Hope I am not creating too much mess. I am trying to understand the effect of tax rate change on NI (net income) and DTL — **year1**year2**year3**year4** Tax rate 40% 40% 30% 30% how and when is the change in tax rate applied to DTL ? I have seen lot questions where change in beginning of year 3 is reflected on accumulated DTL for year 1 and year 2. For example for tax reporting at end of year 2, the DTL and NI are adjusted for changes in rates in year 3. why ? Please advise …
All tax rate changes are applied to the accumulated DTL, DTA. This is discussed in great detail in both the text and the study guides. Reason is 1. Company created the “deferred tax” buckets based on the applicable tax rate. 2. When the tax rate changes – say increased from 30% to 40% --> all the accumulated DTL, DTA now needs to reflect the new tax rate. Because in case of the DTL – when the item reverses in the future, the new tax rate would be applicable. So the increase in the tax rate (e.g. say accumulated DTL was 30K @ 30% --> this would change to 40K @ 40%. The new 10K would flow into the Tax Expense for the period. because Tax Expense = Tax Payable + Delta DTL - Delta DTA. so the delta DTL of 10K would now have to be paid extra. If you had a accumulated DTA of 15K --> This would now change to 20K @ 40%. The 5K would become a saving on your tax expense. Same kind of analysis would have to occur when the tax rate reduces from say 50% to 40%. In this case the DTL would result in a saving, the DTA would result in an increase. Once the Tax Expense on the Income statement – increases or decreases because of the delta DTL, Delta DTA due to the tax change – the Net Income would correspondingly increase or decrease, depending on the numbers themselves. Also be aware of the two fold nature of the tax rate change 1. This causes the thus far accumulated DTA, DTL to change. 2. The new DTL, DTA for the current year in which the tax rate changed (e.g. Year 3 above) would have to be calculated at the new tax rate. Hope this explanation helps. Use the search function to some time in November, when there were a lot of problems solved by the folks currently studying for L2 – and there was a lot of commentary – which helped a lot of us in AF for the Dec exam. CP
Thanks CPK… I have gone through those discussions back in November. But my real problem was why change of tax rate in year 3 is reflected on DTL and DTA being reported at end of year 2. While NI at end of year 2 is calculated using the tax rate in the same year (which makes sense). What about reporting at year 1 end. Will DTL calculation reflect future expected change in tax rate. I vaguely remember reading somewhere that DTL and DTA’s are always caluclated based on expected future tax rates. Is it correct ? Thanks a lot for all your help !!
I can only think of ‘bcos the rule says so’. Also read the following posting from Chebychev before the Dec exam http://www.analystforum.com/phorums/read.php?11,636583,636617#msg-636617
DTA/DTLs are always calculated based on enacted laws. So if in year 1 the tax rate is 30%, that’s the rate that you use for the current year’s calcs, and for all defered tax calcs. If in year 2 the tax law is revised and its says effective in year 4, the rates will drop to 25%, its at that point when you need to revalue your defered tax asset and liability accounts (for amounts that reverse in years 4 and later - you don’t revalue the DTA/DTL for year 3 sicne it will still be 30% that year). That revaluation has to have an offsetting adjustment, which is the catch-up that you net against the current period’s income tax expense.
thanks super and cpk. One last clarification. If rate changes effective in 3rd year. Would there be any adjustments on accumulated DTL/DTA at EOY 1 ? or adjustment will be made only on portion expected to reverse at EOY 1 ? I never came across any question in qbank reagrding tht. Most of the Qs required adjustment computation just a year before when the rates have changed. Can someone please post an example ? Thanks Harry EOY=end of year
thunder the adjustment to DTL and DTA would happen in Year 3 (or to be more generic, in the year during which the tax rate changes are applicable) only. There is an example I remember in the exercise problems on Schweser that dealt with this last year, and it was also discussed on the forum, very definitely. If you want I can look up the problem and post it tomorrow, let me know. CP
please if you can cpk !! meantime I’ll have more questions from capital leasing too 
… thanks a lot !!
please if you can cpk !! meantime I’ll have more questions from capital leasing too thanks a lot !!
Here is one example: A company purchased a new pizza oven directly from Italy for $12,675. It will work for 5 years and has no salvage value. The tax rate is 41 percent, and annual revenues are constant at $7,192. For financial reporting, the straight-line depreciation method is used, but for tax purposes depreciation is accelerated to 35 percent in years 1 and 2, and 30 percent in year 3. For purposes of this exercise ignore all expenses other than depreciation. Assume the tax rate for years 4 and 5 changed from 41 percent to 31 percent. What will be the deferred tax liability as of the end of year 3 and the resulting adjustment to net income in year 3 for financial reporting purposes due to the change in the tax rate? Deferred Tax Liability : Net Income A) $1,572 : $747 B) $1,039 : $507 C) $1,572 : $507 D) $1,039 : $747 And the solution: Choice C Tax Reporting Depr 4436 4436 3803 0 0 Fin. Reporting Depr 2535 2535 2535 2535 2535 Cumulative DTL 779 1559 2078 DTL each period = (Depr Tax - Depr FR) * .41 Since rate changes at the year 4 DTL in Year 3 end will change from 2078 to 2078 * .31/.41 = 1571 Difference in NI because of this change = 2078 - 1571 = 507 CP