Cash flow consequence of deferred liability reversal

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liaaba

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This is from Schweser qbank,

If the increase in Westlake�s deferred tax liability (ignoring its deferred tax assets) in FY2004 and FY2005 is expected to reverse in future years, what would be the anticipated change in future cash flow?
A) A reduction of $2.12 million.
B) An increase of $2.12 million.
C) A reduction of $5.30 million.
D) An increase of $5.30 million.

Your answer: A was incorrect. The correct answer was C) A reduction of $5.30 million.

We know that reported depreciation in FY2004 was 75% of its FY2005 value of $3.6 million, and thus must have been $2.7 million. We also know that taxable depreciation was $4.2 million, and thus deferred tax charges must have been 40% of ($4.2 million - $2.7 million =) $1.5 million, or $600,000 in FY2004.

We previously calculated that deferred tax charges were $1.52 million in FY2005, so the total increase in deferred tax liability in FY2004 and FY2005 would have been ($600,000 + $1,520,000 =) $2.12 million.

Using the formula:

Reduction in future cash flow = deferred tax expense/statutory tax rate
Reduction in future cash flow = $2.12 million / .40
Reduction in future cash flow = $5.30 million.

We could also have arrived at this figure directly by calculating that taxable depreciation was $1.5 million higher than reported depreciation in FY2004 and $3.8 million higher in FY2005. A reversal of the deferred tax liability would have to reflect a reduction in future cash flow by the same amounts (unless the tax rate changed), or a ($1.5 million + $3.8 million =) $5.3 million reduction in future cash flow.

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Not all the figures are provided here since this is part of a multipart question, but the you can take the numbers from the solution.

However, my question about this question is, the second step they did,

Reduction in future cash flow = deferred tax expense/statutory tax rate

I thought this is the difference in taxable income vs pretax income (confirmed from CFAI text), how can this be the reduction in future cash flow?

The way I understand it, the cash flow difference to result from reversal of deferred tax expense is the taxes that will have to paid (or received for assets), but in the solution for this question, they calculated the difference in taxable income and pretax income as the reduction in future cash flow, am I missing something? Any thoughts?
 
any masterminds want to take a go at this? please enlighten us on this question

dec2007 is also wondering about this question...
 
It would help if you put the original question, not just your thoughts.
 
maratikus,

if you read it from the top, you'll see the question....

i'll paste it here again for those of you who couldn't see it...

If the increase in Westlake�s deferred tax liability (ignoring its deferred tax assets) in FY2004 and FY2005 is expected to reverse in future years, what would be the anticipated change in future cash flow?
A) A reduction of $2.12 million.
B) An increase of $2.12 million.
C) A reduction of $5.30 million.
D) An increase of $5.30 million.
 
liaaba Wrote:
-------------------------------------------------------
> maratikus,
>
> if you read it from the top, you'll see the
> question....
>
> i'll paste it here again for those of you who
> couldn't see it...
>
> If the increase in Westlake�s deferred tax
> liability (ignoring its deferred tax assets) in
> FY2004 and FY2005 is expected to reverse in future
> years, what would be the anticipated change in
> future cash flow?
> A) A reduction of $2.12 million.
> B) An increase of $2.12 million.
> C) A reduction of $5.30 million.
> D) An increase of $5.30 million.



Brainless -

When maratikus asks for the original question, he doesn't just mean the words ending in a question mark immediately preceeding the the multiple choice options, he means the stuff that looks like paragraphs consisting of sentences, numbers and possibly a table that was before the stuff you posted.
 
Super I,

If you care to read the entire post, I'm not sure how much the "paragraphs" would add to your understanding/interpretation of the question,

"We know that reported depreciation in FY2004 was 75% of its FY2005 value of $3.6 million, and thus must have been $2.7 million. We also know that taxable depreciation was $4.2 million, and thus deferred tax charges must have been 40% of ($4.2 million - $2.7 million =) $1.5 million, or $600,000 in FY2004.

