Questions about deferred taxes

I have some questions about deferred taxes. I would appreciate if somebody could answer them: 1. To calculate income tax expense, we multiply pretax income with statutory tax rate. But, there is also this equation: Income tax expense=effective tax rate x pretax income. When and why do the statutory tax rate and effective tax rate differ? Which eqaution is valid all the time? 2. The book says: " A deferred tax adjustment is made to SE to reflect gains or losses from carrying available for sale marketable securities at MV." How is this adjustment is done? 3. Q13 on page 221 (Schweser) asks: “The firm has deferred tax liability and is expected to have CAPEX decline in the future. How should the liability be treated for analysis purposes?” The answer is: “The PV should be treated as a liability with the remainder being treated as equity.” Could somebody explain this answer, please? Thank you very much!

minocfa, which SS are you on presently? Are these questions that are coming up while you read the chapter on Taxes in SS10? If not, I would suggest that you wait on these questions till you reach that chapter. It does take some reading, and takes multiple readings to get through that chapter. I would definitely request you to read the CFA text book, though Ashwin, Sondhi and White makes for dry reading, this chapter is quite crucial. If you are reading the SS10 and have these questions - I’ll try to answer them to the best of my memory: 1. The Pretax Income x effective tax rate is applicable when there are “Temporary differences” between Taxes Payable (on the tax statement what is due to the Govt.) and the Tax Expense (on the Financial Statement). This reflects the effects of Deferred Tax Liabs and Deferred Tax assets. Actually this is the way to calculate the Effective Tax Rate which is Income Tax Expense / Pretax Income. IT Payable =Income Tax expense + Change in Deferred Tax Liab - Change in Deferred Tax Assets. 2. This I am not sure about. I will look it up, and once I have that information, I will definitely post back on this thread. 3. A DTL is created when the company uses a different depreciation method e.g. other than Straight line on the Financial statement, and uses Straight Line on the Tax statement. In the initial years of the asset, the Depreciation expense would be higher on the Financial statement, while it would be lower on the Tax statement. This difference (Depr FS - Depr Tax) * Tax Rate = a DTL. Now think about what would happen if there is a CAPEX decline. This means that the Deferred Tax Liability which normally would reverse would not actually reverse, because the depreciation expense in the future period would actually be reducing, hence the DTL should be considered as Equity, and not a liability any more. I am also waiting for Hiredguns1 / Super I to step in and add more commentary to this q. CP

CPK123, I have already finished reading FSA. I have read CFAI FSA several times, and also Schweser. Now, I am reviewing the subjects that were difficult for me. . Unfortunately, I still do not feel comfortable with these deferred taxes… Regarding my questions: 1.We do not know effective tax rate beforehand, right? When we calculate income tax expense, we multiply statutory tax rate with pretax income and record that income tax expense in the IS. Then what do we subtract from that income value so that income tax/pretax income is not equal to statutory tax rate anymore? 3. I think you should reverse what you said. When there is DTL, in the initial years: Tax expense>taxes payable & Depr FS< Depr Tax. If CAPEX decline, does Depr FS or both Depr FS and Depr Tax decline? If Depr FS declines only, actually the diffreence between two depreciations increase, DTL increases…But I do not see how this is related to considering DTL as Equity… Thanks.

  1. ok… made a mistake there. Depr fs is straight line – so you have a higher income depr tax is the accelerated method – so you have a lower taxable income so a DTL has been created. for the first year. now in year 2 – say there is more capex so the depr expense increases and the dtl increases even further. after that say CAPEX reduces, and is not to the extent of the previous years, and this keeps happening. technically the dtl is going to reverse only because the depreciation expense on the financial statement catches up to that on the tax statement. (Remember that total depreciation expense on both the fs and the tax statement should be the same at the end of the estimated life period of the asset). but when the capex declines, the total depreciation expense on the fs will never catchup to that on the ts, so the dtl would never reverse. this is the situation when an analyst must step in and instead of accounting for the dtl as a “true liability” account for it instead as equity. minocfa I would suggest you search for “dtl” on this forum for the past 90 days. some of these questions have been asked and answered there. I am sorry not to be able to provide you a comprehensive answer at this time… CP

Thank you very much, cpk123… Although I could not find the answers to my first two questions, the archive has helped me to understand the concepts a little bit more…

