Understanding Deferred Taxes I | CFA Level I FSA

This topic on Income Taxes is one of the hardest in the CFA curriculum. The key to tackling this topic is to understand the basic principles, so don’t worry too much if there are small details that you may not understand at this point.

In this lesson, we will cover:

• Difference between financial accounting and tax reporting
• Sources of differences between accounting and tax reporting
• Deferred tax assets and deferred tax liabilities
• Tax base and carrying value
• Tax loss carryforward
• Valuation adjustments for deferred tax assets

Fasten your seatbelts, and let’s dive right in!

Financial Accounting vs. Tax Reporting

To understand the differences between financial accounting and tax reporting, let’s start with a simple example:

A company reports a revenue of $100,000 for the year. Deducting costs of $60,000, the company has a pre-tax income of $40,000. This is also known as the accounting profit. Let’s say income is taxed 30%, the company reports a tax expense of $12,000. The net profit is therefore $28,000.

This is known as financial accounting, and what we are familiar with so far.

When it comes to actual income taxes paid, the tax reporting could be different. Under tax reporting, the tax authorities may have different standards when it comes to recognising costs.

Such differences can be permanent, or temporary. We shall discuss some of these differences later.

Let’s assume that under the tax rules, the company is only able to record $90,000 in revenue, and $65,000 in costs. The taxable income is therefore $25,000. The tax payable at a 30% average tax rate is $7,500. This is the actual tax to be paid to the tax authorities for the current period.

Deferred Tax Assets and Deferred Tax Liabilities

Now, to reconcile the discrepancies between the taxes payable, which is the amount of taxes actually paid, and the income tax expense, which is reflected in the income statement, the differences are recorded in the balance sheet as deferred tax assets and deferred tax liabilities. For our example, the tax expense is $12,000, but taxes payable is $7,500. The company has to record a DTL of $4,500 on its balance sheet to reconcile this discrepancy.

When the actual taxes payable is less than the amount accounted for in the income statement, as in this case, a deferred tax liability is recorded in the balance sheet. It is a liability because the “less tax” paid in this period may somehow have to be paid in the future.

Conversely, if the actual taxes payable is more than the amount accounted for in the income statement, a deferred tax asset is recorded in the balance sheet. It is an asset because the “excess tax” paid in this period may be a future benefit.

The relationship between income tax expense, taxes payable, and deferred taxes can be summed up in this equation:

income tax expense = taxes payable + change in deferred tax liabilities – change in deferred tax assets

Key Terms

• Accounting profit: Earnings before tax, found in the income statement.
• Income tax expense: This figure includes cash taxes and deferred taxes.
• Taxable income: The amount of income that is subject to tax by the authorities. It can be a different figure from the accounting profit, as there are differences between accounting treatment and tax treatment.
• Taxes payable: The actual tax liability for the current period.

Now that we have clarified some key terms, let’s discuss what brings about these differences between accounting and taxable profits.

Permanent and Temporary Differences

As mentioned earlier, the differences can be temporary or permanent.

Permanent differences are differences between taxable income and pretax income that will not reverse in the future. They can be caused by revenue that is not taxable, expenses that are not deductible, or tax credits that result in a direct reduction of taxes.

Note that permanent differences do not affect the pre-tax or accounting profit in the income statement. Rather, they affect the tax expense. This causes the firm’s effective tax rate to differ from the statutory tax rate.

The statutory rate is the tax rate of the jurisdiction where the firm operates, whereas the effective tax rate is derived from the income statement.

Permanent differences cause the effective tax rate to differ from the statutory tax rate. As these differences will not reverse in the future, there are no future benefits or obligations to the firm. As such, permanent differences do not result in changes in deferred tax assets or deferred tax liabilities.

Temporary differences, on the other hand, are likely to be reversed in the future. They arise due to timing differences in the recognition of revenue and expenses. As the future reversals bring about potential benefits and obligations to the firm, deferred tax assets and liabilities are created to reconcile these timing differences.

