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:
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.
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.
Rocky Inc. a US-based company, reports the following information:
|Deferred tax asset||100||100|
|Deferred tax asset, net of valuation allowance||75||80|
|Deferred tax liability||70||70|
|Net deferred tax asset||5||10|
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.
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.
Key points of this section are listed below:
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:
Retirement plans 15
Deferred tax liabilities 45
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: