Permanent differences vs. Temporary Difference

Permanent differences
The difference between income tax expense and taxes payable that never reverse should not be treated as a DT asset or DT liability and should be used to adjust the effective tax rate.

Examples:
· tax-exempt income {interest from munis, insurance claims}
· non-deductible expenses {employee perks and insurance premium}

Temporary differences
The difference between income tax expense and taxes payable reverse themselves over time.

Examples:
· depreciation {use of accelerated depreciation in tax accounts versus SL in financial accounts creates a DT liability}
· revenue recognition {booking sales sooner in financial accounts than tax accounts creates a DT liability}
· warranties and customer compensations {create DT assets}.

How should an analyst deal with DT liabilities or assets?

Reversal:
· If they are expected to reverse in the future, they should be treated as normal liabilities or assets.
· If they are not expected to reverse in the future, remove the DT liability from liabilities and add it to equity. Remove the DT asset from assets and subtract it from equity.e.g. if DT liability is soley from the used of acceleration depreciation method.
· Depreciation for tax purpose and the company’s capital expenditures are expected to grow in foreseeable future, DT liability will not reverse and should be considered as equity

Present value:
· Even if DT liability is reversable, it is valued at undiscounted basis but the payment may occur far into the future, analyst should revalue the liability at PV.

Economic depreciaton:
· Accouting depreciaton may understate the true economic value, depreciation value and so overstate the true value of the company

Implications of Valuation Allocation

A deferred tax asset is a reduction in future cash outflow (taxes to be paid). But, the asset has value only if the firm expects to pay taxes in the future. Valuation allowance is as a contra-asset account CR (credit) balance on the balance sheet to reduce the value of their deferred tax assets.
Increasing the valuation allowance increases deferred income tax expense; decreasing the allowance does the opposite. Changes in the allowance affect income tax expense.

Analysts need to do:
· scrutinize the changes in the allowance may be manipulated by management.

Effects of change in tax rates

Fall in tax rates => reduces deferred tax liabilities => reduces tax expense => increases net income.

Rise in tax rates => increases deferred tax liabilities => increase tax expense => reduces net income.

Deferred Method vs. Asset Liability-Method

Deferred Method
It is an income-statement-oriented approach that emphasize matching of expenses with revenues in the period when a temporary difference created. It is not acceptable under GAAP.

The amount of deferred income tax is based on tax rates in effect when temporary differences originate.

Asset-liability Method
The amount of deferred income tax is based on the tax rates expected to be in effect during the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach that emphasizes the usefulness of financial statements in evaluating financial position and predicting future cash flows. It is the only method accepted by GAAP.

Adjustmentsto the deferred tax accounts related to a change in the tax rate
To adjust tax rate change, DT asset and liability are calculated directly and income tax expense is a result of the calculation.

DT liability:
· take all the instances which cause pretax income > taxable income.
· The cumulative difference x tax rate

DT asset:
· Take all instance which cause pretax income< color="#009900">Calculate Tax expense = Taxes payable + Change in deferred tax liability - Change in deferred tax asset.

Tax Terminology

Taxable income:
Income used for calculating income taxes in tax accounts. (tax terms)

Taxes payable (a.k.a. current tax expense):
Actual taxes owed to IRS based on taxable income. (tax term)

Taxes paid:
Cash paid to IRS, include payments or refunds from other periods.(Tax term)

Tax loss carryforward:
Used to reduce taxable income in future years (tax term, treated as deferred tax asset in financial statement if it is likely to recover othewise create a valuation allowance)

Pretax income (EBT):
Income before tax reported in financial accounts. (FS term)

Income tax expense:
Tax calculated based on EBT in financial statements.(FS term)

Income tax expense = tax payable + deferred incoeme tax expenses.

Deferred income tax expense
Difference between taxes payable & income tax expenses (FS term)

Timing differences
Differences between income tax expense and taxes payable that lead to the creation of deferred tax (DT) assets (expected to be recovered from future operations) and DT liabilities (expected to result in future cash outflows).

Deferred tax liability:
Occur when income tax expenses is greater than taxes payable e.g. resulted from difference depreciaton methods are used in tax & financial statements.

Deferred tax asset:
Occur when income tax expenses is smaller than taxes payable e.g. due to warranty expense (as warranty expense cannot be recognized until incurred for tax purposes)

Valuation allowance:
If the chance that a deferred tax asset will not be realized is over 50%, it becomes doubtful and a reserve must be set up against it.

Taxable vs. Financial Income

Taxable income
· Calculated in accordance with prescribed tax regulations and rules.

Financial income
· Measured and reported in accordance with GAAP.

Differences between taxable income and financial income occur because tax regulations and GAAP are frequently different. This will create a temporary difference between the tax basis of an asset or liability and its reported amount in the financial statements. This difference will result in taxable amounts or deductible amounts in future years when the asset is recovered or the liability is settled. This is known as "deferred income taxes".