In the past, I’ve written a few articles on deferred tax assets and deferred tax liabilities. You can find the links to the articles here:
If you don’t have time to reread the articles, you can just revisit the following big picture points:
- In the most simple terms, deferred tax assets potential reductions in future taxes payable whereas deferred tax liabilities are potential increase in future taxes payable. Roughly but suffice to remember DTA can reduce future tax liabilities and DTA can increase future tax liabilities.
- Whether a temporary difference will result in DTA or DTP depends on only one key question – will the tax book income > the financial book income in the future when the difference in timing is resolved (or when the situation reversed)? If the answer is yes, then it will be DTP. If the answer is no, then it will be DTA.
- You only record DTP or DTA at the time of the origination of temporary differences.
- NOLs create tax refund and the amount can be substantial. A recent example is Blackberry’s huge tax refund as a result of massive NOLs.
- NOLs could lower future income taxes if the company is profitable.
I did not use a specific company example in my article series. Since I have spent a decent amount of time on General Motors' (GM, Financial) financial reporting, and I think I have learned a little bit about GM’s deferred taxes. I think it may benefit the readers who are interested in GM if I put together my thoughts on GM’s DTA exposure. But before I continue, I want to clarify that again this is not a recommendation for or against GM’s stock. What I have written here is an analysis on GM’s deferred taxes alone.
Ok, let’s take a look at the DTA table from GM’s 10K.
1. DTA from temporary differences attributable to postretirement benefits other than pension of 2.96 billion and pension and other employee benefit plans of 7.5 billion.
Remember the difference between cash accounting and accrual accounting? Cash accounting recognizes pension expenses when cash contribution and benefits payments are made whereas accrual accounting recognizes pension expenses based on pension formulas (link to the formula).
This DTA arises because GM’s accrual-based pension expenses (GAAP) exceed the tax book pension expenses, which are cash contribution and benefit payments in the present. In the future, when things reverse course, i.e, when GM’s cash contribution and benefit payments are in excess of the GAAP pension expense, the tax benefit related to this DTA will be realized.
2. DTA from warranties, dealer and customer allowances, claims and discounts of 5.5 billion.
Again, cash accounting recognizes warranty expenses when cash payments are made whereas accrual accounting recognizes warranty expenses when they are estimated against revenues according to the matching principle. No cash outlay is needed when warranty expense is first accrued, which means GAAP warranty expense exceeds tax book warranty expense in the beginning. But in the future, when GM has to lay out cash to settle the actual warranty claims, tax book warranty expenses will exceed GAAP expenses and the DTA will be realized.
3. DTA from depreciation differences of PP&E of 2.3 billion and capitalized research expenses of 8.6 billion.
These two DTA items arise from the same reason - timing differences between GAAP and tax book depreciation and amortization methods. Obviously GM is depreciating and amortizing its PP&E and capitalized research expenses faster on an accrual basis than on tax basis.
4. DTA from NOL of 14.1 billion.
As I have explained in my previous articles, NOL occurs when tax book expenses exceed tax book revenues. IRS allows a company to carry it back for two years and carry it forward for 20 years. Note this has nothing to do with the financial book, i.e., you cannot use your current year financial book losses to offset past and future financial book incomes. GM has been massively unprofitable in the past so they have huge net DTAs.
To put everything together, it may seem like GM may pay $34 billion less in taxes in the future. However, not all DTAs are equally beneficial. Some of them require future cash outlay and some of them don’t. Pension, post-retirement benefit related and warranty expenses will fall into the first category. PP&E, capitalized research expenditures, NOL carryforwards and tax credits carryforward would fall into the second category.
For the first group of DTAs, while GM will get to utilize the DTAs, they also have to lay out more cash at the same time. Whereas for the second group of DTAs, no future cash outlay is needed as the cash has been spent upfront. Obviously the second group of DTAs is more valuable from a free cash flow perspective.
