Recognition and Measurement of Current and Deferred Tax. Current taxes payable
or recoverable are based on current tax rates; deferred taxes should be measured
at the tax rate that is expected to apply when the asset is realized or the
liability is settled. This is a fairly obvious concept, but I will illustrate it
anyway. Let's say you have two periods; period 1 and period 2. The tax rate
in this period is 40% and the government has already announced that the tax rate
in the next period is 30%. The tax payable for this period will be based on
the current rate of 40%. The deferred tax assets that will be realized
over here need to be calculated based on the 30% rate.
Similarly deferred tax liabilities need to be recognized or calculated based on
the rate which will be in effect when the liability is settled. All
unrecognized deferred tax assets and liabilities must be reassessed on the
appropriate balance sheet date and measured against their probable future
economic benefit. This again is a fairly straightforward point, where let's say a
company is recording a deferred tax asset at the end of period 1. Now when
recording the deferred tax assets the company needs to assess whether the
deferred tax assets of say 15 is still reasonable or not. Just as an example if
the profitability and the foreseeable future is going to be very low or the
company is actually expecting losses then we need to make an adjustment
because this deferred tax assets might not be realized so given the situation
at this point in time and given our assessment of what
is likely to happen we have to adjust the deferred tax asset
accordingly, and the same concept applies with deferred tax liabilities. From a
testability perspective a couple of items that I want to highlight. Let's say
you come to this point and there is a certain deferred tax liability which you
do not believe will be reversed anytime soon. For example we might have a
deferred tax liability because of straight line depreciation versus
accelerated depreciation but you foresee that the company will be growing for the
next few years and because of that the depreciation amounts will continue to
increase and we will not have a reversal. If that is the case then as an analyst
what you can do is take the deferred tax liability and categorize that as equity.
Many people get confused about this but I'll give you a silly little example
that will help you understand why we do this. Let's say that you take a loan from
your parents and after a few months it becomes obvious to you and your parents
that this loan is not going to be returned so effectively what you can
then do is treat that loan as your equity because it's not going to be
returned. The same concept applies over here, something is shown as a liability
but given the current situation this liability is not going to be paid off,
it's not going to be settled so essentially that liability can be
treated as equity. Another testable point, if there is uncertainty about the timing
and amount of tax payments then analysts should treat deferred tax liabilities as
neither liability nor equity so in the ratio analysis that you do, you
effectively remove this.
Measurement of DTA and Valuation Allowance. If a deferred tax assets will
not be realized because of insufficient future taxable income to recover the tax
asset then the DTA must be reduced. I have alluded to this earlier that let's
say you have period 1 .At the end of period 1 ,you have a certain deferred
tax asset but you do not think there will be sufficient profitability in the next
few years for you to realize this deferred tax asset, then this deferred
tax assets must be reduced. Under US GAAP what we need to do is the following; we
have a deferred tax asset, Let's say the amount is 100, to
reduce the deferred tax assets we use a contra account called the valuation
allowance which is a lot like depreciation. If you want to reduce your
deferred tax asset you increase the valuation allowance, let's say the
valuation allowance is initially 0, you increase that to 20. Since this is a
contra account it reduces the value of the asset, the deferred tax assets in
this case, so our deferred tax assets becomes 80. Next year for example we are
even less sure about profitability then we can increase our valuation allowance
to 30 which means that the net deferred tax assets comes down to 70. So notice as
I said earlier this is a lot like depreciation where depreciation is a
contra account that goes with your long term tangible assets, similarly valuation
allowance is what goes with deferred tax assets. If you get a question on
valuation allowance on the exam you can think of it in terms of depreciation.
Notice that if depreciation goes up that means that your income comes down,
similarly if valuation goes up that means that your net income
comes down. Depreciation is shown as expense on the income statement so if a
company starts with accumulated depreciation of 10, from 10 the
accumulated depreciation goes to 20 then that difference of 10 shows up as
a depreciation expense. Similarly if you have a valuation allowance of 20, from 20
this goes to 30 the difference of 10 shows up as a loss on the income
statement. So again the treatment of valuation allowance and depreciation is
the same. I am telling you this because people generally understand depreciation
and do not get confused when they see a depreciation oriented question. On the
other hand valuation allowance is not so familiar so when you see a question with
valuation allowance you might get confused to overcome that confusion just
solve the problem as if you are working with depreciation rather than valuation
allowance. Here is another sort of question that you can get with valuation
allowance so do this before looking at the solution. With questions like this it
is important to organize your data based on years. What's happening with
valuation allowance is that it is coming down even though your deferred tax asset
is going up. Valuation allowance coming down is a positive sign this means that
expectations of future earning power has increased.
