Peeling away financial reporting issues one layer at a time

Deferred Taxes and Tax Reform: Is a Big (Fictional) Accounting Gain in the Future?

I read today that Congress is likely to consider corporate tax reforms that would reduce the statutory income tax rate from the current 35% to as little as 15%.  The lower income tax rate would be offset by the elimination of a tax deduction for interest, and a “destination-based consumption tax.”  The idea of this latter new form of taxation is that goods would be taxed based on where they were consumed rather than where they were produced.  Accordingly, imports would be subject to Federal taxes, while exports would not.

Whether this novel sort of tax reform would benefit the U.S. economy seems like a very interesting and significant question that will  be forever outside of my area of expertise.  But, it does provide me with an opportunity to explain my misgivings with the reporting of tax expense in financial statements.

I have four concerns:

First, there is the issue of “intraperiod” tax allocation.  Given the broad variety and complexities of tax regimes throughout the world it comes as no surprise that the FASB provides virtually no guidance for distinguishing between an “income tax” and other forms of taxation. Yet, the required two-step income statement relies on such a distinction:

NI = NIBT – Income Tax Expense

This means that income taxes must be separately presented “below the line,” while all of the other many forms of taxes (e.g., property taxes, excise taxes, fuel taxes) are buried in NIBT.  I suppose that the distinction between income taxes and other forms of taxation make it convenient for the analyst to calculate a company’s so-called “effective income tax rate” — as the ratio on income tax expense to NIBT.  But, in this day and age of creative taxation methinks it is devolving into a distinction without much of a difference.  If there is any distinction to be made, its practical significance will be even more diminished should income taxes become a smaller portion of the total.

Therefore, I prefer that all taxes are aggregated in one place on the income statement.  This is in part to have a better idea of how much taxes were accrued, but more important it is to have clearer information about a corporation’s operating profitability before taxes.  The components of taxes paid/accrued are also relevant, so the notes to the financial statements should tabulate total taxes by major categories.

Second, there is the question of reporting “deferred taxes.”  Given the universal applicability of ASC Topic 740 — Income Taxes, I would venture to say that measuring deferred tax expense is the most challenging topic in U.S. GAAP for practitioners.  Yet, its conceptual and practical bases are highly questionable:

Take as an example a machine that cost $15,000.  For tax purposes, it has a five-year life and is subject to double-declining balance depreciation.  Company A will apply straight-line depreciation over five years for financial reporting purposes, while company B will use for its financial reporting the same double-declining depreciation method that it uses for tax purposes.  Both companies are in compliance with U.S. GAAP.

At the end of the first year, Company A will report a deferred tax liability of $1,050 (= [$12,000 – $9,000] x 35%); however, Company B will report no deferred tax liability.  Company A will report total expenses of $4,050; but Company B will report $6,000 in expenses.

Liabilities are supposed to indicate expected future cash outflows.  But, if both companies are identical in every other respect, their future cash outflows are expected to be the same even though liabilities are reported as being different. Ergo, the deferred tax liability must be a red herring.

Third, the basis of measurement of deferred liabilities is itself highly questionable.  Let’s consider the liability accruals that will be made on December 31, 2016, which is just a couple of weeks from today.  ASC 740 states that the currently enacted tax rate must be applied to the timing difference.  Yet, it is reasonably possible, if not highly likely that tax rates will go down in the next couple of years.  In this environment, I can’t say how application of ASC 740 will produce a representational faithful measurement for the liability — and that’s even before you consider that there is no discounting for the time value of money.

Consider what will  happen to financial statements if Congress reduces the corporate tax rate to 15%.  In my earlier example, Company A would reduce the liability and report negative tax expense; but Company B would be unaffected.  Again, I would argue that B’s financial statements are more informative.  In the real world, any company with deferred tax liabilities exceeding deferred tax assets — i.e., the vast majority — will report fictional increases to net income.

Fourth, the amount of tax expense reported is not a good indicator of future tax rates.  In particular, most companies year after year report a higher “effective tax rate” than they actually paid in the period.  The difference is most pronounced with increasing capital intensity.    In my next blog post I will be describing why this is the case, and providing some preliminary data.

But for now, suffice it to say that in the financial accounting system that I am in the process of creating, there won’t be any deferred taxes.  There will be fewer headaches for accountants, more money for shareholders and better information for investors.

PS — You can read the follow-up post here.


  1. Reply Graeme February 26, 2017

    Interesting article Tom,

    Although you have kept this article specific to tax, are you not opening up a discussion about the relevance of historical cost GAAP financial statements, and whether users of financial statements really pay attention to GAAP ETR’s, or jump straight to the non-gaap section of the Company’s press release.

    If we want to retain the view that GAAP financial statements are useful, then I’d contend that GAAP requires Company’s to disclose their depreciation methods and also provide additional information in their deferred tax footnote. If one was so inclined, and these amounts were material, then I’d think you would be able to identify these differences and make any necessary adjustments if you wanted to directly compare the two entities.

  2. Reply andre March 5, 2017

    I posted the following :

    Hey Tom,

    This was a good read and I think this the dialog is important to have at this present time. I book the income tax expense for my company on a monthly basis and I have often wondered how the lower rate between 15-20% would play out on our tax liability and accruals. I am also fairly familiar with deffer tax and agree it is a very cumbersome topic and calculation. currently we have a few CPA’s on staff and this is also a challenging topic for therm. I consulted a friend that is a tax manager for BDO and she is interested in seeing the changes. However, this wont effect 2017 and it may not be fully rolled out in time to impact 2018. Either way, GAAP does not detail out deffer tax so it can be easily interpreted. Hopefully once the tax reform is completed then the FASB will issue new guidance.

  3. Reply Danielle D October 24, 2017

    Great article. I agree that deferred tax liability should be eliminated as it is inconsistent with representing the Balance sheet and income statement accurately. However, this will have a big impact on income statement and decrease income. With depreciation not being a “real” expense, will that e fair to companies showing lower income because of using tax double declining depreciation method?

  4. Reply Heather H November 5, 2017

    I am concerned about what the proposed tax reforms mean to achieve as well. In the NY Times article, it is mentioned that cost of capital investments will be written off immediately instead of depreciating over time. This will greatly understate net income and the tax expenses as a result. It sounds like a scheme for large corporations to get a big tax cut by buying way more assets than they need. Eliminating interest deductions can hurt small businesses who rely on debt financing to run the business. It does seem hasty to outright cut interest deductions out of the tax code.

    Thank you for writing this informative article.

  5. Reply Adam December 2, 2017

    Really good article.

    As I was starting my career, I was really confused by the whole concept of deferred taxes (still take an annual CE to refresh). My favorite part of the article was the side-by-side comparison of the two companies, one taking five-year, DDB depreciation and the other taking straight-line over the same useful life.

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