Income Taxes

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Topics

• Introduction
• Differences between Accounting Profit and Taxable Income
  • Taxable Temporary Differences
  • Deductible Temporary Differences
  • Taxable and Deductible Temporary Differences
  • Permanent Differences
  • Tax Expense
• Deferred Tax Assets and Liabilities
  • Realizability of Deferred Tax Assets
• Corporate Income Tax Rates
• Presentation and Disclosure

Table of Contents

Introduction

Deferred tax assets and liabilities are created because of differences between how and when transactions are recognized for financial reporting purposes relative to tax reporting.

Differences Between Accounting Profit and Taxable Income

Some common terms related to financial reporting are defined below:

• Accounting profit: It is also known as pretax income or earnings before tax (EBT) and appears on the income statement. In simple terms, this is before taxes are calculated. Accounting profit is based on accounting standards.
• Income tax expense: Tax expense, or tax benefit, appears on a company’s income statement, which is created using financial reporting standards. It is calculated based on the accounting profit (profit before tax) using a given tax rate.
• Carrying value: The net value of an asset or liability reported on the balance sheet according to accounting principles.

Some common terms related to tax reporting are defined below:

• Taxable income: It is the portion of income that is subject to income taxes under the tax laws where the company is operating.
• Income tax payable: Income tax payable is calculated on a company’s taxable income using the applicable tax rate. This is the amount that is generally paid to the tax authorities and it appears on the balance sheet. Since it results in a cash outflow, firms minimize taxes payable by showing higher expenses and lower taxable income.
• Tax Base of an Asset: Tax base of an asset is the amount that will be deductible for tax purposes in future periods as economic benefits are realized. It is used to calculate tax payable and is analogous to the carrying amount (net book value) concept. Tax base is the amount allocated to asset for tax purposes whereas carrying amount is based on accounting principles.

Why are accounting profit and taxable income different?

Both report income before deducting tax expense, yet they are different because accounting profit is based on accrual method of accounting (revenues reported when earned and expenses when incurred). On the other hand, taxable income is usually based on cash-basis accounting (revenue recognized when cash is collected and expense reported when cash is paid).

Accounting profit and taxable income differ when:

• Revenues and expenses are recognized in one period for accounting purposes and a different period for tax purposes.
• The carrying amount and tax base of assets/liabilities differ.
• Gain/loss of assets/liabilities in the income statement is different than tax return.
• Some revenues/expenses recognized in the income statement are not considered for tax purposes.

Deferred Tax Assets and Liabilities

Deferred Tax Liabilities

Deferred tax liability (DTL) occurs when income tax expense (financial accounting) is greater than income tax payable. It is a liability because we pay less tax now, thereby creating a liability or an obligation to pay more in the future. Since the tax will be paid later, it is deferred.

Such a situation can happen when:

• Revenue is recognized on income statement before being included on tax return (accrued/unbilled revenue).
• Expenses are tax deductible before being recognized on income statement.

Deferred Tax Assets

Deferred tax assets (DTA) arise when income tax payable is temporarily greater than income tax expense. In other words, taxable income is higher than accounting profit. Since tax is paid in advance, it is considered an asset; it can be viewed as a prepaid expense.

Such a situation can happen when:

• Revenue is taxed before being recognized on income statement (unearned revenue).
• Expense is recognized on the income statement before being tax deductible.

Any deferred tax asset or liability is the result of a temporary difference that is expected to reverse in the future. Deferred tax liability reverses when taxes are paid in the future resulting in cash outflows. Similarly, deferred tax asset reverses when tax benefits are realized in the future resulting in lower cash outflows.

Realizability of Deferred Tax Assets

A DTA may be created only if the company expects to be able to realize the economic benefit of the deferred tax asset in the future.

If it is uncertain whether future economic benefits will be realized from a temporary difference (for example, if the company is being liquidated), the temporary difference will not result in the recognition of a DTA.

If a DTA was previously recognized, but now there is sufficient doubt about whether the economic benefits will be realized, then, under IFRS, the DTA would be reversed. Under US GAAP, a DTA is reduced by creating a valuation allowance (a contra account).

Tax Base of an Asset

Asset tax base is the value of an asset according to tax rules and is used to calculate tax payable. Asset tax base is analogous to carrying amount (net book value).

