I am having trouble grasping this concept. A DTA arises when tax expense (reported by the company) > taxes paid (to the government) right? I am getting hung up on this question, possibly because my understanding is wrong.
If a company has a deferred Tax Asset reported on it’s statement of financial position and the tax authorities reduce the tax rate, which of the following statements is most accurate concerning the change? The existing deferred Tax Asset will:
A decrease in value
B not be affected
C increase in value
I guessed C but the answer is A, my mindset being if you already have a DTA and your tax rate is decreased, your DTA will increase because there is a bigger difference compared to the new rate. Obviously this is wrong.
A DTA arises when a temporary difference between financial reporting and tax reporting will lead to lower taxes in the future; therefore, higher taxes today.
Suppose that you wrote down an impaired asset for $10,000 today, and that your marginal tax rate is 30%. You don’t get that write-down on your tax return – impairment isn’t a taxable event – so you pay $3,000 more in taxes this year, but you expect that you’ll pay $3,000 less in the future when you sell the asset; you record a DTA of $3,000 (= 30% × $10,000).
Next year, the marginal tax rate is dropped to 25%. That $3,000 you thought that you were going to save is now only $2,500 (= 25% × $10,000): your DTA lost $500 of value.
wicher, to help you come exam time you can think of your two examples like this:
Your first example. Imagine you entered a contest and a won a prize. That prize is a voucher that allows you a 50% reduction in your federal income taxes in 2018.
That voucher would have value to you. So think of it like a Deferred tax asset
Fast forward six months, and say Trumpy abolishes the federal income tax and the US goes with a consumption tax. What happens to the value of your voucher? it would go down right, probably to zero since it won’t save you anything anymore.
Your second example : You are a bad CFA candidate. Trump sees you hugging a Mexican and gets mad, and sends you a document demanding that you pay double your federal income taxes in 2018.
That would be bad for your finances. You can think of it as a Deferred tax liability.
Fast forward six months, and the government raises the federal income tax rate by 25%. Is that good or bad for you? I’d say bad. Your liability is even higher now, since rates went up and you need to double a higher tax amount.
This simplified example(s) can help you think through directionality of DTAs/DTLs with changes in tax rates.