The Ice Dragon

Financial Statements Analysis
Financial Statement Analysis
ASSETS & LIABILITIES: DEFERRED TAXES
Marc A. LeFebvre, CFA

Fall 2014
Deferred Tax Objectives
•  Differentiate between temporary and permanent differences between

taxable income and pretax income.
•  Discuss the factors governing the level and trend of deferred tax assets
(DTA) and deferred tax liabilities (DTL)
•  Evaluate the relevance of DTA and DTL to firm valuation
•  Discuss how the “valuation allowance” affects the income statement and
balance sheet
•  Examine the relationship between deferred taxes and cash outflows for
tax purposes
•  Factors affecting the level and trend of DTA and DTL
•  Describe the three different measures of the effective tax rate
Why Do We Study Deferred Taxes?
•  The objective of financial reporting is to provide users with information

needed to evaluate a firm’s financial position, performance and cash
flows. Management’s adoption of various GAAP accounting conventions
allows them to best match a firm’s revenues with expenses.
•  Tax reporting, in contrast, results from social and political influences.
•  Revenue and expense recognition methods used in tax reporting often

differ from those used for financial reporting since the firm has a strong
incentive to select methods allowing it to minimize taxable income and
taxes paid while maximizing cash from operations (CFO).
Income Tax Terminology
•  Tax Return •  Financial Statements

–  Taxable Income –  Pretax Income
–  Taxes Payable –  Income Tax Expense
–  Income Tax Paid
–  Tax Loss Carryforward
–  Deferred Income Tax Expense

–  Deferred Tax Liability (DTL)
–  Deferred Tax Asset (DTA)
–  Valuation Allowance
–  Timing Differences
–  Temporary Differences
Tax Return Definitions
•  Taxable Income – the income subject to tax on the IRS tax return
•  Taxes Payable/Current Tax Expense - tax return liability resulting from

current period taxable income
•  Income Tax Paid (CFO) - actual cash outflow for income taxes +/-
payments or refunds from prior periods
•  Tax Loss Carryforward - the current net taxable loss that can be used to
reduce future taxable income
Financial Statement Definitions
•  Pretax Income - Income before income tax expense
•  Income Tax Expense - expense recognized in the I/S based on current period
pre-tax income; includes taxes payable (IRS) + deferred inc. tax expense (F/S)
•  Deferred Income Tax Expense - accrued income tax expense expected to be

paid or recovered in future years found on I/S.
= taxes payable (IRS) - income tax expense (F/S)
•  Deferred Tax Asset (DTA) - B/S amount expected to be recovered from future
operations
•  Deferred Tax Liability (DTL) - B/S amount expected to result in future cash
outflows
The Liability Method - SFAS 109
•  The central accounting issue is whether the tax effects of transactions for
which GAAP-based and tax based accounting rules differ should be
–  recognized in the period in which they affect taxable income (IRS)
called the deferral method or …
–  recognized in the period in which they are recognized in the financial
statements (creating deferred tax balances) called the liability
method.
•  The effect of these choices produces different measures of operating and

financial performance affecting the firm’s operating and financial
performance.
•  SFAS and IAS recognize the second choice…the liability method.

Deferred Taxes:
Temporary (Reversing) Differences
Deferred tax is caused when the same tax in total passes through the tax
returns and the financial accounts but occurs in different time periods
Deferred Tax Liability Deferred Tax Asset

Tax Return Fin Reporting Tax Return < Fin Reporting
Depr Exp
> Depr Expense Warranty Exp Warranty Exp
The result is that taxable income is The result is that taxable income is
smaller than income before tax and greater than income before tax and
hence we pay less taxes payable hence we pay more taxes payable
today. We pay less tax now at the today. We pay more tax now and
expense of more tax in the future. less tax in the future.
DTL caused by Depreciation DTA arise from Warranty Exp
Note: Deferred tax assets can also be created by tax loss carryforwards
TAX REPORTING Sources of Differences

