The True Nature of Tax Expense
When you look at a company’s profit and loss (P&L) statement, the tax expense shown isn’t just the tax the company expects to pay on its current year’s tax returns. Instead, this tax expense, often referred to as the “tax provision,” is a combination of two key components: current tax and deferred tax.
Breaking Down the Tax Provision
The tax provision consists of:
- Current Tax:
- This is the estimated tax on the company’s current year tax returns. It’s the amount a company expects to pay for the current tax year based on its taxable income.
- Deferred Tax:
- This component reflects the changes in deferred tax assets (DTAs) and deferred tax liabilities (DTLs). Deferred tax is calculated by subtracting the ending DTA/DTL from the beginning DTA/DTL.
Deferred Tax Assets (DTAs) and Liabilities (DTLs)
Deferred Tax Assets (DTAs):
- DTAs represent future tax benefits. They include items such as:
- Net operating loss carryforwards
- Tax credit carryforwards
- Deductible temporary book-to-tax differences
- Essentially, DTAs are components that will result in less tax being paid in the future.
Deferred Tax Liabilities (DTLs):
- DTLs represent future tax expenses. They are comprised of:
- Taxable temporary book-to-tax differences
- These are items that will result in more tax being paid in the future.
The Impact of Changes in DTAs and DTLs
The changes in DTAs and DTLs determine whether a company will report a deferred tax benefit or a deferred tax expense.
- Deferred Tax Benefit:
- Occurs when DTAs increase or DTLs decrease.
- This results in a reduction of future tax expenses.
- Deferred Tax Expense:
- Occurs when DTAs decrease or DTLs increase.
- This results in an increase in future tax expenses.
Calculating the Tax Expense
To determine the total tax expense reported on the P&L, a company adds the deferred tax result (whether a benefit or an expense) to the current tax. This combined amount provides a comprehensive view of the company’s tax obligations, both current and future.
Understanding the components of tax expense on the P&L is crucial for grasping a company’s financial health. The tax provision, encompassing both current and deferred tax, provides a more accurate picture of a company’s tax liabilities and future financial obligations. By breaking down these elements, investors and stakeholders can better assess the financial strategies and potential future performance of a company.