Liabilities - Tax Deferred Liabilities
A deferred tax liability occurs when taxable income is smaller than the income reported on the income statements. This is a result of the accounting difference of certain income and expense accounts. This is only a temporary difference. The most common reason behind deferred tax liability is the use of different depreciation methods for financial reporting and the IRS.
A deferred tax asset is the opposite of a deferred tax liability. Deferred tax assets are reductions in future taxes payable, because the company has already paid the taxes on book income to be recognized in the future (like a prepaid tax).
Deferred tax liability
- Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary differences x enacted tax rate).
- Scheduling of future taxable amounts.
Deferred tax asset
- Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary difference x enacted tax rate).
- Scheduling of deductible amounts.
The Liability Method of Accounting for Deferred Taxes.
There are several different tax-allocation methods:
The amount of deferred income tax is based on tax rates in effect when temporary differences originate. It is an income-statement-oriented approach. It emphasizes proper matching of expenses with revenues in the period when a temporary difference originates. Finally, it is not acceptable under GAAP.
The amount of deferred income tax is based on the tax rates expected to be in effect during the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach. It emphasizes the usefulness of financial statements in evaluating financial position and predicting future cash flows. Most importantly, it is the only method accepted by GAAP.
Implications of Valuation Allocation
A deferred tax asset is a reduction in future cash outflow (taxes to be paid). But, the asset has value only if the firm expects to pay taxes in the future. For example, an Net Operating Loss (NOL) carry-forward is worthless if the firm does not expect to have positive taxable income for the next 20 years. Since accounting is conservative, firms must reduce the value of their deferred tax assets by a deferred tax-asset valuation allowance. This is a contra-asset account CR (credit) balance on the balance sheet - just like accumulated depreciation or the allowance for uncollectible accounts) that reduces the deferred tax asset to its expected realizable value.
Increasing the valuation allowance increases deferred income tax expense; decreasing the allowance does the opposite. Changes in the allowance affect income tax expense. Although the need for an allowance is subjective, its existence and magnitude reveals management's expectation of future earnings. Management can use changes in the allowance to "manipulate" NI by affecting income tax expense. Analysts should scrutinize these types of changes.
Deferred Tax Liability Treatment
If a tax asset or liability is simply the result of a timing difference that is expected to reverse in the future, it is best classified as an asset or liability. But if it is not expected to reverse in the future, it is best qualified as equity.
Deferred tax liabilities that should be treated as equity in the following circumstances:
- A company has created a deferred tax liability because it used accelerated depreciation for tax purposes and not for financial-reporting purposes. If the company expects to continue purchasing equipment indefinitely, it is unlikely that the reversal will take place, and, as such it should be considered as equity. But if the company stops growing its operations, then we can expect this deferred liability to materialize, and it should be considered a true liability.
- An analyst determines that the deferred tax liability is unlikely to be realized for other reasons; the liability should then be reclassified as stockholders' equity.
In some cases the deferred tax liability should not be added to stockholders' equity, but should be ignored as a liability.
Career Education & ResourcesLearn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
ProfessionalsBecome one of the elite who pass these exams by using these simple study methods.
Financial AdvisorsPotential financial advisors, analysts or asset managers have many credentials and degrees from which to choose. Here's a look at the CFA vs. the MBA.
Your PracticeIf you want to become an RIA all you have to do is pay a $165 fee to the SEC and pass the Series 65 exam. Is the bar set too low?
ProfessionalsTo pass the CFA exam, get organized, develop an effective study program and review.
ProfessionalsHere are some pros and cons to consider before you take the CFA charter plunge.
ProfessionalsFinding that first finance job is not easy, but these five tips can boost your chances even before you graduate.
ProfessionalsThe right accounting certification can open the doors of opportunity.
ProfessionalsA financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
Career Education & ResourcesRead about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
A professional designation given by the CFA Institute (formerly ...
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A financial professional who studies various industries and companies, ...
Understand the differences between a Chartered Financial Analyst and a Certified Financial Planner. Learn how each approaches ... Read Answer >>
Understand what it means to hold the Chartered Financial Analyst designation. Learn how a candidate can work to become a ... Read Answer >>
Understand what types of positions a Chartered Financial Analyst can hold. Learn what is available to those who have only ... Read Answer >>
Learn who benefits most when expenses are prepaid. Individuals and businesses often make payments, such as rent or insurance, ... Read Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Answer >>