Reversal of deferred tax asset/liability

[liaaba]

I have 2 questions from Schweser qbank, one on deferred tax asset, the other on deferred tax liability,

Which of the following would make it unlikely for Westlake to realize its deferred tax asset?
A) An increase in the firm�s profit margin.
B) A reduction in the size of the valuation allowance.
C) A lack of taxable income in the future.
D) An increase in tax rates.

Your answer: D was incorrect. The correct answer was C) A lack of taxable income in the future.

A deferred tax asset can only be realized if there is sufficient taxable income in the future to take advantage of the tax asset. Thus, a lack of taxable income would make it unlikely that Westlake could realize its deferred tax asset. An increase in the firm�s profit margin would likely increase taxable income. The valuation allowance represents the portion of deferred tax asset that may not be realized, so a reduction in the size of the valuation allowance would reflect an increase in the likelihood of realizing the deferred tax asset. An increase in tax rates would cause an increase in the deferred tax asset on the balance sheet.

----A and B can be eliminated pretty easily, but my problem with the answer is with C and D. OK, D definitely will not result in a deferred tax reversal. But the problem is with C, I think in the answer, what they refer to as taxable income is pretax income, rather than taxable income for tax purposes, cos doesn't the reversal of deferred tax asset hinge on the fact that pretax income > taxable income (tax purposes), so if you have a lack of taxable income for tax purspose, then you can use the deferred tax asset, any thoughts?

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Which of the following events is most likely to result in a reversal of Westlake�s deferred tax liability?
A) A gradual decline in demand for the firm�s products.
B) An increase in the statutory tax rate.
C) A decline in the effective tax rate.
D) An increase in the firm�s growth rate.

Your answer: C was incorrect. The correct answer was A) A gradual decline in demand for the firm�s products.

Deferred tax liabilities generally reverse when a firm reduces its rate of investment but remains profitable enough to pay taxes. A gradual decline in demand for the firm�s products will increase the chances that the deferred tax liability will reverse by reducing new investment while maintaining profitability. An increase in the statutory tax rate will cause an increase in the firm�s deferred tax liability. Both a decline in the effective tax rate and an increase in the firm�s growth rate would probably coincide with increased investment and reflect increased, not decreased, deferred tax liabilities.

---again, B and D are no brainers. With A, it's not a necessary condition that a comp will reduce investment in response to a reduce in product demand, a very good example would be if the products are becoming obsolete, then comps might increase investment (most likely diff investment than before) to create new product lines/improve existing products to enhance the appeal and demand of their products, however I do accept a reduction in investment as a probable response to a decline in product demand. Now with the effective tax rate, I don't really agree with their interpretation of a decline in the effective tax rate, if the effective tax rate is the reported one, then it's income tax expense/pretax income, since income tax expense changes in the same direction as deferred tax liability, how can a decline in effective tax rate signal a increase in deferred tax liability? Unless the effective tax rate is the alternative one as taxes payable/pretax income, then a decline in taxes payable could mean higher depreciation because of early year depreciation of new investment, so tax base depreciation is higher than for financial reporting, resulting in higher deferred tax liabilities, any thoughts?

 

[dec2007]

Liaaba, I'm also confused about this question. I totally agree with the statement in your last paragraph. The tax that will be paid is the actual reduction in cash flow. Depreciation isn't a real cash expense, so how is it then "reduction in cash flow"?

My understanding is that the 2.12mm will be the actual cash outflow, b/c you'll have to pay the deferred taxes. 5.3mm is the amount by which depreciation on the income statement will exceed the one on tax documents.

If anyone could understand the reasoning behind Schweser's answer, please share

 

[dec2007]

sorry, posted under wrong thread. that was for your other question.

 

[liaaba]

anyone want to comment on those 2 questions above?

you invaluable comments would be much appreciated

 

[hiredguns1]

liaaba, let me preface this by acknowledging that I don't completely understand your commentary surrounding these questions, so forgive any misinterpretations I've made below. I'll take a shot at the questions themselves and portions of your analysis.

First question.

My understanding is that taxable income on the tax return is equivalent to pretax income on the income statement.

A passage from Schweser's 2006 LI Notes, Book 3, p.235 validates answer C.

