FR&A - Income Taxes (Cont.)

11:15 AM

Continuing on Income Taxes

Summarize:

If taxable income (Tax Return) is less than pretax income (Income Statement), a deferred tax liability is created.

If taxable income (Tax Return) is greater than pretax income (Income Statement), a deferred tax asset is created.

Both assume that the difference is expected to eventually reverse.

Think: If you pay LESS IN CASH than you are showing, you're going to have to make up for it - or lower tax return = liability.

Impact of Change in Tax Rate on Statements and Ratios

• Increase in tax rate will increase both DTL and DTA
• Decrease in tax rate will decrease both DTL and DTA
• This is because new tax rate is expected to be in force when liability/asset is reversed
• Income tax expense in the current period:
• income tax expense = taxes payable + change DTL - change DTA

Example

• Firm owns $200,000 carrying value equipment
• Tax base of $160,000 at year end
• Tax rate 40%
• Taxable income is less so you have a liability - (40,000) * 40% = $16,000 DTL
• Firm also has $10,000 from bad debt expense - 0 carrying value
• DTA = $10,000 * 40% = $4,000
• Calculate income tax expense if tax rate decreases to 30%

 Answer

• Income tax expense = taxes payable + change DTL - change DTA
• Change DTL = 40,000 * 0.3 - 40,000 * 0.4 = 12,000 - 16,000 = -4,000
• Change DTA = 10,000 * 0.3 - 10,000 * 0.4 = 3,000 - 4,000 = -1,000
• Change in income tax exp = -4,000 - (-1,000) = -3,000
• Income tax expense decreases by 3,000

Temporary vs. Permanent

• Permanent = will not reverse in future.  Do NOT create DTA or DTL.  Caused by nondeductible expenses, nontaxable revenue, or tax credits
• Cause effective tax rate to differ from statutory
• Effective tax rate comes from income statement:
• effective = income tax exp / pretax income
• Temporary = Difference bw tax base and carrying value that will result in taxable or deductible amounts in the future
• Expected to reverse in the future

Examples

• Depreciable equipment - has tax base $10,000 lower than carrying value
• Taxable income lower than income statement income - need to pay this in the future
• Therefore it makes a DTL
• R&D - tax base $50,000, no carrying value
• Tax base greater than carrying value - you pay taxes on full amount but not on income statement - creates DTA
• Accounts Receivable - tax base $20,000, CV $18,500
• Had to expense $1,500 on income statement, but not on tax return
• Tax return income is higher than IS - so creates a DTA
• Muni bond interest - Tax base and CV both $5,000
• Permanent - muni bond interest is not taxable - no DTA/DTL
• Customer Advance - $0 tax base, $10,000 carrying value
• Temp difference - have to pay taxes on it, taxable income greater than income statement, so this is a DTA
• Warranty liability - $0 tax base, $10,000 carrying value
• Temp - it will be reverse
• Will be deductible in future, so this makes a DTA
• Officers' life insurance
• Not tax deductible, permanent difference

Investments in other firms

• DTL's can arise when parent co recognizes earnings from investments before dividends are actually received
• HOWEVER if the parent can control timing of the dividend and it is probable the temporary difference will not reverse, no DTL is reported
• Will only result in a DTA if temporary difference is expected to reverse, and sufficient taxable profits are expected to exist when reversal occurs

Valuation Allowance for DTA

• Without future taxable income, a DTA is worthless
• US GAAP - if it is more than 50% likely that some or all of a DTA will not be realized, DTA must be reduced by a valuation allowance
• This is a contra account - reduces value of DTA
• Increasing this decreases DTA, increasing tax expense, decreasing net income
• Can be decreased in future if circumstances change
• It is up to mgmt to defend their DTA assumptions
• Can sometimes manipulate earnings this way
• Analysts should always examine likelihood of large deferred tax assets realization
• Also should scrutinize changes in valuation allowance

Common balance sheet examples/sources of temporary differences

• Use of accelerated depreciation for tax and straightline for income
• Analyst should consider growth rate and capital spending levels when determining whether the difference will actually reverse
• Impairments
• Usually make a DTA - writedown is immediately recognized in income statement, but deduction is not allowed until asset is actually sold
• Restructuring
• DTA - costs are recognized when restructuring announced, but not deducted until actually paid
• LIFO / FIFO
• US GAAP, firms that use LIFO for financials must do so for tax
• Other countries tho might have temporary differences from choice of cost flow assumption
• Post employment benefits/deferred comp
• Both are recognized when earned, but not taxable until paid
• Results in DTA that will reverse when actually paid
• Available for sale mkt securities
• Future tax impact of unrealized gains/losses
• No DTL added to balance sheet for future tax liability when gains/losses are realized

IFRS/GAAP - too much detail for now.  Review later.

End

12:30 PM

1.25 hrs