Which Tax Rate Applies to Deferred Taxes Under ASC 740?

Answer A. Ending deductible temporary differences = $200,000 - $80,000 + $120,000 = $240,000, so gross DTA at the enacted 25% = $60,000. Valuation allowance = 20% × $60,000 = $12,000, giving ending net DTA = $48,000. Ending DTL = $280,000 × 25% = $70,000, so ending net deferred tax liability = $70,000 - $48,000 = $22,000. Beginning net deferred tax liability was $60,000 - ($40,000 - $10,000) = $30,000. The net liability decreased from $30,000 to $22,000, a $8,000 decrease (deferred tax benefit).

Why not B: This distractor lures candidates who focus only on the DTL increasing from $60,000 to $70,000 and label that increase as expense. It ignores the simultaneous increase in the net deferred tax asset (after valuation allowance) that reduces the net deferred tax liability, resulting in a net benefit, not an expense.

Why not C: This is tempting if one remeasures the gross DTA ($40,000 → $60,000) and the DTL ($60,000 → $70,000) but forgets to increase the valuation allowance from $10,000 to $12,000. The extra $2,000 valuation allowance increase reduces the net benefit from $10,000 to $8,000.

Why not D: This distractor reflects adding the DTL increase ($10,000) to the valuation allowance increase ($2,000) without offsetting the larger gross DTA remeasurement; that approach double-counts and ignores that the net deferred tax liability actually decreases, producing a benefit rather than an expense.

Answer C. Measure each temporary difference at the enacted rate expected when it reverses. Depreciation: ($140,000 × 30%) + ($100,000 × 25%) = $42,000 + $25,000 = $67,000 deferred tax liability. Warranty: ($70,000 × 30%) + ($50,000 × 25%) = $21,000 + $12,500 = $33,500 deferred tax asset. Net = $67,000 − $33,500 = $33,500 net deferred tax liability, reported as noncurrent under GAAP.

Why not A: This has the correct magnitude but the wrong direction. The taxable temporary difference (depreciation) produces a larger deferred tax liability than the deferred tax asset from warranties, so the net is a liability, not an asset.

Why not B: This result would occur if a candidate applied the 30% rate to all reversals (240,000 × 30% = 72,000 liability; 120,000 × 30% = 36,000 asset; net 36,000). GAAP requires using the enacted rates expected to apply in each reversal period, so the 20X7 portions must be measured at 25%, not 30%.

Why not D: This reflects recognizing only the deferred tax liability from depreciation and ignoring the deferred tax asset from accrued warranties. Both temporary differences must be measured and netted when no valuation allowance is needed.

Answer B. Taxable income = $500,000 + $60,000 (warranty accrual not currently deductible) − $40,000 (excess tax depreciation) = $520,000. Current income tax expense = $520,000 × 25% = $130,000. Deferred taxes are measured at the enacted future rate of 30%: DTA = $60,000 × 30% = $18,000 and DTL = $40,000 × 30% = $12,000, giving a net deferred tax asset of $6,000 (a deferred tax benefit).

Why not A: This reflects the common mistake of applying the current 25% rate to pretax book income ($500,000 × 25% = $125,000) instead of first determining taxable income. It also reflects measuring deferred taxes at 25% rather than using the enacted 30% rate expected to apply when the temporary differences reverse.

Why not C: This choice gets the current tax amount right (taxable income correctly computed), but it flips the sign of the deferred tax result. The warranty accrual produces a larger deferred tax asset ($18,000) than the deferred tax liability from excess tax depreciation ($12,000), so the net is a deferred tax benefit of $6,000, not an expense.

Why not D: This option understates current tax and overstates the deferred benefit because it ignores the deferred tax liability created by excess tax depreciation. The only correct deferred amount in isolation (the $18,000 DTA for warranty) is incomplete, the DTL must also be recognized, and the current tax must be computed on taxable income.

Answer A. Under ASC 740, deferred tax balances are measured using tax laws and rates that are enacted as of the balance sheet date; therefore at 12/31/Y1 Falcon measures the deferred tax liability at $250,000 (25% × $1,000,000). Because the tax-rate reduction was enacted on January 20, Year 2, the effect is recognized in the period that includes the enactment date (Year 2), so Falcon remeasures the liability to $210,000 and records a $40,000 tax benefit in income from continuing operations in Year 2. The Year 1 financial statements are not adjusted, although per ASC 855 a material change in tax law enacted after the balance sheet date should be disclosed as a nonrecognized subsequent event in the Year 1 financial statements.

