Deferred Tax Liability

This reading explains why tax reporting and financial reporting differ, how temporary differences create deferred tax liabilities and assets, and how analysts treat those balances and the related disclosures. A candidate must be able to compute income tax expense from taxes payable and the changes in deferred taxes, remeasure deferred taxes after a change in the tax rate, and calculate and interpret the statutory, effective and cash tax rates.

LOS 35.a — Two sets of books: tax return versus financial statements

Companies prepare their financial statements under IFRS or US GAAP, but they compute the tax they owe under the tax law of each jurisdiction. The two sets of rules often disagree about when an item counts, and sometimes about whether it counts at all. As a result, the tax charge in the income statement rarely equals the tax on the return.

Differences between tax reporting and financial reporting arise when:

• revenues and expenses are recognized in different periods in the income statement and on the tax return;
• some items count for the income statement only, or for the tax return only;
• assets or liabilities have carrying amounts that differ from their tax bases;
• gains or losses are recognized differently in the income statement and on the tax return;
• tax losses from prior periods offset future taxable income;
• adjustments made in the financial statements do not affect the tax return, or affect it in a different period.

Terms on each side

A valuation allowance is a reduction of deferred tax assets that reflects the likelihood that they will not be realized. Under US GAAP it is a contra account.

Temporary versus permanent differences

• A temporary difference arises when an asset's or liability's carrying value differs from its tax base, and the gap will lead to taxable or deductible amounts in later periods. Over the life of the item the same total passes through both the income statement and the tax return; only the timing differs. Temporary differences create deferred tax assets or deferred tax liabilities.
• A permanent difference is a gap between pretax income and taxable income that never reverses. Examples are revenue that is never taxable (such as tax-exempt municipal bond interest in the United States), expenses that are never deductible (such as premiums on life insurance for key officers, or fines and donations where the law disallows them), and tax credits. No DTA or DTL results from a permanent difference. They make the effective tax rate differ from the statutory tax rate.

Taxes payable are driven by taxable income × tax rate. Pretax accounting profit × tax rate does not determine them. Temporary differences therefore make taxes payable differ from income tax expense, and the change in deferred taxes bridges the two. Income tax expense can in turn differ from pretax income × the statutory rate, for the reasons listed under LOS 35.c.

When is a DTL created?

The classic case is accelerated depreciation on the tax return with straight-line depreciation in the accounts. These are called taxable temporary differences: the firm pays less tax now and more tax when the difference reverses.

When is a DTA created?

A deferred tax asset (DTA) is created when

• revenues or gains are taxed in an earlier period than they reach the income statement (for example, unearned revenue taxed on receipt),
• expenses or losses are expensed in the income statement before they are deductible (for example, warranty provisions, bad-debt provisions, post-employment benefits, restructuring accruals, or R&D expensed in the accounts but capitalized for tax), or
• tax loss carryforwards are available to reduce future taxable income.

These are deductible temporary differences: they provide future tax savings.

A quick test: if a temporary difference first makes taxable income lower than pretax accounting profit, a DTL is created; if it first makes taxable income higher than pretax accounting profit, a DTA is created.

The balance sheet test (carrying value vs. tax base)

The DTA or DTL balance is the absolute value of (carrying value − tax base) × tax rate. For a liability such as a warranty provision, the tax base is the carrying value minus the amounts that will be deductible in future tax returns. If the whole provision will be deductible when claims are paid, the tax base is zero.

The income tax expense equation

Income tax expense is also called the tax provision. The current period's transactions created or changed the deferred tax balances, so accrual accounting records those changes in this period's tax expense, on top of the taxes payable on this year's taxable income:

Any rearrangement must preserve the signs, e.g. $\Delta DTL=\text{income tax expense}-\text{taxes payable}+\Delta DTA$ and $\Delta DTA=\text{taxes payable}-\text{income tax expense}+\Delta DTL$. Creating or increasing a DTL raises tax expense; creating or increasing a DTA lowers it.

Changes in the enacted tax rate

DTAs and DTLs are measured at the tax rate expected to apply when they reverse. If the enacted rate changes, existing balances are remeasured. An increase in the rate raises both DTAs and DTLs, and a decrease lowers both. The remeasurement flows through income tax expense. Whether a rate increase raises or lowers that expense depends on the net position. A firm with a net DTL sees its DTL rise by more than its DTA, so tax expense rises. A firm with a net DTA sees its DTA rise by more, so tax expense falls.

When new temporary differences arise in the same year as a rate change, work in this order:

1. Taxes payable = taxable income × the rate in force this year.
2. Cumulative temporary difference at year-end = beginning difference (beginning DTL ÷ old rate) + the difference created this year.
3. Ending DTL = cumulative difference × the rate enacted for the years in which it will reverse.
4. Income tax expense = taxes payable + (ending DTL − beginning DTL).

LOS 35.b — Creating deferred tax balances and treating them in analysis

How the balances build up and reverse

Measuring a deferred tax balance at any date depends on precise definitions of carrying value and tax base.

