Introduction
Income taxes can have a significant impact on the financial performance of a company. This impact can be directly observed on the financial statements of a company. Let's explore how financial statements incorporate taxes paid and owed, income tax disclosures, changes in tax law and valuation allowances and how all of this impacts our assessment of a company's performance and viability.
From an investor's standpoint, forecasting future cash flows of a company often forms the bedrock of investment decisions. Given that taxes can significantly diminish a company's cash reserves, comprehending the current tax implications on asset acquisitions, financing, and location decisions offers valuable insights for any investor scrutinizing a company's prospects.
Understanding Accounting (Book) Income vs. Taxable Income
In financial accounting, we often come across two distinctive types of incomes: Accounting (or book) income and Taxable income. These concepts stem from the fact that companies typically conduct two separate accounting processes, one for reporting to shareholders, and the other for reporting to tax authorities.
Accrual Accounting for Shareholder Reporting
Accrual accounting forms the backbone of shareholder reporting. Under this method, revenues and expenses are recorded when they are incurred, irrespective of when the cash transaction takes place. This approach provides an in-depth understanding of a company's financial health over specific accounting periods.
Features of Accrual Accounting
- Relevant: By providing timely information, accrual accounting facilitates immediate financial decisions.
- Reliable: While estimations are often involved, the accrual method aims for precise income statements and balance sheets, ensuring data reliability.
Tax Accounting for Tax Authorities Reporting
On the other hand, tax accounting is primarily used for reporting to tax authorities. It aligns more closely with cash accounting, where transactions are recorded when cash changes hands.
Tradeoff between Accrual and Tax Accounting
The differences between accrual and tax accounting reflect a tradeoff between relevancy and reliability. While accrual accounting emphasizes timely information, tax accounting prioritizes accurate data recording, even if this means a delay in reporting.
Tax Expense and Accrual Accounting
Similar to other expenses in accrual accounting, tax expense on income is also an accrual number. It estimates future cash outflows, matched with income when it is earned, not necessarily when it is paid. Consequently, the recorded tax expense in general does not equal cash taxes paid in a given period.
Exploring Temporary Differences and Deferred Tax Liabilities
In financial accounting, one of the key concepts that creates a difference between the book and tax income is the existence of temporary differences. These differences give rise to deferred tax liabilities, an important component of a company's financial health.
Deferred Tax Liabilities: An Overview
Deferred tax liabilities typically occur when there's a temporary timing difference that causes the pre-tax income under Generally Accepted Accounting Principles (GAAP) to be greater than taxable income under the tax code.
Deferred Tax Liability (DTL)
- Tax Income < Book Income
- Taxes Paid < Tax Expense
Where tax income refers tax accounting income, book income is the GAAP income, taxes paid is the tax accounting tax value, and tax expense is the GAAP tax expense or provision.
This discrepancy primarily arises due to:
- Depreciation: Businesses often use different methods for tax and financial accounting purposes. For example, accelerated depreciation for tax purposes and straight-line depreciation for financial reporting.
- Prepaid Expenses: These are often immediately deductible for tax purposes but are recognized over time for financial accounting.
- Revenue Recognition: Some revenues may be recognized for book purposes before they are for tax purposes.
Deferred tax liability is effectively an accrual that estimates taxes expected to be paid in the future. The reason for this is that the tax expense is matched to the revenue that caused the expense.
