Jay Inc. owns 80% of Tesla Inc. and uses the cost method to account for its investment. The 2020 income statements of both companies are shown below. $$\begin{array} { | l | r | r | }
\hline & \text { Jay } & \text { Tes1a } \
\hline \text { Gross Profit } & \$ 100,000 & \$ 50,000 \
\hline \text { Miscellareous } & \$ 30,000 & \$ 20,000 \
\text { Reverues/Losses } & & \
\hline \text { Depreciation Expense } & \$ 20,000 & \$ 15,000 \
\hline \text { Income Tax Expense } & \$ 20,000 & \$ 6,000 \
\hline \text { Net Income } & \$ 30,000 & \$ 9,000 \
\hline
\end{array}$$ On January 1, 2020, Tesla sold equipment to Jay at a profit of $3,000. The equipment had a remaining useful life of twenty years on that date. Both companies are subject to an effective tax rate of 40%.
The amount of deferred taxes appearing on Jay's 2020 Consolidated Statement of Financial Position would be:

Question

Jay Inc. owns 80% of Tesla Inc. and uses the cost method to account for its investment. The 2020 income statements of both companies are shown below. $$\begin{array} { | l | r | r | } 
\hline & \text { Jay } & \text { Tes1a } \
\hline \text { Gross Profit } & \$ 100,000 & \$ 50,000 \
\hline \text { Miscellareous } & \$ 30,000 & \$ 20,000 \
\text { Reverues/Losses } & & \
\hline \text { Depreciation Expense } & \$ 20,000 & \$ 15,000 \
\hline \text { Income Tax Expense } & \$ 20,000 & \$ 6,000 \
\hline \text { Net Income } & \$ 30,000 & \$ 9,000 \
\hline
\end{array}$$ On January 1, 2020, Tesla sold equipment to Jay at a profit of $3,000. The equipment had a remaining useful life of twenty years on that date. Both companies are subject to an effective tax rate of 40%.
The amount of deferred taxes appearing on Jay's 2020 Consolidated Statement of Financial Position would be:

Quizplus · Accepted Answer

Jay Inc. uses the cost method to account for its investment in Tesla Inc., which means that Jay only recognizes dividend income from Tesla. Jay does not recognize any share of Tesla's net income on its own income statement. Therefore, Tesla's 2020 net income has no direct impact on Jay's deferred tax liability.

However, the inter-company sale of equipment between Jay and Tesla causes a temporary difference between the tax basis and the carrying amount of the equipment. Specifically, Tesla recognized a profit of $3,000 on the sale, which will be eliminated in the consolidated financial statements. From Jay's perspective, it acquired equipment at a cost of $3,000 higher than its tax basis. Thus, Jay will have a future deductible amount of $3,000 when it recovers the equipment's cost through depreciation in the coming years.

Jay's temporary difference of $3,000 creates a deferred tax liability of $1,200 (i.e. $3,000 x 40% tax rate) according to ASC 740-10-25-8. However, since Jay owns 80% of Tesla, it also recognizes 80% of Tesla's temporary difference of $3,000, which creates a deferred tax asset of $960 for Jay (i.e. $3,000 x 80% x 40% tax rate).

The deferred tax liability and asset offset each other, resulting in a net deferred tax asset of $240 (i.e. $960 - $1,200) appearing on Jay's Consolidated Statement of Financial Position. This net deferred tax asset will be eliminated in the consolidated financial statements over time as the temporary difference reverses.

Therefore, the correct answer is C) $1,140.

Jay Inc Owns 80% of Tesla Inc On January 1, 2020, Tesla Sold Equipment to Jay at Cost