All,
I have a quick question - if DTA increases, how is the accounting equation (A = L + OE) balanced? Does Liabilities go up, or OE?
Similarly, if DTL increase, how is this balanced?
I am sorry if this is a basic question. I am a beginner, and hence I thought of asking this question.
Thanks in advance.
It’s usually partially an increase in equity and partially a decrease in cash.
A DTA arises because you will have lower taxes in the future, usually because you have higher taxes today. Higher taxes today means that cash is lower, but it also means that income is higher, so equity is higher (through retained earnings). So the balance is that DTA increases, cash decreases some, equity increases some stays the same, liabilities stay the same.
Similarly, a DTL arises because you will have higher taxes in the future, usually because you have lower taxes today. That means lower income today, so lower equity (through retained earnings), but higher cash. So assets increasse some, liabilities increase (the DTL), and equity decreases some.
No need to apologize: DTAs and DTLs cause problems for a lot of candidates. I wrote an article covering some info on DTAs and DTLs: http://financialexamhelp123.com/dtas-and-dtls-how-to-keep-them-straight/. Maybe I should expand it a bit to include answers to this sortof question.
You’re welcome in arrears.
Thanks S2000magician!
Hello S2000magician,
I have another follow-up question. (It just struck me.)
I got your explanation. However, how will I know how much increase in equity and how much decrease in cash will cause this? Example – let’s say DTL =$20K. was caused by different depreciation methods used by IRS and GAAP. How will $20K balance out ? I am curious. Any tips?
Thanks in advance.
You’re welcome.
Howdy.
Originally, when I was going to answer your question, “. . . if DTA increases, how is the accounting equation (A = L + OE) balanced? Does Liabilities go up, or OE?”, I was going to answer, “Neither.” An increase in a DTA is exactly offset by a decrease in cash, so liabilities don’t change and equity doesn’t change. Similarly, an increase in a DTL is exactly offset by an increase in cash; equity doesn’t change
However, it’s more complicated than that. (Isn’t it always, in FRA?) There are effects caused by the DTA/DTL itself, and there are effects caused by the situation that gave rise to the DTA/DTL, and the two are, essentially, inseparable. I’ll give you an example with a DTL (using your number), so that you can understand what I mean.
Suppose that Company A, Company B, and Company C are identical in every respect save one: depreciation. They all have EBITDA of $1 million. None has any interest expense. All have a tax rate of 20%. Company A uses straight-line depreciation for its financial statements, and double declining balance (DDB) for its taxes; Company B uses straight-line for both. Company C uses DDB for both. Company A shows $100,000 in depreciation on its income statement, but $200,000 on its tax return. Company B shows $100,000 for both. Company C shows $200,000 for both. Thus, Company A has a DTL (lower taxes today because of the higher depreciation, so higher taxes in the future), and the value of that DTL is $20,000 (= ($200,000 – $100,000) × 20%). Company B has no DTL. Company C has no DTL.
Company A has taxable income of $800,000 (= $1,000,000 – $200,000), and pays income taxes of $160,000 (= $800,000 × 20%). Company A’s EBT is $900,000 (= $1,000,000 – $100,000), and its tax expense (on its income statement) is $180,000 (= $160,000 (taxes payable) + $20,000 (increase in DTL)), so its net income is $720,000 (= $900,000 – $180,000).
Company B has taxable income of $900,000 (= $1,000,000 – $100,000), and pays income taxes of $180,000 (= $900,000 × 20%). Company B’s EBT is $900,000 (= $1,000,000 – $100,000), and its tax expense (on its income statement) is $180,000 (= $180,000 (taxes payable), so its net income is $720,000 (= $900,000 – $180,000).
Company C has taxable income of $800,000 (= $1,000,000 – $200,000), and pays income taxes of $160,000 (= $800,000 × 20%). Company C’s EBT is $800,000 (= $1,000,000 – $200,000), and its tax expense (on its income statement) is $160,000 (= $160,000 (taxes payable), so its net income is $640,000 (= $800,000 – $160,000).
Comparing Company A to Company B, we find that Company A has:
Comparing Company A to Company C, we find that Company A has:
In each case, there is an effect ($20,000 more cash, $20,000 DTL) caused by the DTL itself. In the second case, there is also an effect ($100,000 more in long-term assets, $80,000 more equity, $20,000 less cash) caused by the different depreciation methods (or, more specifically, the different depreciation amounts ) used; and it’s the choice of depreciation methods that gives rise to the DTL.