An Example: Depreciation and Deferred Tax Liabilities
Consider a hypothetical company that purchases an asset worth $30,000 with a salvage value of $0. Assume that each year the company has $100,000 in income before depreciation and income taxes (IBDT) and a tax rate of 30%. For tax accounting, the company uses accelerated depreciation and deducts the full purchase amount in the first year. For financial reporting, it uses a straight-line depreciation schedule over three years. The situation would look like this:
| Year | Tax Reporting (Full Deduction) | Straight-Line Depreciation | Tax vs. Book Difference | Cumulative Tax-Book Difference |
|---|---|---|---|---|
| 1 | $30,000 | $10,000 | $20,000 | $20,000 |
| 2 | $10,000 | -$10,000 | $10,000 | |
| 3 | $0 | $10,000 | -$10,000 | $0 |
Now, to understand the impact on deferred tax liabilities, we need to calculate the deferred tax liability at the end of each year and the deferred tax expense. Assuming a tax rate of 30%, the deferred tax scenario would be:
| Year | Cumulative Tax-Book Difference | Tax Rate | Deferred Tax Liability End of Year | Deferred Tax Expense |
|---|---|---|---|---|
| 1 | $20,000 | 30% | $6,000 | $6,000 |
| 2 | $10,000 | 30% | $3,000 | -$3,000 |
| 3 | $0 | 30% | $0 | -$3,000 |
Balance Sheet Equation: Impact of Depreciation
Over the three-year period, the depreciation expense influences the balance sheet equation, impacting cash, deferred tax liabilities, and retained earnings (R/E). Again, consider that the company has $100,000 in IBTD.
From a tax perspective, with an accelerated depreciation expense of $30,000 in the first year, the cash tax bill in the first year will be:
\[ \begin{align} \text{Tax Reporting Tax Expense} &= 30\% \times (\text{IBTD} - \text{Depreciation Expense}) \\ &= 30\% \times ($100,000 - $30,000) \\ &= $21,000 \end{align}\]From a financial reporting perspective, in the first year using straight-line depreciation there would have only been a depreciation expense of $10,000 resulting in:
\[ \begin{align} \text{Financial Reporting Tax Expense} &= 30\% \times (\text{IBTD} - \text{Depreciation Expense}) \\ &= 30\% \times ($100,000 - $10,000) \\ &= $27,000 \end{align}\]It can be seen that the difference between the expected tax bill from financial reporting and tax reporting is $6,000. This was also illustrated above where the cumulative tax-book difference in the first year was calculated as $30,000 - $10,000 = $20,000. At the current corporate tax rate that is how the $6,000 deferred tax liability was calculated.
This can be viewed as a long-term payable where we recognize that under tax reporting we used accelerated depreciation to reduce our tax bill this year. Financial reporting expects that the straight line depreciation will be used for savings in tax expense in years 2 and 3, but that is not how the tax authority sees it. The Deferred Tax Liability account helps to reconcile these differences.
The following table shows the financial reporting balance sheet equation entries for the three-year life of the company relating to the purchase of the PP&E for $30,000 and the tax implications of that purchase. The key here is the deferred tax liability that was accumulated in year 1 and reduced back to zero by year 3.
| Year | Transaction | Cash | - Depreciation | + PP&E= | Deferred Tax Liability | + R/E |
|---|---|---|---|---|---|---|
| 1 | Purchase PP&E. | ($30,000) | $30,000 | |||
| 1 | Depreciation Expense. | $10,000 | ($10,000) | |||
| 1 | Increase DTL by deferred $6,000. Tax Paid on $100,000 less $30,000 accelerated depreciation. |
($21,000) | $6,000 | ($27,000) | ||
| 2 | Depreciation Expense | $10,000 | ($10,000) | |||
| 2 | Tax Rept. Tax Exp. = $30,000 Fin. Rept. Tax Exp. = $27,000 |
($30,000) | ($3,000) | ($27,000) | ||
| 3 | Depreciation Expense | $10,000 | ($10,000) | |||
| 3 | Tax Rept. Tax Exp. = $30,000 Fin. Rept. Tax Exp. = $27,000 |
($30,000) | ($3,000) | ($27,000) |
This table shows that in the first year the tax reporting tax expense (the actual cash tax bill) was $6,000 less than the financial reporting tax expense due to the tax reporting using accelerated depreciation and the financial reporting using straight line depreciation.
In the second and third years the cash tax bill is $30,000, the accrual based financial reporting tax expense was $27,000, and the Deferred Tax Liability account was used to reconcile the difference each year. Effectively, the $6,000 tax savings the first year was spread out and paid over the following two years.
