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Reading 27: Income Taxes for Firms HARDEST READING (Deferred tax…
Reading 27: Income Taxes for Firms
HARDEST READING
Deferred tax terminology
Taxable income
Amount of Income subject to taxes
Accounting Profit
Pretax financial income. Earning before tax (EBT).
Deferred tax assets DTA (Pay more tax now, but less tax later)
Balance sheet asset that is created when taxes payable (tax return) > income tax expense (income statement) due to temporarily differences.
Deferred Tax Liabilities DTL (Pay less tax now, but more tax later)
Balance sheet liability that is created when tax expense > taxes payables due to temporarily differences
(GAAP only) Valuation Allowance (contra-account)
Reserve against deferred tax assets that might not reverse in the future
Decrease in VA means that future earning power will increase
Increase in VA means that future earning power will decrease
Reduction in valuation allowance = reduction in tax provision
Taxes Payable
Actual tax liability for the current period (based on taxable income)
Income-tax Accounting
Modified-cash accounting
Differences with Accrual-Accounting
timing differences
from
Accrual vs. Modified cash accounting
Differences in reporting methods and estimates
permanent differences
things that are only allowed in one accounting methods but not the other
Income tax paid
Actual cash payment for taxes
Tax loss carryforward: (current Negative taxable income). available to reduce taxes in future years, can result in deferred tax assets
Tax base: Net amount of asset or liability used for tax reporting
Income tax expense
Tax on the income statement (includes cash taxes and deferred taxes) = Tax Payable + \( \Delta\) Deferred Tax Liabilities - \( \Delta\) Deferred Tax Asset
Carrying value: balance sheet value of asset or liability
Difference between IFRS and GAAP regarding DTA and DTL
IFRS DTA and DTL are presented non-current asset/ liabilities
GAAP: depending on timing of expected reversal, DTA and DTL can be either current or non-current
Deferred tax liabilities/ Assets
Origins.
Deferred tax assets (DTA)
Tax deduction < accounting expense
Taxable income is greater than profit before tax, and hence we pay more tax today but will pay less tax in the future
Deferred tax liablilties (DTL)
Taxable income is smaller than profit before tax, and hence we pay less tax today and more tax in the future
Tax deduction (in tax return) > accounting expense (in income statement)
Non-reverse Deferred Tax Liabilities
Typically because of expected continuing growth in the future.
Is treated as equity
Temporary (timing) differences
Revenue and expenses recognized in different period for accounts and tax (e.g. warranty expenses for goods)
financial statement: Firm estimate this amount
tax return: warranty has to be really expensed first before being recognized
Specific revenues and expenses not recognized for tax or accounting purposes
Carrying value of assets and liabilities may differ (e.g. depreciation)
financial statement: straight-line depreciation
tax return: accelerated depreciation
Tax loss carry forwards
Gains/ losses from asset disposals calculated differently for tax and financial statement
financial report: difference between proceeds and carrying value
tax return: $ sold vs. $ purchased
Calculate tax base
Tax base of asset
is: Amount deductible for tax purposes in future period as economic benefits are realized
can be different from carrying value due to cumulative (temporary timing) differences
(tax base - asset carrying value) x tax rate = DTA or DTL
carrying value > tax base: DTL
carrying value < tax base: DTA
Asset Tax Base = Asset's Cost - Previous Depreciation/ Amortization
If the asset is sold, the tax gain (or loss) = Sale price - Asset Tax Base.
Non-taxable benefits: tax base and carrying value will be the same (permanent differences)
Tax base of liability
is: Carrying value of the liability minus any amounts that will be deductible on the tax return in the future
(tax base - liability carrying value) x tax rate = DTA or DTL
carrying value > tax base: DTA
carrying value < tax base: DTL
However, Tax base of (revenue received in advance) = carrying value - the amount of revenue that will not be taxed in the future
Calculate income tax expense, income tax payable, deferred tax asset (liabilities)
Income tax expense = Tax Payable + \(\Delta \)DTL - \(\Delta \)DTA
Permanent vs. Temporary difference in Pretax Accounting Income, and Taxable Income.
Temporary difference
Difference between tax base and the carrying value of asset (or liability), that will result in taxable (or deductible) amount in the future.
Permanent difference
The difference between taxable income and pretax income that will not reverse in the future.
Tax exempt income or non-deductible expenses
Tax credits for some expenditures
Result: effective tax rate \( \not\neq \) statutory rate
effective tax rate = \(\frac{Income.Tax.Expense}{Pretax.Income} \)
Permanent difference will not create DTA nor DTL
Temporary differences at initial recognition
Carry amount \( \not\neq \) tax base at initial recognition
Rule: if there is no impact on accounting profit or taxable profit at the time of the transaction, then no deferred tax item is recorded.