If expectations of future earnings power had decreased then we would be
increasing our valuation allowance which would be reducing the deferred tax asset.
Presentation and Disclosure. This is a very long-winded segment in the
curriculum. What I will do is highlight some of the most
important points and then also illustrate how some of the information
is presented in the sorts of questions that you might get in terms of
presentation and disclosure. One obvious item is that companies are required to
disclose the deferred tax assets and deferred tax liabilities. The basic
number needs to be shown on the face of the balance sheet and then details need
to be shown in the footnotes. For example, with the deferred tax assets you might
have a net value of 20 but where this 20 is coming from needs to be shown in the
footnotes, for example, here with deferred tax assets we might have accrued
expense is, 10, so that's one component. Tax loss carry forward is also contributing
to your deferred tax asset, then we have a valuation allowance of 1 and your net
deferred tax asset is 20. With deferred tax liabilities, you might have a situation
like this where part of the deferred tax liability is coming because of the
difference between straight line and accelerated depreciation, part might be
coming because of retirement plans and so on. You don't really need to
understand the details, all you need to know is that there might be several
components that contribute to deferred tax liability. Sometimes you will see the
term 'net deferred tax liability', this generally refers to deferred tax
liability minus deferred tax assets. The term net deferred tax assets, you need to be
careful about, sometimes the curriculum uses this term as the deferred tax
assets minus the valuation allowance but at times the term net deferred tax assets
might refer to the fact that deferred tax assets are greater than deferred tax
liabilities and you are being given the difference between the two. You have to
read the question very carefully to understand the context. The next question
is where must information be presented. under IFRS, deferred tax assets or
liabilities are classified as non current. Under US GAAP, the
classification is based on the underlying asset or liability. Section 8
comparison of US GAAP and IFRS. Again the curriculum gives us a long laundry list
that is available in exhibit 5, I'll just make some high-level points because I
don't think this material is overly testable. By and large the accounting
treatment on the US GAAP and IFRS is fairly similar but there are differences.
Here are some that I want to highlight, as you have seen in earlier readings.
Upward revaluations are prohibited under US GAAP but permitted under IFRS. The
valuation allowance concept is US GAAP specific, in other words, with US GAAP as
we've discussed if you have a deferred tax assets equal to 100, if
you want to reduce this then you set up a valuation allowance
whereas with IFRS you can directly change the deferred tax asset.
Classification as current or non-current. As we've seen under IFRS, the
classification is non current whereas under US GAAP the classification depends
on the underlying asset or liability so again I think this is the core material. If
you want to be totally rigorous, you look at exhibit 5, but I can assure you if you
go through all of exhibit 5 you will find it extremely confusing but don't
worry too much, I think the probability of being tested on that material is
extremely remote because most of the items that you will see in exhibit 5
are items that you will be studying at level 2. That brings us to the end of this
reading. I will highlight the elements that you need to be most careful about.
Terminology is important. You need to understand
the terms that I have used in this lecture, so for example, accounting profit
relative to taxable income. You need to understand how deferred tax liabilities
and assets are created. You need to understand the difference between tax
base and carrying amount. This formula is important, the deferred tax liability is
carrying amount minus tax base into tax rate. If you get a negative number that
means that you have a deferred tax asset. The income tax expense is equal to
income tax payable plus change in deferred tax liability. This really
should be net deferred tax liability where we have the final value for the
net deferred tax liability minus the beginning value. As I discussed in the
lecture if you are given deferred tax liability and deferred tax assets
separately then you do change in deferred tax liability minus the change
in deferred tax asset. If there is a decrease in the income tax rate then
both your deferred tax liabilities and deferred tax assets come down. If there
is a increase in the income tax rate then your deferred tax liabilities and
assets go up. You need to understand the concept of temporary versus permanent
differences. Deferred tax assets and liabilities are only created because of
temporary differences. When you have a permanent difference then that changes
the effective tax rate and the effective tax rate is given by the income tax
expense divided by the pre-tax income, and this comes purely from the income
statement which is a financial reporting concept. As usual I will suggest that you
read the summary, review all the learning objectives. The learning objectives
mentions several ratios or the fact that you need to be aware of the impact
on ratios. Now I have not talked about ratios because I have seen
generally few questions related to ratios but as long as you understand
what's happening to defer tax assets and deferred tax liabilities and so on and
if you recognize what's happening to income tax expense then you can
automatically figure out what's happening with ratios. The examples in
this reading can be quite long and cumbersome. You can read them once if you
want, but if you find that the example is rambling too much don't get concerned
because the actual exam questions are likely to be reasonably straightforward.
Most of the practice problems are a very good indication of what you will get on
the exam so do those carefully, and then as I often say practice from other
sources also because the more you practice the better you will understand
this material and the better you will do on the final exam.