CFA Practice Question

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CFA Practice Question

A firm has deferred tax liabilities that exceed deferred tax assets. Suppose there is an increase in future tax rates (when tax assets and liabilities will reverse). This will lead to total assets of the firm ______.

A. increasing and net equity increasing
B. remaining the same and net equity increasing
C. decreasing and net equity decreasing
Correct Answer: A

DTAs and DTLs can be confusing; to make it simple, think of it this way. Suppose the tax balance sheet (TBS) and the book balance sheet (BBS) start out identical at the beginning of 2010. Suppose, during 2010, the firm pays $100 more actual tax (income tax paid) than income tax expense. Also suppose all tax is paid in cash and there are no changes to taxes payable, etc. At the end of 2010, what will be the difference between TBS and BBS?

If there are no deferred assets or liabilities, then the cash for these two will be different: BBS cash will exceed TBS cash by $100. How much cash will the firm actually have? Well, the amount given by TBS rather than BBS will be correct (as TBS reflects actual cash that was paid).

Now, we don't really want financial statements that give us an incorrect amount of cash. So what do we do? We have to reduce cash for BBS by $100 for it to show how much cash the firm actually has. But assets don't just disappear. That would make, for example, the income statement incorrect. $100 has disappeared; where did it go? Was it a loss? No, there wasn't any such loss. So what to do? Simply add an asset to BBS and call it a deferred tax asset. It is not cash, but in the future when it reverses, it will reduce the tax bill, so it is valuable like an asset.

A deferred tax asset is like a prepaid expense. Suppose the DTA was to reverse in 2015, and it is now 2011. Now what happens when, say, the tax rate for 2015 increases? How will this impact the BBS in 2011? Now the firm realizes that instead of having to pay $100 less in 2015, it will have to pay, say, $120 less (due to the increase in tax rates, and the fact that part of the tax is prepaid). So, the firm should increase the DTA from $100 to $120. This will reduce income tax expense by $20, increase total assets by $20, and increase equity by $20. Liabilities should be unaffected.

Similar arguments apply to DTLs, except these calculations would start with the firm having paid less tax (income tax paid) than income tax expense by $100. Without adding the DTL, this would result in the BBS cash item being less, by $100, than the TBS cash item (which is the correct amount of actual cash held by the firm). So, to make the BBS show the correct amount of cash held by the firm, increase cash by $100 (which makes it equal the correct cash held by the firm) and introduce a liability DTL for $100 on the right-hand side.

Think of it as if the description of the firm, as presented by the BBS, shows that $100 of the firm is owned by the IRS, which will get that money when the DTL reverses. The BBS is acknowledging that the firm currently has an extra $100 in cash because it delayed paying the IRS (which makes the IRS one of the claimants of the firm's assets).

User Contributed Comments 19

User Comment
gmilchev :)
gill15 Dont even want to read there a one line answer...otherwise skip...
thekobe it is C, since the DTL exceed DTA
bantoo Very simple. The decrease in DTL will be more than DTA. The net impact is still positive. So, Assets will increase and so the equity. The right answer is A.
johntan1979 This is a confusing question because:
1. There is an increase in tax rate, AND
2. There is a reversal

I suppose you can incorporate BOTH, i.e. increased tax rate, and then the reversal, which I assume is what this question wants.

DTL > DTA, hence the net is DTL.

Based on the explanation given by AnalystNotes, if the net is DTA and tax rate increases, then:
Higher DTA, lower tax expense, higher total assets, higher equity

So if now the net is DTL, so it should be the opposite of all that. HOWEVER, a reversal (in the last year) reverses the effect of the opposite effect. Therefore, the answer is A, higher total assets and equity.
2014 text book says if tax rate increases; DTA and DTL increase.
A seems rite.
jonan203 tl:dr
robbiecow Net DTL: Reduction in tax rate will reduce liabilities, reduce income tax expense, and increase equity

Net DTA: Reduction in tax rate will reduce assets, increase income tax expense, and decrease equity

Net DTL: Increase in tax rate will increase liabilities, increase income tax expense, and reduce equity

Net DTA: Increase in tax rate will increase assets, decrease income tax expense, and increase equity
mdejesus Who TF thought it would be a good idea to write such a long explanation???
ascruggs92 johntan1979, all "reversal" means is that the benefit/or liability will be realized at that point. saying that the tax rate increases in the year of reversal (i.e. reconciliation between tax and accounting B/S) simply means that the current net DTA or net DTA needs to be recalculated at the new rate. In this question there is a net DTL; assuming the same rate of increase is applied to both the DTA and DTL, the DTL increases more due to its larger starting balance. A larger net DTL means lower assets & equity. so C is correct
ashish100 2014 takes the first prize.
xd2163 I do not agree with the answer.
If DTL > DTA, then after adjusting for tax rate change, Delta DTL > Delta DTA. Once they are reversed, or in other words, realized, we have Delta L > Delta A. We know that Delta A = Delta L + Delta E. To balance the equation, Delta E has to be less than 0. Therefore, my take is that asset will increase, liability will increase to a larger extent, and equity will decrease.
maryprz14 Amazing explanation. Could never be more clear than this. Thanks, Analyst notes.
isalya confused me even more. They just increase DTL and DTA by higher rate. I thought effect after actual utilization shoud be calculated. so se would get Dr income tax expense CR DTA and higher Dr DTL CR income tax expense
dbedford If you paid an extra $100 in taxes to the IRS based on their methods than what you showed payable on your financial statement then you have to reflect that you have less cash somehow because you actually paid the $100 to the IRS so... you show it as a DTA. Now if in the future the tax rate increases and that $100 paid in the past should be $120 under the newer future rate then you increase your DTA to $120 and instead of claiming that you paid $100 in the past you show that you paid $120 which increases your assets by $20 that you didnt pay but that you got to take advantage of frmo the future tax rate on your DTA
sshetty2 this explanation is epic; thank you AN!
maryprz14 Hey everyone; I get my words back, this question is confusing and I am not even sure if the answer is right.
Ewan2015 This makes no sense. If my DTL is larger than my DTA I would have a net DTL (i.e. I owe money to the tax authorities in the future for activity occurring in the past). If I then apply a higher tax rate to my net DTL my DTL gets bigger I would therefore have a decrease in net assets and a decrease in equity.
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