Revenue 10,000 •  Temporary (Reversing) differences
Tax allowable costs (8,000) (see below)
Taxable income 2,000 Taxes payable •  Permanent (Nonreversing)
Taxes payable@ 30% (600) differences
1,400 Sources of Temporary Differences
•  Accrual vs. cash accounting
•  Differences in reporting methods
FINANCIAL ACCOUNTING and estimates
•  Depreciation
Revenue 10,000 •  Impairments
Accrual based costs (5,000) Income tax •  Restructuring
Pre-tax income 5,000 expense •  Inventories
Inc Tax Exp @ 30% (1,500) •  Post employment benefits
3,500
Taxes payable 600 < Income Tax Expense 1,500 therefore 900 DTL results!
Deferred Tax Liabilities (DTL)

“I Gotta Pay the IRS Later!”
•  Under SFAS 109, a firm will recognize a deferred tax liability when future
taxable income (IRS) is expected to exceed pretax income (F/S).
•  The standard mandates the recognition of deferred tax liabilities for all
temporary timing timing differences expected to generate net taxable
amounts in future years. This results in a future cash outflow.
•  Common temporary timing differences arise from varying deprecation

methodologies. Typically, a firm’s use of longer lives or straight-line for
financial reporting than for tax reporting. This creates a difference
between the carrying amount of the asset and its tax basis on the B/S
•  FASB argued that deferred tax consequences meets the definition of a

liability under SFAC 9 and therefore recognized as a liability on the B/S
DTL Example - 1
•  An asset has an original cost $200,000 depreciable life of four years

and a zero salvage value.
•  The asset is expected to produce $150,000 annual revenue.
•  DDB is used for tax purposes, straight-line for financial reporting purposes
•  Tax rate is 40%
•  Calculate the deferred tax liability for the next four years
DTL Example - 1 Solution

Tax Reporting Year 1 Year 2 Year 3 Year 4 Total
Revenue $150,000 $150,000 $150,000 $150,000 $600,000
Depr. - DDB 100,000 50,000 25,000 25,000 200,000
Taxable Income $50,000 $100,000 $125,000 $125,000 $400,000
Taxes Payable 40% $20,000 $40,000 $50,000 $50,000 $160,000
Net Income $30,000 $60,000 $75,000 $75,000 $240,000
Fin. Reporting Year 1 Year 2 Year 3 Year 4 Total

Revenue $150,000 $150,000 $150,000 $150,000 $600,000
Depreciation SL 50,000 50,000 50,000 50,000 200,000
Pretax Income $100,000 $100,000 $100,000 $100,000 $400,000
Inc Tax Exp 40% $40,000 $40,000 $40,000 $40,000 $160,000
Net Income $60,000 $60,000 $60,000 $60,000 $240,000
DTL Example - 1 Solution
Deferred Tax Liability Year 1 Year 2 Year 3 Year 4

Inc Tax Expense (F/S) $40,000 $40,000 $40,000 $40,000
Taxes Payable (IRS) $20,000 $40,000 $50,000 $50,000

Annual Deferred Taxes $20,000 $0 ($10,000) ($10,000)
Deferred Tax Liability $20,000 $20,000 $10,000 $0

Cumulative
Deferred Tax Liability Example - 2
A firm acquires an asset for $21,000 with a three year useful life and no
salvage value. The asset will generate $16,000 of annual revenue for three
years. The tax rate is 30% and the firm is allowed to depreciate the asset
using DDB for tax purposes and straight line for financial reporting purposes.
Tax Reporting (IRS)

Year 1 2 3
$ $ $
Revenue 16,000 16,000 16,000
DDB depreciation (14,000) (4,667) (2,333)
Taxable income 2,000 11,333 13,667
Tax payable @ 30% (600) (3,400) (4,100) ------->
Income after tax 1,400 7,933 9,567
Deferred Tax Liability Solution - 2

