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• Taxable Income – the income subject to tax on the IRS tax return
• Income Tax Paid (CFO) - actual cash outflow for income taxes +/-
payments or refunds from prior periods
• Tax Loss Carryforward - the current net taxable loss that can be used to
reduce future taxable income
• Income Tax Expense - expense recognized in the I/S based on current period
pre-tax income; includes taxes payable (IRS) + deferred inc. tax expense (F/S)
• Deferred Tax Asset (DTA) - B/S amount expected to be recovered from future
operations
• Deferred Tax Liability (DTL) - B/S amount expected to result in future cash
outflows
Financial Statements Analysis
• The central accounting issue is whether the tax effects of transactions for
which GAAP-based and tax based accounting rules differ should be
– recognized in the period in which they affect taxable income (IRS)
called the deferral method or …
– recognized in the period in which they are recognized in the financial
statements (creating deferred tax balances) called the liability
method.
Deferred tax is caused when the same tax in total passes through the tax
returns and the financial accounts but occurs in different time periods
The result is that taxable income is The result is that taxable income is
smaller than income before tax and greater than income before tax and
hence we pay less taxes payable hence we pay more taxes payable
today. We pay less tax now at the today. We pay more tax now and
expense of more tax in the future. less tax in the future.
DTL caused by Depreciation DTA arise from Warranty Exp
Note: Deferred tax assets can also be created by tax loss carryforwards
Financial Statements Analysis
• The standard mandates the recognition of deferred tax liabilities for all
temporary timing timing differences expected to generate net taxable
amounts in future years. This results in a future cash outflow.
DTL Example - 1
• DDB is used for tax purposes, straight-line for financial reporting purposes
• Calculate the deferred tax liability for the next four years
A firm acquires an asset for $21,000 with a three year useful life and no
salvage value. The asset will generate $16,000 of annual revenue for three
years. The tax rate is 30% and the firm is allowed to depreciate the asset
using DDB for tax purposes and straight line for financial reporting purposes.
1 2 3
Note:
Tax Expense Worksheet $ $ $
Simply taking the pre
Accounting S. L. Dep 7,000 7,000 7,000 tax income × statutory
Tax Return DDB Dep (14,000) (4,667) (2,333) rate to calculate the
Expense Difference (7,000) 2,333 4,667 tax expense will not
work when there are:
Tax Rate 30% 30% 30%
• Permanent timing
Deferred Tax Expense (2,100) 700 1,400
differences
Tax Payable (IRS) (600) (3,400) (4,100) • Deferred tax assets
+ and liabilities
Deferred Tax Expense (2,100) 700 1,400
=
Inc Tax Expense (F/S) (2,700) (2,700) (2,700)
• DTAs result whenever Income Tax Payable (IRS) >Tax Expense (F/S)
• Management and its auditors must defend the recognition of all DTAs
Financial Statements Analysis
• Recall, tax loss carryforwards arise when a tax return loss can be
used to offset future taxable income. These carryforwards are often
considered deferred tax assets (DTA).
Valuation Allowance
• For a DTA to be realized and be beneficial (asset), the firm must have
future taxable income
• If it is more likely than not that a portion of the DTA will not be realized due
to insufficient future income, then the DTA must be reduced by the
valuation allowance, which is a reduction in income from continuing
operations.
Financial Statements Analysis
DTA Example -1
• A firm has annual sales of $5,000 for each of the next two years
• The actual warranty expenditure of $200 was not made until the end of the
second year
A firm has revenues of $8,000 for each of three years. The firm estimates the
warranty expense to be 12.5% of revenues each year. The actual expenditure of
$3,000 to meet warranty claims was not made until the third year.
1 2 3
Note:
Tax Expense $ $ $
Simply taking the pre
Accounting Expense 1,000 1,000 1,000 tax income × statutory
Tax Return Expense 0 0 (3,000) rate to calculate the
Difference 1,000 1,000 (2,000) tax expense will not
work when there are:
Tax Rate 30% 30% 30%
300 300 (600) • Permanent timing
Deferred Tax Expense
differences
Tax Payable (IRS) (2,400) (2,400) (1,500) • Deferred tax assets
+ Δ Deferred Tax 300 300 (600) and liabilities
Tax Expense (F/S) (2,100) (2,100) (2,100)
• SFAS 109 permits the offsets of deferred tax effects only within each tax-
paying component and tax jurisdiction.
