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CFA Level I · CFA Level I Exam · Analysis of Income Taxes

At year-end, a company reports a liability for warranty provisions with a carrying amount of 80,000. Warranty costs are deductible for tax only when paid, so the tax base of the liability is zero. The tax rate is 25%. The deferred tax item most likely recognized is:

The warranty liability has a zero tax base, so a deductible temporary difference of 80,000 exists. Multiplying by the 25% tax rate gives a deferred tax asset of 20,000, because the cost will reduce future taxable income when paid.

  1. Aa deferred tax liability of 20,000
  2. Ba deferred tax asset of 20,000Correct
  3. Ca deferred tax asset of 80,000

Explanation

Tax base of the liability is carrying amount less future deductible amounts, which gives zero. The deductible temporary difference is 80,000 - 0 = 80,000. Deferred tax asset = 80,000 x 25% = 20,000. The 80,000 option fails to apply the tax rate.

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