In the previous two posts in the Income Taxes series, we looked deeply into deferred tax assets and liabilities and tax bases v s carrying values. In today’s post we will look into the impact of changes in tax rates on deferred tax assets and liabilities.
Impact of Changes in Tax Rates on DTA and DTL
Deferred tax assets and liabilities are determined based on current tax rates. However, with changes in tax rates, the existing deferred tax assets and liabilities need to be adjusted accordingly.
If the tax rate increases, deferred taxes will also increase, i.e. deferred tax assets and liabilities will increase. Similarly, if the tax rate decreases, deferred taxes also decrease.
The changes in tax rates also affect the income tax expense, which is the tax recognized on the income statement.
Income tax expense is given as;
Tax payable + Δ DTL – Δ DTA
This is because, DTL, is the excess of income tax expense over tax payable, while DTA is the excess of tax payable over income tax expense.
If the tax rate increases, an increase in the DTL will result in an increase in the income tax expense, while the increase in DTA will reduce the income tax expense.
Similarly, if the tax rate decreases, decrease in the DTL will lead to lower income tax expense and decrease in DTA will lead to higher income tax expense.
This can be understood intuitively. Looking at it at the other way round, increase in income tax expense leads to higher DTL and lower DTA and a reduction in income tax expense leads to a higher DTA and lower DTL.
Permanent and temporary differences between Pre-tax income and taxable income
Pre-tax income is the accounting profit before taxes reported on the income statement, while taxable income is the income that is taxable as per statutory laws.
Temporary differences arise between the two when certain revenues become taxable before they can be recognized on the income statement or certain expenses are recognized on the income statement before they become tax deductible or vice versa. Temporary differences lead to deferred taxes, i.e. creation of DTA and DTL. DTA and DTL can be created only when the differences between the tax base and carrying value will reverse itself in future and the balance sheet is expected to provide future economic benefits.
On the other hand, permanent differences are those that will not reverse in the future. Permanent differences do not lead to deferred taxes. Permanent differences result from income and expenses that are not taxable or deductible under the tax legislation and tax credits that result in direct reduction in taxes.
Permanent differences lead to differences between a company’s effective tax rate and the statutory tax rate (tax rate in the jurisdiction where the firm operates). The effective tax rate is given as;
Effective tax rate = income tax expense / pre-tax income
The effective tax rate may also differ from the statutory tax rate if the company operates in more than one jurisdiction.
That’s all in this post….stay posted for more in the Income Taxes series…
For solved examples please refer to the CFA Institute books or CFA study materials. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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