An important point to recognize here that is useful when reading financial statements is that if a company reports that they have a $6,000 deferred tax liability and a tax rate of 30%, then that means that their depreciation from a tax perspective was \(\frac{$6,000}{30\%} = $20,000\) greater than their financial reporting depreciation (most likely due to tax using accelerated deprecation and financial reporting using straight-line depreciation. This can be observed by the difference of \(\text{Tax Reporting Tax Expense}\) - \(\text{Financial Reporting Tax Expense}\). Keeping this in mind can be useful when analyzing financial statement tax disclosures.
Understanding temporary differences and deferred tax liabilities is key to comprehending the complexities of financial accounting. By understanding these concepts, businesses can gain deeper insight into their financial status and make better-informed decisions.
Understanding Deferred Tax Assets
In the financial accounting landscape, deferred tax assets play a crucial role when a company's pre-tax income according to Generally Accepted Accounting Principles (GAAP) is lower than its actual taxable income as determined by the tax code.
Deferred Tax Assets: An Overview
Deferred tax assets typically arise when a company pays more in cash taxes in the current year, with the expectation of paying less in subsequent years. This scenario often occurs when there are temporary differences between the recognition of income and expenses for tax and financial reporting purposes.
Deferred Tax Asset (DTA)
- Tax Income > Book Income
- Taxes Paid > Tax Expense
Where tax income refers tax accounting income, book income is the GAAP income, taxes paid is the tax accounting tax value, and tax expense is the GAAP tax expense or provision.
Primary Reasons for Discrepancies Leading to Deferred Tax Assets
- Deferred Revenue: When a company receives cash for goods or services not yet delivered, the cash is considered taxable income by tax authorities but is deferred for financial reporting purposes. This leads to a temporary difference that requires a deferred tax asset.
- Accrued Expenses: Expenses may be recognized for financial reporting before they are deductible for tax purposes. This can create a temporary difference and result in a deferred tax asset.
- Net Operating Losses: If a company has a tax loss that can be carried forward to offset future taxable income, a deferred tax asset is recognized.
- Credit carryforwards: Some tax credits may not be fully usable in the current period and can be carried forward to reduce future taxable income, creating a deferred tax asset.
- Pension and post-retirement benefits: Companies often recognize expenses related to pensions and other post-retirement benefits before these amounts are deductible for tax purposes, leading to a deferred tax asset.
- Stock-Based Compensation: Companies can recognize expenses for financial reporting purposes when stock options are granted, but these are not deductible for tax purposes until the options are exercised, creating a deferred tax asset.
Matching Principle and Deferred Revenue
The matching principle of GAAP requires us to recognize revenue when the sale is mostly complete, leading to the concept of deferred revenue. This is income received by a company for goods or services that it has not yet delivered or performed. For financial reporting purposes, this cash is not considered revenue until the company has fulfilled its obligations to the customer.
However, the tax code treats this cash differently. It typically considers any cash received as taxable income, regardless of whether the associated goods or services have been delivered. This means that a company may have to pay tax on deferred revenue even though it has not recognized this revenue for financial reporting purposes.
The Role of Deferred Tax Asset Account
To reconcile the difference between GAAP financial reporting and tax reporting, companies use a Deferred Tax Asset account. When a company receives cash that is taxable but not yet recognized as revenue, it records a deferred tax asset. This account represents the future tax benefit that the company will receive when it recognizes the revenue in future periods.
Essentially, the Deferred Tax Asset account is a future tax break. It ensures that the financial reporting matches the economic reality of the company's situation: the company will pay less tax in the future when it recognizes the deferred revenue because it has already paid the tax on this income.
Understanding deferred tax assets is crucial for understanding a company's financial position. This concept reflects the relationship between a company's financial reporting and tax obligations, highlighting the complexity of financial accounting in a world where tax codes and GAAP may not always align.