Why not B: This is tempting because the law was enacted before issuance, but it treats a post-balance-sheet change in law as an adjustment to the prior-period balance; ASC 740 measurement is based on laws enacted as of the balance sheet date, so the Year 1 amounts remain based on the 25% rate and the effect is recognized in the period of enactment (Year 2).

Why not C: This confuses the rate's effective date with recognition timing: ASC 740 requires remeasurement in the period of enactment (Year 2), not deferred until the year the new rate takes effect.

Why not D: This is tempting because some tax effects are reported in OCI, but here the temporary difference affects continuing operations so the tax effect is recognized in income from continuing operations, not OCI.

Answer A. Under U.S. GAAP (ASC 740), deferred tax assets and liabilities are measured using tax rates that have been enacted as of the balance-sheet date and are expected to apply when the temporary differences reverse. Proposed or likely-but-unenacted changes are ignored until they are enacted. Therefore, Hall should measure the deferred tax liability using the enacted 21% rate applicable to 20X7.

Why not B: This is tempting because the liability relates to future tax payments, but ASC 740 requires use of enacted rates as of the balance-sheet date, not management's forecasts of what might be enacted later. An un-enacted proposed rate change does not affect measurement.

Why not C: The effective tax rate is a period-based reporting metric, not the basis for calculating a specific deferred tax liability. Deferred taxes are calculated by applying the enacted tax rate expected to apply when the temporary difference reverses to the temporary difference amount.

Why not D: The historical tax rate at acquisition is irrelevant to deferred tax measurement. Measurement depends on the enacted rate expected to be in effect when the temporary difference reverses, not on historical rates.

Answer D. Deferred tax balances are measured using enacted tax rates expected to apply when the temporary differences reverse. Because the new 25% rate was enacted in Year 2, Lark must remeasure the deferred tax liability in Year 2, even though the lower rate begins in Year 3. The taxable temporary difference is $400,000, so the remeasured liability is $100,000, creating a $20,000 reduction recognized as an income tax benefit in continuing operations.

Why not A: This distractor appeals to the mistaken idea that a lower future tax rate removes the deferred tax obligation. The deferred tax liability is reduced, not eliminated, because the taxable temporary difference still exists and will still create future taxable amounts when it reverses.

Why not B: This is tempting because candidates often focus on the effective date of the new rate rather than the enactment date. Under ASC 740, deferred taxes are remeasured when the tax law is enacted, not when the new rate first becomes effective.

Why not C: This choice is tempting because the underlying reversals happen in future periods, which can make OCI seem like a holding place for the adjustment. However, the tax effect of a rate change is generally recognized in continuing operations unless the related deferred tax originally came from items recorded in OCI or equity, which the question specifically rules out.

Answer C. The $300,000 warranty accrual is a deductible temporary difference (book expense now, tax deduction when paid in Year 2). Year 1 taxable income = $800,000 + $300,000 = $1,100,000, so current tax expense = $1,100,000 × 25% = $275,000. The deferred tax asset is measured at the enacted rate expected to apply when the difference reverses (22%), so DTA = $300,000 × 22% = $66,000.

Why not A: Tempting because it uses the correct 22% rate for the deferred tax asset, but it miscomputes current tax by using pretax book income ($800,000 × 25% = $200,000). The warranty accrual is not deductible in Year 1 and must be added back to determine taxable income.

Why not B: This reflects two common mistakes: computing current tax on pretax book income (800,000) and measuring the deferred tax asset at the Year 1 rate (25% × $300,000 = $75,000). Deferred taxes are measured using the enacted rate expected when the temporary difference reverses (22%).

Why not D: Tempting if a candidate thinks tax effects are recorded only when the deduction is on the tax return, but ASC 740 requires recognition of a deferred tax asset for deductible temporary differences in the period the difference originates (subject to valuation allowances). The stem states Pine expects sufficient taxable income, so a DTA should be recorded in Year 1.