FINANCIAL STATEMENT (F/S)
Year 1 2 3
$ $ $
Revenue 16,000 16,000 16,000
S. L. Depreciation (7,000) (7,000) (7,000)
Pre-tax income 9,000 9,000 9,000
Inc. Tax Exp @ 30% (2,700) (2,700) (2,700)
Income after tax 6,300 6,300 6,300
Income Statement Effect Total
Taxes Payable (IRS) 600 3,400 4,100 8,100
Income Tax Expense (F/S) 2,700 2,700 2,700 8,100
Balance Sheet DT Liability 2,100 1,400 0
Deferred Tax Liability Solution - 2
1 2 3
Note:
Tax Expense Worksheet $ $ $
Simply taking the pre
Accounting S. L. Dep 7,000 7,000 7,000 tax income × statutory
Tax Return DDB Dep (14,000) (4,667) (2,333) rate to calculate the
Expense Difference (7,000) 2,333 4,667 tax expense will not
work when there are:
Tax Rate 30% 30% 30%
•  Permanent timing
Deferred Tax Expense (2,100) 700 1,400
differences
Tax Payable (IRS) (600) (3,400) (4,100) •  Deferred tax assets
+ and liabilities
Deferred Tax Expense (2,100) 700 1,400
=
Inc Tax Expense (F/S) (2,700) (2,700) (2,700)
Recall, Income Tax Expense = Taxes Payable + Deferred Tax Expense

Deferred Tax Liability Balance Sheet Impact
Balance Sheet Effect: Total
Taxes payable (IRS) (600) (3,400) (4,100) 8,100
Income Tax Expense (F/S) 2,700 2,700 2,700 8,100
Deferred Tax Expense (F/S) 2,100 (700) (1,400) 0
Balance Sheet DT Liability 2,100 1,400 0 n/a
Recall, Deferred Income Tax Expense - accrued income tax expense

expected to be paid or recovered in future years.
= taxes payable (IRS) - income tax expense (F/S)
Deferred Tax Assets (DTA) - Think Coupon at IRS
•  DT Assets are balance sheet amounts representing the cumulative

difference between income tax expense (F/S) and taxes payable (IRS)
that are expected to be recovered from future operations
•  DTAs result whenever Income Tax Payable (IRS) >Tax Expense (F/S)
•  SFAS 109 allows the recognition of deferred tax assets whenever

deductible temporary timing differences generate an operating loss or tax
credit carryforward.
•  Management and its auditors must defend the recognition of all DTAs
Valuation Allowance (DTA) & Carryforwards
•  Recall, tax loss carryforwards arise when a tax return loss can be
used to offset future taxable income. These carryforwards are often
considered deferred tax assets (DTA).
•  The realization of tax loss carryforwards depends on future taxable

income as well, the expected benefits are recognized as deferred tax
assets. Under SFAS 109, such assets are recognized in full but a
valuation allowance maybe required if recoverability is unlikely.
Valuation Allowance
•  Deferred tax assets have valuation allowances (DTL’s do not!)
•  The valuation allowance is a contra account (offset/reduction) against tax

assets based on the likelihood that these assets will not be realized in the
future.
•  For a DTA to be realized and be beneficial (asset), the firm must have
future taxable income
•  If it is more likely than not that a portion of the DTA will not be realized due
to insufficient future income, then the DTA must be reduced by the
valuation allowance, which is a reduction in income from continuing
operations.
DTA Example -1
•  A firm has annual sales of $5,000 for each of the next two years
•  The firm estimates that warranty expense will be 2% of annual sales

($100 = $5,000 x 2%)
•  The actual warranty expenditure of $200 was not made until the end of the
second year
•  Assume tax rate of 40%
DTA Example -1 Solution
Tax Reporting Year 1 Year 2 Fin. Reporting Year 1 Year 2

Revenue $5,000 $5,000 Revenue $5,000 $5,000
Warranty expense 0 200 Warranty accrual (100) (100)
Taxable Income $5,000 $4,800 Pretax Income $4,900 $4,900
Taxes Payable 2,000 1,920 Income Tax Expense 1,960 1,960
Net Income $3,000 $2,880 Net Income $2,940 $2,940
Deferred Tax Asset Example - 2
A firm has revenues of $8,000 for each of three years. The firm estimates the
warranty expense to be 12.5% of revenues each year. The actual expenditure of
$3,000 to meet warranty claims was not made until the third year.
Tax Reporting (IRS)

Year 1 2 3 Total
$ $ $ $
Revenue 8,000 8,000 8,000 24,000
Cash Repairs - - (3,000) (3,000)
Taxable income 8,000 8,000 5,000 21,000
Taxes Payable @ 30% (2,400) (2,400) (1,500) (6,300)
Income after tax 5,600 5,600 3,500 14,700
Deferred Tax Asset Solution - 2
Financial Reporting 1 2 3 Total

$ $ $ $
Revenue 8,000 8,000 8,000 24,000
Warranty Expense (1,000) (1,000) (1,000) (3,000)
Pre-tax income 7,000 7,000 7,000 21,000
Tax Expense@ 30% (2,100) (2,100) (2,100) (6,300)
Income after tax 4,900 4,900 4,900 14,700
Deferred Tax Asset 300 600 0 0

Δ Deferred Tax 300 300 (600)
Taxes Payable > Income Tax Expense creates a DTA

Deferred Tax Asset Solution - 2
1 2 3
Note:
Tax Expense $ $ $
Simply taking the pre
Accounting Expense 1,000 1,000 1,000 tax income × statutory
Tax Return Expense 0 0 (3,000) rate to calculate the
Difference 1,000 1,000 (2,000) tax expense will not
work when there are:
Tax Rate 30% 30% 30%
300 300 (600) •  Permanent timing
Deferred Tax Expense
differences
Tax Payable (IRS) (2,400) (2,400) (1,500) •  Deferred tax assets
+ Δ Deferred Tax 300 300 (600) and liabilities
Tax Expense (F/S) (2,100) (2,100) (2,100)
F/S Presentation and Disclosure Requirements
•  Since multinational firms operate in many tax jurisdictions, their financial

reporting must summarize their tax positions for all consolidated entities.
•  SFAS 109 permits the offsets of deferred tax effects only within each tax-
paying component and tax jurisdiction.
•  DTA and DTL must be separated into current and long term portions
based on the types of assets and liabilities generating the deferral.
•  DTAs resulting from carryforwards are classified by reference to their

expected future reversal dates.
F/S Presentation and Disclosure Requirements cont.
•  SFAS requires disclosure of:
1.  Separate disclosure of DTA and DTL, valuation allowance and the net
change in the allowance for each period
2.  Any unrecognized DTL for the undistributed earnings of domestic and
foreign subsidiaries and joint ventures.
3.  The current year tax effect of each type of temporary difference
4.  Components of the income tax expense (taxes payable + Def Inc Tax
Expense)
5.  Reconciliation of reported income tax expense and the amount based
on the statutory income tax rate
6.  Tax loss carryforwards and credits
Deferred Taxes - Analytical Issues
•  In order to effectively determine the firm’s future cash flows, earnings

power and financial leverage, the analysis of changes in deferred tax
assets and liabilities, deferred tax expense and changes in the valuation
allowance must be considered.
•  The key analytical issue is whether the DTA or the DTL will reverse in
the future.
–  If they will not reverse in the future, it is highly debatable whether the
deferred taxes are assets or liabilities (cash flow consequences)
–  It maybe more appropriate to classify them as decreases or
increases in equity
Three Factors Affecting the Level and Trend of Deferred Taxes
•  Tax law and accounting method changes

In general, if the tax rate increases, the increase in deferred tax
liabilities increases the current tax expense (decreases for a DTA)
This holds if DT liability exceeds DT asset – which is generally the case
•  Growth in the firm

This defers the DTL reversal event and can indefinitely do so if the firm
continues to grow by adding more assets to the B/S at higher values
•  Other Items
Non recurring items – case by case basis
Extraordinary items - restructuring expenses
Equity adjustments – unrealized gains and losses
Effects of Changes in Tax Laws and Acct Methods
•  When a new tax law is enacted the effects must be recognized

immediately
•  All deferred tax assets and liabilities are revalued using the new tax rate
that is expected to be in place when the liability reverses
•  Increases in tax rates (tax cuts) will affect deferred tax liabilities and
assets, and the adjustment is included in current-period income tax
expense.
•  For analytical purposes, the analyst can adjust future DTL estimates while
legislation is pending.
Increase in Tax Rates

