Can someone explain this, I’m having a really hard time understanding this.
I think I get “Tax base for assets”. I think of it as the amount left that can be depriated for tax purposes. So, if you buy something for $100K, on your financial report, it gets depriaciated to $80K which is the carrying value, but on your income taxes, you depreciated differently, so it’s now worth $70K, which is it’s tax base. That’s the right way of looking at it right?
So following the above logic I’m trying to make sence of what a tax base is for liabilities. In my Schweser notes it says that it is “the carrying value of the liability minus any amounts that will be deductible on the tax return in the future”. What does this mean exactly and why/how is it useful. Can someone interpret this in a way that I can understand instead of just memorizing. The tax base for assets is logical and intuitive, but the liabilities isn’t.
The example they give in Schwese is for Warranty liability. A firm estimates $5K warranty expens on goods already sold. They say the carrying value is $5K (makes sence), but the tax base is ZERO (don’t get it). The logic is ($5,000 carrying value - $5,000 warranty expense deductible in the future). What does that mean though, arghhhhh! Will the tax base then increase as the warranties start to get exercised?
btw - I had a look in older posts about this and people raved on about some free sample Elan guides that did a good job explaining this. The link doesn’t seem to work anymore though. Anybody got this free sample and care to flick it over to me?
The carrying value is the $5,000 that the firm made up as a placeholder for future liabilities. The tax base is what’s left over after you subtract any tax deductions from that liability in the future. Since the $5,000 represents only future liabilities, and all of it will be tax deductible when realized as an expense, there is an equal $5,000 in future tax benefits. Thus, $5,000 - $5,000 = 0.
Sorry aaronhotchner, it’s still really fuzzy. Should I abandon my approach of trying to reconcile the tax base for assets to the the tax base for liabilities. I think of the tax base for assets as “what’s left in the tank” to expense for tax purposes. So when I think of the liabilities, in the case of the $5K of warranty, I think that it should be $5K because that’s what’s left in the tank to expense for tax purposes.
When is the tax base for a liability non-zero? Maybe I’ll get it if I understand this. Both examples in Schweser have tax bases of ZERO.
Every time the tax consequence is not equal to the carrying amount of the liability, there will be a non-zero tax base.
Let’s say you have accrued expenses that you’ve already deducted for tax purposes. Your current liabilities include those accrued expenses on the books, but there is no longer a future tax deduction because you’ve already made the tax deduction. So the tax base is the carrying amount less future tax deductions (equal to zero), and thus the carrying amount is equal to the tax base. This can be extended such that, for example, only 80% of your accrued expenses have been deducted for tax purposes for whatever reason. Now the tax base for the accrued expenses will be the carrying value less the 20% of the carrying value that will have future associated tax deductions.
Another example would be accrued fines. They are a current liability, but if they do not impact taxes (that is, paying the fine is not a tax-deductible expense), then the carrying value will be the same as the tax base.
The carrying value and tax base will also be the same if unearned revenue is accrued but the recognized revenue will be tax-free.
It’s basically the complement for liabilities. It’s not how much you’re going to deduct for tax purposes in the future; it’s everything you’re NOT going to deduct.
Ok, I’m starting to see a little bit of light at the end of the tunnel.
Is the following interpretation I’m starting to make correct:
The tax base (of assets or liabilities) is just a number there to calculate the tax asset or tax liability by doing (carrying value - tax base). Therefore, to make this relationship work, the tax base of a liability has to be “everything you’re NOT going to deduct from the liability” (i.e. ZERO in the case of the warranty) so that a non-zero tax asset can be calculated ($5K - 0) * (tax rate).
I’m hanging on for dear life on the above statement, but is that correct?
That all sounds reasonable, yes. The warranty expense represents a tax asset because it will be used in the future to reduce taxes owed. If the tax base on the $5k warranty were $5k, the temporary difference would be $0, and thus the tax asset would be 0 * (tax rate) = 0, but that would only occur if the warranty expense did not affect the firm’s taxes. For the purpose of assets, the firm wants a large tax base because the tax base represents the value of future tax deductions. For liabilities, the firm wants a small tax base because the tax base of a liability represents the value that cannot be used for tax deductions.
It helps to think about the general role of assets and liabilities. Increases in assets increase your taxes, and increases in liabitilies decrease your taxes. The tax base always does the opposite. A higher tax base for an asset counteracts other asset increases (creating deferred tax asset), and a higher tax base for a liability counteracts other liability increases (creating deferred tax liability).