Accounting for Deferred Taxes

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					What are deferred taxes?
The need for deferred tax accounting arises because companies often postpone or pre-pays taxes
on profits pertaining to a particular period.

Deferred tax liability
There may be a difference in the way certain items of expense are allowed to be treated for tax
purposes and how a company actually treats them.

Tax laws allow full depreciation in the first year after a company acquires certain assets.
However a company may actually write off the depreciation over several years on its financial
statements. The company may charge depreciation at lower rates than allowed under tax laws.
Or it may use a different method of charging depreciation.

Example: Pre-issue expenses – expenses on R&D or expenses incurred on mergers, may be
allowed to be written off over a fixed number of years. The company may stretch the write-off
over a longer period.

In these cases, a company ends up postponing part of its tax liability on this year's profits to
future years. This is because, in the current year, its profits for tax purposes would be lower than
the profits computed for accounting purposes.

New accounting standards require that a company carve out a part of its current year's profits
(equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax
liability serves the purpose of a reserve, which will be drawn down in the future years to meet
the company's future tax liability.

Deferred tax asset
The tax laws may not recognize some of the expenses that a company has accounted for in its
accounts. For instance, provisions made at the discretion of the management, such as those for
bad debts, which are not fully recognized by tax authorities.

In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the
profits that the taxman calculates would be higher than those computed by the company.
Therefore a company would save on tax in the years when the expenses or provisions actually

Accounting for a deferred tax asset?
A company may recognize the excess tax paid over and above the tax liability as a "deferred tax
asset". However, in the interests of conservative accounting, companies should recognize such
deferred tax assets only if they actually anticipate that their income in future will be enough
to allow the company to set off the losses or the excess tax paid. In other words if a company is
not profitable in the future there will be no tax savings to benefit from and therefore accounting
for this asset is not justified.

If the analyst’s purpose is forecasting and he seeks to identify the persistent components of
FCFF, then it is not appropriate to add back deferred tax changes that are expected to reverse
in the near future. In some circumstances, however, a company may be able to consistently
defer taxes until a much later date. If a company is growing and has the ability to indefinitely
defer tax liability, an analyst adjustment to net income is warranted.

“Conversely, companies often record expenses for financial reporting purposes (e.g.,
restructuring charges) that are not deductible for tax purposes. In this instance, current tax
payments are higher than reported on the income statement, resulting in a deferred tax asset
and a subtraction from net income to arrive at cash flow on the cash flow statement. If the
deferred tax assets is expected to reverse (e.g., through tax depreciation deductions) in the
near future, the analyst would not want to subtract the deferred tax asset in his cash flow
forecast to avoid underestimating future cash flows. On the other hand, if the company is
expected to have these charges on a continual basis, a subtraction is warranted to lower the
forecast of future cash flows.” 1

If a company knows that it will have a tax benefit in the future they will recognize that benefit by
accounting for a deferred tax asset. However, if the recognition of the acquired deferred tax
benefit results from an identifiable event after its occurrence it would be reported as a reduction
of income tax expense for that period.

Adjusting for a deferred tax asset
There are two classifications for a deferred tax asset:
       1. Expense:
              a. Is a bonifide GAAP expense today
              b. It is not a tax deduction today
       Is NOT subtracted from the cash flow calculation

          2. Revenue
                a. Not a bonifide GAAP expense today
                b. It is however taxable income.
          Subtracted from the cash flow calculation

Why account for deferred taxes?
By recognizing deferred tax liabilities in its books, a company makes sure that the tax liability
for any particular year is reflected in that year's financials and does not carry over to future
profits. It brings investors one step closer to understanding exactly how much of a company's
profits for a period are from its operations (rather than from fiscal savings).

    Free Cash Flow Valuation
VIACOM INC 10-K 2003-12-31: Balance Sheet

ASSETS                                     2003/12/31      2002/12/31        2001/12/31       2000/12/31
Deferred tax assets, net (Note 11)        $69,000,000     $238,600,000      $359,700,000     $336,300,000
Deferred tax assets, net (Note 11)             $0         $289,000,000
            Total Deferred tax assets     $69,000,000     $527,600,000      $359,700,000     $336,300,000

Deferred tax liabilities, net (Note 11)   $297,200,000         $0           $1,131,200,000   $931,500,000

Total Deferred taxes                      $228,200,000    ($527,600,000)    $771,500,000     $595,200,000
Changes in Deferred taxes                 $755,800,000   ($1,299,100,000)   $176,300,000

VIACOM INC 10-K 2003-12-31: Cash Flow

                                           2003/12/31      2002/12/31        2001/12/31       2000/12/31
Increase in income taxes payable          $663,700,000    $826,600,000      $439,400,000     $442,000,000
and net deferred tax liabilities

    PricewaterhouseCoopers – MASB 25

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