Financial Reporting & Analysis

Income Taxes
Reading - 31

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Accounting Profit and Taxable Income
Company reports Accounting Profits on its income statement
in accordance with the prevailing accounting standards
However the taxable income is computed based on the tax
laws o f the jurisdiction
Because of differences in guidelines for how income is
reported on a companys financial statements and how it is
measured for income tax purposes, accounting profits and
taxable income may differ.
Income Tax Method Accounting Method

Revenue 100 Revenue 100

Expenses Income Tax Expense
Expenses ( Tax) 60 50
(Accounting) = Income Tax Payable
Taxable Income 40 Taxable Income 50 + Deferred Tax
Tax Payable @ 30% 12 Tax Expense @ 30% 15
Profit 28 Profit 35
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Terms in Tax
Income Tax Method Financial Accounting
Taxable Income Accounting Profit Earning
Proportion of income Before Tax
subject to income tax Tax Expense Aggregate of
Income Tax Payable Income Tax Payable and
changes in Deferred Taxes,
Calculated as tax rate * Appears on the income
Taxable Income, shown on statement
the balance sheet Tax Payable + DTL - DTA
Income Tax Paid Actual Deferred Tax Liability
amount of taxes paid in the Balance sheet line item
period arises when Tax Payable <
Tax Expense, it is a
temporary difference
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Terms in Tax..
Income Tax Method
Tax Base The amount at
which an asset or a liability
is valued for tax purposes
Tax Loss Carry Forward
loss experienced in the
current period that may be
used to reduce future
taxable income
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Financial Accounting
Deferred Tax Asset
Balance sheet line item
arises when Tax Payable >
Tax Expense, it is a
temporary difference
Valuation Allowance
Reserve created against
deferred tax assets
Carrying Amount Amount
at which the asset or
liability is valued as per
accounting principles
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Reporting of Deferred Taxes
Both Deferred tax assets and Deferred tax liabilities are shown
on the balance sheet
According to IFRS Both DTA and DTL are classified as Non
current.
Under US GAAP Can be shown as both current and non-
current based on the classification of the underlying asset or
liability
A DTA or DTL is based on the temporary difference that results
in an excess or deficit amount paid for taxes, which a company
expects to recover in from future operations
The changes in DTL or DTA are added back /subtracted from
the income taxes payable to report the tax expense in that
period

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Reasons for differences
Revenues and expenses might be recognized in one period for
accounting purposes and a different period for tax purposes
Specific revenues and expenses might be recognized for
accounting purposes and not for tax purposes and vice versa
Carrying amount and tax base of asset and liabilities might
differ
Subject to tax rules , tax losses of prior years might be used to
reduce taxable income in later years, resulting in differences
in accounting and taxable income (tax loss carry forward)
Deductibility of gains and losses of assets and liabilities may
vary for accounting and income tax purposes

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Deferred Tax
Deferred Tax Liability
Income Tax Expense >
Accounting Expenses
Taxable Income < Accounting
Profit
Company pays less tax today
and more tax in the future
Thus it acts as a source of fund
and hence a liability
Tax Base of asset < Carrying
Value of asset (hence
offsetting entry in liabilities
side of balance sheet)
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Deferred Tax Asset
Income Tax Expense <
Accounting Expenses
Taxable Income > Accounting
Profit
Company pays more tax today
and less tax in the future
Thus it acts as a use of fund
and hence a asset
Tax Base of asset > Carrying
Value of asset (hence
offsetting entry in asset side of
balance sheet)
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 Deferred Tax Assets
When Expense is greater in the Financial Accounting v/s Income Tax Method

Financial Accounting Method Income Tax Method

2004 2005 2006 2004 2005 2006

Revenue 25,000 30,000 40,000 Revenue 25,000 30,000 40,000
Other Net Gains - - 2,000 Other Net Gains - - 2,000
Inventory changes 200 180 400 Inventory changes 200 180 400
Raw materials and consumables used (8,000) (4,000) (5,700) Raw materials and consumables used (8,000) (4,000) (5,700)
Depreciation (Depreciate in 5 years) (4,000) (4,000) (4,000) 7 Depreciation (Depreciate in 7 years) (2,857) (2,857) (2,857)
Other expenses (4,500) (5,900) (6,000) Other expenses (4,500) (5,900) (6,000)
Interest Expense (6,000) (3,000) (2,000) Interest Expense (6,000) (3,000) (2,000)
Profit Before Tax 2,700 13,280 24,700 Profit Before Tax 3,843 14,423 25,843
Income Tax Expenses @ 30% 810 3,984 7,410 Income Tax Payable @ 30% 1,153 4,327 7,753

