Seeing is believing!

Before you order, simply sign up for a free user account and in seconds you'll be experiencing the best in CFA exam preparation.

Subject 5. Recognition and Measurement of Current and Deferred Tax

Deferred tax assets and liabilities are re-assessed on each balance sheet date.

  • They are measured against the criteria of probable future economic benefits.
  • The tax rate used to calculate them should be the one that is expected to apply when the asset is realized or liability settled.
  • They are not discounted to present value although they are related to amounts at some future date.

Valuation Allowance

Deferred tax assets are reduced by a valuation allowance to amounts that are "more likely than not" to be realized, taking into account all available positive and negative evidence about the future. For determining whether deferred tax assets must be reduced by a valuation allowance, all available positive and negative evidence must be considered. Information concerning recent pretax accounting earnings generally is critical. For example, if a firm has been recording material cumulative losses recently, it will be hard to justify a conclusion that tax credits can be realized in the near future. This will be evidence supporting the use of a valuation allowance ("negative evidence"). It is not necessary to quantify positive evidence for the conclusion that a valuation allowance is not required unless significant negative evidence exists. Where both positive and negative evidence exist, judgment must be used in evaluating what evidence is more persuasive. More weight should be given to objectively verifiable evidence.

Recognition of Current and Deferred Tax Charged Directly to Equity

A firm's deferred tax liability during an accounting period represents the portion of income tax expense that has not been paid. Therefore, from a pure accounting perspective, deferred tax liabilities are an accounting liability. However, from a financial analyst's perspective, whether deferred tax liabilities should be considered liabilities or not depends on whether they will reverse in the future. If they will, resulting in a cash outflow, then they should be treated as liabilities. If not, then they should be treated as equity! As deferred tax liabilities are created by temporary differences, reversal of a deferred tax liability depends on the reversal of the temporary difference that created it.

Changes in a firm's operations or tax law may result in deferred taxes that are never paid or recovered. For example, the use of accelerated depreciation methods for tax reporting creates a temporary difference. Normally, when there is less depreciation in later years, the deferred tax liability created by more depreciation in earlier years will be reversed. However, for firms with high growth rates, increased investments in fixed assets result in ever-increasing new deferred tax liabilities, which replace the reversing one. That is, a firm's growth may continually generate deferred tax liabilities. In this case, the deferred taxes are unlikely to be paid. Therefore, for such high-growth firms, deferred tax liabilities will not reverse and should be treated as equity.

Deferred tax liabilities are recorded at their stated value. Even if deferred taxes are eventually paid, payments typically occur far in the future. The present value of those payments is considerably lower than the stated amounts. Thus, the deferred tax liability should be discounted at an appropriate interest rate and the difference should be treated as equity.

In some cases, financial statement depreciation understates the value of economic depreciation. Instead, the accelerated depreciation in tax reporting is a better measure. Examples of such cases include equipment obsolescence due to technology innovation and rising price levels. Deferred tax liabilities are neither liabilities nor equity if they are not expected to reverse, and should be ignored by financial analysts.

  • They are not liabilities since they will not reverse.
  • They are not equity since adding the entire tax liabilities to equity overstates the value of the firm.

In practice, the financial analyst must decide on the appropriate treatment of deferred taxes on a case-by-case basis.

Treatment of Operating Losses

Tax losses can be carried back and applied to prior years to obtain refunds of taxes paid. They can also be carried forward to future periods. Because the realization of tax loss carry forward depends on future taxable income, the expected benefits are recognized as deferred tax assets. Such assets are recognized in full but a valuation allowance may be required if recoverability is unlikely.

Practice Question 1

Establishing a valuation allowance reduces ______.

I. the deferred tax asset
II. income
III. the deferred tax liability

Correct Answer: I and II

Practice Question 2

Which of the following statements concerning valuation allowance for deferred tax assets is FALSE?

A. Valuation allowance is not a discretionary tool.
B. Realization of a valuation allowance in the future has income and cash flow implications.
C. A valuation allowance need not be taken even if the tax rate changes, as they may not be reversible in the future.

Correct Answer: A

The timing and amount of a valuation allowance is discretionary and management may use it to manipulate earnings.

Practice Question 3

A reduction in the valuation allowance will ______

I. reduce reported income taxes.
II. reduce actual income taxes.
III. reduce accounting income.
IV. increase accounting income.

A. I and III
B. I and IV
C. II and IV

Correct Answer: B

Actual income taxes are never affected by a change in a valuation allowance established for financial reporting.

Study notes from a previous year's CFA exam:

5. Recognition and Measurement of Current and Deferred Tax