Reading 35

Accounting rules (IFRS/U.S. GAAP) often differ from tax laws → I/S tax expense ≠ actual taxes owed.

Tax-Return Terminology

• Taxable income — income subject to tax (per tax return).
• Taxes payable — tax liability from taxable income (= "current tax expense" — not the same as income tax expense).
• Income tax paid — actual cash flow for taxes (incl. prior-period adjustments).
• Tax loss carryforward — past loss used to reduce future taxable income → may create DTA.
• Tax base — net amount of asset/liability for tax purposes.

Financial-Reporting Terminology

• Accounting profit — pretax financial income (= income before tax = EBT).
• Income tax expense — I/S expense including taxes payable + Δ DTL − Δ DTA.
• DTL — B/S liability from I/S tax expense > taxes payable; expected future cash outflows.
• DTA — B/S asset from taxes payable > I/S tax expense; expected future tax savings.
• Valuation allowance — U.S. GAAP contra account reducing DTA when realization is doubtful.
• Carrying value — net B/S value.
• Permanent difference — no future reversal; does not create DTA/DTL.
• Temporary difference — between tax base and carrying value; creates DTA/DTL.

Deferred Tax Liabilities (DTLs)

I/S tax expense > taxes payable. Created when:

• Revenues/gains recognized in I/S before taxable
• Expenses/losses tax-deductible before recognized in I/S

"Taxable temporary differences" — firm will pay more tax when they reverse. Classic example: accelerated depreciation for tax + SL for financials.

Deferred Tax Assets (DTAs)

Taxes payable > I/S tax expense. Created when:

• Revenues/gains taxable before recognized in I/S (e.g., unearned revenue)
• Expenses/losses recognized in I/S before tax-deductible (warranty, bad debt provisions, post-employment benefits)
• Tax loss carryforwards available

"Deductible temporary differences" — provide future tax savings.

Permanent Differences

Will not reverse. Don't create DTA/DTL. Examples: tax-exempt municipal-bond interest, nondeductible key-officer life insurance, tax credits. Cause effective tax rate ≠ statutory rate.

Tax Expense Formula

\[\text{Income tax expense} = \text{Taxes payable} + \Delta\text{DTL} - \Delta\text{DTA}\]

↑DTL → ↑tax expense; ↑DTA → ↓tax expense.

Changes in Enacted Tax Rate

Existing DTAs and DTLs are remeasured at the new rate so they reverse to zero on the future reversal date. Tax-rate increase → both ↑; rate cut → both ↓. Adjustment flows through tax expense.

For a difference to be temporary, the total amount through I/S and tax return over the life of the asset/liability must be the same.

Realizability of DTAs

Neither DTA nor DTL is discounted on the B/S. DTAs are assessed each B/S date for likelihood of realization (need sufficient future taxable income).

• IFRS: directly reduce DTA when realization uncertain.
• U.S. GAAP: keep gross DTA but add a valuation allowance (contra-account). Creating/increasing the allowance increases tax expense, decreases NI.

Management's discretion → potential earnings management. Look at order backlogs, contracts, history of using NOLs.

Treatment for Analytical Purposes

• If a DTL is expected to reverse → treat as liability.
• If not expected to reverse in foreseeable future (e.g., continued growth in capex) → treat as equity (subtract from DTL, add to equity).

Reported tax expense often differs from pretax income × statutory rate due to:

• Different tax rates in different jurisdictions
• Permanent differences (tax credits, exempt income, nondeductible expenses, capital-gain rate differentials)
• Changes in tax rates and legislation
• Tax holidays

Temporary differences typically do not make statutory and effective rates differ.

Three tax rates:

1. Statutory tax rate — corporate rate in domicile country.
2. \[\text{Effective tax rate} = \dfrac{\text{income tax expense}}{\text{pretax income}}\]
3. \[\text{Cash tax rate} = \dfrac{\text{cash taxes paid}}{\text{pretax income}}\]

Reconciliation between statutory and effective is required in footnotes.

For forecasting trends, focus on continuous reconciliation items (different country rates, tax-exempt income, nondeductibles); be aware of sporadic items (large asset sales, tax-holiday savings). Check tax-holiday termination dates and any future repayment requirements.

Common temporary differences:

• Accelerated tax depreciation → DTL. Check growth and capex.
• Impairments → DTA (I/S charge now; tax deduction only on sale/disposal).
• Restructuring → DTA (I/S charge at announcement; tax deduction when paid).
• Inventory LIFO: U.S. firms must use LIFO for tax if used for books → no temporary difference. Other countries may have temp differences.
• Post-employment benefits, deferred comp → DTA.
• Unrealized gains/losses on AFS securities → deferred tax adjustment in equity (no DTL on B/S yet).

Required disclosures:

• DTL, DTA, valuation allowance, change in allowance
• Unrecognized DTL on undistributed subsidiary/joint-venture earnings
• Current-year tax effect of each type of temporary difference
• Components of income tax expense
• Reconciliation of reported tax expense vs. statutory rate
• Tax loss carryforwards and credits