•  If the tax rate increases…
–  The increase in DTL increases the current tax expense
–  The increase in DTA decreases the current tax expense
–  As long as DTL > DTA (usually the case), the net impact of the
increase in the tax rate will be to:
•  increase the tax expense
•  decrease net income
•  decrease shareholder’s equity
Deferred Liability Deferred Asset

Increase in tax rate Increases DT Liability Increase DT Asset
Increase tax expense Decrease tax expense
Decrease in Tax Rates

•  If the tax rate decreases…
–  The decrease in DTL decreases the current tax expense
–  The decrease in DTA increases the current tax expense
–  As long as DTL > DTA (usually the case), the net impact of the
decrease in the tax rate will be to:
•  decrease the tax expense
•  increase net income
•  increase shareholder’s equity
Deferred Liability Deferred Asset

Decrease in tax rate Decreases Liability Decrease Asset
Decrease tax expense Increase tax expense

Changing Tax Rates (Reduced) Example - 1
•  A firm has revenue of $10,000 for years one and two
•  The firm purchased equipment at a cost of $3,000 at the beginning of year

one
•  The equipment has a three year life expectancy with no salvage value
•  Straight-line used for financial reporting and DDB for tax reporting
•  Tax rate is 30%
Changing Tax Rates (Reduced) Solution - 1

Year 1 Year 2
Revenue $10,000 $10,000
Straight Line Depreciation $1,000 $1,000
DDB Depreciation 2,000 667
Pretax Income (SL Depr) 9,000 9,000
Taxable Income (DDB Depr) 8,000 9,333
Year 1
Taxes Payable = tax rate x taxable income = 0.30 x $8,000 = $2,400
Def Tax Liab = tax rate x (DDB - SL) = 0.30 x ($2,000 - 1,000) = $300
Tax Expense = taxes payable + addition to def. taxes = $2,400 + 300 = $2,700
Year 2
Def Tax Liab = tax rate x (DDB - SL) = 0.30 x ($667 - 1,000) = - $100
Tax Expense = taxes payable + reduction to def. taxes = $2,800 - 100 = $2,700
Changing Tax Rates (Reduced) Solution - 1
•  Now assume at the beginning of year 2 the tax rate is reduced from 30%
to 20%.
•  The deferred tax liability from year one of $300 using 30% would be
revalued to $200 reflecting the new tax rate of 20%.
•  The $100 decrease (benefit) in the deferred tax liability would reduce year
2 income tax expense:
Year 2
Deferred Taxes = new tax rate x (DDB - SL) = 0.20 x ($667 - $1,000) = - $67
Tax Expense = (taxes payable - reduction in deferred taxes yr 2 - benefit
from reduced tax rate on year 1 deferred taxes) = $1,867 - 67 - 100 =
$1,700
Example 2 – Effect of Tax Rate Change
•  Firm earns $20,000 in revenue for the next 3 years
•  Asset original cost $24,000, straight-line depreciation for financial

reporting, DDB for tax reporting, no salvage value
•  Tax rate of 40% reduced to 35% in year 2

Deferred Tax: Effect of Tax Rate Change Example - 2
Tax Reporting (IRS)

Year 1 2 3
$ $ $
Revenue 20,000 20,000 20,000
DDB Depreciation (16,000) (5,333) (2,667)
Taxable income 4,000 14,667 17,333
Tax Payable @ 40% (1,600) (5,133) (6,067)
Net Income 2,400 9,534 11,266
Financial Reporting 1 2 3
$ $ $
Revenue 20,000 20,000 20,000
SL Depreciation (8,000) (8,000) (8,000)
Pre-tax income 12,000 12,000 12,000
Tax Expense (4,800) (3,800) (4,200)
Net Income 7,200 8,200 7,800
Tax Expense 4,800 3,800 4,200