An Example: Deferred Revenue and Deferred Tax Assets (DTA)
Consider a scenario where a landscaping company sells a there year contract to provide year-round landscaping maintenance for a large client facility and pays $75,000 upfront for the service.
Because the service has not yet been provided, and since the landscaping company uses accrual accounting, the revenue cannot be recognized until the service has been provided. This is accounted for by a balance sheet equation entry of incrementing the cash account by $100,000 as well as incrementing the Deferred Revenue liability account by the same amount.
From a tax perspective, the landscaping company has earned the $100,000 dollars since it has received the cash. So from a tax reporting perspective and an actual cash payment perspective, with a tax rate of 25%, the company will have a tax bill of $25,000 the first year.
The following table illustrates how this could be accounted for on the financial reporting using the balance sheet equation.
| Year | Transaction | Cash | + Deferred Tax Asset= | Deferred Revenue | + R/E |
|---|---|---|---|---|---|
| 1 | Cash Received for Services | $100,000 | $100,000 | ||
| 1 | Tax Paid Create DTA |
($25,000) | $25,000 | ||
| 1 | Recognize Revenue | ($33,334) | $33,334 | ||
| 1 | Match Deferred Tax to Revenue | ($8,334) | ($8,334) | ||
| 2 | Recognize Revenue | ($33,333) | $33,333 | ||
| 2 | Match Deferred Tax to Revenue | ($8,333) | ($8,333) | ||
| 3 | Recognize Revenue | ($33,333) | $33,333 | ||
| 3 | Match Deferred Tax to Revenue | ($8,333) | ($8,333) |
After the third year the $25,000 added to the deferred tax asset as well as the $100,000 added to the deferred revenue account will have been depleted. Note that in each year the deferred tax asset is decreased by the same amount as the retained earnings. This matches effectively matches the prepaid tax with the actual accrual revenue that generated the prepaid tax.
This accounting effectively is used to reconcile that we prepaid tax in the first year and as a result have less tax liability in the second and third year.
Impact of Tax Rate Changes on Deferred Tax Assets
The following table illustrates the impact of a decrease in tax rate on a company that has a deferred tax asset in place. We will reuse the previous example and show the impact that a reduction in corporate tax rate would have if the tax rate were reduced in the second year from 25% to 10%.
In year 1 the DTA under a 25% tax rate was $25,000. In year 2 the current value of the DTA would be \($25,000 - $8,334 \approx $16,666\). That means that the net tax reporting revenue was \(\frac{$16,666}{25\%} \approx $66,664\) more than the financial reporting recognized revenue. The updated deferred tax asset can then be calculated as \($66,664 \times 10\% \approx $6,666\). This means that the DTA needs to be reduced by \($16,666 - $6,666 = $10,000\). Further, the value of the DTA to be matched to the revenue to be recognized in years 2 and three will be \($33,333 \times 10\% \approx $3,333\) each year.
Because a DTA is created when the actual tax paid (tax reporting tax expense) is greater than the financial reporting tax expense, the cash taxes for future revenue have already been paid. As can be seen in the below table, the reduced income tax rate means that less tax would otherwise be due in each year when the unearned revenue is eventually recognized. So from a financial reporting perspective there is a net loss on the DTA of $10,000.
| Year | Transaction | Cash | + Deferred Tax Asset= | Deferred Revenue | + R/E |
|---|---|---|---|---|---|
| 1 | Cash Received for Services | $100,000 | $100,000 | ||
| 1 | Tax Paid Create DTA |
($25,000) | $25,000 | ||
| 1 | Recognize Revenue | ($33,334) | $33,334 | ||
| 1 | Match Deferred Tax to Revenue | ($8,334) | ($8,334) | ||
| 2 | Recognize Revenue | ($33,333) | $33,333 | ||
| 2 | Adjust DTA due to reduced tax rate | ($10,000) | ($10,000) | ||
| 2 | Match Deferred Tax to Revenue | ($3,333) | ($3,333) | ||
| 3 | Recognize Revenue | ($33,333) | $33,333 | ||
| 3 | Match Deferred Tax to Revenue | ($3,333) | ($3,333) |
Deferred Tax Assets and the Valuation Allowance
In the financial world, Deferred Tax Assets (DTAs) play a pivotal role. To better understand this concept, let's dive deeper into what DTAs are and how they relate to the valuation allowance.
