1. At the beginning of Year 1, Company X purchased a machine costing $6,000 with a 3-year estimated service life and no salvage value. For financial reporting (book) purposes, Company X uses straight-line depreciation with a 3-year life. For income tax reporting, the machine is depreciated with a 2-year life. The machine is used to manufacture a product that will generate annual revenue of $5,000 for three years. Warranty expenses are estimated at 10% of revenues each year; all repairs are provided in Year 3. The tax rate is 40% in all three years.
What is the balance at the end of Year 2 of Company X's deferred tax asset and liability? Answer: 1,000 and 800

I'm trying to figure out your numbers. Can you show your work? I'm wondering if you applied the tax rate. Thanks.

10% of 5,000 for two years = 1000
40% of 1000 for two years = 800

The 10% refers to the amount of warranty expense to be recognized on the books. For tax purposes, you only recognize the expenses when actually incurred. What this means is that you are matching the warranty expense to the revenues for the purposes of your books. Each year you will earn $5,000 and therefore you will accrue $500 in warranty expense and warranty payable each year. If you actually incur any warranty costs, for book purposes they are debited to the warranty payable. For taxes, you don't recognize the accrued warranty - thus you have a deferred amount of $500 the first year, an additional $500 the second year, and finally $500 in the third year. Unless there are actual expenses, there is no tax effect. Your problem states that the $1500 is provided in Year 3. At the end of Year 2, you have deferred $1,000 ($500 times 2 years), but you have to apply the tax rate to this. FYI - At the end of Year 3, there is no longer a deferral as the expenses now match for tax and books at $1500 each.

It doesn't appear that you are considering the info about depreciation. They are telling you that there is a difference in how depreciation is recorded for books versus taxes. This will also cause a deferral. Why don't you see if you can work that out?

Applying the 40% tax rate to $1,000 leads to $400 asset

That's right for the deferred asset for the warranty. Now you have to figure the deferred liability regarding the depreciation.

The deferred liability regarding depreciation would be $800

Right. Good job. :) I think I'm realizing you had that already. Sorry.

Yeah, riiiight