Tax Payable 1,600 5,133 6,067
DT Liability 3,200 1,867 0

1 2 3
Tax Expense $ $ $
Accounting Dep 8,000 8,000 8,000 Issue: Year 1 Liability

created at 40% but
Tax Return Dep (16,000) (5,333) (2,667) reverses at 35%
Depr Difference (8,000) 2,667 5,333
(8,000) × 40% = (3,200)
Tax Rate 40% 35% 35%
(8,000) × 35% = (2,800)
Deferred Tax Exp (3,200) 933 1,867
Difference (400)
Tax Payable (1,600) (5,133) (6,067)
Correction 400
+ Deferred Tax Exp (3,200) 933 1,867
= Tax Expense (4,800) (3,800) (4,200)
Effect of the Growth on a Firm

•  For most firms using S.L. depreciation, the deferred tax liability grows over
time.
•  For growing firms who are continually adding fixed assets at increased
prices or higher-cost, the result is an ever-increasing DTL due to the
difference between the use of S.L. depreciation for financial reporting
purposes vs. accelerated methods used for tax reporting purposes.
•  As a result of the firm’s growth, either in real or nominal terms, the net
DTL will increase over time and will never reverse. This will have a
positive effect on cash flow since future taxes will not be paid.
•  If the firm reduces its acquisition of fixed assets and reversals exceed
originations, the related DTL will decline. Effect on cash is uncertain.
Effects of Nonrecurring Items and Equity Adjustments
•  The following items may also affect income tax expense, taxes paid and
deferred tax assets and liabilities:
–  Nonrecurring items such as restructuring charges may have

current and potential future tax consequences. These charges
generate deferred tax assets since the expense for restructuring
can not be taken for IRS purposes until the actual cash expense
has occurred much like warranty expenses.
–  Extraordinary charges such as losses from early retirement of debt
(next week) are reported after tax.
–  Equity adjustments that bypass the I/S may have current and
deferred tax consequences. Common items include unrealized gains
or losses on marketable securities and currency translation
adjustments (FASB 52).
Are Deferred Taxes Liabilities or Equity?
•  From a solvency perspective, how should deferred tax liabilities be

handled?
•  Deferred tax liabilities are liabilities created from circumstances where

income tax expense (F/S) exceeds taxes payable (IRS) and we know
that changes in a firm’s operations (equipment purchasing) or tax laws
may result in these deferred taxes never being paid.
•  Even if these deferred taxes are eventually paid, the present value of
those payments should reduce the balance sheet liability stated
amounts.
•  The DTL should be discounted at an appropriate discount rate.

Are Deferred Taxes Liabilities or Equity?…cont.
•  From an analytical perspective we need to examine the components for

the deferred tax liability and evaluate which components have a high
likelihood of reversing or for continued growth.
–  Reversing DTL: Only those liabilities that are likely to reverse should
be considered a liability. The liability should be discounted to a
present value by the numbers of years until the expected reversal.
–  Nonreversing DTL: If the DTL is not expected to reverse the deferred

taxes are not a liability but rather should be reclassified on the B/S as
shareholder’s equity. Had the liability not been originally recorded,
prior period tax expense would have been lower, both net income and
equity would have been higher
Crux of the DTL Argument
•  If for example, the DTL arose from the use of straight line depreciation vs.
accelerated depreciation and…
–  If you feel that tax depreciation (MACRS or DDB) is a better measure

of “economic” depreciation than financial statement SL depreciation,
than adding the DTL to equity overstates the value of the firm.
–  If the deferred tax liability is unlikely to result in a cash outflow,

than future cash flows and firm value will be greater, than adding
the DTL to equity should increase the value of the firm.
–  Ultimately, it is the analyst that must decide this adjustment

Analysis of DTA’s and Valuation Allowance
•  Deferred tax assets may be indicators of future cash flow, reported

income or both.
•  We should examine the possibility of those assets for the likelihood of use
and timing of the reversal
•  A reduction in a valuation allowance (increase in DTA) will result in an

increase (gain) in reported income and stockholder’s equity.
Analysis of DTA’s and Valuation Allowance cont…
•  Given management’s discretion, the valuation allowance has become

another factor used to evaluate the “quality of earnings”
–  Conservative approach is to offset most or all of DTA with a VA