Understanding Deferred Tax Assets (DTAs)
Deferred Tax Assets are essentially prepaid assets. In simpler terms, they are future tax savings that arise due to temporary differences between financial reporting and tax accounting.
A common example is the Net Operating Loss (NOL). If a company incurs a loss in a given year, it may carry this loss forward to offset taxable income in future years, thereby creating a deferred tax asset. Essentially, the company is "prepaying" its taxes for future years, or more accurately, deferring the utilization of a tax benefit to a future period.
Realizability of Deferred Tax Assets
However, what happens if a company doesn't expect to generate enough income in the future to fully utilize the DTA? This is where the concept of "realizability" comes into play.
If a firm does not anticipate generating sufficient future taxable income, the DTA is not realizable. In such scenarios, the firm must reduce the carrying amount of the DTA. The manner in which this reduction is accounted for is through the creation of a valuation allowance.
The Role of Valuation Allowance
A valuation allowance is a contra-asset account used to offset a DTA. If a company assesses that it's more likely than not (a threshold that generally translates to a likelihood of more than 50%) that it won't realize some portion of its DTA, it must establish a valuation allowance. This process is similar to creating an allowance for doubtful accounts.
For example, if a company has a DTA of $1,000,000 but estimates that $200,000 of it won't be realizable, it will create a valuation allowance of $200,000. The DTA will be reported as $800,000 ($1,000,000 DTA less $200,000 valuation allowance) in the financial statements.
Net Operating Losses and Deferred Tax Assets
Consider a scenario where a company incurs a net operating loss. A net operating loss creates a DTA because the company can carry forward the loss to offset future taxable income, thereby reducing future tax payments. However, since a firm cannot pay negative taxes, if the future taxable income isn't expected to be high enough to utilize the DTA, a valuation allowance must be set up.
Understanding the interplay between DTAs, realizable income, and valuation allowance is crucial for accurate financial reporting and understanding a company's tax position. Just like an allowance for doubtful accounts ensures that receivables are not overstated, a valuation allowance ensures that DTAs are not overstated, providing a more accurate picture of a company's financial health.
Understanding Effective Tax Rate
The effective tax rate is an important measure in corporate finance, offering valuable insights into a company's tax scenario. It's defined as the tax expense divided by the GAAP (Generally Accepted Accounting Principles) pre-tax income. Unlike the statutory tax rate, which is set by law, the effective tax rate reflects the actual proportion of a corporation's earnings that goes towards taxes. Firms will often provide tax disclosures in their financial statements that explain the reasons why there is a difference between the statutory tax rate of the jurisdiction the firm is subject to and the firms effective income tax rate.
\[ \text{Effective Tax Rate (ETR)} = \frac{\text{Provision for Income Taxes}}{\text{Pre-Tax Income}}\]Note that the tax expense here is referring to the financial reporting tax expense which is also often referred to as the provision for income taxes in the financial reports.
Why Effective Tax Rate Differs from Statutory Tax Rate
Various factors can cause a corporation's effective tax rate to differ from the statutory tax rate. Key among these factors are what are known as "permanent differences". These differences arise when certain items are recognized by GAAP but not by tax authorities such as the US Internal Revenue Service (IRS). Some primary sources of permanent differences include:
- Fines and penalties: When a corporation pays fines or penalties to the government, it often considers these an expense under GAAP. However, the IRS typically does not recognize these payments as deductible expenses.
- Foreign earnings: Corporations may face different tax rates on earnings abroad, depending on the tax laws in the foreign country. This can lead to variations between the statutory and effective tax rates.
