LM09 Income Taxes

Part 3

9. Recognition and Measurement of Current and Deferred Tax

The amount of current tax payable or refundable from tax authorities is based on the applicable tax rates at the balance sheet date. Deferred taxes should be measured at the tax rate applicable when the asset is realized or the liability is settled. In short, the tax rate at the time when the reversal in temporary difference (taxable income and profit before tax) occurs.

Let’s illustrate the current tax and deferred tax concepts with the help of a simple example. The tax applicable for Period 1 is 30% and the government has announced the tax for Period 2 will be reduced to 25%. Current tax will use 30% while deferred tax will be calculated using 25%.

All unrecognized deferred tax assets and liabilities must be reassessed on the appropriate balance sheet date and should be measured against their probable future economic benefit. In the example above, at the end of period 1 the profitability in future, and beyond period 2, must be assessed to see if DTA/DTL can be recognized.

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. Assume for Period 1 in the example above there is a DTL because of the different depreciation methods used for accounting and tax reporting purposes. Also assume the company is expected to grow at a rate of 30% in the foreseeable future, making the depreciation amounts higher with no reversal in sight. In such cases, the liability will be treated as equity.
• 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.

Instructor’s Note

For the exam, you may think of valuation allowance in terms of depreciation. When depreciation expense goes up, net income comes down. Similarly, if valuation allowance goes up, net income comes down. Depreciation is shown as an expense on the income statement. Similarly, an increase in valuation allowance is shown as a loss on the income statement.

Example

Rocky Inc. a US-based company, reports the following information:

1. What does the decrease in valuation allowance imply about future profitability?
2. How does the reduction in valuation allowance impact income tax expense and net income?
3. What is the impact on deferred taxes if the tax rate is reduced to 35%?

Solution to 1:

The decrease in valuation allowance implies that the company is more likely to benefit from the deferred tax asset. This is probably because the company expects higher profitability in the future.

Solution to 2:

The reduction in valuation allowance causes the tax expense to be lower and the net income to be higher.

Solution to 3:

If the tax rate is reduced from 40% to 35% that 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.

Instructor’s Note

If the valuation allowance is equal to the deferred tax asset, this implies that a company expects no taxable income prior to the expiration of the deferred tax asset.

When a company decreases the valuation allowance, it implies a higher probability that the deferred tax asset will benefit the company.

10. Presentation and Disclosure

Key points of this section are listed below:

• Deferred tax assets and liabilities must be disclosed.
• Under IFRS, deferred tax assets or liabilities are classified as non-current.
• Under US GAAP, the classification (current versus non-current) is based on the underlying asset or liability.
• The deferred tax asset and deferred tax liability amount should be shown on the balance sheet. But, details of how we arrive at the number should be disclosed in the footnotes.

Here is an example of what might be disclosed in the footnotes:

Deferred tax assets:

Accrued Expenses                             10

Tax loss carry forward                     11

Deferred tax assets                           21

Valuation allowance                          -1

Net deferred tax asset                      20

Deferred tax liabilities:

Depreciation                                      30

Retirement plans                               15

Deferred tax liabilities                      45

11. Comparison of US GAAP and IFRS

Note: This section is not very testable.

Please see Exhibit 5 from the curriculum. It summarizes the key similarities and differences between IFRS and US GAAP.

Some differences include:

• Deferred tax recognition for goodwill
• Deferred tax recognition with respect to investments in subsidiaries (both foreign and domestic)
• Tax rate to be used for preparing numerical reconciliation
• Use of a valuation allowance

Share on :