Business Combinations
No deferred tax on goodwill or goodwill impairments
Deferred tax may arise on fair value adjustments of assets and liabilities acquired
Subsidiaries, Joint Ventures, Associates
Recognition of earnings (recorded in IS) vs. dividends (recorded in Tax Return)
Deferred tax (DTL) unless:
Parent controls timing of reversal
Timing difference is unlikely to reserve
Valuation Allowance for Deferred Tax Assets
If DTA cannot be realized (due to insufficient future taxable income to recover tax asset), then DTA must be reduced by a Valuation Allowance.
Valuation Allowance is a contra-account that reduces the DTA value on the balance sheet.
Valuation allowance can be used to manipulate income
Increasing VA will decrease income
Decreasing VA will increase income
DTA can be re-evaluated upward by reducing Valuation Allowance if circumstance changes.
A Valuation allowance reduces a deferred tax asset
GAAP: Full DTA Shown, offeset by valuation allowance
IFRS: DTA is shown after adjusting for probability asset will be realized (allowance not shown separately)
Measurement of current and deferred tax items
Measurement of deferred tax items depends on the tax rate expected to be in force when the underlying temporary difference reverses.
Applicable tax may depend on how the temporary difference will be settled.
If a change that leads to a deferred tax item is taken directly to equity (ex: upward revaluation) the deferred tax item should also be taken directly to equity.
Tax-rate reconciliation
Firm must reconcile their effective income tax rate with applicable rate in the country where the business is domiciled.
Analyzing trend in individual reconciliation items can aid understanding past earnings and forecasting future tax rate, future earnings and cash flow.
Examples
State income taxes increasing
Tax benefits from foreign operations decreasing
Volatile special items, with offsetting effects from asset sales and "other"
Suggests additional information is needed for an analyst to forecast the company's effective tax rate
Differences in IFRS and GAAP Income Tax Accounting
Revaluation of PP&E and intangible asset
GAAP: Prohibits upward revaluation.
IFRS:Permits upward revaluation --> effect deferred tax.
Deferred tax assets
GAAP: Full recognition, reduced by valuation allowance
IFRS: Recognized if recovery probable
Undistributed profits from subsidiaries, associates, joint ventures
GAAP: No need to DTL if unlikely to reverse in future
IFRS Deferred tax (DTL) unless:
Parent controls timing of reversal
Timing difference is unlikely to reserve
Tax-rate changes
If the tax rate at time of reversal is different from current tax rate?
DTA and DTL values are adjusted for changes in future tax rates
Tax rate decreases
DTL DOWN
Income tax expense DOWN
DTA DOWN
Income tax expense UP
Tax rate increases
DTL UP
Income tax expense UP
DTA UP
Income tax expense DOWN
Net effect (on tax expense) depends on relative sizes of \(\Delta \)DTL and \(\Delta \)DTA
Effect on tax payable:
Future tax rate DOWN
Tax payable DOWN
(other things equal)
Net Income UP
CFO UP
Future tax rate UP
Tax payable UP
(other things equal)
Net income DOWN
CFO DOWN
if DTA > DTL
(net tax asset)
Future tax rate UP
Assets UP
Income Tax expense DOWN
Future tax rate DOWN
Assets DOWN
Income Tax expense UP
if DTA < DTL
(net tax liability)
Future tax rate UP
Liabilities UP
Income Tax expense UP
Future tax rate DOWN
Liabilities DOWN
Income Tax expense DOWN
Comparison of deferred tax items
Analyst should examine disclosures showing
Change in DTLs by source/category (e.g., excess of tax over book depreciation)
Change in DTAs by source/category (e.g., write-down of inventory, restructure, defined benefit pension)
Change in valuation allowance
Required Deferred Tax Disclosures
Deferred tax liabilities/ assets: Any valuation allowance, and net change in valuation allowance
Unrecognized deferred tax liability for undistributed earnings of subsidiaries and joint ventures
Current-year tax effect of each type of temporary difference
Components of income tax expense
Tax loss carryforwards and credits
Reconciliation of difference between tax expense as a % of pre-tax income and statutory tax rate
Analysis
Be aware of differences in tax reconciliation between periods
Look for cumulative differences due to asset impairments and post-retirement benefits
Restructuring charges can create a deferred tax asset (not currently tax deductible)