Deferred Tax Items Disclosures

Income tax disclosures included in the notes to financial statements can provide analysts with very useful information. Therefore, including income tax disclosures in the notes to financial statements can have a material impact on financial statement analysis, including the derivation of financial ratios.

Disclosures relating to deferred tax items and effective tax rate reconciliation are important because:

• Income tax disclosures can be used to reconcile how a company’s income tax provision was determined, beginning with its reported income before taxes.
• Disclosures can highlight the current income tax provision and indicate if the net income tax provision results from offsetting by deferred tax benefits.
• Whether in percentage terms or absolute dollar amounts, disclosures may also display the reconciliation of how income tax provisions are derived from the US federal statutory rate.
• Disclosures can provide detailed information on the derivation of deferred tax assets and liabilities.
• Disclosures can indicate if any valuation allowance was applied against net deferred tax assets. An explanation may also be found for why the valuation allowance has changed.
• Disclosures also help to determine if there is any operating loss carryforwards or unused tax credits.

Impact of Disclosures on Financial Statements and Ratios

Other considerations relating to the usefulness of disclosures include the following:

• A change in the federal statutory tax rate could make net deferred assets less valuable.
• As reported on the income statement, a reduction in the valuation allowance could lead to a reduction in the income tax provision. Similarly, it can occasion a decline in reported income taxes in future periods.
• A company acquiring another company may use the target company’s tax loss carry-forwards to offset its tax liabilities. The value to the acquiring company would be the present value of the carry-forwards, based on the acquiring company’s tax rate and expected realization time. The higher the profitability and tax rate of an acquiring company, the sooner it will be able to benefit.
• A deferred tax liability should be classified as debt if it’s expected to reverse with subsequent tax payment(s). If the liability is not expected to reverse, it should be treated as equity. Additionally, a deferred tax liability should be excluded from debt and equity in case of uncertainty on the amounts and timing of tax payments arising from the reversal of temporary differences. These classifications (debt or equity) will affect the computation of financial ratios involving debt or equity, such as profitability ratios.

Question 1

GammaCorp’s tax provision resulted in effective tax rates attributable to earnings from ongoing operations, excluding the cumulative effect of changes in accounting principles, which differed from the statutory corporate income tax rate of 30%, as detailed below:

$$\begin{array}{l|c|c}
\textbf{Year Ended 31 December} & \textbf{Year 3} & \textbf{Year 2}& \textbf{Year 1} \\ \hline
\text{Expected corporate }&&\\\text{income tax expense (benefit)}&&\\ & \text{(\$ 120,000)} & \text{\$780,000} &\text{\$690,000}\\ \hline
\text{Change in Valuation}&&\\ \text{allowance for}&&\\ \text{deferred tax asset} & (160,000) & (770,000) &(760,000)\\ \hline \text{Income tax expense}&230,000&60,000&85,000\\
\end{array}
$$

Over the three years shown, adjustments to the valuation allowance for deferred tax assets most likely indicate:

A. increased likelihood of future profitability.
B. a decreased likelihood of future profitability.
C. assets being carried at a value lower than their tax base.

The correct answer is A.

Throughout the three-year period, adjustments to the valuation allowance reduced cumulative income taxes by USD 1,830,000 (= USD 160,000 + USD 770,000 + USD 760,000). The reductions in the valuation allowance indicate that the company is “more likely than not” to generate enough taxable income to utilize the deferred tax assets.

Question 2

Which of the following statements is the least accurate?

1. An acquiring company may not use a target company’s tax loss carry-forwards to offset own tax liabilities.
2. A deferred tax liability should be classified as debt if expected to reverse with a subsequent tax payment.
3. Note disclosures can indicate the reconciliation of how income tax provisions are derived from the US federal statutory rate.

Solution

The correct answer is A.

An acquiring company may use a target company’s tax loss carry forward to offset its tax liabilities.

Options B and C are correct statements.