Tax Base and Carrying Value

So how do these timing differences come about? To understand this, we first have to understand the concept of a tax base.

We know that the carrying value of an asset is the value of the asset reported in the balance sheet, net of accumulated depreciation and amortisation. That is the accounting side of the story.

Now, we know the tax man may not thoroughly agree with the accountant. For example, the accountant decides that the best treatment for depreciating an asset is to use the straight-line method, with no residual value. The tax man, on the other hand, says only the double declining balance method is allowed.

So, under tax reporting, the amount of depreciation of the asset is higher in the initial years. The value of the asset, less the accumulated depreciation under tax reporting, is the tax base of the asset.

While the carrying value is the value of the asset on the balance sheet, net of depreciation and amortisation, the tax base of an asset is the amount deductible for tax purposes in future periods as the economic benefits of the asset are realised.

While the carrying value and the tax base can be the same, they can also be different, as in this case. This is what causes the temporary differences in the accounting profit and the taxable income for the period. Such differences, as mentioned earlier, will likely reverse in the future.

Deferred Taxes Example: Depreciation Methods

In this example, we examine a transportation firm that acquired a fleet of pre-owned buses for $90,000, with a 3-year useful life and no salvage value. The buses generate $60,000 of annual revenue for each of the 3 years. The firm uses the straight-line depreciation method for accounting purposes and the double declining balance method for tax purposes.

Objective: Compute the deferred tax asset or liability for the 3 years as a result of the different depreciation methods used.

Long Method

Quick Method: Using Carrying Value and Tax Base

Deferred Tax Assets: Loss Carryforwards

When a firm makes a loss, it can book a tax loss carryforward. This deferred tax asset can be used to offset future taxes when the company returns to profitability. However, deferred tax assets are beneficial only if the company is profitable and has to pay income taxes.

Valuation Allowance

Deferred tax assets can be adjusted with valuation allowance to reflect the probability that the deferred tax asset will not be realized in future periods. If there is a greater than 50% probability that some or all of a DTA will not be realized, the DTA must be reduced by a valuation allowance according to U.S. GAAP.

An increase in valuation allowance decreases the net DTA, which increases the tax expense and reduces net income for the period. Conversely, a decrease in valuation allowance results in higher net income for the period.

Effects of Changes in Tax Rates on Financial Statements and Ratios

Changes in tax rates can have a significant impact on a company’s financial statements and financial ratios. When tax rates change, both deferred tax assets (DTAs) and deferred tax liabilities (DTLs) must be adjusted accordingly. The adjustments can impact a company’s net income, balance sheet, and various financial ratios.

Impact on Net Income

When tax rates increase, deferred tax assets will increase, and deferred tax liabilities will decrease. This results in a higher tax expense and a lower net income for the period. Conversely, when tax rates decrease, deferred tax assets will decrease, and deferred tax liabilities will increase. This results in a lower tax expense and a higher net income for the period.

Impact on Balance Sheet

Changes in tax rates also affect the balance sheet. An increase in tax rates will cause the carrying value of deferred tax assets to increase, and the carrying value of deferred tax liabilities to decrease. Conversely, a decrease in tax rates will cause the carrying value of deferred tax assets to decrease and the carrying value of deferred tax liabilities to increase.

Impact on Financial Ratios

Changes in tax rates can impact various financial ratios, such as profitability ratios, liquidity ratios, and solvency ratios. For example:

• Profitability ratios like net profit margin and return on equity may be affected by changes in tax rates due to the impact on net income.
• Liquidity ratios like the current ratio and quick ratio may be affected by changes in deferred tax assets and liabilities on the balance sheet.
• Solvency ratios like the debt-to-equity ratio and debt ratio may be affected by changes in deferred tax liabilities on the balance sheet.

It is essential for analysts to carefully examine the impact of changes in tax rates on a company’s financial statements and ratios to obtain an accurate understanding of its financial performance and position. By doing so, analysts can better assess the company’s financial health and make informed decisions regarding investments or creditworthiness.