My pleasure.
Hello S2000magician,
First of all, I would like to thank you for taking time to answer my query. I really appreciate your guidance and detailed responses.
However, I have a few follow-up questions in your response, if you don’t mind.
I didn’t get this part. Are you saying that Company A saved $20K because of DTL? If yes, then I am confused in your second case.
I am a bit lost. I am not sure why you are saying that A and C have same cash. Could you please explain this? I believe A should have more cash than C because it’s postponing the payment of taxes via DTL. However, I could be wrong. I am a newbie to accounting.
Moreover, I believe the reason why you are saying that A has $80K more in equity than Company C’ has in its equity is that the difference between the two respective net incomes is $80K. Because, net income goes into Equity portion, one company will show additional earnings. (This also sounds intuitive because if we use straight line depreciation instead of DDB, then the goal is to increase earnings, to show better performance. However, please confirm if my understanding is correct.)
I am lost with the {" "} portions above. Can you please explain this? I would really appreciate your help.
I believe the moral of the story is that DTLs help to increase cash. DTAs reduce cash. Hence, the equations get balanced. Do you think I am right?
Thanks in advance!
Glad to be of help.
Not in the least.
Yes. The DTL is a future liability. Why will you have to pay $20,000 more in taxes in the future? Because you paid $20,000 less in taxes today. (And how were you able to do that? By having $100,000 _ more _ in expenses (on your tax return) today, lowering your taxable income.) Therefore, compared to Company B, you have $20,000 more in cash.
Company A and Company C have the same depreciation for taxes: $200,000. Thus, they have the same taxable income: $800,000. Thus, they pay the same amount in taxes: $160,000. They start with the same amount of cash (they’re identical companies), they pay the same amount of cash for taxes, so they end with the same amount of cash.
Remember, the amount you pay in taxes depends only on your tax return, not on your income statement. They have the same tax returns, so they pay the same amount in taxes. Both companies are postponing paying the taxes by having higher depreciation on their tax return the first year. That’s the key: whether you pay taxes today or taxes in the future depends on what’s on the tax return, not on what’s on the income statement.
(You should compare Company B to Company C: neither has a DTL. But Company C has $20,000 more cash than Company B. Why?)
Absolutely correct.
So, why does Company A have higher net income and higher total assets (and that stupid DTL) than Company C, while having the same amount of cash? The same-amount-of-cash thing arises because their tax returns are the same; the different-net-income-and-assets-and-DTL thing arises because their income statements are different. And why are their income statements different (while their tax returns are the same)? Because Company A used a different amount of depreciation on its income statement than on its tax return, while Company C used the same amounts on both.
Company A uses different depreciation amounts on its income statement ($100,000) than on its tax return ($200,000). This creates a $20,000 DTL, offset by $20,000 more cash (than if it had had $100,000 depreciation on each). When comparing to Company B (which did have $100,000 depreciation on each), that’s the extent of the differences. So, when two companies have the same income statements, but different tax returns, you’ll see a difference in cash, and a DTA or DTL, and that’s it.
When comparing to Company C, those differences ($20,000 DTL, $20,000 more cash) are still there (because Company A still has different numbers on its income statement and its tax return), but there is another set of differences, caused by Company C having more depreciation on its income statement than Company A has: those differences are $20,000 more cash, $100,000 less in long-term assets, and $80,000 less equity. When two companies have different depreciation on their income statements, those are the differences you’ll see: cash, long-term assets, equity. Here, it happens that the two cash differences ($20,000 more for A because of the DTL, $20,000 more for C because of the higher depreciation on its tax return) offset each other exactly; Companies A and C end up with the same cash.
It would be an interesting exercise for you to compare these three companies to Company D: identical except for depreciation (I know: big surprise!), which is $150,000 for both its income statement and its tax return. I await the results of your comparison.
You are, indeed.
D’accord.
Hello S2000magician,
As always, thank you for your detailed post. This post is awesome!
The answer to your first question is that A and C pay different amount of taxes, as determined by 20% of taxable income. The difference is $20K, meaning B pays more tax than C. Am I right?
I thought of first rewriting the entire problem so that others can follow.