Carrying Value Tax Base

Beginning 20,000 20,000 20,000 Beginning 20,000 20,000 20,000

Accumulated Depreciation (4,000) (8,000) (12,000) Accumulated Depreciation (2,857) (5,714) (8,571)
Ending Value 16,000 12,000 8,000 Ending Value 17,143 14,286 11,429

Change in Deferred Tax Liability - - - As expense is greater in the financial accounting the taxable income
Change in Deferred Tax Asset 343 343 343 as per financial accounting is lower than as per tax method. Thus the
actual tax to be paid will be higher.
Income Tax Payable 1,153 4,327 7,753 Balance Sheet Impact - Deferred Tax Assets will increase (as
+ Change in Deferred Tax Liability - - - Carrying Value of Asset < Tax Base)
- Change in Deferred Tax Asset (343) (343) (343) Income Statement Impact - Income Tax Expense = Income Tax
Income Tax Expense 810 3,984 7,410 Payable - Change in Deferred Tax Asset

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Deferred Tax Assets
DTA arises when
Higher expenses are charged on the financial statements than
on the tax returns
Taxable income is higher than pretax or accounting profit
Taxes payable are higher than income tax expense
A liabilitys tax base is lower than its carrying value
Accounting entries for a change in the DTA
Increase in DTA increases the total assets on the balance sheet
Increase in DTA is subtracted from taxes payable in the
calculation of income tax expense, so it increases the net
income, retained earnings and equity

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 Deferred Tax Liability
When Expense is lower in the Financial Accounting v/s Income Tax Method

Financial Accounting Method Income Tax Method

2004 2005 2006 2004 2005 2006

Revenue 25,000 30,000 40,000 Revenue 25,000 30,000 40,000
Other Net Gains - - 2,000 Other Net Gains - - 2,000
Inventory changes 200 180 400 Inventory changes 200 180 400
Raw materials and consumables used (8,000) (4,000) (5,700) Raw materials and consumables used (8,000) (4,000) (5,700)
Depreciation (Depreciate in 10 years) (2,000) (2,000) (2,000) 7 Depreciation (Depreciate in 7 years) (2,857) (2,857) (2,857)
Other expenses (4,500) (5,900) (6,000) Other expenses (4,500) (5,900) (6,000)
Interest Expense (6,000) (3,000) (2,000) Interest Expense (6,000) (3,000) (2,000)
Profit Before Tax 4,700 15,280 26,700 Profit Before Tax 3,843 14,423 25,843
Income Tax Expenses @ 30% 1,410 4,584 8,010 Income Tax Payable @ 30% 1,153 4,327 7,753

Carrying Value Tax Base

Beginning 20,000 20,000 20,000 Beginning 20,000 20,000 20,000

Accumulated Depreciation (2,000) (4,000) (6,000) Accumulated Depreciation (2,857) (5,714) (8,571)
Ending Value 18,000 16,000 14,000 Ending Value 17,143 14,286 11,429

Change in Deferred Tax Liability 257 257 257 As expense is lower in the financial accounting, the taxable income
Change in Deferred Tax Asset - - - as per financial accounting is higher than as per tax method. The
actual tax to be paid will be lower.
Income Tax Payable 1,153 4,327 7,753 Balance Sheet Impact - Deferred Tax Liability increases as (Carrying
+ Change in Deferred Tax Liability 257 257 257 Vaue of Asset > Tax Base)
- Change in Deferred Tax Asset - - - Income Statement Impact - Income Tax Expense = Income Tax
Income Tax Expense 1,410 4,584 8,010 Payable + Change in Deferred Tax Liability

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Deferred Tax Liability
DTL arises when
Higher expenses are charged on the tax return as compared to
the financial statements
Taxable income is lower than pretax or accounting profit
Taxes payable are lower than income tax expense
An assets tax base is lower than its carrying value
Accounting entries for a change in the DTL
Increase in DTL increases liabilities on the balance sheet
Increase in DTL is added to tax payable in the calculation of
income tax expense, so it decreases net income, retained
earnings and reduces owners equity

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Determining the Tax Base of An Asset
An assets tax base in the amount that will be expensed on
the income statement in the future as the economic benefits
are realized from the asset.
Example, if the historical cost of the asset is $10,000 and
$4,000 worth of accumulated depreciation had already been
charged against it on the tax returns over previous period ,
the assets tax base equals $6,000
The carrying value of the asset is simply the historical cost of
the asset minus the accumulated depreciation charged
against over previous years on the companies financial
statements

