Warranty Accrual Deferred Tax Asset: ASC 740 Calculation

Answer C. Lark recognized warranty expense for financial reporting in Year 1, but the tax deduction will occur later when warranty payments are made. Because the tax deduction is expected in a future period, the timing difference will reduce future taxable income when it reverses. That makes it a deductible temporary difference, which gives rise to a deferred tax asset (assuming sufficient future taxable income).

Why not A: This is tempting if a candidate confuses the current book expense with a current tax benefit. Here taxable income is not reduced in Year 1 (no tax deduction until paid), so the reversal will lower future taxable income, a deductible temporary difference (DTA), not a taxable temporary difference (DTL).

Why not B: Permanent differences do not reverse. Because the warranty amounts will be deductible for tax purposes when paid in a future period, the difference is temporary (it reverses) rather than permanent.

Why not D: Under ASC 740, temporary differences that exist at the reporting date give rise to deferred taxes. At December 31 the book expense has been recorded but the tax deduction has not, a temporary difference already exists.

Answer D. The allowance creates a deductible temporary difference because Lane recognized bad debt expense for book purposes before it can deduct the amount on its tax return. When the accounts are later written off, taxable income will be lower, producing a future tax benefit. The deferred tax asset equals $40,000 × 21% = $8,400.

Why not A: Some candidates might think book-only estimates never affect taxes. However, the tax deduction is delayed until specific accounts are written off, so the difference is temporary and will reverse, creating a deferred tax asset.

Why not B: Candidates may recall that temporary differences create deferred taxes and confuse the direction. Here the timing difference results in future tax deductions (lower taxable income when the write-offs occur), so the correct result is a deferred tax asset, not a liability.

Why not C: This distractor appeals to those who treat the future tax savings as an immediate receivable. Because no tax deduction has been taken yet, there is no current tax receivable; the benefit is for future periods and should be recorded as a deferred tax asset.

Answer C. This creates a deductible temporary difference because the expense is recognized for book purposes before it is deductible for tax. The company will receive the tax deduction in a future period when warranty claims are paid, so the future tax benefit is recorded as a deferred tax asset.

Why not A: Candidates may see 'taxed later' and assume a benefit, but taxable income is lower now and higher later; tax will be paid in a future period on income already recognized for books, so this generally creates a deferred tax liability.

Why not B: Tempting because it involves timing differences, but higher tax depreciation now reduces taxable income in Year 1 and typically results in higher taxable income later relative to book, this produces a deferred tax liability, not an asset.

Why not D: This gives the company a tax deduction before the book expense is recognized, lowering current taxable income and increasing future taxable income relative to book, so it points to a deferred tax liability rather than an asset.

Answer D. The warranty accrual is deductible for tax when the cash payments occur in Year 2, so it is a deductible temporary difference that gives rise to a deferred tax asset. Deferred taxes are measured using the enacted tax rate expected to apply when the difference reverses (Year 2), so the amount is $120,000 × 30% = $36,000.

Why not A: Incorrect, the tax effect of temporary differences is recognized when the temporary difference exists in the financial statements, even though the actual tax deduction occurs later.

Why not B: Tempting because it uses the Year 1 enacted rate (25%), but deferred tax balances are measured using the rate expected to apply when the temporary difference reverses (Year 2 at 30%).

Why not C: This confuses the direction of the effect. A future tax deduction (warranty paid in Year 2) reduces future taxes payable and therefore creates a deferred tax asset, not a liability.

Answer C. Warranty expense is recognized for book now but deductible for tax when paid in 20X6, creating a future deductible amount and thus a deferred tax asset (120,000 × 25% = 30,000). Tax depreciation in excess of book depreciation produces lower taxable income now and higher taxable income later (a future taxable amount), so it gives rise to a deferred tax liability (200,000 × 25% = 50,000). Interest on municipal bonds is a permanent difference excluded from taxable income and therefore creates no deferred tax. Rent that was taxed when collected in 20X5 but will be recognized for book in 20X6 is taxable earlier than book and therefore creates a future deductible amount and a deferred tax asset (80,000 × 25% = 20,000).

Why not A: This choice wrongly treats municipal bond interest as a temporary difference; municipal bond interest is a permanent difference and does not generate deferred taxes. It also incorrectly concludes that a previously taxed revenue item cannot give rise to deferred tax, timing differences between tax and book recognition (taxed-now, booked-later) do create a deferred tax asset.

Why not B: This is tempting because depreciation and timing of revenue both involve timing differences, but it mislabels the rent. The rent was taxed earlier than book recognition, so when the rent is recognized for financial reporting it will not be taxable then, this produces a future deductible amount (deferred tax asset), not a liability.

Why not D: This distractor reflects the mistaken view that deferred taxes are recorded only when the tax return is affected. Under ASC 740, deferred taxes are recognized when temporary differences arise, so the warranty accrual creates a DTA immediately. Also, municipal bond interest is a permanent difference and does not create a DTA.