000 = $157,500
ITE = TP + change in DTL
93. Answer: A
ITE = 157,500 + 50,000 = $207,500
94. Answer: B
A deferred tax liability arises when:
 Lower expenses are charged in the income statement compared to the tax return.
 Pretax profit is higher than taxable income.
 An asset’s tax base is lower than its carrying value.
95. Answer: C
A deferred tax liability arises when an asset’s tax base is lower than its carrying value.
96. Answer: B
SCHEDULES :
Tax Reporting :
1 2 3 4 Total
Years
($) ($) ($) ($) ($)
Revenue 150,000 150,000 150,000 150,000 600,000
Depreciation expense 140,000 70,000 35,000 15,000 260,000
Taxable income 10,000 80,000 115,000 135,000 340,000
Taxes payable (40%) 4,000 32,000 46,000 54,000 136,000
Profit after tax 6,000 48,000 69,000 81,000 204,000
Financial Reporting:
1 2 3 4 Total
Years
($) ($) ($) ($) ($)
Revenue 150,000 150,000 150,000 150,000 600,000
Depreciation expense 65,000 65,000 65,000 65,000 260,000
Pre-tax income 85,000 85,000 85,000 85,000 340,000
Income tax expense (40%) 34,000 34,000 34,000 34,000 136,000
Profit after tax 51,000 51,000 51,000 51,000 204,000
97. Answer: C
See schedule.
98. Answer: B
See schedule.
99. Answer: A
See schedule.
100. Answer: C
Profit after tax for tax reporting purposes is lower in the early years and higher in the later years. Total
profit after tax and total depreciation expense are the same over the life of the asset across the two
statements.
101. Answer: A
Taxes payable is $30,000 less than income tax expense. Therefore, the company will recognize a
deferred tax liability of $30,000.
102. Answer: C
By the end of Year 4, total income tax expense over the 4 years is the same as total taxes payable over
the 4 years. Therefore, the DTL balance at the end of Year 4 equals zero.

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