Most companies use straight-line depreciation for financial statements and accelerated depreciation for income tax returns. So this means they have more taxes in the P&L statement as compared to the actual taxes paid. So they created a deferred tax liability for this because eventually they do have to pay this tax. When they do pay this extra tax, at that time, the DTL in the books will progressively reduce. This I fully understand.
However, I don’t understand creation of deferred tax liability for goodwill. Goodwill can be amortized in tax returns so companies pay less tax. Goodwill cannot be amortized in accounting statements. So they will have more taxes in the P&L statement as compared to actual taxes paid. However, these aren’t taxes which will need to get paid later (unlike the accelerated depreciation case). So what is the basis for creating the Deferred Tax Liability? When will liability be decreased progressively?
I did miss that you mentioned that it isn’t amortized on the financial statements; sorry about that.
You’re talking about permanent differences between tax returns and income statements; permanent differences don’t give rise to deferred tax assets or deferred tax liabilities.
I also though tthat amortization should not give rise to DTL but McKinsey’s book indicates otherwise. Hence the question
From McKinsey’s Valuation, 6th Edition Chapeter “REORGANIZING THE ACCOUNTING STATEMENTS: IN PRACTICE” Page 179
To evaluate goodwill and acquired intangibles properly, you need to make two adjustments. First, subtract deferred tax liabilities related to the amortization of acquired intangibles. Why? When amortization is not tax deductible, the accountants create a deferred tax liability at the time of the acquisition that is drawn down over the amortization period (since reported taxes will be lower than actual taxes). To counterbalance the liability, acquired intangibles are artificially increased by a corresponding amount, even though no cash was laid out.
While purchase price allocation, after allocating purchase price to book values of assets, excess purchase price is first allocated to any asset write ups to fair market values for book purposes only but not for the tax purposes. Hence incremental depreciation arises for accounting purpose results in lower NI and lower taxes while no change in NI and taxes for tax purposes. Because of this tax difference DTL is created (tax rate x change in asset values to market values). After which excess purchase price is then allocated to newly created DTL before arriving to Goodwill figure. Note that since accounting depreciation is greater in such a case, DTL will be negative and in fact increases the Goodwill amount created in the acquisition transaction!
Sorry for coming back to this - I am a little confused again. The write up creates a permanent tax difference between Book & actual taxes. I thought permanent differences don’t create DTAs or DTLs - only temporary differences do. So how come a DTL is created in the above case?
In your earlier comment, you wrote “_excess purchase price is first allocated to any asset write ups to fair market values for book purposes only but not for the tax purposes _”
I understood this to mean that asset writeups are ignored in the tax returns.
May be I misunderstood? Can you please clarify - if it’s not for tax purpose - how does it cause a temporary tax difference?
Also, from the original McKinsey paragraph I quoted earlier
_ When amortization is not tax deductible , the accountants create a deferred tax liability at the time of the acquisition that is drawn down over the amortization period (since reported taxes will be lower than actual taxes). To counterbalance the liability, acquired intangibles are artificially increased by a corresponding amount, even though no cash was laid out._
If the Amortization is not tax deductible but is deductible in the book, then it won’t be a timing difference, right? It would be a permanent difference.
However, unlike in Straight Line vs Accerelated Depreciation where the end tax is going to be the same, here it’s not the case - right?
I mean the tax savings on book due to the increased amortization may not match the increased tax during sale of asset because that can vary based on the price at which the asset is sold. So how will that be reconciled?
Is this a real example of permanent difference or a made up one? I mean does tax exempt interest need to be shown in the book as a taxable interest as per GAAP?
The amount of the DTL / DTA will depend only on the difference between the carrying value for financial purposes and the carrying value for tax purposes. It will resolve itself no matter what the price of the asset is when they dispose of it.
For example, suppose that you have an asset valued at $100, and that the tax rate is 30%. Suppose that you write it up to $150 for financial purposes, but not for tax purposes, creating a DTL of $15 (= $50 × 30%).
If you later sell the asset for:
$100, then you have a $50 loss on the income statement but $0 for taxes. The financial loss reduces tax expense by $15, offsetting the DTL.
$150, then you have $0 on the income statement, but a taxable gain of $50. That increases taxes payable by $15, offsetting the DTL.
$120, then you have a $30 loss on the income statement, but a $20 taxable gain. The financial loss reduces tax expense by $9 and increases taxes payable by $6, offsetting the DTL.
As you can see, the value when you dispose of the asset doesn’t matter.