Why does DTL ‘turn’ to Equity when you know the DTL won’t reverse? Can anyone explain the mechanics of this?
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It should be considered equity if it is not expected to reverse. If the “liability” will never be realized due to continuous expansion, it is not really a liability, it is equity (benefit to the company in the form of positive CF that would have otherwise been spent on taxes). ie The offset to the additional cash (Asset) should be to Equity instead of Liabilities.
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McLeod, thanks for the info. What part of equity does it turn into?
it doesn’t turn into equity, or any specific part of equity. Assets are sourced (as the equation says) from borrowed money (liabilities) or money contributed by owners (equity) Liabilities are amounts due that ultimately are expected to be paid. If you have a liability that that due to the nature of a business will never get paid it starts to take on many of the characteristics of equity and so you ANALYTICALLY treat it as if it was equity. You do that for ratio purposes. It doesn’t get turned into any specific equity line or component of equity. (tho many will say lump it into retained earnings if you don’t just show a single line for equity in your analysis)
Question Is their essentially anything considered as continuous expansion. Cause eventually every business will stop expanding so is there like a time limit that people look at before they consider whether or not to consider DTL equity
hopeful231 Wrote: ------------------------------------------------------- > Question > Is their essentially anything considered as > continuous expansion. > Cause eventually every business will stop > expanding so is there like a time limit that > people look at before they consider whether or not > to consider DTL equity I’m not sure but I’d say this is a jugdment call. It may depend on the industry the business is or other variables. I don’t think there’s a general time limit for this.
I’m still trying to understand the “reversal” part. I’ll quote from the Secret Sauce, and I need some help: “…if a company’s assets are growing, it may be the case that a DTL is not expected to reverse in the foreseeable future; an analyst should treat this “liability” as additional equity. If the liability is expected to reverse, the liability should be adjusted to present value terms to the extent practicable…” Can someone explain how expansion/asset growth makes DTL non-reverseable???
Could be a section of the company that is not doing well but the rest of the company is expanding. Like if Time Warner took off but AOL is still in the toliet.
Different depreciation methods: using straight line for the IS and an accelerated method for the tax return: on the tax return, you would consume your deduction sooner (accelerated), and later down the life of the asset you’ll have smaller deductions, therefore you’ll have higher future taxes => a deferred liability. As the company expands and buys more assets, therefore increases deduction currently (accelerated) on taxes, and increases the liability later => growing deferred liabilities. If deferred liabilities are constantly growing or remain stable, you should consider DTL as equity for analysis (a sort of equity that the government has in your company).
So when it talks about not being reversed, it’s in regards to the depreciation of new assets?!?!?
soxboys21 Wrote: ------------------------------------------------------- > So when it talks about not being reversed, it’s in > regards to the depreciation of new assets??? Perpetual asset growth is the most likely scenario that would result in non-reversal of DTLs. However, there are other scenarios that could create such a situation e.g. congress may grant an industry tax deferral of a specific cost. This deferral period may expire for example in 5 or 10 years, at which point, per congressional vote, it may or may not become permanent i.e. no reversal. In the short term the firm may be required report a DTL in anticipation of reversal (if the deferral period ends), however, the analyst will have to make an assumption about the probability that the deferral will become permanent and whether to subsequently treat the DTL as equity for analytical purposes. The point is depreciation is not the only situation where DTLs are created and possibly will not reverse. However, from a pedagogical perspective, it is the most practical example.
Super I - thanx!, that’s helpful
I might sound like an amateur here but is IRS ok with the fact they never gonna get their money? (that’s my understanding of “never gonna be reversed”)
As long as your company increases continuously and by that pays more taxes, gives jobs, and keeps people occupied, i guess IRS doesn’t mind owning some equity in your company.
good point
I think some of you misunderstand…you don’t actually “owe” the DTL to the government…the DTL is an accounting construct…