Deferred Taxes II: Effects of Tax Rate Changes and More | CFA Level I FSA
In this second part on deferred taxes, we’ll dive into the effects of tax rate changes on financial statements and explore common sources of temporary differences that result in deferred taxes. We’ll also discuss the required disclosures regarding deferred taxes and the differences in accounting between IFRS and US GAAP.
Recap of Key Concepts from Deferred Taxes I
Before we proceed, let’s quickly recap some key concepts from the previous lesson:
- Financial accounting can differ from tax reporting. Financial accounts follow standards and guidelines from the accounting standards board, while tax reports follow rules from tax authorities.
- Accounting profit is the pre-tax income from the income statement, while taxable income is the income subject to tax based on the tax return.
- Deferred tax assets (DTA) and deferred tax liabilities (DTL) are created on the balance sheet due to discrepancies between accounting profit and taxable income.
- Income tax expense includes tax payable and changes in deferred tax assets and liabilities, and is calculated using the following formula: Income Tax Expense = Tax Payable + Change in DTL – Change in DTA.
Effects of Tax Rate Changes on DTA, DTL, and Income Tax Expense
Now, let’s discuss the impact of tax rate changes on deferred tax assets, deferred tax liabilities, and the income tax expense for the period:
- When the tax rate increases, both DTA and DTL should be increased to account for the higher tax rate going forward.
- When the tax rate decreases, both DTA and DTL should be decreased to account for the lower tax rate going forward.
- The net effect on the income tax expense depends on whether DTA or DTL is higher. If DTA is higher, the net effect is a lower income tax expense when the tax rate increases and a higher income tax expense when the tax rate decreases. If DTL is higher, the net effect is a higher income tax expense when the tax rate increases and a lower income tax expense when the tax rate decreases.
EXAMPLE
Hatch Industries owns a fleet of heavy vehicles with a carrying value of $500,000 on its balance sheet and a tax base of $400,000. In the same period, the firm has recognized an impairment of $300,000 in its income statement on the sinking of one of its ships. This impairment is not yet deductible for tax purposes, but the company expects it to be in the future. Given that the tax rate is 30%, compute the likely value of the DTA and DTL on the company’s balance sheet based on the provided information.
DTL (heavy vehicles) = (Carrying value – Tax base) × Tax rate
= ($500,000 – $400,00) x 0.3
= $30,000
For the fleet of heavy vehicles, the carrying value is higher than the tax base, resulting in a DTL of $30,000.
DA (impairment charge) = (Tax base – Carrying value) × Tax rate
= ($300,000 – $0) x 0.3
= $90,000
For the impaired ship, the carrying value is $0, and the tax base is $300,000, resulting in a DTA of $90,000.
Now, let’s say the tax rate is to be increased from 30% to 35%. Compute the change in income tax expense due to the tax increase, given that there is no change in the carrying values and tax bases.
Income tax expense = Taxes payable + ΔDTL – ΔDTA
ΔDTL (heavy vehicles) = (Carrying value – Tax base) × ΔTax rate
= ($500,000 – $400,00) x 0.05
= $5,000
To calculate the change in DTL, we multiply the difference between the carrying value and tax base of the fleet of heavy vehicles by the change in tax rate, resulting in an increase in DTL of $5,000.
ΔDTA (impairment charge) = (Tax base – Carrying value) × ΔTax rate
= ($300,000 – $0) x 0.05
= $15,000
Similarly, to calculate the change in DTA, we multiply the difference between the tax base and carrying value of the impaired ship by the change in tax rate, resulting in an increase in DTA of $15,000.
Δlncome tax expense =ΔDTL – ΔDTA
= $5,000 – $15,000 = -$10,000
Given that all else remains the same, the change in income tax expense as a result of the tax increase is simply the change in DTL minus the change in DTA. We have a decrease of $10,000.
Common Sources of Temporary Differences and Deferred Taxes
Next, let’s explore some common sources of temporary differences that result in deferred taxes:
- Depreciation and amortization: Differences in depreciation methods used for financial accounting and tax reporting can create temporary differences.
- Revenue recognition: The timing of revenue recognition for financial accounting and tax reporting purposes can vary, leading to temporary differences.
- Expenses: Certain expenses, like impairment losses or bad debt expenses, may be recognized in financial accounting before they’re deductible for tax purposes, causing temporary differences.
Required Disclosures Regarding Deferred Taxes
Companies must disclose information about their deferred taxes, including:
- Components of income tax expense (e.g., current tax expense and deferred tax expense).
- Reconciliation of statutory tax rate to effective tax rate.
- Significant components of deferred tax assets and liabilities.
- Valuation allowances for deferred tax assets.
- Unrecognized tax benefits and changes in unrecognized tax benefits during the reporting period.
Differences in Accounting Between IFRS and US GAAP
Finally, let’s discuss some key differences in accounting for deferred taxes under IFRS and US GAAP:
And that wraps up our discussion on Deferred Taxes II! By now, you should have a better understanding of the effects of tax rate changes on financial statements, common sources of temporary differences, and the differences in accounting for deferred taxes between IFRS and US GAAP.
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