Deferred tax assets/liability

Hi everyone! I am having trouble understanding exactly how deferred taxes work. For example, here is my intuition of how it works shown with an example: Let’s say a company buys a machine for $1000 with no residual value and useful like of 5 years. The company uses straight line depreciation for F/S and double declining for the taxman. The company always generates $500 of annual income and the tax rate is 10%. Now here is the schedule : Reported in F/S Reported to tax man: Journal Entry: End of Year 1- Depreciation: 200 400 tax expense 30 DTL 20 Carrying Value: 800 600 tax payable 10 End of Year 2- Depreciation: 200 240 tax expense 30 DTL 4 Carrying Value: 600 360 tax payable 26 End of Year 3- Depreciation: 200 144 tax expense 30 Carrying Value: 400 216 DTA 6 tax payable 36 End of Year 4- Depreciation: 200 86 tax expense 30 Carrying Value: 200 130 DTA 11 tax payable 41 End of Year 5- Depreciation: 200 130 tax expense 30 Carrying Value: 0 0 DTA 7 tax payable 37 It is my impression that, in general, for each capital asset that a company owns, it would determine the DTA or DTL for each asset for each year, and then net the two to determine the DTA or DTL for this asset. And then net for all assets to determine the final DTA or DTL. I’ve also read some where about DTL’s never reversing, but I cannot understand how this would ever be possible… If someone could point out any problems with my understanding I would really appreciate it. thanks!

Quote: I’ve also read some where about DTL’s never reversing, but I cannot understand how this would ever be possible… If the company continually buys new assets, the liabilities would not reverse. So they would need to be added to equity.

Okay, so when they say that DTL do not reverse, they are not referring to the DTL that resulted from an individual asset, but all assets in aggregate, and because the company keeps adding new assets, it will always have a DTL on balance sheet. That does make sense, but I cannot see why that should be treated as equity. If DTL is treated as equity in this case, then wouldn’t this imply that a company that continuously borrows money (e.g a company like Northern Rock that used commercial paper to fund its mortgage origination loans) should also have it’s loans payable treated as equity? But as far as I know, this is not the suggested treatment. So I guess my question now is what is the difference is between loans payable that is continuously rolled over (so it will also always be on balance sheet), and DTL that would result in DTL treated as equity but loans payable not? thanks.

doubled, here’s a somewhat recent post of mine on this topic. While hardly definitive, it may be of some value to you. Also, if I remember correctly, DTL can also stem from permanent differences in taxable income on financial statements vs. actual tax returns (I think employee benefit plans play a role here, but I’ve gotta look this up again). But like you’re saying, I typically consider DTL w/in the context of asset accumulation and depreciation methods.,597125,597437#msg-597437

The “treated as equity” is one of many things that I suspect go back to some well known analyst who never took accounting and everyone was afraid to cross. It’s as stupid as looking at minimum lease commitment schedules under operating leases and making an adjustment to a company’s balance sheet for the PV of those amounts. One company may have a 10 year lease while another has one for 5 years. First one will put on more debt on its balance sheet, but the second will still need to rent space in years 5-10. No one considers that fact, or that the first company may have locked in a very favorable long-term rental rate, yet they look worse analytically because they get a higher amount of obligations put on their balance sheet. Just remember, its about knowing what CFAI expects, not necessarily about agreeing with them or using it in practice.

They are treated as equity because they are something that the company is yet to pay the IRS (and forever won’t pay bcs of continuous capex) and so it’s like added money that the company owns for which they pay no interest (as they would if you considered it a debt) and so it can be considered as equity (money that is extra that they can spend and whose profits are benefitting the share holders). I would think thats why its considered as equity. Does that help at all or was I way off?

Great points, I was hoping you and/or TMurf would chime in. Your comments about the varied lease terms remind me of the Equivalent Annual Annuity (EAA) and Least Common Multiple of Lives approaches CFAI has us learn for evaluating the NPV of mutually exclusive capital budgeting projects. In practice, do you typically ignore the operating lease commitments outright, attempt to place them on equal footing (e.g. EAA), or some other methodology?

Doubled, NEVER net DTA and DTL, they are considered separately (unless it is for the same asset and the DTA or DTL will reverese for that asset). If a DTA will not reverse, create a valuation allowance account. If a DTL will not reverse, treat the current portion of DTL as a liability, and the rest as equity.

You must classify the DTLs and DTAs as current or noncurrent. Then determine the current DTA/DTL by netting them. Do the same for noncurrent DTA/DTL. So a balance sheet can have a current DTA and a noncurrent DTL. or current DTL and a noncurrent DTL etc…

But aren’t DTL and DTA netted to determine their outcome on NI and hence Equity?