Monday, October 10, 2011

Tax Deferred Liabilities

CFA Level 1 - Liabilities

A deferred tax liability occurs when taxable income is smaller than the income reported on the income statements. This is a result of the accounting difference of certain income and expense accounts. This is only a temporary difference. The most common reason behind deferred tax liability is the use of different depreciation methods for financial reporting and the IRS.

A deferred tax asset is the opposite of a deferred tax liability. Deferred tax assets are reductions in future taxes payable, because the company has already paid the taxes on book income to be recognized in the future (like a prepaid tax).


Deferred tax liability

Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary differences x enacted tax rate).
Scheduling of future taxable amounts.

Deferred tax asset

Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary difference x enacted tax rate).
Scheduling of deductible amounts.

The Liability Method of Accounting for Deferred Taxes.

There are several different tax-allocation methods:

Deferred Method
The amount of deferred income tax is based on tax rates in effect when temporary differences originate. It is an income-statement-oriented approach. It emphasizes proper matching of expenses with revenues in the period when a temporary difference originates. Finally, it is not acceptable under GAAP.

Asset-liability Method
The amount of deferred income tax is based on the tax rates expected to be in effect during the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach. It emphasizes the usefulness of financial statements in evaluating financial position and predicting future cash flows. Most importantly, it is the only method accepted by GAAP.

Implications of Valuation Allocation
A deferred tax asset is a reduction in future cash outflow (taxes to be paid). But, the asset has value only if the firm expects to pay taxes in the future. For example, an Net Operating Loss (NOL) carry-forward is worthless if the firm does not expect to have positive taxable income for the next 20 years. Since accounting is conservative, firms must reduce the value of their deferred tax assets by a deferred tax-asset valuation allowance. This is a contra-asset account CR (credit) balance on the balance sheet - just like accumulated depreciation or the allowance for uncollectible accounts) that reduces the deferred tax asset to its expected realizable value.

Increasing the valuation allowance increases deferred income tax expense; decreasing the allowance does the opposite. Changes in the allowance affect income tax expense. Although the need for an allowance is subjective, its existence and magnitude reveals management's expectation of future earnings. Management can use changes in the allowance to "manipulate" NI by affecting income tax expense. Analysts should scrutinize these types of changes.

Deferred Tax Liability Treatment
If a tax asset or liability is simply the result of a timing difference that is expected to reverse in the future, it is best classified as an asset or liability. But if it is not expected to reverse in the future, it is best qualified as equity.

Deferred tax liabilities that should be treated as equity in the following circumstances:

A company has created a deferred tax liability because it used accelerated depreciation for tax purposes and not for financial-reporting purposes. If the company expects to continue purchasing equipment indefinitely, it is unlikely that the reversal will take place, and, as such it should be considered as equity. But if the company stops growing its operations, then we can expect this deferred liability to materialize, and it should be considered a true liability.
An analyst determines that the deferred tax liability is unlikely to be realized for other reasons; the liability should then be reclassified as stockholders' equity.

Look Out!

In some cases the deferred tax liability should not be added to stockholders' equity, but should be ignored as a liability.
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