A company enters into a 4-year lease for equipment with annual payments of $80,000 due at the end of each year and an implicit interest rate of 5%. For book purposes, the company classifies the lease as a finance lease, but for tax purposes the lease is treated as an operating lease (i.e., the company deducts the $80,000 payment when made each year). Tax rate is 25%. At inception, compute the lease liability and right-of-use (ROU) asset. Then, for Year 1, compare the total book expense under the finance lease classification with the expense that would be recorded if the lease were classified as an operating lease. Determine the deferred tax asset (DTA) or deferred tax liability (DTL) that arises at the end of Year 1 under the finance lease classification, and show the journal entry to record tax expense.

The present value of the lease payments is the lease liability and initial ROU asset value.

PV = $80,000 × [1 – (1.05)^(-4)] / 0.05 = $80,000 × 3.54595 = $283,676.

Initial ROU asset and lease liability are both $283,676.

Year 1 book expense – finance lease:

• Interest expense: $283,676 × 0.05 = $14,184
• Depreciation: $283,676 ÷ 4 = $70,919
• Total expense = $85,103

Year 1 expense if operating lease:

• Straight-line rent expense = $80,000

The finance lease front-loads expense: Year 1 book expense exceeds the operating lease expense by $5,103.

Year 1 tax deduction: $80,000 (rent payment). Taxable income is higher than book pre-tax income by the same $5,103 because the tax deduction ($80,000) is less than the book expense ($85,103). The company pays more cash tax today relative to the book tax expense on the income statement, creating a deferred tax asset (DTA).

DTA = $5,103 × 25% = $1,276 (rounded).

Tax journal entry at end of Year 1: Assume pre-tax book income before the lease is X. Book pre-tax including lease = X – 85,103. Current tax payable = (X – 80,000) × 25%. Total income tax expense (book) = current tax – DTA creation = (X – 80,000)×25% – 1,276.

• Dr Income tax expense (to P&L) = (X – 80,000)×25% – 1,276
• Dr Deferred tax asset = 1,276
• Cr Cash / Taxes payable = (X – 80,000)×25%

The DTA will reverse in later years when the sum of depreciation and interest falls below $80,000, making book expense lower than the tax deduction.

Follow-up pressure:

• Explain why the DTA is $1,276 specifically from the $5,103 difference rather than from the entire $80,000 tax payment, and walk me through where that $5,103 comes from in the balance sheet accounts themselves.
• If the tax rate increased to 30% immediately after inception, would your DTA at the end of Year 1 still be $1,276, and what exact adjustment would you make to the journal entry?
• You said the DTA reverses when book expense falls below the tax deduction: show me the exact Year 3 book expense, the difference versus the $80,000 deduction, and the specific DTA reversal entry for that year.