1.We do not know effective tax rate beforehand, right? When we calculate income tax expense, we multiply statutory tax rate with pretax income and record that income tax expense in the IS. Then what do we subtract from that income value so that income tax/pretax income is not equal to statutory tax rate anymore? This is where the concept of the permanent differences and the temporary differences come in. Both permanent differences and temporary differences (DTL and DTA) cause the effective tax rate to be different from the statutory tax rate. Statutory tax rate: Tax Expense on Financial Statement / Pre tax income on Financial statement. Effective Tax rate: Tax expense on the Tax Statement / Pre tax income on Financial Statement So anything that causes the Tax expense on the Tax statement to be different from the tax expense on the Financial statement – causes the difference between the effective and the statutory tax rates. Do not know, if this makes it any clearer. Q 3. When should an analyst consider a DTL to be part of equity. A DTL is an accounting liability, and meets the definition of a liability under US GAAP. It represents that portion of a period’s income tax expense reported on the Income statement that HAS NOT BEEN PAID. Even though DTL are accounting liabilities, they are not legal liabilities, because they do not represent taxes that are actually owed to the Govt. Taxes owed to the Govt and not been paid are called Taxes Payable. They are classified as Current liabilities on the Balance sheet because they are usually due within a short time period. DTL however, must be separated into their current and non-current components based upon the character of the transaction that created the liability. DTL resulting from depreciation methods are associated with non-current assets and therefore are classified as non-current. (The same is true of DTA. E.g. DTA created by warranty expense are classified as current as they relate to the current operating cycle. DTA created due to operating loss carry forwards will be classified as current or non-current depending on the time they are anticipated to reverse). If a firm is growing and new fixed assets are being acquired, new DTL will be created continually. Thus the DTL balance may never decrease. Furthermore, changes in tax laws and/or a company’s operations may result in the deferred taxes never being paid. For these reasons, many analysts treated DTL as if they are a part of a company’s equity capital. Technically, this should only be done if the analyst is convinced that the DTL will increase or remain stable in the foreseeable future. This is the case when a company is expected to continually acquire new assets (or more expensive assets) so that the aggregate temporary differences will increase (or remain stable) over time. Under such circumstances (which is normal for most firms), DTL can be viewed as being zero-interest loans from the government, that will (in the aggregate) always increase without ever being repaid. The rationale for treating perpetually stable or growing DTL as equity for analytical purposes is that a perpetual loan that requires no interest or principal payments has the characteristics of permanent equity capital. On the other hand, if the company’s DTL are expected to decline over time, they should be treated as legitimate liabilities for analytical purposes. It is often argued that such deferred tax liabilities should be discounted for the time value of money (the taxes are not paid until future periods). US GAAP and IAS GAAP do not require time value of money adjustments for DTL, but this should be considered by the analyst. In some cases, the analyst may ignore the DTL for analytical purposes when it is difficult to determine whether they will take on the characteristics of a true liability or equity capital over time. Ultimately, the analyst has to decide whether DTL should be characterised as Liability, Equity, or neither based on the facts and circumstances of the individual situation. WHEW that was a long post. CP

Thank you very much, cpk123. A few comments: 1. The formula you gave are actually different on the book: effective tax rate= income tax expense on Financial Statement /pretax income on Financial Statement (CFAI) And I think statutory tax rate should be: taxes payable on Tax Statement/taxable income on Tax Statement. Are taxable income and pretax income always the same? How could you use pretax income in the denominator of both of your formulas? 3. When DTL is part of liability or equity, do we subtract it as part of income tax expense from Ret. Earnings to keep the equality A=L+SE? When we have DTA, is it like contra account to income tax expense? So, we add it to Ret .Earnings, right? Again thank you very much for your time and effort!

as far as I understand, nothing changes to the Income tax expense. It is a classification between L and SE. So something (DTL) was originally a L Now it moves to the (SE) bucket instead. So L reduces, SE Increases. CP

Guys, You are overthinking and overcomplicating what they mean in the first question > 1. To calculate income tax expense, we multiply > pretax income with statutory tax rate. But, there > is also this equation: > Income tax expense=effective tax rate x pretax > income. > > When and why do the statutory tax rate and > effective tax rate differ? Which eqaution is valid > all the time? > Sometimes the books use generalizations/simplifications, and sometimes they try to be technically correct. Statutory tax rates are graduated. So let’s say corporate tax rates are 15% on the first $50K, and 25% on everything above that. The first statement on how to calc income tax expense is technically correct. But, when they give you problems where you need to calc taxes or tax effect they don’t want you to waste time mechanically tranching out pre-tax income, so they give you the blended, or effective rate to use to simplify the process. (Note that sometimes you may encounter marginal tax rate, meaning the income or expense item has tax applied at the highest corp tax level, not the blended amount to be more accurate)

#1 ) SUPER ^ I agree. Think of your own personal taxes for statuatory rates. You might be in the 25% bracket, however you don’t pay 25% on ALL of your income. #2) Not exactly sure what you are asking, but AFS securities are marked to market as unrealized gains / losses in Other Comprehensive Income (SE section) per Financial Reporting however Tax Reporting does not allow write offs or gain recognition until security sales are REALIZED. Represents a temprorary difference. #3) If CapEx is to decline, you will expect your DTL to reverse because the Financial Reporting Depreciation Expense will catch up to the Tax Reporting Depreciation Expense. As it is expected to reverse, we should property include it as a Liability, however at its Present Value, because from an analysis standpoint and economically speaking, we know that only the present value (better representation of market value) will actually be reversed.

Thank you all for your answers. CFAI book says: “To the extent that deferred tax assets have been offset by a valuation allowance, realization of those assets will increase reported income as well as generate cash flow. If no valuation allowance has been provided, then realization will have no effect on reprted income, although cash flow will still benefit.” Could somebody maybe paraphrase what this paragraph tries to say? Thank you.

I have a DTA from depreciation or some other non-cash charge. I don’t expect to be able to benefit from that DTA because for example, I don’t expect to have enough income in the future to benefit from it. I express that by taking a valuation allowance which says I probably won’t be able tp benefit from this DTA by the amount of the valuation allowance. But a miracle happens, I have lots of income, and so I can take advantage of the DTA. That valuation allowance going away represents income to me. And cpk is a new fine asset to this board (Super I is a fine old asset).