How is a deferred tax liability or assets created?
A deferred tax liability or asset is created when there are temporary differences between book tax and actual income tax. There are numerous types of transactions that can create temporary differences between pre-tax book income and taxable income, thus creating deferred tax assets or liabilities. While tax, in itself, is a complicated matter to analyze, deferred tax assets and liabilities add another layer of complexity in tax accounting.
To understand what is driving these deferred taxes, it is valuable for an analyst to examine the tax footnotes provided by a company. Often, a company will outline what major transactions during the period have made changes to the balances of deferred tax assets and liabilities. Companies will also reconcile effective tax rates in these footnotes.
Understanding changes in deferred tax assets and deferred tax liabilities, or rather than the net value of the two, allows for improved forecasting of cash flows.
What type of information to look for?
Below are just some major classes of information to look for in footnotes. Understanding this information should allow an analyst to make sense of the changes in deferred tax balances. These transactions are sometimes apparent in the income statement or balance sheet.
Information to look for includes:
- Warranty, bad debt, and/or write-down estimates
- Policy on capitalizing and depreciating fixed assets
- Policy on amortizing financial assets
- Revenue recognition policy
Analyzing the effects of a deferred tax liability or asset
After understanding the changes and causes of the deferred tax balance, it is important to also analyze and forecast the effect this will have on future operations. For example, deferred tax assets and liabilities can have a strong impact on cash flow. An increase in deferred tax liability or a decrease in deferred tax assets is a source of cash. Likewise, a decrease in deferred tax liability or an increase in the deferred tax asset is a use of cash.
Analyzing the change in deferred tax balances should also help to understand the future trend in which these balances are moving towards. Will these balances continue growing, or is the likelihood of reversal in the near future high?
These trends are often indicative of the type of business undertaken by the company. For example, a growing deferred tax liability could signal that a company is capital intensive. This is because the purchase of new capital assets often comes with accelerated tax depreciation that is larger than the decelerating depreciation of older assets.
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