A publicly traded company, Alpha Corp., reported pretax financial income of $1,000,000 for the year ended December 31, Year 1. Included in this amount is $150,000 of warranty expense, for which the actual warranty payments made during Year 1 were $100,000. For tax purposes, warranty expense is deductible only when paid. Alpha Corp.'s enacted tax rate is 25%. What is the deferred tax liability or asset related to the warranty expense at December 31, Year 1?
- ADeferred tax liability of $37,500.
- BDeferred tax asset of $12,500.
- CDeferred tax liability of $12,500.
- DDeferred tax asset of $37,500.
Show answer & explanationAnswer & explanation
Correct answer: B. Deferred tax asset of $12,500.
The difference between financial warranty expense ($150,000) and tax-deductible warranty expense ($100,000) creates a temporary difference. Financial income includes $150,000 expense, while taxable income will only include $100,000 expense for Year 1. This means the company expensed more for financial reporting than for tax purposes in Year 1, resulting in lower financial income. In future periods, when the remaining $50,000 ($150,000 - $100,000) of warranty is paid, it will be deductible for tax purposes but will not be an expense for financial reporting again. This future tax deduction will reduce future taxable income, leading to lower future tax payments. Therefore, a deferred tax asset is created. The temporary difference is $50,000 ($150,000 expensed financially - $100,000 deducted for tax). Deferred tax asset = $50,000 * 25% = $12,500.
Why the other options are wrong
- A. This incorrectly uses the full $150,000 expense as the temporary difference.
- C. A deferred tax liability arises when taxable income is lower than financial income initially, leading to higher future tax payments.
- D. This incorrectly uses the full $150,000 expense as the temporary difference and also implies a different tax rate or calculation error.
Deferred Tax Asset (Temporary Difference)
A deferred tax asset arises from temporary differences that will result in deductible amounts in future years when the carrying amount of an asset or liability is recovered or settled, leading to lower future tax payments.
- Recognized when financial income > taxable income (initially).
- Results in lower future tax payments.
- Common examples: warranty expense, bad debt expense (accrual vs. cash basis).
Memory trick: Future tax savings are assets, future tax bills are liabilities.