Understanding Deferred Tax Liabilities

Earlier this week, we looked at deferred tax assets. Today, we'll look at the liabilities.

As noted in my previous article, deferred taxes exist because accounting methods for shareholder income (what the company tells you) and taxable income (what the company tells the taxman) are different.

Let's use an example from the funny pages. Popeye's chum Wimpy was always asking for a hamburger today in exchange for payment next Tuesday. In other words, he wanted the benefit up front, but he wanted to delay his payment for as long as possible. Like Wimpy, companies want to do the same thing with their taxes. The longer they can defer (or delay) taxes, the longer they have use of that cash, which means they can use it to make more money. Companies paint as dreary a picture as possible to the taxman in order to reduce or delay tax payments, but to someone they're trying to impress -- shareholders -- they'll probably show a rosier picture.

When companies delay their tax payments, they create deferred tax liability accounts (DTLs) to reflect future tax obligations. The most common reason for DTLs is depreciation. When a company buys property, plant, or equipment (PP&E), it makes assumptions that either depreciate (reduce the value of) this PP&E slowly or quickly. To you, the shareholder it's trying to impress, the company depreciates slowly, showing you higher income. For the taxman, the company accelerates depreciation, which lowers income and tax payments.

Theoretically, over time, this will eventually reverse, and the company will have to pay up. Because of this, the company books DTLs to reflect future tax obligations. Some other events that can prompt DTLs include research and development- or merger-related expenses, where management estimates can make shareholder and taxable incomes different.

Liability or equity?
To throw a little confusion into the mix, DTLs can be permanent, and instead of reflecting a future tax payment, the DTL might be more similar to equity. Because many companies are growing and continually adding PP&E, the difference in depreciation methods never reverses, and the DTLs related to depreciation are more like equity than liabilities.

For example, fairly asset-intensive companies like Kroger (NYSE: KR  ) generally have to build more grocery stores in order to increase their revenues. Thus, Kroger's PPE base increases over time, and the difference in speeds between shareholder and taxable depreciation methods tends not to reverse. In 2001, Kroger reported $401 million in DTLs related to depreciation differences. Five years later, instead of dwindling away, DTLs had increased to $1.1 billion.

As another example, Berkshire Hathaway (NYSE: BRKa  ) is sitting on some pretty hefty future capital gains taxes, thanks to astute stock purchases. Berkshire's stake in American Express (NYSE: AXP  ) , as of the most recent annual report, had a cost basis of $1.3 billion, but it's currently worth nearly $9 billion. The gain of $7.7 billion is taxable, and if we assume that, upon the sale, Berkshire will have to pay a 35% capital gains tax on its windfall, we'd have to set up a $2.7 billion deferred tax liability to reflect Berkshire's potential future tax payments. However, because Berkshire may never sell, the DTLs on these long-term holdings occupy some sort of netherworld between equity (what Berkshire owns) and liability (what it owes).

In overview
When checking out DTLs, always try to understand the source of the difference in shareholder and taxable income, and whether the difference is valid or not. In Berkshire's case, DTLs related to permanent equity holdings are unlikely to reverse, so shareholders can take comfort knowing that they won't get stuck with a huge tax bill anytime soon.

For some more accounting basics:

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. Berkshire Hathaway is an Inside Value pick. The Motley Fool has a disclosure policy.


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