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A lesson in deferred tax
When the
Financial Accounting Standards Board (FASB) adopted Standard No. 109 (Accounting
for Income Taxes) in the early 1990s, deferred taxes were widely covered
in the financial news. But in recent years, few periodicals have published
articles on this topic. Valuation professionals, however, can’t afford to
lose sight of deferred taxes, because they can materially affect a company’s
value.
What are deferred taxes?
Companies pay income tax on IRS-defined taxable income. On their generally
accepted accounting principles (GAAP) financial statements, however, firms
record income tax expense based on accounting “pretax net income.” In a given
year, taxable income and pretax net income may substantially differ. A common
reason for this temporary difference is depreciation expense.
For income taxes, the IRS allows companies to use accelerated depreciation
methods to lower the taxes paid in the early years of an asset’s useful life.
Alternatively, companies frequently use straight-line depreciation for GAAP
reporting purposes. As the asset ages, the temporary difference in
depreciation expense reverses itself.
If a company’s pretax net income and its taxable income differ, it must
record deferred taxes on its balance sheet. The company records a deferred
tax asset for the future benefit it will receive if it pays the IRS more tax
than an income statement reflects. If the opposite is true, the company
records a deferred tax liability for the additional future amount it will
owe.
These temporary reporting method differences are not the only reason
companies record deferred tax liabilities. Deferred tax assets may occur from
three other sources: capital loss carryforwards, operating loss carryforwards
and tax credit carryforwards.
Like other assets and liabilities, deferred taxes are classified as either
current or long-term. Regardless of their classification, deferred taxes are
recorded at their cash value (that is, no consideration of the time value of
money). Deferred taxes are also based on current income tax rates. If tax
rates change, the company revises its balance sheet and the change flows
through to its income statement.
While deferred tax liabilities are recorded at their full amount, deferred
tax assets are offset by a valuation allowance that reflects the possibility
the asset will expire before the company can use it. Deciding how much
deferred tax valuation allowance to book is highly subjective and left to
company management’s discretion. In fact, some executives may use these
allowances to manipulate profits, because any changes to the allowance flow
through to the company’s income statement.
How do valuators calculate deferred taxes?
Deferred taxes are confusing and subject to GAAP rules, which often differ
from real-life economics. Unlike accountants, valuation professionals
generally view deferred taxes from the perspective of a company’s potential
buyers and sellers.
A company that offers buyers significant tax savings later could be worth
more than an identical business without deferred tax assets, and vice versa.
Key issues are whether the deferred taxes are transferable to new owners, and
the extent to which ownership changes may affect the realization of tax
deferrals.
Balance sheet considerations. When the balance sheet is used to derive
a company’s value, the valuation expert may address deferred tax assets and
liabilities in a variety of ways. For instance, he or she may adjust the
recorded cash values to their net realizable values using the company’s cost
of capital. The valuation professional might also address any anticipated tax
rate hikes or cuts.
Cash flow considerations. Deferred taxes also affect the income
statement and, ultimately, the company’s cash flows. Depending on the
situation, historical income statements may receive normalizing adjustments
for deferred tax items, such as annual changes to the deferred tax valuation
allowance, that make their way to the company’s bottom line.
When making cash flow projections, the company’s effective tax rate could be
raised or lowered to reflect deferred tax liabilities or assets,
respectively. Or the valuator might employ a discounted cash flow analysis to
reflect the projected timing of deferred tax recognition.
Alternatively, the company might estimate the net realizable value of tax
deferrals and add this estimate to its preliminary value conclusion, much
like the treatment of a nonoperating asset or liability.
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