The original cost of an asset is $600,000. The asset has a 3-year life and no salvage value expected. For tax purposes, the asset is depreciated using an accelerated depreciation method with tax return depreciation of $300,000 in year 1, $200,000 in year 2, and $100,000 in year 3. The firm adopts straight-line method of depreciation in its income statements. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is $500,000 each year. The firm’s tax rate is 40%. Calculate the firm’s income tax expense, and deferred tax liability for each year of the asset’s life.
What do you understand by the term ‘Deferred Tax’? Gerald Ltd. revalued a property from a carrying value of $4 Million to its fair value of $6.2 million during the reporting period. The property cost $6.5 Million, and its tax base is $3.5 Million. The tax rate is 30%. Explain the deferred tax implications.
The correct answer and explanation is :
✅ Answer Part 1: Depreciation and Deferred Tax Liability Calculation
Given:
- Asset cost = \$600,000
- Life = 3 years
- Salvage value = \$0
- Straight-line depreciation = \$600,000 ÷ 3 = \$200,000 per year
- EBITDA = \$500,000/year
- Tax rate = 40%
1. Depreciation Comparison
| Year | Tax Depreciation | Book (Straight-Line) Depreciation | Temp. Difference |
|---|---|---|---|
| 1 | \$300,000 | \$200,000 | \$100,000 |
| 2 | \$200,000 | \$200,000 | \$0 |
| 3 | \$100,000 | \$200,000 | -\$100,000 |
2. Taxable Income & Tax Expense Calculation
EBITDA = \$500,000
Year 1:
- Book EBIT = \$500,000 – \$200,000 = \$300,000
- Taxable income = \$500,000 – \$300,000 = \$200,000
- Tax expense (book) = \$300,000 × 40% = \$120,000
- Tax payable (IRS) = \$200,000 × 40% = \$80,000
- Deferred Tax Liability = \$120,000 – \$80,000 = \$40,000
Year 2:
- Book EBIT = \$300,000
- Taxable income = \$300,000
- Tax expense = \$120,000
- Tax payable = \$120,000
- Deferred Tax Liability = \$0
Year 3:
- Book EBIT = \$300,000
- Taxable income = \$500,000 – \$100,000 = \$400,000
- Tax expense = \$120,000
- Tax payable = \$160,000
- Deferred Tax Liability = \$120,000 – \$160,000 = -\$40,000 (reversal)
Summary:
| Year | Tax Expense | Tax Payable | Deferred Tax Liability |
|---|---|---|---|
| 1 | \$120,000 | \$80,000 | \$40,000 |
| 2 | \$120,000 | \$120,000 | \$0 |
| 3 | \$120,000 | \$160,000 | (\$40,000) |
✅ Answer Part 2: Concept of Deferred Tax & Revaluation
What is Deferred Tax?
Deferred tax refers to the tax effects of temporary differences between the carrying amount of an asset or liability in the financial statements and its tax base. These differences cause taxable or deductible amounts in future periods when the asset is recovered or the liability is settled.
- Deferred Tax Liability (DTL): Future tax payable when tax depreciation is higher now and less later (accelerated methods).
- Deferred Tax Asset (DTA): Future tax benefit from deductible temporary differences or loss carryforwards.
✅ Deferred Tax Implication of Property Revaluation
Given:
- Carrying value (pre-revaluation): \$4M
- Fair value (after revaluation): \$6.2M
- Tax base: \$3.5M
- Revaluation surplus = \$6.2M – \$4M = \$2.2M
- Temporary difference = \$6.2M – \$3.5M = \$2.7M
- Tax rate = 30%
Deferred Tax Liability = \$2.7M × 30% = \$810,000
This DTL arises because the company will report a higher gain in the future when it disposes of the property (based on the fair value), but for tax purposes, the base is only \$3.5M. Since the revaluation gain is recognized in Other Comprehensive Income (OCI), the deferred tax on this gain is also recorded in OCI.
✅ Key Takeaway:
Deferred tax is a crucial accounting concept that ensures accurate representation of tax impacts over time due to temporary differences. In the case of asset revaluation or using different depreciation methods for tax and accounting, it aligns financial reporting with expected future tax obligations.