MODULE 9: ANALYSIS OF INCOME TAXES

Differences Between Accounting Profit and Taxable Income

1. Accounting profit is profit before tax under accounting rules.
2. Taxable income is income under tax law.
3. Taxes payable is the cash tax owed now.
4. Income tax expense is the tax cost reported in the income statement, including current tax plus deferred tax effects.
5. Temporary differences reverse later and create deferred tax assets or deferred tax liabilities.
6. Permanent differences never reverse and do not create deferred tax items.

Deferred Tax Assets and Liabilities

1. The learning outcome here is: explain how deferred tax liabilities and assets are created and the factors that determine how deferred tax liabilities and assets should be treated for financial analysis. In plain English: accounting and tax rules often do not recognize income and expenses at the same time. Deferred tax is the bridge between the two worlds.

2. Accounting profit is profit before tax on the income statement. Taxable income is income calculated using tax law. Taxes payable is the amount owed to the tax authority now. Income tax expense is the tax cost reported on the income statement after matching current and future tax effects.

3. Do not mix these up:

1. Temporary difference means the accounting-tax difference reverses later. Permanent difference means it never reverses. This is the whole fork in the road. Temporary difference creates deferred tax. Permanent difference does not.

1. Example of a permanent difference: a fine may be recorded as an expense in accounting profit but may not be deductible for tax. The tax authority basically says, “Nice try, you cannot reduce taxable income for that.” Since the difference will never reverse, no deferred tax asset or deferred tax liability is created.

2. Example of a temporary difference: depreciation. A company may use straight-line depreciation in its financial statements but faster depreciation for tax. Total depreciation over the asset’s life is still the same, but the timing is different. That timing gap creates deferred tax.

HOW TO DECIDE DEFERRED TAX ASSET VS LIABILITY

1. For assets, use this rule:

1. For liabilities, the rule flips:

1. The easiest memory: if the tax authority has been paid too much today or gave you too little deduction today, you may have a deferred tax asset. If the tax authority has been paid too little today because you got tax relief early, you may have a deferred tax liability.

2. Accelerated tax depreciation usually creates a deferred tax liability. The company deducts more depreciation for tax now, so taxable income and cash taxes are lower today. Later, tax depreciation will be lower, so taxable income and cash taxes will be higher. That future tax payment is the liability.

3. Advance payments from customers can create a deferred tax asset if tax law taxes the cash immediately but accounting revenue is recognized only later when the company performs. The company pays tax before recognizing accounting income, so it has effectively prepaid tax.

4. Research costs can create a deferred tax asset if accounting rules expense the cost immediately but tax rules require capitalization and amortization. Carrying amount may be zero, but tax base is still positive. That future tax deduction has value.

5. Development costs can create a deferred tax liability if the accounting carrying amount is higher than the tax base. The company has recognized an asset in the financial statements, but the tax base is lower, so future taxable amounts may be higher.

CORE FORMULA

1. Income tax expense combines current taxes and deferred tax movement.

1. If deferred tax liability increases, income tax expense rises above taxes payable. If deferred tax asset increases, income tax expense falls below taxes payable. This is why cash tax and income tax expense can tell very different stories.

2. Reston Partners example from the curriculum: equipment cost is GBP 20,000. Accounting depreciation is GBP 2,000 per year over 10 years. Tax depreciation is GBP 2,857 per year over 7 years. Tax depreciation is faster, so tax base falls faster than carrying amount. Carrying amount exceeds tax base, so the company records a deferred tax liability.

1. If the statutory tax rate changes, deferred tax assets and deferred tax liabilities must be remeasured. A lower future tax rate reduces the value of both. A deferred tax asset becomes less valuable because each future deduction saves less tax. A deferred tax liability becomes smaller because each future taxable amount costs less tax.

REALIZABILITY AND VALUATION ALLOWANCE

1. A deferred tax asset is only useful if the company expects enough future taxable profit to use it. A loss-making company can have a big deferred tax asset on paper, but if it never earns taxable income, that asset is like a discount coupon for a shop you will never visit.

