Accounting - Advanced Conceptual Questions

Question 1

Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?

Answer 1

A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future – in other words, you’ve underpaid on taxes and need to make up for it in the future.

A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future – you’ve paid too much before, and now you get to save on taxes in the future.

Both DTLs and DTAs arise because of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes.

You see them most often in 3 scenarios:

1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes).
2. When Assets get written up for book, but not tax purposes, in M&A deals.
3. When pension contributions get recognized differently for book vs. tax purposes.

Question 2

How can both DTAs and DTLs exist at the same time on a company’s Balance Sheet? How can they both owe and save on taxes in the future?

Answer 2

This one’s subtle, but you frequently see both of these items on the statements because a company can owe and save on future taxes – for different reasons.

For example, they might have Net Operating Losses (NOLs) because they were unprofitable in early years, and those NOLs could be counted as Deferred Tax Assets.

But they might also record accelerated Depreciation for tax purposes, but straight-line it for book purposes, which would result in a DTL in early years.

Question 3

How do Income Taxes Payable and Income Taxes Receivable differ from DTLs and DTAs? Aren’t they the same concept?

Answer 3

They are similar, but not the same exact idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the current year.

For example, if a company owes $300 in taxes at the end of each quarter during the year, on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months, at which point Income Taxes Payable would decrease once again.

By contrast, DTAs and DTLs tend to be longer-term and arise because of events that do NOT occur in the normal course of business.

Question 4

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when analyzing its financial statements?

Answer 4

• Restructuring Charges
• Goodwill Impairment
• Asset Write-Downs
• Bad Debt Expenses
• One-Time Legal Expenses
• Disaster Expenses
• Changes in Accounting Policies

Note that to qualify as an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if one of these charges is “below the line,” then you do not add it back for the EBITDA / EBIT calculation.
Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation when calculating EBITDA, but that these are not “non-recurring charges” because all companies have them every year – they’re just non-cash charges.

Question 5

How do Net Operating Losses (NOLs) affect a company’s 3 statements?

Answer 5

The “quick and dirty” way: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pre-Tax Income number (which should stay the same). Then you can deduct whatever you used up from the NOL balance (which should be a part of the Deferred Tax Asset line item).

A more complex way to do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you record the difference as an increase to the Deferred Tax Liability on the Balance Sheet.

This method reflects the fact that you’re saving on cash flow – since the DTL, a Liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.

Question 6

What happens to the Deferred Tax Asset / Deferred Tax Liability line item if we record accelerated Depreciation for tax purposes, but straight-line Depreciation for book purposes?

Answer 6

If Depreciation is higher on the tax schedule in the first few years, the Deferred Tax Liability will increase because you’re paying less in cash taxes initially and need to make up for it later.

Then, as tax Depreciation switches and becomes lower in the later years, the DTL will decrease as you pay more in cash taxes and “make up for” the early tax savings.