Question

For the year ended December 31, Year 1, Health Company reported a $300,000 warranty expense in its income statement. The expense was based on actual warranty costs of $60,000 in Year 1 and expected warranty costs of $70,000 in Year 2, $80,000 in Year 3, and $90,000 in Year 4. At December 31, Year 1, deferred taxes should be based on a _________.

1) $300,000 deductible temporary difference
2) $240,000 deductible temporary difference
3) $300,000 taxable temporary difference
4) $240,000 taxable temporary difference

Answer 1

Deferred taxes at the end of Year 1 for Health Company should be based on a $240,000 temporary difference, which is the difference between the $300,000 warranty expense recognized for accounting purposes and the $60,000 actual costs deductible for tax in Year 1.

Step-by-step explanation:

For the year ended December 31, Year 1, Health Company reported a $300,000 warranty expense in its income statement, which included actual warranty costs of $60,000 for Year 1 and expected warranty costs of $70,000 for Year 2, $80,000 for Year 3, and $90,000 for Year 4. Deferred taxes at December 31, Year 1, should be based on the difference between the warranty expense recognized for accounting purposes and the actual warranty costs deductible for tax purposes in Year 1.

Given that the company recognized a warranty expense of $300,000 but only incurred $60,000 in actual costs during Year 1, the deductible temporary difference is $240,000 ($300,000 - $60,000). This temporary difference will reverse in future years as the company incurs the remaining warranty costs. Therefore, the correct answer is a $240,000 deductible temporary difference.