Reading 35: Analysis of Income Taxes

Book 2: FSA

What is the core idea behind deferred taxes?

there are timing differences between how companies recognize the taxes they owe vs how tax authorities recognize how much taxes a company owes

Taxable Income def

the income subject to tax based on the tax return

• how much the tax authorities say a company owes

Taxes Payable

how much taxes a company actually owes and pays over a period

What is Taxes Payable also called?

current tax expense

Taxes Payable =

taxable income x tax rate

Income Tax Paid

the actual cash flow for income taxes including payments or refunds from other years

Tax Loss Carryforwards

the current or past loss that can be used to reduce taxable income from other years

When does a Tax Loss Carryforward occur?

When taxable income < 0

Tax Base

the amount of an asset or liability used for tax reporting purposes

• how much of an asset or liability is able to be taxed

Accounting Profit

the pretax financial income based on fianncing accounting standards

Income Tax Expense

expense recognized on the income statement that includes taxes payable and changes in DTLs and DTAs

• the tax amount the company records and says they pay

Income Tax Expense =

current tax expense + (change in DTLs - change in DTAs)

Deferred Tax Liabilities (DTL)

an excess of income tax expense over taxes payable that are expected to result in future free cash flows

• the company is recognizing more taxes paid than it actually is

  • Tax Expense > Taxes Payable

Deferred Tax Assets (DTAs)

an excess of income tax expense over taxes payable that are expected to result in future tax savings

• The company is paying more in taxes than it is recognizing

  • Taxes Payable > Tax Expense

Valuation Allowance

the reduction of DTAs based on the likelihood the assets will not be realized

Carrying Value

the net balance sheet value of an asset or liability

Permanent Differences

the difference between taxable income and pretax income that will not reverse in the future

• do not result in DTAs or DTLs

Temporary Differences

the difference between the tax base and the carrying value of an asset or liability that will result in either taxable amounts or deductible amounts in the future

• creates DTAs or DTLs

When does a DTL occur?

revenues are recognized before they are included on the tax return

expenses are tax deductible before they are recognized on the income statement

When does a DTA occur?

revenues are taxable before they are recognized on the income statement

expenses are recognized on the income statement before they are tax deductible

Asset: Carrying Value > Tax Base =

DTL

Asset: Carrying Value < Tax Base =

DTA

Liability: Carrying Value > Tax Base =

DTA

Liability: Carrying Value < Tax Base =

DTL

What causes a permanent difference?

revenue that is not taxable

expenses that are not deductible

tax credits that result in a direct reduction of taxes

Do changes in the statutory tax rate change the DTL and DTA values?

yes

True or False: DTLs and DTAs are carried on the balance sheet at their discounted present value.

False

they are carried on value based on the likelihood that there will be future cash flows to realize the benefits of the DTAs and DTLs

When the value of a DTA is diminished, how do IFRS and GAAP firms adjust it?

IFRS ==> lower the value on the balance sheet

GAAP ==> full value is carried out by creating a valuation allowance

How does a valuation allowance impact the income statement?

decreases net income and increases income tax expense

If DTLs are expected to reverse in the future, treat them as __________. If DTLs are not expected to reverse in the future, treat them as ______.

liabilities, equity

Statutory Tax Rate

the tax rate in that jurisdiction

Reasons why firm’s tax rate is different than the statutory tax rate?

different tax rate in different tax jurisdictions

permanent tax differences

• Tax credits, tax-exempt income, nondeductible expenses

Changes in tax rates and legislation

tax holidays in some countries

Cash Tax Rate =

cash taxes payed/pretax income

Which items should analysts consider when understanding the reconciliations from the statutory tax rate to the effective tax rate?

continuous reconciliations

Examples of Continuous Reconciliations

different tax rates in different countries, tax-exempt income, nondeductible expenses

Do impairments result in a DTA or DTL?

DTA

the write-down is recognized immediately but tax deductibility is not realized until the asset is sold

Does accelerated and straight-line depreciation result in a DTA or DTL?

DTL

Do restructuring charges result in a DTA or DTL?

DTA

these are expensed immediately but you don’t recognize the deductibility until they are actually paid

Do post-employment and deferred compensation result in a DTA or DTL?

DTA

these expenses are recognized immediately but are not deductible until they are actually paid out

Do gains and losses on AFS securities create a DTA or DTL?

neither

the DTL or DTA is adjusted