The second part of your question is interesting. Here’s what I could think: --------------------- Company A’s income statement Dep = 100K Carrying Value of Asset = 900K Tax Expense = 180K Net Income = 720K DTL = 20K Tax (IRS) Dep = 200K Carrying value of Asset= 800K Tax Paid = 160K --------------------- Company B’s income statement Dep = 100K Carrying Value of Asset = 900K Tax Expense = 180K Net Income = 720K B’s Tax (IRS) Dep = 100K Carrying value of Asset= 900K Tax Paid = 180K --------------------- Company C’s income statement Dep = 200K Carrying Value of Asset = 800K Tax Expense = 160K Net Income = 640K C’s Tax (IRS) Dep = 200K Carrying Value of Asset = 800K Tax Expense = 160K --------------------- Company D’s income statement Dep = 150K Carrying Value of Asset = 850K Tax Expense = 170K Net Income = 680K D’s Tax (IRS) Dep= 150K Carrying value of Asset= 850K Tax Paid = 170K ------------------------ Ok…Now you have asked to compare three things: Cash, Assets and Equity. (I think assets is straightforward – by going with SL Depreciation on income statement instead of DDB, which is done for tax purposes, we are trying to increase the value of the asset.) Cash— 1) Now I will try comparing the cash. A has the maximum cash because the taxes paid are the lowest. However, A will have to the taxes in the future. Hence, it’s hit with DTL. However, C doesn’t report additional cash (hence, better earnings) on the income statement. As a result, C is not hit with DTL. I would say C is the honest guy.
It sounds as though you’re getting this.
One correction: ultimately, all four companies will return to being identical, because, eventually, all of the depreciation amounts will be equal. (Thus, Company C won’t ever report better (i.e., higher) _ equity _ than Company A; it will report higher net income later on, and its equity will catch up to Company A’s.)
Hello S2000magician,
Thanks for your reply.
Thanks. I think the credit goes to you for helping a newbie like me.
I didn’t get this. I believe that we assumed that no dividends will be paid. Hence, any increase in net income will translate to gains in equity. I do agree with your point about depreciation being down in the future cycles. Please help me.
Thanks
You are correct that increases in net income will translate to gains in equity. After the first year, Company A has $80,000 more equity than Company C. Suppose that in year 2 they have the same net income; Company A still has $80,000 more equity. If, in year 3, Company C has $30,000 more net income than Company A (because Company C now has lower depreciation than Company A), Company C will still have $50,000 less equity. They’re catching up (because of higher net income), but they’ll never pass Company A.
Thanks S2000magician!
You’re welcome.
Hello S2000magician - I am curious. DTA and DTLs, I believe, should involve time value of money factor. However, in computing DTAs and DTLs, we didn’t use any interest rates.
I am asking this question within the context of CFA-L1. This question came to my mind while studying pension plan/benefits. This could be out of scope. However, I would appreciate your thoughts.
Sorry for barging in on Magician’s question.
This question also came to mind when I was studying for L1.
DTA’s and DTL’s don’t accrue any interest. That is you don’t pay any interest on DTL’s to Tax authorities and you don’t get any interest on DTA’s from Tax authorities, in the context of CFA L-1 curriculum. (Although in reality, every country has different tax rules so there might be some exceptions). Also, DTL’s are not included in Total capital as they don’t accue any interest.
If interest was to be charged on DTL’s, then this would significantly reduce the attraction/usage of DTL. I mean is not it the whole point of using DTL?: to earn interest income on tax liabilities by paying them in a future time period.
It would not matter if you pay taxes now vs later if the interest cost on DTL’s and your Investment returns were same.
I view these as anyone’s questions; no need to apologize.
Nicely answered, by the way.
Thanks people! However, if what Finkid said is correct, EVERY company would craft a technique to defer maximum possible taxes to the future to benefit from the time value of money in a growing economy, leading to a potential bankruptcy of the government. I could be wrong. I hope we are not deviating from the syllabus of CFA Level 1. I am sure there must be some catch, some rule to stop this. Thoughts please?
Thanks
There are practical limits to the amount of time a company can defer taxes, but I’m sure that most companies do that to the best of their ability.
As Magician said, they must already be doing it to the best of their ability. In fact, some companies have created a special position of Tax manager (at least where I live), whose sole job is to minimize tax expense.
The first catch is there are DTAs as well so it somewhat balances out. Secondly, imo, tax rates will be raised in future given the kind of pathetic fiscal conditions most of the governments are in right now, so the companies will be paying higher taxes (at the new higher tax rate) in future when these DTLs reverse. And governments hardly ever go bankrupt. Corporate taxes is not the only source of revenue for them. There are personal taxes and indirect taxes as well. They can also borrow, print money or seize your assets.