LOS E requires us to:
evaluate the effect of tax rate changes on a company’s financial statements and ratios.
Effects of Changes in Tax Rates
a. We create the deferred tax assets and liabilities based on the tax rates present on the date of financial statements. But these rates are subject to amendments and revisions by the income tax department. Thus, in case of changes in the rates of income taxes, the balances in the deferred tax accounts must also be adjusted.
b. When there is a rise or fall in the tax rates, there is also a respective rise or fall in the deferred tax assets or liabilities as well.
We can explain this with the help of the following example:
Example:Suppose the tax base of an asset, its carrying value, and deferred tax liability (assuming a tax rate of 40 %) are:
Now, suppose the tax rates in the third year fall from 40 % to 30 %. Therefore, in year 3, the deferred tax liability would be: DTL = (C – TB) × t i.e. DTL = (5,000 – 0) × 30% = 1,500 Therefore, the deferred tax liability has fallen by $ 500 ($ 2,000 – $ 1,500). Thus, we need to decrease the deferred tax liability by adjusting against the profit reserves. |
Impact of the Changes in Rate of Income Tax
Income Tax Expense (ITE), can be interpreted as Tax Payable (TP) as adjusted for the Change in Deferred Tax Assets (ΔDTA) or the Change in Deferred Tax Liability (ΔDTL). This can be written in the form of an equation as:
ITE = TP + ∆DTL – ∆DTA
Therefore, if a company has net deferred tax liability,
a. a reduction in tax rates would decrease the amount of liabilities and income tax expense but it would increase the amount of owner’s equity, and
b. an increase in tax rates would increase the liabilities and income tax expense but would decrease the amount of owner’s equity.
However, if a company has net deferred tax asset,
a. a reduction in tax rates would decrease the amount of assets and owner’s equity, but it would increase the amount of income tax expense, and
b. an increase in the tax rates would increase the amount of assets and owner’s equity, but it would decrease the amount of income tax expense.