Taking the Mystery Out of Deferred Taxes

Deferred tax assets and liabilities can confuse just about everyone. When reviewing a borrower’s financial statements, you may wonder what they are and how the company quantifies them. Wonder no more.

Understanding the Differences

An artificial byproduct of book and tax accounting methods, deferred taxes are future taxable amounts or deductions that arise from temporary differences between accounting income and taxable income.

Financial statements prepared under Generally Accepted Accounting Principles (GAAP) require income taxes to be calculated based on GAAP earnings. But in reality, companies pay taxes on their taxable income. Borrowers record a deferred tax asset if they pay more tax than is reflected in their financial statements. If the reverse occurs, a deferred tax liability is reported.

A common reason for differences between GAAP and taxable income is depreciation expense. For tax purposes, companies use accelerated depreciation methods to minimize taxable income in the early years of a fixed asset’s life. But they often use straight-line depreciation for GAAP purposes to maximize earnings per share and to minimize artificial fluctuations in earnings.

Differences between GAAP and tax depreciation methods typically result in companies reporting deferred tax liabilities, because the actual tax paid is temporarily lower than what’s reported on the GAAP income statement.

Deferred tax assets frequently result from held-over tax benefits, such as capital loss carryforwards, operating loss carryforwards and tax credit carryforwards. These items arise because a company lacks taxable income to use the carryforwards in the current period — but the company expects to earn sufficient taxable income to use them in future periods.

The Subtleties

Like all balance sheet accounts, deferred taxes may be current or long-term, depending on whether the borrower expects to use them over the next 12 months. Deferred tax liabilities are recorded at their full amount, without regard to the time value of money.

Deferred tax assets are offset by the possibility that the asset will expire, tax rates will change or the company won’t earn sufficient income to use a carryforward. Each year, borrowers reassess their deferred tax allowances, and any adjustments flow through to the income statement.

You can’t always count on deferred taxes. GAAP permits some leeway in how companies report and adjust deferred taxes. And some carryforwards may not be transferable if ownership changes.

Clarity Mixed with Obfuscation

Lenders should understand every line item on their borrowers’ financial statements, including the risks that assets might be overvalued, liabilities might be understated or management might manipulate the numbers for a rosier outlook.

For more information on how we can help your community bank, please contact Sonny MacArthur at smacarthur@pkm.com or 404-420-5631.