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Tax Base of Assets
Development Costs (Other Depreciable Assets)
Tax Base = Cost Accumulated tax Allowable Depreciation
Carrying Value = Cost Accumulated Accounting Depreciation
Example
ABC company depreciates tan asset worth $15000 with straight line
method for accounting purposes. Life of equipment is 5 years. For
tax accounting purposes the company uses a double declining
balance method. Find out the carrying value and tax base of the
asset at end of year 1
Solution
Carrying Value = 15000 (15000 / 5) = 12000
Tax Base = 15000 2* (15000 / 5) = 9000
Timing Difference created = $3000 will result in an increase in
Deferred Tax Liability by 3000 * Applicable Tax Rate

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Tax Base of Assets
Research & Development Costs
Tax Base = Cost Proportion of costs to be expensed per tax method
Carrying Value = 0 as R&D expenses should be expensed off
Example
ABC company incurred $5 million in research and development
costs. Applicable tax legislation requires research and development
costs to be expensed over four years. Find out the carrying value
and tax base of the asset at end of year 1
Solution
Carrying Value = 0 (R&D costs are to be expensed off as per US GAAP
and IFRS)
Tax Base = 5,000,000 5,000,000 / 4 = 3,750,000
Timing Difference created = $3,750,000 will result in an increase of
Deferred Tax Asset by 3,750,000 * Applicable Tax Rate

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Determining the Tax Base of a Liability
Two Types of liabilities result from accrual accounting
Unearned revenue
Accrued expenses
Tax base of accrued expense liability
Carrying amount of the liability on the balance sheet amounts
that have not been expensed for tax purposes yet, but can be
expensed in the future
Tax base of unearned revenue liability
Carrying value of the liability the amount of revenue that has
already been taxed and therefore will not be taxed in the future

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Tax Base of Liability
Unearned Revenues
Carrying value of the liability the amount of revenue that has
already been taxed and therefore will not be taxed in the future
Example
ABC Corp recognized $10 million for advanced rent received from a
lessee. Rent received in advance is deferred for accounting
purposes but taxed on a cash basis
Solution
Advance rent is Unearned Revenue (Liability as per accounting
treatment)
Carrying Value = $10 million
Tax Base = 0
Timing Difference created = $10 million will result in an increase
in Deferred Tax Asset by $10 million * Applicable Tax Rate

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Tax Base of Liability
Accrued Expenses
Carrying amount of the liability on the balance sheet amounts
that have not been expensed for tax purposes yet, but can be
expensed in the future
Example
ABC Corp has a warranty expense of $1000 for two years. The expenditure was not
recognized until year two, at which point it becomes tax allowable
Solution
Warranty Paid is a Accrued Expense (Liability as per accounting
treatment)
At the end of year 1
Carrying Value = $1000
Tax Base = 0
Timing Difference created = $1000 will result in an increase
in Deferred Tax Asset by $1000 * Applicable Tax Rate

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Tax Base of Liability
Example
A firm has revenues of $8000 for each of three years. Other
expenses incurred by the company are $4000 for each year.
The firm estimates the warranty expense to be 12.5% of
revenues each year. The actual expenditure of $3000 to meet
the warranty claims was not made until the third year.
Calculate the effects on deferred tax assets for each year.

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 Tax Base of Liability
Solution When Expense is lower in the Financial Accounting v/s Income Tax Method

Financial Accounting Method Income Tax Method

2004 2005 2006 2004 2005 2006

Revenue 8,000 8,000 8,000 Revenue 8,000 8,000 8,000
Warranty Expense (1,000) (1,000) (1,000) Warranty Expense - - (3,000)
Other Expenses (4,000) (4,000) (4,000) Other Expenses (4,000) (4,000) (4,000)
Profit Before Tax 3,000 3,000 3,000 Profit Before Tax 4,000 4,000 1,000
Income Tax Expenses @ 30% 900 900 900 Income Tax Payable @ 30% 1,200 1,200 300

Carrying Value Tax Base

Beginning Accrued Warranty Expense - 1,000 2,000 Beginning Accrued Warranty Expense - - -
Warranty Expenses Accrued 1,000 1,000 1,000 Warranty Expenses Accrued - - 3,000
Ending Value 1,000 2,000 3,000 Ending Value - - 3,000

