Deferred Tax Assets and Liabilities

I'll admit that I'm new to IB so maybe I'm a bit slow, but I feel like we've got to get back to basics a bit here. The question is 'do we add/subtract DTL/DTA from cash flow from operations to get free cashflow.' The answer to this question is clearly no. As I said in my previous post, DTL/DTA are a balance and shouldn't be subtracted from a flow.

That said, if the question is 'how does DTA/DTL impact my valuation?', you need to consider what a DTL/DTA actually is. These balances represent notional GAAP assets or liabilities that represent the timing difference between GAAP income and tax income. To that end, we would want to build a schedule based upon the DTA or DTL that reflect specifically when the tax payments or benefits are going to be incurred and make the appropriate adjustments to net income accordingly.

So let's say that we have a deferred tax asset of 1K. As our projection goes on, we should recognize the fact that we're going to amortize our 1K of deferred tax asset which will be reflected as a loss in terms of net income. That said, this loss would clearly be non-cash and would needed to be added back on our cash flow statement.

For this type of thing, I feel like it's helpful to think about concrete examples for valuation. Let's say that we own a building that we lease to a family. Now, let's say that the family prepays in rent for the following year. From a GAAP perspective. we can't recognize that revenue because we haven't earned it, but from a tax perspective, we care about that money in the bank, so we pay tax on cash even if it was prepaid. As such, we set up a deferred tax asset. Why? Because we've already paid tax on income that we will receive in the following year(s). As such, if we're trying to calculate cash flow from net income, we take out the impact of the increase in DTA (because it's non-cash). In future years, the DTA is going to decrease which will be added back when we go from net income to cash flow (again because it's non-cash). You might wonder why we even bother setting up the DTA, but the reason is that it reflects the economics of the taxation. Let's say that we didn't set up a DTA when our tenants prepaid, well, we would be paying taxes on income that we hadn't earned, and our business would look significantly less profitable than it actually was.

EDIT: The way to think about tax is this: tax is just another flow out of the company. Deferred tax liabilities essentially represent the fact that we will need to pay a higher percentage of our cash income. DTLs and DTAs help us calculate the actual cash impacts of these timing differences.