Impact of Tax Rate Changes

Income tax rate changes can significantly impact a company’s financial statements and the financial ratios which are derived from them. It is important, therefore, for an analyst to take note of any proposed changes to tax laws that may inform changes to the income tax rates and consequently have a material impact when enacted.

Impact of Tax Rate Changes on a Company’s Financial Statements and Ratios

Any change in the income tax rate will result in adjustments being made to the carrying values of existing deferred tax assets and liabilities. Increments (decrements) in the tax rate will lead to increments (decrements) in reported amounts for deferred tax assets and liabilities.

The effect of the change will also be reflected in the determination of the accounting profit in the period during which the change is enforced. This results from the fact that the changes in the income tax rate will also affect the measurement of income tax expense in the year under review.

Question 1

A new tax law results in the income tax rate decreasing from 30% to 25%. What effect is this most likely to have on a company’s deferred taxes and net profit after tax?

1. Deferred taxes: Increase; Net profit: Increase
2. Deferred taxes: Decrease; Net profit: Increase
3. Deferred taxes: Increase; Net profit: Decrease

Solution

The correct answer is B.

A decrease in the income tax rate will result in a decrease in both the company’s deferred taxes and the income tax expense. A decrease in income tax expense will lead to an increase in net profit (after tax).

Question 2

All else being equal, a proposed increase in tax rates would affect a company that has a substantial amount of tax assets by:

1. Increasing the company’s asset turnover ratio.
2. Decreasing the company’s asset turnover ratio.
3. It wouldn’t affect the company’s asset turnover ratio.

Solution

The correct answer is B.

An increase of the tax rate would increase the value of the company’s tax assets. Since the Asset turnover ratio = Revenue/Total assets, an increase in the company’s assets would decrease this ratio.