Change in Deferred Tax Liability - - - As expense is greater in the financial accounting the taxable income
Change in Deferred Tax Asset 300 300 (600) as per financial accounting is lower than as per tax method. Thus the
actual tax to be paid will be higher.
Income Tax Payable 1,200 1,200 300 Balance Sheet Impact - Deferred Tax Assets will increase (as
+ Change in Deferred Tax Liability - - - Carrying Value of Liability > Tax Base)
- Change in Deferred Tax Asset (300) (300) 600 Income Statement Impact - Income Tax Expense = Income Tax
Income Tax Expense 900 900 900 Payable - Change in Deferred Tax Asset

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Effect of changes in Tax Rates
When tax rate rises
Balance of both DTA and DTL rises
When tax rate falls
Balance of both DTA and DTL falls

Formula:

Income Tax Expense = Taxes Payable + Change in DTL Change in DTA

Deferred tax asset is adjusted with the valuation allowance to

reflect the probability that it will not be realized in future
periods

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Effect of changes in Tax Rates
If a company has a net DTL (DTL > DTA) a reduction in tax rates
would reduce liabilities, reduce income tax expense and
increase equity
If a company has a net DTA (DTL < DTA) a reduction in tax
rates would reduce assets, increase income tax expense and
reduce equity
If a company has a net DTL (DTL > DTA) a increase in tax rates
would increase liabilities, increase income tax expense and
reduce equity
If a company has a net DTA (DTL < DTA) a increase in tax rates
would increase assets, reduce income tax expense and
increase equity

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Temporary versus permanent differences
Temporary differences arise because of differences between
tax base and carrying value of assets and liabilities
Permanent differences are differences between tax and
financial reporting of revenues and expenses that will not
reverse at any point in the future.
Examples of the items giving rise to permanent differences
Revenue items that are not taxable
Expense items that are not tax deductible
Tax credits for some expenses that directly reduce taxes

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Temporary versus permanent differences
Permanent differences do not result in deferred
taxes.
They result in a difference between effective and
statutory tax rates and should be considered in
the analysis of effective tax rates
A firms effective tax rate is given by:
Formula

Effective Tax Rate = Income Tax Expense / Pretax Income

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Temporary Differences between Pretax Income and Taxable Income

Examples of differences that are expected to reverse in the

future:
Accelerated depreciation for tax
Impairments
Restructuring
Warranty expense > Actual costs
Inventory Accounting
Gain and Losses on marketable securities

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Temporary differences
Taxable temporary differences
Result in DTL
Future taxable income
Carrying amount of asset > tax base
Carrying amount of liability < Tax base
Deductible temporary differences
Result in DTA
Future tax deductions
Carrying amount of asset < tax base
Carrying amount of liability > Tax base

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Temporary differences

Carrying Value v/s

Balance Sheet item Results in
Tax Base
Carrying Amount >
Asset DTL
Tax Base
Carrying Amount <
Asset DTA
Tax Base
Carrying Amount >
Liability DTA
Tax Base
Carrying Amount <
Liability DTL
Tax Base

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Valuation Allowance
DTA must be evaluated at each balance sheet date to ensure
that they will be recovered
In case of any doubts regarding their realization, their carrying
value should be reduced to the expected recoverable amount.
DTA is reduced by creating a contra-asset account called as
Valuation Allowance
Increase in valuation allowance reduces DTA
Reduction in DTA causes an increase in income tax expense
Higher income tax expense causes a lower net income
Thus a lower retained earnings
If the likelihood of realizing deferred tax assets increases, the
previous reduction in DTA is reversed by reducing the
valuation allowance

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Required Deferred Tax Disclosures
DTL/DTA, any valuation allowance, and net change in
valuation allowance
Unrecognized deferred tax liability for undistributed earnings
of subsidiaries and joint ventures
Current year tax effect of each type of temporary difference
Components of income tax expense
Tax loss carry forwards and credits
Reconciliation of difference between income tax expense as a
% of pretax and statutory tax rate

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Deferred Tax Liabilities as Equity
Consider a firm with deferred tax liabilities from accelerated
depreciation:
Capital expenditures are expected to grow for the foreseeable
future; therefore, the liability is not expected to reverse
Analyst should reduce liabilities on the balance sheet and
increase equity by the same amount (as payment need not be
done)
His can reduce the debt to equity ratio significantly
If the capital expenditures of the same firm are expected to stop
or slow significantly, expect the liability to reverse in the future.
Consider the DTL as a true liability (as liability will be paid)

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