FR&A - Income Taxes

Aaaaaaaargh taxes

10:30 AM

Taxable Income - income that will be subject to tax based on the tax return
Taxes Payable - aka current tax expense - tax liability on balance sheet created by taxable income
Income tax paid - actual cash flow
Tax loss carryforward - current or past loss that can be used to reduce taxable income
Tax base - net amount of an asset or liability used for tax reporting purposes

Accounting profit - EBT
Income tax expense - includes taxes payable AND change in deferred tax assets/liabilities
DTL - Excess of income taxes over taxes payable, leading to future cash outflows
DTA - opposite
Valuation allowance - reduction of DTA based on likelihood asset will not be realized
Carrying value - net balance sheet value of an asset/liability
Permanent difference - a difference in tax return income and income statement income that will not reverse in the future
Temporary difference - a difference between tax base and carrying value of an asset/liability that will result in taxable or deductible amounts in the future

Deferred Tax Liabilities

• Income tax expense > taxes payable
• Happens when:
• Revenues (or gains) are recognized on income statement before included on tax return due to temporary differences
• Expenses (or losses) are tax deductible before they hit the income statement
• Expected to reverse
• Most common way they are created is through differing depreciation methods between tax return and income statement

Deferred Tax Assets

• Taxes payable > income tax expense
• Happens when:
• Revenues (gains) taxable before they hit income statement
• Expenses (losses) hit income statement before they are tax deductible
• Tax loss carryforwards are available to reduce future taxable income
• Also expected to reverse
• Common causes - post-employment benefits, warranty expenses, tax loss carryforwards

Analytical approach

• If DTL expected to reverse in future, treat as a liability
• If NOT expected to reverse, count it as EQUITY
• Key question: "When or will the total DTL be reversed in the future???"
• Treatment varies case by case

Depreciation example

• Take difference between tax and book depreciation and multiply difference by the tax rate to get the liability
• Sale of the machine for example would result in a different gain between the two - this would reverse the DTL

R&D

• $75,000 was expensed during year, but on tax return, it's amortized over 3 years, straightline
• End of yr 1, tax base is $50,000, and carrying value = 0 (it was all expensed!)
• Earnings on income statement will be LOWER than earnings on tax report
• Creates a deferred tax ASSET - you pay lower taxes than your tax expense on the income statement

Accounts receivable

• Bad debt expense - for tax purposes this cannot be expensed until receivables are deemed WORTHLESS
• Results in deferred tax ASSET

Tax base of liabilities

• Equals carrying value minus any amounts that will be tax deductible in the future
• Exception: revenue received in advance is carrying value minus amount of revenue that will NOT be taxed in the future

Customer Advance

• $10,000 received at year end for goods to be shipped next year - i.e. it is not revenue yet
• Carrying value of liability: $10,000
• Will be reduced when goods ship next yr
• Customer advance has already been taxed - so $10,000 will NOT be taxed in the future
• Thus tax base is 0
• Since it has been taxed but not yet reported as revenue on IS, this creates a deferred tax asset

Warranty liability

• Warranty expense is not deductible until the warranty work is done
• Say you have a $5,000 warranty liability - this will all be deductible in future (when work is done) so the carrying value is zero
• Delayed recognition of this expense for tax purposes results in deferred tax asset

Note payable

• Principle of $30,000, interest at 10% paid quarterly
• Treated same way on income statement and tax return
• No timing difference, so there is no DTA or DTL

Example of DTL

• Original cost of an asset is $600,000
• 3 year life, no salvage
• Depreciation of $300,000, $200,000 and $100,000 for tax purposes
• Income statement uses straightline $200,000 per year
• EBITDA = $500,000 each yr, tax rate is 40%

Answer

• Income tax expense (IS) will be higher in first year than actual taxes payable - this means you'll have to pay more in the future so you have a DTL
• CV and tax base of the asset after yr 1:
• CV = $600,000 - $200,000 = $400,000
• Tax Base = $600,000 - $300,000 = $300,000
• Difference = $100,000
• Difference * tax rate = $40,000 of DTL
• In yr two, book and tax depreciation are the same, so there is no difference in tax expense and tax payable
• There is also therefore no change in the DTL 
• In yr three, you will pay more taxes than shows up as expense on the IS
• DTL will reverse

Example of DTA

• Firm has sales of $5,000 for each of two yrs
• Estimates warranty expense to be 2% of annual sales ($100 each yr)
• Actual expenditure of $200 was not made until second yr
• Tax rate 40%

Answer

• Cannot deduct for tax purposes in year 1
• Results in higher taxable income than IS income
• You pay more taxes in year 1
• Creates a $40 DTA in year 1
• In year 2, this will reverse

Impact of tax rate change on financial statements/ratios

• When tax rate changes, DTA and DTL are adjusted to reflect
• Increase in tax rate increases BOTH DTAs and DTLs
• Decrease does opposite
• Changes in balance sheet values affect income tax exp in current period
• income tax exp = taxes payable + change DTL - change DTA

Example

• Firm owns equipment with carrying value $200,000
• Tax base of $160,000 at year end
• Tax rate 40%
• (200,000 - 160,000) * 40% = $16,000
• Deferred tax liability - will have to pay it in future years
• Firm also has DTA of $10,000 from bad debt (recognized as expense on income, but not yet taxed)
• Creates a DTA of (10,000 - carrying value of zero) * 40% = $4,000
• Now tax rate decreases to 30%

Answer

• DTL is decreased to (200,000 - 160,000) * 30% = 12,000
• Change in DTL is -4,000
• DTA is decreased to (10,000 - 0) * 30% = 3,000
• Change in DTA is -1,000
• Income tax exp = taxes payable + (-4,000) - (-1,000)
• Total change in income tax exp = -3,000

Break

11:30 AM

1 hour