FSA 9 Analysis of Income Taxes

Two separate rulebooks describe the same company. Financial reporting follows accounting standards (IFRS set by the IASB, or US GAAP set by the FASB), while tax follows the law of the jurisdiction. Because the two rulebooks recognize revenues and expenses on different schedules, the profit figure each produces is different, and reconciling the two is the whole subject of this reading.

Accounting profit is the pretax figure on the income statement, also called income before taxes; by definition it is measured before any provision for income tax expense. Taxable income is the amount the tax law says is subject to tax, and it is the base for income tax payable, a liability on the balance sheet (or income tax recoverable, an asset, when the company has overpaid). The cash a company remits for income tax in a period draws down that income tax payable balance.

Tax base versus carrying amount

Every asset and liability carries two values. The carrying amount is the value recorded in the financial statements. The tax base is the value assigned to the same item for tax purposes. When accounting rules and tax rules value an item differently, the two numbers diverge. Common reasons include the following:

• a revenue or expense recognized in one period for accounting and in a different period for tax;
• an item recognized for accounting but never for tax, or the reverse;
• gains and losses on assets and liabilities that are deductible on different schedules for the two purposes;
• a tax loss carried forward from an earlier year that reduces a later year’s taxable income; and
• a prior-year restatement recognized unevenly, or in different periods, across the two purposes.

The classic case is depreciation. Tax law often permits accelerated depreciation (front-loading the expense to cut early-year tax bills), while the financial statements use straight line. A machine might be written off at 10 percent a year for accounting yet 50 percent in the first tax year. The yearly expense differs, but both methods eventually depreciate the full cost over the useful life, so the gap closes on its own.

Temporary and permanent differences

A difference that eventually reverses, like the depreciation gap above, is a temporary difference, and only temporary differences create deferred tax. A difference that never reverses is a permanent difference, and it creates no deferred tax at all. Temporary differences split further into two types.

A taxable temporary difference is one that will produce taxable income in a later period. It arises when the carrying amount of an asset is above its tax base, or the tax base of a liability is above its carrying amount. Taxable temporary differences give rise to a deferred tax liability.

A deductible temporary difference is one that will reduce taxable income in a later period, when the item is recovered or settled. It arises when the tax base of an asset is above its carrying amount, or the carrying amount of a liability is above its tax base. Deductible temporary differences produce a deferred tax asset. Such an asset is recognized only when future profits are reasonably expected, against which the benefit can be used. That expectation requires enough taxable temporary differences, tied to the same tax authority and same entity, that unwind over the same periods in which the deductible differences reverse.

Read the pattern as a rule of thumb: for an asset, a carrying amount above the tax base signals a future taxable amount and therefore a liability; for a liability, the mirror image holds.

Permanent differences

Permanent differences are gaps between tax law and accounting rules that will never reverse, so they create no deferred tax. Typical examples are income or expense items the tax law disallows, such as penalties and fines that are expenses for reporting but not deductible, and tax credits that directly cut the tax bill, such as credits for buying solar power or an electric vehicle. Because a permanent difference never produces a deferred tax item, it always drives a wedge between the company’s own tax rate and the statutory corporate rate.

Tax expense

The tax expense on the income statement, also called the provision for income taxes, is not the same as taxes paid. It combines income tax payable (or recoverable, when there is a benefit) with any change in deferred tax assets and liabilities. Reporting it this way follows the matching principle: it captures the tax consequences of every activity in the period, even when the cash effect lands in a future year.

Deferred tax assets and liabilities are the balance sheet residue of temporary differences. A deferred tax asset represents tax already paid, or losses carried forward from earlier periods, that the income statement has not yet reflected; it is a future saving. A deferred tax liability arises when financial accounting tax expense exceeds the tax expense figured under the tax rules; it is a future obligation. At each reporting date the company recompares tax bases and carrying amounts, recomputes both balances, and adds the change to income tax payable to arrive at the tax expense that appears on the income statement.

Effect of a change in the statutory rate

Because a deferred balance is a temporary difference multiplied by the tax rate, a change in the statutory rate revalues every deferred item. Suppose a tax authority cuts the corporate rate from 35 percent to 21 percent. The future benefit embedded in a deferred tax asset shrinks, so its recorded value falls; likewise the future obligation in a deferred tax liability shrinks, so its recorded value falls too.

