Plaxo Corporation has a tax rate of 35% and uses the straight-line method of depreciation for its equipment, which has a useful life of four years. Tax legislation requires the company to depreciate its equipment using the following schedule: year 1- 50%, year 2 - 30%, year 3 - 15% and year 4 - 5%. In 2006 Plaxo purchases a piece of equipment with a four year life and an original cost of $100,000. What amount will Plaxo record as a deferred tax asset or liability in 2006?

Question

Quizplus · Accepted Answer

Under tax legislation, Plaxo must depreciate the equipment at 50% in year 1, which is higher than the straight-line method. This creates a timing difference between book and tax depreciation. In year 1, Plaxo will record depreciation of $25,000 (50% of $100,000) for tax purposes, but only $25,000/4 = $6,250 for book purposes. The difference of $18,750 [$25,000 - ($6,250 x 4)] creates a deferred tax liability because Plaxo will have to pay this additional tax in future years when the book depreciation catches up to the tax depreciation. The deferred tax liability will be calculated as $18,750 x 35% = $6,562.50 for year 1, and will reduce the net income by this amount. The remaining $12,187.50 ($18,750 - $6,562.50) will be carried forward to year 2, when the timing difference will be less due to the lower tax depreciation rate. The total deferred tax liability will be $25,000 over the four-year life of the equipment.

Plaxo Corporation Has a Tax Rate of 35% and Uses