- Stock compensation: Under GAAP, corporations can recognize expenses when they grant stock options. However, these are typically not deductible for tax purposes until the options are exercised.
Comparison of Effective Tax Rates Across Countries
The effective tax rate can vary significantly from one country to another, influenced by the specific tax laws and regulations in each jurisdiction. As of 2021, per stats.oecd.org:
- United States: The US corporate statutory tax rate was 21%, but the effective tax rate varied depending on factors like state taxes and deductions.
- France: France had one of the highest corporate tax rates in the world, with a statutory rate of 28.4%.
- Japan: Japan also had a high corporate tax rate, with a statutory rate of 23.2%.
- Australia: The corporate tax rate in Australia was also quite high, at a statutory rate of 30%.
- United Kingdom: The UK had a relatively low corporate tax rate, with a statutory rate of 19%.
- Germany: Germany had a combined corporate income tax, solidarity surcharge, and trade tax that resulted in high statutory corporate tax rates of between 15.8%.
- Canada: Canada's federal corporate tax rate was 15%.
Keep in mind that these are the statutory tax rates, and the effective tax rates can be lower due to various factors including those discussed earlier. The following is a rough estimate of country average effective tax rates for the same countries as above as of 2021 per stats.oecd.org
- United States: The effective corporate tax rate varied significantly, but on average it was estimated to be around 22.3%.
- France: The effective corporate tax rate was lower than the statutory rate, estimated at around 25.9%.
- Japan: Japan's effective corporate tax rate was approximately 28.4%.
- Australia: The effective corporate tax rate in Australia was roughly 28.5%.
- United Kingdom: The UK's effective corporate tax rate was estimated at about 12.6%.
- Germany: Germany's effective corporate tax rate was around 26.6%, due to their combined tax system.
- Canada: Canada's effective corporate tax rate was about 23.8%, considering federal and provincial taxes.
Please note these are approximations and can differ between companies and over time. For the most accurate information, consult recent tax data or a tax professional.
Understanding the effective tax rate and its differences from the statutory tax rate is vital for anyone seeking to grasp a company's tax position. It provides a more accurate picture of a company's tax burden, and can offer valuable insights when comparing the tax positions of companies across different countries.
Conclusion
In general, accounting income does not equal taxable income due to these different methods and purposes of accounting. This dichotomy has significant implications for understanding a company's performance, tax obligations, and overall financial health.
We have reviewed corporate financial accounting, focusing on the areas of income reporting, accrual and tax accounting, and the divergences that often arise between them.
We explored the nuances of Accounting (Book) Income vs. Taxable Income and the need for companies to maintain two types of accounting - one for shareholder reporting and another for tax authorities. We saw how accrual accounting serves shareholder reporting, while tax accounting aligns more with tax authority reporting. This divergence often results in temporary differences that can lead to the creation of Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs).
We further investigated the implications of these differences using an illustrative example of depreciation, explaining how timing differences between tax reporting and financial reporting can result in Deferred Tax Liabilities. Moreover, we highlighted that these differences, when leading to the prepayment of taxes or anticipation of future tax benefits, give rise to Deferred Tax Assets.
Notably, when these DTAs are not fully realizable due to insufficient future taxable income, companies must create a valuation allowance - a safeguard that ensures the DTAs are not overstated. We provided an example here too, drawing parallels with the allowance for doubtful accounts.
In the area of taxation, we analyzed the concept of the effective tax rate, providing a glimpse into why it may differ from statutory tax rates. Permanent differences, foreign earnings, and stock compensations were cited as prime factors contributing to this discrepancy. Further, we compared effective tax rates of different countries, underscoring the influence of tax laws and regulations in each jurisdiction on these rates.
Overall, we've uncovered that corporate financial accounting is a complex set of regulations, estimates, and principles. Understanding its intricacies is vital to appreciating a company's financial health and tax position. Whether you're a shareholder, a tax authority, or an interested observer, the financial landscape unravels intriguing insights when viewed through the lens of accrual and tax accounting.