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Deferred Taxes

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Deferred taxes: A common “problem area”

I want to briefly focus on deferred taxes because it’s a topic that pops up quite frequently in our public modeling and valuation seminars, as well as our corporate training. It turns out this is a topic that many analysts and associates are not very comfortable with. So here goes …

Which Books?

Companies have two sets of books — one with a set of numbers for financial reporting and another for tax return purposes. What investors or analysts typically see are the financial reporting numbers as found in a company’s annual report or other financial filings filed with the SEC. These are reported according to GAAP standards and are ultimately presented in a manner that is most useful to anyone looking to get a clear understanding of the economics of the business.

For tax purposes, however, the government usually has its own set of rules (no surprise there!).

It is typically less concerned with providing a clear understanding of the business to investors and more concerned with collecting taxes whenever cash flows through the business, and providing tax relief when cash flows out. Thus, a company’s tax return is likely to look somewhat different than its financial reporting. How is the difference accounted for, then, on the financial-reporting books (the ones we actually get to see) when there appears to be a difference between what a company reports in its annual or quarterly filing as its tax expense and what it actually ends up paying to the government for that period? Let’s look at a common example:

Temporary difference leading to a deferred tax liability (DTL)

Below is an example of the creation of a deferred tax liability.

Fact pattern

  • Company buys a $30 piece of equipment (PP&E)
  • Useful life of 3 years
  • For book purposes, depreciate using straight-line method
  • For tax purposes, depreciate using MACRS (Yr 1=50%, Yr 2=33%, Yr 3=17%)


Interpreting the Numbers

As the example above illustrates, the DTL is created to reflect that due to different book vs. tax depreciation rates, there is a temporary timing difference leading to a lower payment to the IRS than reported for book purposes. The liability is reversed when the higher payment is made to the IRS in 2010.

Note that at any year in the example, the DTL could have been calculated as the difference between the book and tax value of the PPE x the tax rate. For example, after year 1, the difference between book and tax PPE is $20-$15 = $5. This $5 times the 40% tax rate gives us a DTL of $2.

Also, when there is a temporary timing difference leading to an initially higher payment to the IRS than reported for book purposes (often in light of net operating losses, differences in book vs. tax revenue recognition rules), a deferred tax asset (DTA) is created.

One Word to Describe the IRS: Nice?

Notice that even though total taxes paid to the IRS and reported for GAAP are the same in the end, the company actually pays less taxes early on (taxes payable) and can delay paying a larger portion until the later years. This accelerated depreciation for tax reporting allows the company to retain more cash early on and provides an incentive for companies to invest in their businesses through the purchase of necessary assets. Thus, the government is actually trying to stimulate economic activity by giving companies a tax break for reinvestment. How nice!

Not all differences create deferred taxes

In the example, we saw a temporary difference (which ultimately reversed itself) in book and cash taxes because of the difference between the book and tax depreciation methods used for book vs. tax purposes. However, permanent differences, arising from items such as tax-exempt interest income, do NOT create deferred tax items and simply lead to a difference in tax rates used to calculate book vs. cash taxes.

Modeling deferred taxes

Taking the mystery out of financial modeling is one of our key aims here at Wall Street Prep. Many complex and puzzling topics, such as deferred taxes and NOLs, present a challenge to the financial analyst, who is looking to both understand and model out these, and other, items.

Let Wall Street Prep de-mystify these topics and show you how many of these items can be incorporated into one’s financial model by:

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