An analyst gathered the following data for four profitable companies operating in the same industry: Company: DTA: DTL: 1 50,000 200,000 2 300,000 400,000 3 85,000 50,000 4 170,000 115,000 If the applicable corporate income tax rate is decreased and nothing else changes, which company will MOST LIKELY experience the largest decrease in reported equity? I thought it was company 2, thinking that DTL could be counted towards equity when analyzing the company…maybe. Since it has the largest DTL, then I guess that would make sense. However, “the answer people” think it is company 4. Any ideas?
When the Tax rate reduces as they are saying it will, both the DTL and the DTA would reverse. In the current situation, look at Co. 4 Its Tax Expense = Tax Payable + 115 - 170 = Tax payable - 55 Say Tax rate for the above was 25% When the Tax rate decreases say to 20% TaxExpenseNew = Tax Payable - 55 / .25 * .20 = tax Payable - 44 TaxExpenseNew - TaxExpense = TaxPayable - 44 - Tax Payable + 55 = 11 So Tax Expense will increase, as a result of which Net Income and thus Equity will reduce by 11. The Larger the DTA over the DTL – when tax rate decreases, you would have the NI Reducing.
Don’t think about the absolute value of the DTL, think about net DTL-DTA. Company 4 has the largest net number 170k - 115k. When tax rate decreases, that net tax asset (DTA-DTL) loses value thus decreasing the reported equity value. I could be wrong though.
Good explanation cpk. I suppose that sort of makes intuitive sense. If DTA>DTL, a decrease in taxes reduces your NI and thus equity. If DTL>DTA, the exact opposite is true and a decrease in taxes could actually increase NI and equity (because you owe less taxes).
easy way to remember: INCREASE in tax rate increases both DTA/DTL (so DECREASE in tax rate decreases both DTA/DTL) then work out their net positions: 1 150,000 DTL 2 100,000 DTL 3 35,000 DTA 4 55,000 DTA so if tax rate decreases, all of these amounts will also decrease… now, which will most likely cause a decrease in equity? i’d say 4, cos its got the biggest asset…decrease in liability wont cause a decrease in equity, based on the accounting equation (A=L+E) but, i could also be wrong… anyone else?