Link between Tax Base and DTL

Deferred Tax Liability = (Carrying Amount – Tax Base) $\times$ Tax Rate

• If the carrying amount and tax base are the same then DTL is 0.
• If the carrying amount is greater than the tax base, then there will be a deferred tax liability.
• If carrying amount is less than the tax base, then there will be a deferred tax asset.

Both DTL and DTA should be measured at the tax rate which is expected to apply when the liability is settled (reversed).

Link between Income Tax Expense, Tax Payable, and DTL

Income Tax Expense = Income Tax Payable + Change in Net DTL - Change in Net DTA

where

• Change in Net DTL = Ending Value of Net DTL – Beginning Value of Net DTL
• Change in Net DTA = Ending Value of Net DTA – Beginning Value of Net DTA

Determining the Tax Base of an Asset/Liability

Asset tax base is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized. The tax base of a liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future.

Temporary and Permanent Differences between Taxable and Accounting Profit

Permanent differences are differences between tax and financial reporting of revenue (expenses) that will not be reversed at some future date. These differences do not give rise to DTLs and DTAs.

Examples include:

• Income or expense items not allowed by tax legislation. One example that leads to a permanent difference is when a company incurs a penalty or fine on breaking a civil or criminal law.
• Tax credits for some expenditures that directly reduce taxes.

As no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s effective tax rate and statutory tax rate.

Temporary differences between taxable and accounting profit arise from a difference between the tax base and the carrying amount of assets and liabilities. DTLs and DTAs are only created if there is temporary difference which is expected to reverse in the future.

Corporate Income Tax Rates

There are three types of tax rates that are relevant to analysts:

• Statutory tax rate: The tax rate established by law.
• Effective tax rate: Tax amount reported on the income-tax statement divided by the pre-tax income.
• ==Cash tax rate: ==Tax actually paid divided by pre-tax income.

Differences between cash taxes and reported taxes occur due to timing differences between accounting and tax calculations. These differences are reflected as a deferred tax asset or a deferred tax liability on the balance sheet.

Statutory tax rate and effective tax rates can be different for a number of reasons, such as tax credits, adjustments to previous years, withholding tax on dividends, etc.

The effective tax rate of a company that operates in multiple countries is the weighted average of the effective tax rates in each country. If the company is expected to report higher profits in a country with a high tax rate and lower profits in a country with a low tax rate, then its effective tax rate will increase. The effective tax rate is used to forecast earnings on the income statement and the cash tax rate is used to forecast cash flows.

To improve the quality of forecasts, the analyst should adjust for one-time events. Information provided in the notes to the financial statements can be used to identify such events.

If a company’s effective tax rates are consistently lower than statutory rates or the effective tax rates reported by competitors, then analysts must scrutinize the reason when forecasting tax expense.

Presentation and Disclosure

Measurement of DTL

The treatment of deferred tax liability is discussed below:

• DTL should be classified as debt if the liability is expected to reverse in the future when taxes are paid.
• If it is determined that a DTL will not be reversed, then DTL should be reduced and the amount by which it is reduced should be treated as equity. There is no cash outflow expected in the future.

• If there is uncertainty about the timing and amount of tax payments, analysts should treat DTLs as neither liabilities nor equity.

Measurement of DTA and Valuation Allowance

If it is determined that the DTA will not be realized because of insufficient future taxable income to recover the tax asset, then the DTA must be reduced.

Under US GAAP, a DTA is reduced by creating a valuation allowance (a contra account). DTA and net income decrease in the period in which a valuation allowance is established. DTA can be revalued upward by decreasing the valuation allowance which would increase earnings.

Changes in Income Tax Rates

The measurement of deferred tax assets/liabilities is based on current tax law. But, if there is any subsequent change in tax laws or new income tax rates, then existing deferred tax assets and liabilities must be adjusted to reflect those changes. When income tax rate changes, deferred tax assets and liabilities are calculated based on the new tax rate.

Relationship between tax rate, DTL, and DTA

• Decrease in tax rate reduces both deferred tax liabilities and deferred tax assets.
• Increase in tax rate increases both deferred tax liabilities and deferred tax assets.

Solution

1. Company is more likely to benefit from the deferred tax asset. This is probably because the company expects higher profitability in the future.
2. Tax expense to be lower and the net income to be higher.
3. Reduces both the deferred tax asset and deferred tax liability. Since the company has a net deferred tax asset, a reduction in the tax rate will cause the net deferred tax asset to be lower. Consequently, the equity value will also decrease.