Disclosures Relating to Deferred Tax Items

Income tax disclosures that are included in the notes to financial statements can provide analysts with very useful pieces of information. Inclusion of income tax disclosures in the notes to financial statements, therefore, can have a material impact on the results of financial statements analysis, inclusive of the derivation of financial ratios.

Disclosures Relating to Deferred Tax Items and Effective Tax Rate Reconciliation

• 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 income tax provision that is current, and indicate if the net income tax provision results from the 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 relating to 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 as to 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;
• a reduction in the valuation allowance could lead to a reduction in the income tax provision as reported on the income statement. Similarly, it can occasion a reduction 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 own 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;
• deferred tax liability should be classified as debt if it is expected to reverse with subsequent tax payment(s). If, instead, the liability is not expected to reverse, it should be treated as equity. Additionally, a deferred tax liability should be excluded from both debt and equity in case of uncertainty on both the amounts and timing of tax payments arising from the reversal of temporary differences. These classifications (debt or equity) will, of course, affect the computation of financial ratios which involve debt or equity; for example, profitability ratios.

Question

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 its own tax liabilities.
2. A deferred tax liability should be classified as debt if it is 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, in fact, use a target company’s tax loss carry-forwards to offset its own tax liabilities.

Options B and C are correct statements.