–  Liberal approach is to recognize all of the DTA without an off-
setting valuation allowance
•  To eliminate distortions to the I/S, analysis should be based on net

income excluding the effects of changes in the valuation allowance
Effective Tax Rates - Forecasting
Effective tax rate Income tax expense

Pretax Income
tax rate on corporate income

Statutory tax rate =
specified in the tax code
Two types of difference between reported earnings and taxable income:
•  timing differences •  permanent differences
Both reported tax expense and pretax income are affected by management
choices of revenue and expense recognition.
The difference between the effective tax rate and the statutory tax rate is
due solely to permanent differences
Alternative Effective Tax Rates for Forecasting Purposes
Taxes Payable (IRS) This method uses taxes payable (current

tax expense) based on revenue and
Pretax Income (F/S)
expense recognition used on the tax return
relative to financial reporting pretax income
Income Tax Paid (IRS) This method uses cash taxes paid based
on revenue and expense recognition used
Pretax Income (F/S)
on the tax return relative to financial
reporting pretax income
Cash taxes paid can be found on the SCF under CFO

Cash taxes will differ from taxes payable due to interim tax payments and refunds
Analysis of the Reconciliation Between the

Effective and Statutory Tax Rates
•  Firms are required to disclose a reconciliation between the company’s effective

income tax rate and the applicable statutory rate
•  Calculation of the effective rate
–  Reported effective rate = income tax expense/pre-tax income
–  Alternate effective rate = taxes payable/pre-tax income
–  Cash effective rate = income tax paid/pre-tax income
•  Reasons this may be different from statutory rate include
–  Different tax jurisdictions (countries)
–  Permanent tax differences (tax credits, tax-exempt income, etc.)
–  Changes in tax rates
–  Tax holidays in some countries

Deferred Taxes:
(Nonreversing) Permanent Differences
Differences in taxable and pre-tax incomes that are never reversed since
revenue or expenses may not be reported for either F/S or IRS purposes
Permanent Revenue Differences Permanent Expense Differences
•  Tax-exempt interest revenue •  Tax-exempt interest expense

•  Proceeds from life insurance •  Life insurance premiums on
on key employees key employees
•  Certain dividends not fully •  Tax credits
taxed
Statutory tax rate ≠ effective tax rate

Tax expense ≠ Pre-tax income × statutory rate
Summary Analytical Treatment of Deferred Taxes
•  If liabilities are likely to reverse •  Deferred tax assets

–  They should be discounted to the present
value and treated as a liability –  If they are unlikely to
–  The difference between reported value and reverse they should be
discounted value should be treated as reduced by a contra account
equity “the valuation allowance”
–  Increases debt to equity –  This increases the debt to
equity ratio
•  Is liabilities are unlikely to reverse
–  They should be treated as equity without
•  Deferred assets imply an
discounting increase in future cash flow
–  Lowers the debt to equity ratio
•  Deferred liabilities imply a reduction in future
cash flow

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Financial Statements Analysis

Financial Statement Analysis

ASSETS & LIABILITIES: DEFERRED TAXES

Marc A. LeFebvre, CFA

Financial Statements Analysis

Deferred Tax Objectives

• Differentiate between temporary and permanent differences between

Why Do We Study Deferred Taxes?

• The objective of financial reporting is to provide users with information

• Tax reporting, in contrast, results from social and political influences.

• Revenue and expense recognition methods used in tax reporting often

Financial Statements Analysis

Income Tax Terminology

• Tax Return • Financial Statements

– Deferred Income Tax Expense

Tax Return Definitions

• Taxes Payable/Current Tax Expense - tax return liability resulting from

Financial Statements Analysis

Financial Statement Definitions

• Pretax Income - Income before income tax expense

• Deferred Income Tax Expense - accrued income tax expense expected to be

The Liability Method - SFAS 109

• The effect of these choices produces different measures of operating and

• SFAS and IAS recognize the second choice…the liability method.

Financial Statements Analysis

Deferred Tax Liability Deferred Tax Asset

TAX REPORTING Sources of Differences

Financial Statements Analysis

Deferred Tax Liabilities (DTL)

• Common temporary timing differences arise from varying deprecation

• FASB argued that deferred tax consequences meets the definition of a

• An asset has an original cost $200,000 depreciable life of four years

• The asset is expected to produce $150,000 annual revenue.