Realizability and the valuation allowance

A deferred tax item is recorded only when the related future economic benefit is expected to materialize. Take a builder that receives customer advances taxed immediately but recognized as accounting income only once the work is done. If the firm is a going concern with steady earnings, the future benefit is not in doubt and the deferred item is appropriate. If instead realization is doubtful (for example the firm is being wound up), the temporary difference does not support a deferred tax asset.

The two standards handle a doubtful, already-recognized deferred tax asset differently. Under IFRS, the existing deferred tax asset is reversed directly. Under US GAAP, the company sets up a valuation allowance that writes the asset down to the amount whose realization is more likely than not. Either way, a great deal is left to management judgment about future profitability, which is exactly why analysts scrutinize these disclosures.

Reading a deferred tax disclosure

Companies list the temporary differences that build up their net deferred position. The excerpt below (in US dollar thousands) nets deferred tax assets, a valuation allowance, and deferred tax liabilities into a single net figure for two years.

Taxes payable depend mostly on where taxable income is earned and the rate in each place, and sometimes on the nature of the business (research and development credits, accelerated depreciation, and similar special treatment). Three rates matter to analysts, and they usually differ from one another.

• The statutory tax rate is the corporate rate set by the country of domicile.
• The effective tax rate is reported income tax expense divided by pretax income.
• The cash tax rate is cash tax actually paid in the period divided by pretax income.

The gap between cash taxes and reported taxes traces back to timing differences between the accounting and tax rules, and it shows up as the change in deferred tax assets or liabilities. For forecasting, the effective tax rate drives projected earnings and the cash tax rate drives projected cash flow.

The statutory rate and the effective rate part ways for several reasons: non-deductible expenses, adjustments to earlier years, withholding tax on dividends, and tax credits. A big driver is operating in more than one country. The effective rate then becomes a profit-weighted blend of the rates in each country. A company earning most of its profit where rates are high, and little where they are low, ends up with an effective rate above the simple average of the two rates.

An effective rate persistently below the statutory rate, or below what competitors report, is not necessarily a red flag, but it deserves attention when forecasting. When building an estimate, analysts strip out one-off events; if volatile equity-method income is a large share of pretax profit, the effective rate excluding it forecasts better. A rate built on normalized operating income, stripped of results from associates and special items, is often the best starting point for the future tax expense in an earnings model. In a full model, the effective tax appears in the profit and loss projection and the cash tax appears on the cash flow statement, and the difference between them should equal the change in the deferred tax balance.

Income tax information reaches investors through three channels: the income statement (the tax provision), the balance sheet (deferred tax assets and liabilities, plus taxes payable), and the income tax note, which is often one of the longest disclosures in the report. The note reconciles the provision back to the statutory rate and breaks out the deferred tax assets and liabilities item by item.

Consider Micron Technology (MU), a US technology company. For fiscal 2017 its income tax provision was USD114 million on income before taxes of USD5,196 million. The note shows this provision as USD153 million of current tax offset by a USD39 million deferred benefit on foreign taxes. Micron also reports the reconciliation in dollars rather than percentages, so the tax at the US federal statutory rate is USD5,196 × 0.35 = USD1,819 million (the statutory rate was 35 percent). Micron carried deferred tax assets of USD766 million and deferred tax liabilities of USD17 million on its 2017 balance sheet, the assets shown within noncurrent assets and the liabilities within other noncurrent liabilities.

The reconciliation reads as a bridge: a large statutory charge of 1,819 is nearly wiped out by 1,571 of foreign tax relief (Micron earns most of its income abroad, where rates are lower), leaving a provision of just 114. Micron also discloses gross deferred tax assets of USD3,782 million reduced by a USD2,321 million valuation allowance, US net operating loss carryforwards totaling USD3.88 billion, and net deferred tax assets of USD749 million.

Reconstructing results from the rate reconciliation

A reconciliation stated in dollars can be run backward to recover the pretax result. In the disclosure below, the expected tax is computed at a 34 percent statutory rate, so a negative expected charge signals a pretax loss.