DTL recognized as liab or equity therefore, liability, comparing, continue, expected

islandgyrl

An analyst is comparing a firm to its competitors. The firm has a deferred tax liability that results from MACRS for tax purposes. The firm is expected to continue to grow in the future. How should the liability be treated for analytical purposes?

A) Equity at full value
B) Liability at full value
C) PV should be treated as a liability with the remainder treated as equity

The answer is "A" and the reason given is that the DTL is not expected to reverse in the foreseeable future therefore the liability should be treated as equity in its full value.

My question is why would the company not be expected to be able to generate enough profit to cover the DTL? If the company is growing, that would suggest that in the future, they will make enough money to use the DTL which would mean it needs to be accounted for as a liability (bc cash payment for taxes in the future can be expected).

Any suggestions?? Thanks.

spartanag07

I'll give you the reason that the answer is A, but I am too lazy to come up with a comprehensive example.

If the company continues to purchase more and more units of newer equipment each successive year for the forseeable future, TOTAL depreciation on the tax return will continue to exceed depreciation on the income statement for the forseeable future (as depreciation on new assets on an accelerated basis will continue to exceed straight line depreciation). Therefore, the DTL will not be expected to reverse in the future, and should be treated as equity.

That being said, I don't think this concept is in the curriculum this year. Can someone who has read the curriculum reading confirm this? It used to be there before for sure. What version fo the QBank are you using?

Recognition of DTL has nothing to do with future profits. You're confusing it with DTA, which must be revised downwards (through a valuation allowance) if there is no expectation of future profits to revover these assets.

Good luck with taxes!

shootingstar

Thanks for the note. If I understand correctly you are saying that for a DTL to be recognized as a liability (and therefore be deemed temporary), it does not matter if the firm is profitable. It only matters that if in the forseeable future, the cost basis of net PPE would be lower than the tax basis. Since, in the above example, the firm will continue to purchase PPE (perpetually increasing tax depreciation while reporting depreciation remains the same) the tax basis will continue to be lower than the cost basis in the future (or atleast until the firm stops with the capital expenditures).

That may have been a bit wordy...let me know if I should rephrase. Thanks for the help!

Mechanic

You are absolutely correct my friend. No need to rephrase. You stated it quite crisply.

bluejazzy

Spartan262 -

Where did you find this question?

marsilni

Schweser notes, end of reading concept checkers for SS9 Reading 38. It is question 12. Page 251 of book 3.