ACC 6050 Module 7 Written Assignment: Theory of Tax Allocation and Cash Flows Example

A Liability That Never Comes Due? The Theory of Deferred Taxes and What Cash Flows Reveal

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Master of Science in Accounting, Thomas Edison State University

ACC-6050: Fundamentals of Accounting II

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Month Day, Year

A Liability That Never Comes Due? The Theory of Deferred Taxes and What Cash Flows Reveal

Introduction

Taxable income and accounting income differ, so the tax a company pays in a year rarely equals what its accounting income would imply. Interperiod tax allocation records deferred taxes so that tax expense matches the accounting income of each period. Wolk et al. (2017) note that this practice, now routine, rests on contested theory.

Why Allocate at All?

Without allocation, the flow-through approach, tax expense would equal taxes payable. A company that depreciates assets faster for taxes than for books would report low tax expense in early years and high expense later, even though nothing about its operations changed. Allocation smooths this by recognizing that today's tax savings will reverse when the differences unwind. Supporters argue that allocation matches tax costs with the income that causes them; critics argue that taxes are owed only on taxable income, and that deferred amounts may never be paid.

Comprehensive Versus Partial Allocation

Comprehensive allocation, required under U.S. GAAP, recognizes deferred taxes for all temporary differences. Partial allocation, used in the United Kingdom for a time, recognizes only those differences expected to reverse in the foreseeable future without being replaced. The case for partial allocation is strongest for growing companies: as a firm keeps buying equipment, new accelerated depreciation offsets the reversal of old differences, so the deferred tax liability as a whole never shrinks and arguably is not a real obligation.

Deferred Versus Liability Method

Under the deferred method, used in the United States before 1992, deferred taxes were recorded at the rates in effect when differences arose and not updated, so the balance was a deferred charge or credit rather than a measure of future payments. Today's required liability method values deferred taxes at the enacted rates for the years the differences unwind and revalues them whenever rates change, in keeping with the framework's asset-liability view (Financial Accounting Standards Board [FASB], 1992). The 2017 rate cut from 35 to 21 percent showed the effect: companies remeasured their deferred balances immediately, producing large one-time gains or charges.

Should Deferred Taxes Be Discounted?

If a deferred tax liability will be paid years from now, its present value is less than its face amount. Discounting would reflect the time value of money, consistent with how other long-term liabilities are measured. Standard setters have rejected it, citing the difficulty of scheduling reversals and choosing a rate, and the complexity it would add. As a result, deferred taxes are the only major long-term liability carried at undiscounted amounts.

Evidence: Do Deferred Taxes Predict Payments?

The objection to comprehensive allocation is empirical: do deferred tax liabilities ever turn into payments? Laux (2013) examined U.S. companies and found that deferred tax assets and liabilities were associated with future tax payments in the expected directions, with liabilities predicting higher future payments, although the relation was weaker for liabilities from depreciation in growing firms. The evidence supports the view that deferred taxes carry information about future cash flows, while partly confirming critics' concerns about recurring differences.

Application: Delaware Valley Equipment Rentals

Delaware Valley Equipment Rentals, a composite company renting excavators and lifts, expands its fleet every year and uses bonus depreciation for taxes. Its deferred tax liability has grown from $14 million to $41 million over six years and has never declined. Its cash flow statement shows income taxes paid averaging only 6 percent of pretax income, while tax expense averages 23 percent. A user relying on reported tax expense would overstate the company's near-term cash taxes; one relying on the cash flow statement sees that growth keeps deferring payment. Under partial allocation, much of the $41 million might not be recognized. Under comprehensive allocation, it is, and Laux's findings suggest it is not meaningless: if fleet growth slowed, reversals would raise cash taxes sharply. For Delaware Valley's lenders, the deferred liability signals a cash tax exposure that depends on growth, and the cash flow statement shows how much tax is actually leaving the company now.

Conclusion

Interperiod tax allocation rests on matching and on the asset-liability view, but partial allocation and discounting remain serious alternatives that standard setters have rejected for practical reasons. Evidence suggests deferred taxes do predict future payments, though less reliably for recurring differences. Delaware Valley shows why users need both the accrual measure of tax expense and the cash flow statement's record of taxes paid.

References

Financial Accounting Standards Board. (1992). Accounting for income taxes (Statement of Financial Accounting Standards No. 109).

Laux, R. C. (2013). The association between deferred tax assets and liabilities and future tax payments. The Accounting Review, 88(4), 1357-1383. https://doi.org/10.2308/accr-50417

Wolk, H. I., Dodd, J. L., & Rozycki, J. J. (2017). Accounting theory: Conceptual issues in a political and economic environment (9th ed.). Sage Publications.