Accounting For Deferred Taxes Notes
What are deferred taxes?
The need for deferred tax accounting arises because companies often postpone or pre-pays taxes on profits pertaining to a particular period.
Deferred tax liability
There may be a difference in the way certain items of expense are allowed to be treated for tax purposes and how a company actually treats them.
Tax laws allow full depreciation in the first year after a company acquires certain assets. However a company may actually write off the depreciation over several years on its financial statements. The company may charge depreciation at lower rates than allowed under tax laws. Or it may use a different method of charging depreciation.
Example: Pre-issue expenses – expenses on R&D or expenses incurred on mergers, may be allowed to be written off over a fixed number of years. The company may stretch the write-off over a longer period.
In these cases, a company ends up postponing part of its tax liability on this year's profits to future years. This is because, in the current year, its profits for tax purposes would be lower than the profits computed for accounting purposes.
New accounting standards require that a company carve out a part of its current year's profits (equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's future tax liability.
Deferred tax asset
The tax laws may not recognize some of the expenses that a company has accounted for in its accounts. For instance, provisions made at the discretion of the management, such as those for bad debts, which are not fully recognized by tax authorities.
In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the profits that the taxman calculates would be higher than those computed by the company. Therefore a company would save on tax in the years when the expenses or provisions actually materialize.
Accounting for a deferred tax asset?
A company may recognize the excess tax paid over and above the tax liability as a "deferred tax asset". However, in the interests of conservative accounting, companies should recognize such deferred tax assets only if they actually anticipate that their income in future will be enough to allow the company to set off the losses or the excess tax paid. In other words if a company is not profitable in the future there will be no tax savings to benefit from and therefore accounting for this asset is not justified.
If the analyst’s purpose is forecasting and he seeks to identify the persistent components of FCFF, then it is not appropriate to add back deferred tax changes that are expected to reverse in the near future. In some circumstances, however, a company may be able to consistently defer taxes until a much later date. If a company is growing and has the ability to indefinitely defer tax liability, an analyst adjustment to net income is warranted.
“Conversely, companies often record expenses for financial reporting purposes (e.g., restructuring charges) that are not deductible for tax purposes. In this instance, current tax payments are higher than reported on the income statement, resulting in a deferred tax asset and a subtraction from net income to arrive at cash flow on the cash flow statement. If the deferred tax assets is expected to reverse (e.g., through tax depreciation deductions) in the near future, the analyst would not want to subtract the deferred tax asset in his cash flow forecast to avoid underestimating future cash flows. On the other hand, if the company is expected to have these charges on a continual basis, a subtraction is warranted to lower the forecast of future cash flows.” 
If a company knows that it will have a tax benefit in the future they will recognize that benefit by accounting for a deferred tax asset. However, if the recognition of the acquired deferred tax benefit results from an identifiable event after its occurrence it would be reported as a reduction of income tax expense for that period.
Adjusting for a deferred tax asset
There are two classifications for a deferred tax asset:
- Is a bonifide GAAP expense today
- It is not a tax deduction today
Is NOT subtracted from the cash flow calculation
- Not a bonifide GAAP expense today
- It is however taxable income.
Subtracted from the cash flow calculation
Why account for deferred taxes?
By recognizing deferred tax liabilities in its books, a company makes sure that the tax liability for any particular year is reflected in that year's financials and does not carry over to future profits. It brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations (rather than from fiscal savings).
 Free Cash Flow Valuation
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