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 is Explanation is :
✅ Part 1: Calculating Income Tax Expense and Deferred Tax Liability
Asset Cost: \$600,000
Life: 3 years
No salvage value
Straight-Line Depreciation (Income Statement): \$600,000 ÷ 3 = \$200,000/year
Accelerated Tax Depreciation:
- Year 1: \$300,000
- Year 2: \$200,000
- Year 3: \$100,000
EBITDA: \$500,000/year
Tax Rate: 40%
Year-by-Year Tax Calculation
Year 1:
- Accounting Depreciation = \$200,000
- Tax Depreciation = \$300,000
- 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 (DTL) = \$120,000 − \$80,000 = \$40,000
Year 2:
- Accounting Depreciation = \$200,000
- Tax Depreciation = \$200,000
- EBIT = \$500,000 − \$200,000 = \$300,000
- Taxable Income = \$500,000 − \$200,000 = \$300,000
- Tax Expense = \$300,000 × 40% = \$120,000
- Tax Payable = \$300,000 × 40% = \$120,000
- Deferred Tax Liability = \$0
- Cumulative DTL remains \$40,000
Year 3:
- Accounting Depreciation = \$200,000
- Tax Depreciation = \$100,000
- EBIT = \$500,000 − \$200,000 = \$300,000
- Taxable Income = \$500,000 − \$100,000 = \$400,000
- Tax Expense = \$300,000 × 40% = \$120,000
- Tax Payable = \$400,000 × 40% = \$160,000
- Deferred Tax Liability Reversed = \$120,000 − \$160,000 = −\$40,000
- Final DTL = \$0
✅ Part 2: Understanding Deferred Tax & Revaluation Implication
Deferred tax refers to tax effects that are recognized in accounting but not yet realized in tax filings. It arises from temporary differences between the carrying amount of assets or liabilities in financial statements and their tax base. A Deferred Tax Liability (DTL) indicates taxes payable in future periods due to temporary taxable differences. Conversely, a Deferred Tax Asset (DTA) arises when tax is overpaid or carried forward.
Gerald Ltd. Property Revaluation
- Carrying Value: \$4M
- Revalued Fair Value: \$6.2M
- Tax Base: \$3.5M
- Revaluation Surplus = \$6.2M − \$4M = \$2.2M (recognized in OCI)
- Temporary Difference = \$6.2M − \$3.5M = \$2.7M
- Tax Rate: 30%
- Deferred Tax Liability = 30% × \$2.7M = \$810,000
This DTL is recognized in Other Comprehensive Income (OCI) alongside the revaluation surplus, as it relates to items not affecting profit or loss immediately.