We previously calculated that deferred tax charges were $1.52 million in FY2005, so the total increase in deferred tax liability in FY2004 and FY2005 would have been ($600,000 + $1,520,000 =) $2.12 million. "

This is NOT my comments, this is the SOLUTION given by schweser. The point of my question was with,

"Using the formula:

Reduction in future cash flow = deferred tax expense/statutory tax rate
Reduction in future cash flow = $2.12 million / .40
Reduction in future cash flow = $5.30 million.

We could also have arrived at this figure directly by calculating that taxable depreciation was $1.5 million higher than reported depreciation in FY2004 and $3.8 million higher in FY2005. A reversal of the deferred tax liability would have to reflect a reduction in future cash flow by the same amounts (unless the tax rate changed), or a ($1.5 million + $3.8 million =) $5.3 million reduction in future cash flow. "

and specifically,

"Reduction in future cash flow = deferred tax expense/statutory tax rate"

It's not so brainless if you care to read and use your brain to analyze for a sec....
 
In any case, here are the paragraphs that would hopefully give more background....

"Westlake Spa and Beauty has been in business for many years as a day spa, but recently introduced its own line of beauty and skin care equipment, Beauty by Westlake. The line is targeted to other spa facilities, and includes such items as massage tables, manicure and pedicure stations, and European-style facial equipment. In FY2005, Westlake found a national distributor for Beauty by Westlake, and the leap to national distribution drove revenue for the firm from $18.5 million in FY2004 to $26.7 million in FY2005. The firm uses a May 31 fiscal year end.

The firm�s sudden expansion fueled a $2.7 million increase in gross profit in FY2005, from $6.4 million in FY2004, to $9.1 million. The only difference between Westlake�s reported figures for revenue and gross profit is cost of goods sold (COGS), which includes depreciation. The increase in profit before tax was even more dramatic, with FY2005 pre-tax profit jumping nearly 60 percent from $4.2 million to $6.6 million. Advance orders for 2006 suggest that demand will grow in double digits again during the upcoming fiscal year.

A key aspect of the success of Beauty by Westlake is the firm�s unusual guarantee. In order to gain market share from its more established competitors, each piece of equipment in the Beauty by Westlake line comes with a three-year warranty. The firm reserved one percent of the 2005 increase in revenue for warranty expense that year, but spent only $12,000 on warranty replacements in 2005. Jack Phelps, the firm�s CFO, considers it unlikely that the firm will actually spend as much money as he is reserving for warranty expense. However, he wants to be cautious since the line of products is new, and the firm has no historical experience on which to base estimates of future warranty expenses.

The sudden increase in demand for Beauty by Westlake has forced the firm to invest heavily in new production equipment. Reported depreciation expense in FY2004 was only 75 percent of the FY2005 figure. Taxable depreciation, however, was $7.4 million in FY2005 compared with reported depreciation of $3.6 million. This is a significant jump from FY2004, when taxable depreciation was $4.2 million. With Westlake�s 40 percent tax rate, that represents a substantial benefit to cash flow.

Phelps determines that he needs to raise additional capital in order to fund Westlake�s continued expansion. The debt-to-equity (D/E) ratio is already higher than he would like, so he decides to look for equity investors. He consults Ricardo Graham, the senior partner for private equity at the investment firm Graham Dodson.

Graham is impressed by Westlake�s rapid growth, but is also concerned about the D/E ratio. Phelps argues that the firm�s substantial deferred tax liabilities should be added into equity since they are likely to be repaid. Graham responds that �an appropriate adjustment for the firm�s deferred tax liabilities would result in a lower D/E ratio.�

This is small solace to Graham, however, because the adjustment for deferred tax liabilities would lower Westlake�s return on equity (ROE). Phelps counters, however, that the related adjustment for the firm�s deferred tax expense would increase FY2005 net income by more than one-third."
 
does anyone have a clue about their calculation of the reduction in cash flow?
 
i'll consider this a lost question, I talked to some of my accoutant friends, and none of them have a clue as to why they divided by the statutory tax rate to get the reduction in cash flow....
 
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