• Tax rate is 40%

Financial Statements Analysis

DTL Example - 1 Solution

Fin. Reporting Year 1 Year 2 Year 3 Year 4 Total

DTL Example - 1 Solution

Deferred Tax Liability Year 1 Year 2 Year 3 Year 4

Taxes Payable (IRS) $20,000 $40,000 $50,000 $50,000

Deferred Tax Liability $20,000 $20,000 $10,000 $0

Financial Statements Analysis

Deferred Tax Liability Example - 2

Tax Reporting (IRS)

Deferred Tax Liability Solution - 2

Balance Sheet DT Liability 2,100 1,400 0

Financial Statements Analysis

Deferred Tax Liability Solution - 2

Recall, Income Tax Expense = Taxes Payable + Deferred Tax Expense

Deferred Tax Liability Balance Sheet Impact

Balance Sheet Effect: Total

Taxes payable (IRS) (600) (3,400) (4,100) 8,100

Income Tax Expense (F/S) 2,700 2,700 2,700 8,100

Deferred Tax Expense (F/S) 2,100 (700) (1,400) 0

Balance Sheet DT Liability 2,100 1,400 0 n/a

Recall, Deferred Income Tax Expense - accrued income tax expense

Financial Statements Analysis

Deferred Tax Assets (DTA) - Think Coupon at IRS

• DT Assets are balance sheet amounts representing the cumulative

• SFAS 109 allows the recognition of deferred tax assets whenever

Valuation Allowance (DTA) & Carryforwards

• The realization of tax loss carryforwards depends on future taxable

Financial Statements Analysis

•  Differentiate between temporary and permanent differences between

•  The objective of financial reporting is to provide users with information

•  Tax reporting, in contrast, results from social and political influences.

•  Revenue and expense recognition methods used in tax reporting often

•  Tax Return •  Financial Statements

–  Deferred Income Tax Expense

•  Taxes Payable/Current Tax Expense - tax return liability resulting from

•  Pretax Income - Income before income tax expense

•  Deferred Income Tax Expense - accrued income tax expense expected to be

•  The effect of these choices produces different measures of operating and

•  SFAS and IAS recognize the second choice…the liability method.

•  Common temporary timing differences arise from varying deprecation

•  FASB argued that deferred tax consequences meets the definition of a

•  An asset has an original cost $200,000 depreciable life of four years

•  The asset is expected to produce $150,000 annual revenue.

•  Tax rate is 40%

•  DT Assets are balance sheet amounts representing the cumulative

•  SFAS 109 allows the recognition of deferred tax assets whenever

•  The realization of tax loss carryforwards depends on future taxable

•  Deferred tax assets have valuation allowances (DTL’s do not!)

•  The valuation allowance is a contra account (offset/reduction) against tax

•  The firm estimates that warranty expense will be 2% of annual sales

•  Assume tax rate of 40%

•  Since multinational firms operate in many tax jurisdictions, their financial

•  DTAs resulting from carryforwards are classified by reference to their

•  SFAS requires disclosure of:

•  In order to effectively determine the firm’s future cash flows, earnings

•  Tax law and accounting method changes

•  Growth in the firm

•  When a new tax law is enacted the effects must be recognized

•  A firm has revenue of $10,000 for years one and two

•  The firm purchased equipment at a cost of $3,000 at the beginning of year

•  Tax rate is 30%

•  Firm earns $20,000 in revenue for the next 3 years

•  Asset original cost $24,000, straight-line depreciation for financial

•  Tax rate of 40% reduced to 35% in year 2

–  Nonrecurring items such as restructuring charges may have

•  From a solvency perspective, how should deferred tax liabilities be

•  Deferred tax liabilities are liabilities created from circumstances where

•  The DTL should be discounted at an appropriate discount rate.

•  From an analytical perspective we need to examine the components for

–  Nonreversing DTL: If the DTL is not expected to reverse the deferred