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.

User Contributed Comments 9

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kalps: Operating loss - deferred tax asset if you are carrying it forward for use against future income. However, if ther recoverability is low then a valuation allowance must be made.
teddajr: Very difficult topic !!
mirfanrana: recognized for tax reporting but not for financial reporting thats why permanent differnce and no deferred tax assets or liabilities.
gulfa99: very low probability that i will do well in this section (tax) ;(
papajeff: I just had the same feeling Gulfa. Remember that is ok to do poorly, just not more poorly than most!
johntan1979: Somehow I find this section easier to understand than the previous tax sections... weird.

All the best to y'all! CFA is a journey. Passing or failing is not as important as the process itself!
jonan203: right on jt1979!!! so far the tax subjects seem more difficult to me relative to the prior topics covered in analystnotes...

probably because i've never taken a course or done any work related to tax accounting...
gill15: This is actually a unit where reading the text helps. It's not hard. You have to pick and choose analyst notes at times. Most of the time I used this site.
Taxes --- CFA books
Bootstrapping, and some Fixed income stuff -- CFA books...
kingirm: Agree with gill15... fixed income part is not quite adequate on ANs