2. Under International Financial Reporting Standards (IFRS), if future economic benefits are doubtful, an existing deferred tax asset is reversed. Under US GAAP (U.S. GAAP), a valuation allowance is created to reduce the deferred tax asset to the amount more likely than not to be realized.

3. Micron Technology in the curriculum had large tax loss carryforwards and a large valuation allowance. That allowance was basically management saying: “We have tax benefits on paper, but we are not confident enough that all of them will be usable.” If profits improve later, reducing the allowance can increase reported earnings even though no new cash came in.

4. This is where analysts should be skeptical. A company can suddenly look more profitable because it releases a valuation allowance, not because the core business improved. After the global financial crisis, banks and cyclical companies had huge tax loss carryforwards. When profits came back, some of those tax assets became usable and accounting earnings got a boost. Useful, yes. But not the same as selling more products.

5. For acquisition analysis, tax loss carryforwards can be valuable. If a profitable acquirer can use the target’s losses to reduce future taxes, it may be willing to pay more. The value depends on the acquirer’s tax rate, expected taxable income, and when the tax benefits can actually be used.

HOW ANALYSTS TREAT DEFERRED TAX LIABILITIES

1. Treat a deferred tax liability as a real liability if it is expected to reverse and require a future cash tax payment. Example: accelerated tax depreciation usually reverses when tax depreciation becomes lower later.

2. Treat a deferred tax liability more like equity if it is not expected to reverse. If a company keeps buying new assets and keeps rolling forward the same kind of tax deferral, the cash payment may be pushed out for a very long time.

3. Exclude the deferred tax liability from both debt and equity if the amount and timing of reversal are too uncertain. That is the cleanest treatment when you cannot honestly say whether it behaves like debt or equity.

1. Real-world hook: Berkshire Hathaway has long benefited from tax deferral because unrealized gains and other timing differences can postpone taxes for years. Think of it like an interest-free loan from the tax authority. It is not free money forever, but if the payment is delayed for decades, the economic value is very real.

2. Real-world danger: tax assets can flatter a weak company. A bank with large losses may show deferred tax assets, but those assets depend on future taxable profits. If the bank cannot earn enough, the asset must be reduced. That reduction hits income and equity, which can make already weak capital ratios look worse.

1. The story test is the best test. Deferred tax asset means “future tax relief, if usable.” Deferred tax liability means “future tax payment, if it reverses.” The analyst’s job is not to memorize labels. The analyst’s job is to ask: will this actually become cash tax, cash saving, or nothing?

Tax Rates and Disclosures

1. Do not look at the tax line only as a percentage of sales and stop there. The sharper check is income tax expense / earnings before tax because that gives you the effective tax rate. That tells you what share of pretax profit the company is actually handing over in tax.
2. If the effective tax rate falls, do not clap immediately. Ask the obvious follow-up: did the business genuinely move profit into a lower-tax jurisdiction, or did something one-off make the tax bill look lighter this year?
3. Tax numbers are dangerous because they can make net income look healthier even when the business itself did not improve. If profit rises mainly because the tax rate fell, that is not the same thing as stronger pricing, better cost control, or better operating performance.
4. When disclosures show a tax change. Your job is to ask, “Why did this move, and can it repeat?” That is the whole game here.

1. Think about two shops that each earn pretax profit of USD 100. The first shop pays USD 30 in tax, so it keeps USD 70. The second shop pays USD 20, so it keeps USD 80. Same pretax profit. Same business performance before tax. But one looks better after tax just because the tax bite is smaller. That is the core intuition here.

2. Apple could sell the same iPhone to the same customer, but if more of the profit was routed through a lower-tax place like Ireland, net income could look stronger even when the basic business engine had not suddenly become better. The same logic is why people kept staring at large companies like Google, Meta, or General Electric and asking how profits could look so huge while tax expense looked so light. For the analyst, the right question is never “wow, net income jumped.” The right question is “did operations improve, or did the tax structure improve?”