Welcome back to school! Congratulations to a new class of about 350 Traditional and Integrated MPA Students! I’m sure that you all will have a great time in this program.
The question that probably remains is why am I blogging about summer review even though school has started. Three reasons: (1) You can still take a look at these blogs as you study for your classes; (2) Another summer will come for which to review by (seeing as the blogs are archived, they’ll be accessible for a couple years); and (3) We’re still in the triple-digits, so by my standards, it’s still summer.
First, some thoughts for this week.
Pat Summit
It was recently reported that Pat Summit has been diagnosed with dementia. If you are unfamiliar with Pat Summit, she is the head women’s coach at the University of Tennessee, where she has been at the reigns for 37 seasons and won eight national championships. More importantly, she is a symbol for hard-nosed tenacity and mental toughness for basketball players of any level of the sport—men and women. College basketball’s winningest head coach, Summit is an inspiration to anyone facing a challenge.
Coach, we wish you the best.
Congratulations to the Texas Football Team!
Balance has been restored to the force as football season is now in full swing. The Longhorns defeated Rice in their season opener this past Saturday 34-9 behind 239 passing yards from Garrett Gilbert (115 to Mike Davis) and 86 rushing yards from Malcolm Brown. The Longhorns will face BYU next week at DKR. (The line is up to 6 ½ in favor of Texas, and of course, I’m picking over!) Congratulations, and we look forward to supporting y’all next week!
Blocked Merger?
The Department of Justice is suing AT&T for its attempt to block its proposed $39B acquisition of T-Mobile. The DoJ says that the two companies combined would “serve customers throughout the United States, with networks that each reach the homes of at least 90 percent of the U.S. population.” It also claims that smaller providers are different than the major providers—similar to the manner that Big Four accounting firms differ even from mid-cap firms. Most importantly, though, the DoJ cites these “anticompetitive” measures as due to T-Mobile’s investments in technology and low prices; the elimination of T-Mobile from the field, it feels would “substantially lessen competition in violation of…the Clayton Act” (the 1914 antitrust addendum to the Sherman Antitrust Act). The acquisition was originally announced in March, and AT&T intends to “vigorously contest this matter.”
I’ll be sure to keep current with this story; until then, a personal favorite: FAS 109.
Summer Review: SFAS No. 109
This standard is actually one of the most intuitive standards, although one of the trickiest to execute because one has to think whether the tax law is favorable or not. That being said, this standard also gives a lot of insight about what the management of a company predicts will happen in the long-term. Check it out:
Scenario 1: Pablo Inc. has net income of $100 and taxable income of $100. Awesome—we simply say that Pablo Inc owes $35 in taxes and expense that for the current year.
Scenario 2:Pablo Inc. has net income of $100 and taxable income of $80. Now it gets a bit tricky because according to GAAP, Pablo “earned” $100. Not a big deal though: this simply means that $20 of those earnings will be recognized by the IRS later in some other period; thus, that liability is deferred. Hence the name, “deferred tax liability.” On the books, expense the entire $35 because of the matching principle (that is, we incurred that liability with our activities during that period), and credit $28 to payable or “current” and credit the other $7 to deferred tax liabilities.
What just happened?
We can do this for several reasons. First of all, always remember that in the long-run, it is the hope that dollars and earnings will be the same; thus, the assumption that we will make those dollars in another period for either GAAP or IRS is theoretically sound. In other words, the idea that we will make those extra $20 in Scenario 2 in a different period is a likely one. Second, the reason we expense those taxes in that period even though we didn’t pay for them yet is in line with the matching principle. That is, we made that revenue in that period and should match the tax expense to that activity as well; the fact that the IRS says we don’t owe the money that period doesn’t mean that we didn’t perform an activity to incur a tax expense. Thus, we only owe $28 now, but we performed $35 worth of taxable activity during that year, regardless of when it’s due.
Scenario 3: Pablo Inc has net income of $100 and taxable income of $120. Doh! Pablo owes $42 in taxes, even though according to GAAP he only incurred $35 of them this period. What a drag! Not a biggie: still debit an expense of $35 because of the matching principle and credit the current portion of $42…wait, that doesn’t balance. We have a deferred tax asset, which means that we’ll see this reverse in our favor…next year. (No, this is not really favorable; we’ll get to this in just a bit though.) So also debit $7 to deferred tax assets.
All of this is based off of differences in timing for recognition by the two sets of accounting principles. Always remember these tips to help get your thoughts organized: (1) Whatever you owe this period is the “current portion”; this is the amount that shows up at the very bottom of you Form 1120. (2) Tax Expense, or the proper “Provision for Income Tax,” is the same as any other expense—you want to match it to the same period that you incur it regardless of when you pay it. This is completely for GAAP purposes. So if I sell a widget in the period and that’s a taxable activity, I incur the tax expense in that period no matter when the IRS wants to collect the taxes. The amount the IRS wants to collect this period is in the “current” portion already. (3) Current taxes plus deferred taxes equal tax expense. Nice way to check.
Two more tidbits about FAS 109:
Misnomers?
Usually anything with the word “liability” in it seems to be deconstructive towards assets (in the sense that your total equity is reduced by your liabilities). However, a deferred liability means that you’re going to lose those assets later. From a finance perspective, that means that you’ll lose less present value because you’ll be losing the same amount of nominal dollars in a later period. In other words, if you look at Scenario 2, you’ll pay $7 later, but they’ll be inflated a bit. Thus, deferred tax liabilities are kind of a good thing.
Likewise, a deferred tax asset is kind of bad because you pay now and “see an asset”—which you don’t really—later. It’s just the opposite of a deferred tax liability. This may pose a bit of a problem. Keep reading…
Valuation Allowance
In order to get your “deferred tax asset,” you have to have taxable income in the future. But what if you don’t? Well, then you’re sure not going to be seeing any sort of reverse or NOL benefit in the future. Thus, FAS 109 sets up what’s called a Valuation Allowance against the DTA line item. If you feel that you won’t see those DTAs, then you use this contra account to show it.
What it’s really showing, though, is your belief that you’re not going to be making enough income within the given timeframe (determined by the corresponding tax law) to qualify for the “deferred asset.” You have to wonder what the complications of this sort of entry would mean though. It could be a sign that the company is not going to be generating the cash flows necessary to stay afloat. Thus, I have always felt that the valuation allowance is an account that can really show a lot of insight into the assumptions of management in terms of their forecasts.
Final Thoughts
Don’t let this standard intimidate you. It is intuitive if you really take the time to think it through. It gives a lot of information about which tax bracket the company sees itself in, its future financial health, and its tax planning expertise. I’ll probably continue to post some of these “Summer Review” posts every now and then, as I planned out the standards I wanted to cover a while back. Hopefully the summer review will end before December though. Until then, enjoy accounting for deferred taxes.