Below you will find a portion of a company’s actual income tax footnote noting i
ID: 2530023 • Letter: B
Question
Below you will find a portion of a company’s actual income tax footnote noting its income tax provision and its deferred tax assets and liabilities. Given that the value of a company is determined by its future discounted cash flows, project how the change in the federal statutory rate from 35 percent to 21 percent would affect the income tax provision, the deferred tax assets, and the deferred tax liabilities in 2017 and thus the valuation of the company.
Income Tax Provision
In millions of dollars
2016
2015
2014
Current
Federal
$
1,016
$
861
$
181
Foreign
3,585
3,397
3,281
State
384
388
388
Total current income taxes
$
4,985
$
4,646
$
3,850
Deferred Income Taxes
Deferred income taxes at December 31 related to the following:
In millions of dollars
2016
2015
Deferred tax assets
Credit loss deduction
$
5,146
$
6,058
Deferred compensation and employee benefits
3,798
4,110
Repositioning and settlement reserves
1,033
1,429
Unremitted foreign earnings
9,311
8,403
Investment and loan basis differences
4,829
3,248
Cash flow hedges
327
359
Tax credit and net operating loss carry-forwards
20,793
23,053
Fixed assets and leases
1,739
1,356
Other deferred tax assets
2,714
3,176
Gross deferred tax assets
$
49,690
$
51,192
Valuation allowance
—
—
Deferred tax assets after valuation allowance
$
49,690
$
51,192
Deferred tax liabilities
Deferred policy acquisition costs and value of insurance in force
$
(5
)
$
(327
)
Intangibles
(1,711
)
(1,146
)
Debt issuances
(641
)
(850
)
Other deferred tax liabilities
(665
)
(1,020
)
Gross deferred tax liabilities
$
(3,022
)
$
(3,343
)
Net deferred tax assets
$
46,668
$
47,849
In millions of dollars
2016
2015
2014
Current
Federal
$
1,016
$
861
$
181
Foreign
3,585
3,397
3,281
State
384
388
388
Total current income taxes
$
4,985
$
4,646
$
3,850
Explanation / Answer
The books appear to have been prepared by the asset-liability method. Under this method, if the tax rate changes, then all the deferred tax assets and liabilities should be revalued using new tax rates.
A deferred tax asset is an accounting position where the business has paid more tax than applicable for the period or paid the tax in advance. The deferred tax asset is reversed in the future when the business becomes liable to pay the tax on the income earned in the future period.
A deferred tax liability asset is an accounting position where the business has paid less tax than applicable for the period or chosen to pay the tax in future, based on some regulatory adjustments. The deferred tax asset is reversed in the future when the business pays more tax in the future than actually applicable for the future period.
Since this tax is paid as per current tax rates 35%, when the tax rate decreases to 21%, the deferred tax asset decreases in value and the effective tax rate becomes higher. This is because the tax asset is discounted at a lower rate. Also, the deferred tax liability becomes higher in value.
There is no cash impact because changes in deferred tax balances are noncash items added back to net income in computing cash flows from operating activities. The valuation of the company, however, becomes lower as the assets are now lower. Please note that the overall tax paid by the business will be the same. The deferred tax assets and liabilities are the timing differences.
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