"For deferred tax assets to be beneficial, the firm must have future taxable income. If it is more likely than not (> 50% probability) that a portion of deferred tax assets will not be realized (insufficient future taxable income to take advantage of the tax asset), then the deferred tax asset must be reduced by a valuation allowance."

Second question.

I don't think your example works. In this context, when Schweser says "investment," they mean acquisition of long-lived assets like PP&E (i.e. stuff that gets depreciated). Recall that one of the most common sources of DTL is the use of accelerated depreciation for tax-return purposes, while using slower depreciation for financial statement purposes.

So with demand for the company's products decreasing, it'll likely slow down its investment in productive capacity, deferred tax liabilities stop increasing as existing PP&E becomes fully depreciated, and like Schweser's explanation states, if the firm continues to be profitable enough to pay taxes then those DTL begin reversing.

Your example of "investment" is what I'd describe as R&D, which like other intangible assets are typically only reported on the balance sheet when acquired from another firm. Otherwise, the costs for developing intangible assets internally are expensed in the current period. This isn't a long-lived asset that gets depreciated and generates additional DTL (i.e. doesn't prevent the DTL from reversing).

Regarding response C, the affect of changes in the effective tax rate aren't material to this question. This will affect income tax expense and decrease both DTL and DTA.

Income tax expense = taxes payable + delta(DTL) - delta(DTA)

However, we're concerned with events that will "most likely" result in a reversal of the DTL, not impact income tax expense or the value of DTL or DTA. The balance of DTL does decrease as reversal occurs, but this still isn't our primary concern in this question.

The increase in DTL they're describing stems indirectly from the decrease in effective tax rates. They're assuming investment increases, which could increase DTL, as we discussed above.

The use of "most likely" rather than "will definitely" is very important. Often there's no great answer to a CFAI (or practice) question, so you've got to select the least-terrible response and move on.

Finally, I'll caution against making assumptions beyond what's explicitly revealed in a question's introduction. You just have to accept that these questions typically oversimplify things, and resist the natural temptation to draw on your past experience and education which will almost certainly result in you making assumptions and/or engaging in reasoning that will not only waste time, but lead you astray from the correct response. This is particularly true of the ethics section.

I made this exact mistake a few days ago when I bungled the CFO question someone else posted. I made erroneous assumptions instead of just confining my reasoning to evidence presented in the question.

Hopefully this helps.

 

[liaaba]

hiredguns1, wow, thanks for your reply,

"First question.

My understanding is that taxable income on the tax return is equivalent to pretax income on the income statement. "

---My understanding is that deductions for pretax income on income statement is not necessarily the same as deductions for tax purposes (such as depreciation that would give rise to DTL), unless of course by taxable income you assume they're referring to revenue (like pre expense deductions), in which case then a lack of "taxable income" would make it unlikely to reverse DTA (i.e. no revenue, so no taxes paid...). I was doing this question under the assumption that by taxable income, they refer to the net income before tax that would be subject to taxes (i.e. after deductions of all expenses)

' "For deferred tax assets to be beneficial, the firm must have future taxable income. If it is more likely than not (> 50% probability) that a portion of deferred tax assets will not be realized (insufficient future taxable income to take advantage of the tax asset), then the deferred tax asset must be reduced by a valuation allowance." '

---I saw the a similar but less detailed statement in the CFAI text as well...

"Second question.

I don't think your example works. In this context, when Schweser says "investment," they mean acquisition of long-lived assets like PP&E (i.e. stuff that gets depreciated). Recall that one of the most common sources of DTL is the use of accelerated depreciation for tax-return purposes, while using slower depreciation for financial statement purposes.
...."

---not even necessarily R&D, for example, suppose a comp is in an industry with slowly declining demand, but is operating with obsolete equipment (or relatively older), so their cost structure less efficient compared to others in the industry, then, this comp and replace their existing equipment with newer equipment in order to become more competitive and stay profitable right, I mean, not every comp will just sit and want their demand dwindle and cut investment and wait for the end of the world. I do accept their reasoning however, and it wasn't that I think this is a bad/wrong answer....it's just their reasoning is somewhat weak I thought