For a depreciable asset, the carrying value is cost less accumulated book depreciation. The tax base is cost less accumulated tax depreciation, which equals the tax depreciation still to be deducted in future returns. Liabilities follow the tax-base rule given under LOS 35.a, with one exception: revenue received in advance is taxed on receipt, so its tax base is the carrying value less amounts that will not be taxable in future.

The DTL builds while tax depreciation runs ahead of book depreciation. It then reverses to zero once tax deductions stop but book depreciation continues. In Years 1–2 income tax expense exceeds taxes payable by $2,400 a year; in Years 3–4 it is $2,400 lower.

Warranties. The provision is recognized at the time of sale under the matching principle, while the tax deduction waits until repair costs are incurred. The liability's tax base is therefore zero (LOS 35.a).

Receivables. A receivable of $50,000 carries a bad-debt allowance of $4,000, so its carrying value is $46,000. If bad debts are deductible only when they are written off, the tax base is the full $50,000. The asset's carrying value is below its tax base, so at a 25% tax rate there is a DTA of $4,000\times 0.25=\$1,000$.

Realizability of deferred tax assets

Deferred tax balances are not discounted to present value. A DTA has value only if the firm will earn enough future taxable income to use it, so DTAs are reviewed at every balance sheet date.

Management must be able to support the carrying amount of every DTA. Evidence against realization includes cumulative recent losses and a history of tax loss carryforwards expiring unused. Evidence for realization includes order backlogs and existing profitable contracts. The judgement is subjective, so changes in the valuation allowance are a potential tool of earnings management: a surprise reduction in the allowance boosts earnings.

Treatment for analytical purposes

The central question is whether, and when, the DTL will reverse.

In practice treatments vary, so the analyst decides case by case whether, and when, each DTL will reverse.

Reclassifying a DTL as equity leaves total assets unchanged, lowers liabilities and raises equity. The debt-to-equity ratio and the financial leverage ratio (assets/equity) therefore fall. Return on equity also falls because its denominator is larger. Return on assets is unaffected, since neither net income nor total assets changes.

LOS 35.c — Statutory, effective and cash tax rates

Three tax rates measure different things:

The effective and cash tax rates both use pretax (accounting) income as the denominator. The statutory rate is not computed from the financial statements at all; it is set by tax law and applied to taxable income. When only net income is given, add income tax expense back first: pretax income = net income + income tax expense.

Why the effective rate differs from the statutory rate

• Different tax rates in different jurisdictions (foreign operations)
• Permanent differences: tax credits, tax-exempt income, nondeductible expenses, and different tax treatment of capital gains versus operating income
• New tax legislation or changed tax rates
• Tax holidays granted in some countries

Temporary differences typically do not make the effective and statutory rates differ, because deferred tax expense adjusts income tax expense back toward statutory rate × pretax income. They do, however, make the cash tax rate differ from the effective rate.

Using the rate reconciliation

The footnotes must reconcile the statutory rate to the effective rate. Understanding why reported income tax expense differs from tax at the statutory rate helps the analyst forecast earnings and cash flows. For each reconciling item, look at its relative size, its trend so far and the direction it is expected to take; the footnotes and management's discussion and analysis are the sources. Percentages can be converted into amounts when that helps. When studying trends and forecasting, include only reconciliation items that are continuous in nature and set aside those that are sporadic:

For a tax holiday (a temporary exemption from tax in a jurisdiction), find out when it ends and whether accumulated taxes become payable at that point. Volatile reconciliation items make the effective rate hard to forecast and reduce comparability with peers.

LOS 35.d — Deferred tax disclosures and their analytical use

Common temporary differences

Exam convention: the future tax on unrealized gains and losses from available-for-sale securities is recorded as a deferred tax adjustment to stockholders' equity, and the balance sheet shows no DTL for it. Current practice: for available-for-sale debt securities (US GAAP) and FVOCI assets (IFRS 9), ASC 740 and IAS 12 recognize the deferred tax liability (or asset) on the balance sheet and charge the related tax to other comprehensive income, so the income statement tax expense is unaffected. Unrealized gains on these securities therefore appear among deferred tax liabilities in disclosure tables.

On the balance sheet, deferred tax assets and liabilities are classified as noncurrent under both IFRS and US GAAP. They are not split into current and noncurrent portions by expected reversal date.

What is typically disclosed

• DTLs, DTAs, any valuation allowance and the net change in the allowance during the period
• Any unrecognized deferred tax liability (DTL) that relates to earnings retained by subsidiaries or joint ventures
• For each kind of temporary difference, its tax effect in the current year
• The components of income tax expense (current and deferred)
• A reconciliation between reported income tax expense and tax computed at the statutory rate
• Tax loss carryforwards and credits

Reading the disclosures

• If income tax expense keeps exceeding taxes payable, DTLs are growing faster than DTAs (deferred tax expense is positive).
• A decrease in the valuation allowance lowers deferred tax expense and raises reported earnings. It signals that management now expects more future taxable income, so check that it is justified.
• With a straight-line book schedule and an accelerated tax schedule, taxes payable can be computed year by year. Taxable income is pretax income before depreciation minus tax depreciation, and taxes payable are taxable income × rate. When only temporary differences exist and the tax rate does not change, income tax expense is pretax accounting income × rate.