Video: Deferred Tax due to Depreciation Exercise for CFA Exam

Question:

A company bought a machine which costs $1000. For accounting purpose, straight-line deprecation for 10 years is used. For taxation purpose, accelerated depreciation was used and it is 0.35 for the first year. If the tax rate is 0.28, what is the deferred tax increased in first year due to this?

Answer:

When doing this type of question, keep 2 tables in your mind. One is the balance sheet and the other is the income statement.

For the balance sheet, it is related to the “accounting purpose”, so the asset should decrease at a rate of $1000/10=$100/year.

But for the income statement, the depreciation equals to 0.35*$1000 = $350 in the first year. Because of this, the company is saving $350*0.28 = $98. However, in terms of the asset life, in the first year, the asset just depreciated $100. The tax saving due to the “real depreciation” is only $100*0.28 = $28. Therefore, we are saving $98-$28 = $70 extra due to adapting different depreciation scheme for taxation purpose. So, the deferred tax account has to increase by $70.

From the balance sheet point of view, you generate extra $70 cash in the balance sheet (because you don’t have to pay that amount of tax). You need to balance it by adding $70 to the liability which is the deferred tax account.