Disclosures Relating to Deferred Tax Items

Introduction

Income tax disclosures that are included in the notes to financial statements can provide analysts with very useful information. Their inclusion 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 identify if there is any operating loss carry forwards 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, or a reduction in reported income taxes in future periods.
  • An acquiring company may use a target company’s tax loss carry-forwards to offset its own tax liabilities. The value to the acquirer would be the present value of the carry-forwards, based on the acquirer’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 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 when both the amounts and timing of tax payments arising from the reversal of temporary differences are uncertain. These classifications (debt or equity) will of course affect the computation of financial ratios which involve debt or equity; for example, profitability ratios.

Question 1

Which of the following statements is least accurate?

A. Note disclosures can indicate the reconciliation of how income tax provisions are derived from the US federal statutory rate.

B. An acquiring company may not use a target company’s tax loss carry-forwards to offset its own tax liabilities.

C. A deferred tax liability should be classified as debt if it is expected to reverse with a subsequent tax payment.

Solution

The correct answer is B.

An acquiring company may in fact use a target company’s tax loss carry-forwards to offset its own tax liabilities. Statements A and C are correct.

Question 2

Marshall & Marshall Ltd. reported total assets of $200,000, total equity of $120,000, and total debt of $80,000 including a tax liability of $50,000 in its 2010 financial reports.  However, the company got acquired during the year 2011. What’s the company’s debt to equity ratio before and after the liquidation decision?

A. 0.67 before the liquidation; 0.18 after the liquidation

B. 0.18 before the liquidation; 0.67 after the liquidation

C. 0.67 before the liquidation; 0.67 after the liquidation

Solution

The correct answer is A.

The classification of a deferred tax liability as debt or equity depends on the likelihood of paying that liability. If the liability is likely to be paid, the liability is classified as a debt. If the liability is unlikely to be paid, the liability is classified as equity.

Reading 29 LOS 29i:

Analyze disclosures relating to deferred tax items and the effective tax rate reconciliation and explain how information included in these disclosures affects a company’s financial statements and financial ratios

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