• DTA and DTL must be separated into current and long term portions
based on the types of assets and liabilities generating the deferral.
1. Separate disclosure of DTA and DTL, valuation allowance and the net
change in the allowance for each period
2. Any unrecognized DTL for the undistributed earnings of domestic and
foreign subsidiaries and joint ventures.
3. The current year tax effect of each type of temporary difference
4. Components of the income tax expense (taxes payable + Def Inc Tax
Expense)
5. Reconciliation of reported income tax expense and the amount based
on the statutory income tax rate
6. Tax loss carryforwards and credits
• The key analytical issue is whether the DTA or the DTL will reverse in
the future.
– If they will not reverse in the future, it is highly debatable whether the
deferred taxes are assets or liabilities (cash flow consequences)
– It maybe more appropriate to classify them as decreases or
increases in equity
Financial Statements Analysis
• Other Items
Non recurring items – case by case basis
Extraordinary items - restructuring expenses
Equity adjustments – unrealized gains and losses
• All deferred tax assets and liabilities are revalued using the new tax rate
that is expected to be in place when the liability reverses
• Increases in tax rates (tax cuts) will affect deferred tax liabilities and
assets, and the adjustment is included in current-period income tax
expense.
• For analytical purposes, the analyst can adjust future DTL estimates while
legislation is pending.
Financial Statements Analysis
– As long as DTL > DTA (usually the case), the net impact of the
increase in the tax rate will be to:
• increase the tax expense
• decrease net income
• decrease shareholder’s equity
– As long as DTL > DTA (usually the case), the net impact of the
decrease in the tax rate will be to:
• decrease the tax expense
• increase net income
• increase shareholder’s equity
• The equipment has a three year life expectancy with no salvage value
• Straight-line used for financial reporting and DDB for tax reporting
• Now assume at the beginning of year 2 the tax rate is reduced from 30%
to 20%.
• The deferred tax liability from year one of $300 using 30% would be
revalued to $200 reflecting the new tax rate of 20%.
• The $100 decrease (benefit) in the deferred tax liability would reduce year
2 income tax expense:
Year 2
Taxes Payable = tax rate x taxable income = 0.20 x $9,333 = $1,867
Deferred Taxes = new tax rate x (DDB - SL) = 0.20 x ($667 - $1,000) = - $67
Tax Expense = (taxes payable - reduction in deferred taxes yr 2 - benefit
from reduced tax rate on year 1 deferred taxes) = $1,867 - 67 - 100 =
$1,700
Financial Reporting 1 2 3
$ $ $
Revenue 20,000 20,000 20,000
SL Depreciation (8,000) (8,000) (8,000)
Pre-tax income 12,000 12,000 12,000
Tax Expense (4,800) (3,800) (4,200)
Net Income 7,200 8,200 7,800
1 2 3
Tax Expense $ $ $
• For growing firms who are continually adding fixed assets at increased
prices or higher-cost, the result is an ever-increasing DTL due to the
difference between the use of S.L. depreciation for financial reporting
purposes vs. accelerated methods used for tax reporting purposes.
• As a result of the firm’s growth, either in real or nominal terms, the net
DTL will increase over time and will never reverse. This will have a
positive effect on cash flow since future taxes will not be paid.
• If the firm reduces its acquisition of fixed assets and reversals exceed
originations, the related DTL will decline. Effect on cash is uncertain.
Financial Statements Analysis
• The following items may also affect income tax expense, taxes paid and
deferred tax assets and liabilities:
• Even if these deferred taxes are eventually paid, the present value of
those payments should reduce the balance sheet liability stated
amounts.
– Reversing DTL: Only those liabilities that are likely to reverse should
be considered a liability. The liability should be discounted to a
present value by the numbers of years until the expected reversal.
• If for example, the DTL arose from the use of straight line depreciation vs.
accelerated depreciation and…
• We should examine the possibility of those assets for the likelihood of use
and timing of the reversal
Both reported tax expense and pretax income are affected by management
choices of revenue and expense recognition.
The difference between the effective tax rate and the statutory tax rate is
due solely to permanent differences
Income Tax Paid (IRS) This method uses cash taxes paid based
on revenue and expense recognition used
Pretax Income (F/S)
on the tax return relative to financial
reporting pretax income
Differences in taxable and pre-tax incomes that are never reversed since
revenue or expenses may not be reported for either F/S or IRS purposes
Permanent Revenue Differences Permanent Expense Differences