Hi all, tried conflating tens/hundreds of past WSO threads to answer this but getting nowhere.
I'm trying to nail modelling 3-stat LBO's with full operating period to be in good stead when PE comes around the corner, but I'm confused on a few things re DTL modelling. I'll apologise for the pre-amble as this is a bit of a log to keep things fresh.
I understand the DTL arises through the temporary difference created from asset write-up, resulting from the different standards of Book and Tax treatments. The tax shield from the extra depreciation arising from the write up, is not recognised in the tax treatments, so the tax is still required (deferred tax liability)…. Horrible explanation as trying to speed through but you get the point.
The DTL is logged on the balance sheet 'in-full' at the transaction and is then amortised. As the depreciation expense for the asset increases, taxes are owed in equal increments to the government in each year of the assets remaining useful life. (because of the individual depreciation difference in each year... book/tax).
Questions
Initial Transaction
I'll simplify the transaction mechanics, to assume the transaction is an acquisition only (one accounting mechanism), no acquisition then merger with push downs ect…; further simplifications, assume all purchase price allocation is PP&E write-up and is £100,000, with original asset Value £100,000, on a full cash transaction.
1.a) What are the TargetCo accounting entries for this initial transaction? - are they:
Entries: Dr Asset (Write-up) £100,000 (BS), Cr Deferred Tax Liability £30,000 (BS),
Cr Equity/Retained Earnings £70,000 (BS)
1.b) How does this transaction influence the three statements?
Depreciation Expense = Increase
Income tax = Increase (yearly attributed DTL payment)
Asset written up = increase
DTL = increase (full 30k)
Equity/Retained Earnings = increase
D&A add back to reach CF from Operating
1.ci) - is there such thing as a DTL expense on the cash flow statement? I've seen it mentioned, but I can't understand why you would subtract DTL expense for the year, first on the income statement and then again on the cash flow statement, that seems like it would be removing income twice...?
1.cii) - With regard to the double entry for the asset depreciation (Dr depreciation expense), what other line item is influenced when this is written down, what is the 'equal opposite'?
surely the Equity value doesn't decrease?
Operating Period
2.a) In the case of the DTL amortising, what are the accounting entries?
2.b) In the case of the DTL amortising, what happens to/how does this flow through the three statements across the 4-7yr operating period?
Example:
With our 5-year useful life, assuming an original value of £100,000 and write up of £100,000 the single asset’s book value would depreciate at £40,000 each year, whereas its tax value would depreciate at £20,000. The difference in depreciation serves as a tax shield for £20,000 each year. So the DTL Tax we would owe each year = £20,000*30%= £6,000.
Each year in our operating model the calculations would look like this
Income Statement: The Income Tax Expense would increase by £6,000 each year.
Balance sheet: The DTL (starting val £30,000) would be reduced by £6,000 each year as we pay our tax liability down.
Cash Flow Statement: The Depreciation £40,000 would be added back each year to get Cash Flow From Operating Activities.
This must be wrong... what am I missing?
Many thanks to any/all answers and corrections.
Based on the most helpful WSO content, here's a detailed breakdown of your questions regarding LBO modeling, PP&E write-up, and Deferred Tax Liabilities (DTL):
Initial Transaction
1.a) TargetCo Accounting Entries for Initial Transaction
1.b) Influence on the Three Statements
Income Statement: - Depreciation Expense: Increases due to the write-up. - Income Tax Expense: Increases due to the yearly attributed DTL payment.
Balance Sheet: - Assets: Increase by £100,000 due to the write-up. - DTL: Increases by £30,000. - Equity/Retained Earnings: Increases by £70,000.
Cash Flow Statement: - Depreciation: Added back to reach Cash Flow from Operating Activities.
1.ci) DTL Expense on the Cash Flow Statement
There is no such thing as a DTL expense on the cash flow statement. The DTL is a balance sheet item and is not directly expensed on the income statement or cash flow statement. The confusion might arise from the fact that the DTL affects the tax expense on the income statement, but it is not a separate line item on the cash flow statement.
1.cii) Double Entry for Asset Depreciation
When depreciation expense is recorded: - Dr Depreciation Expense: This reduces net income on the income statement. - Cr Accumulated Depreciation: This reduces the book value of the asset on the balance sheet.
The "equal opposite" entry is the reduction in the asset's book value through accumulated depreciation. Equity does not decrease directly due to depreciation; instead, net income decreases, which indirectly affects retained earnings.
Operating Period
2.a) Accounting Entries for DTL Amortization
Each year, as the DTL is amortized: - Dr Deferred Tax Liability: £6,000 (Balance Sheet) - Cr Income Tax Expense: £6,000 (Income Statement)
2.b) Flow Through the Three Statements Across the Operating Period
Example Calculation: - Book Depreciation: £40,000 per year - Tax Depreciation: £20,000 per year - Difference: £20,000 per year - Tax Shield: £20,000 * 30% = £6,000 per year
Income Statement: - Income Tax Expense: Increases by £6,000 each year due to the DTL amortization.
Balance Sheet: - DTL: Decreases by £6,000 each year as the tax liability is paid down. - Accumulated Depreciation: Increases by £40,000 each year, reducing the net book value of the asset.
Cash Flow Statement: - Depreciation: £40,000 added back each year to Cash Flow from Operating Activities.
Summary
This should clarify the mechanics of DTL in LBO modeling and how it flows through the financial statements.
Sources: Difficult Accounting Technical - IBD, DCF Modeling Course ~ Pre-training text.pdf, 21 Finance Interview Questions and Answers, The Three Most Common Technicals, Net debt: The definite list
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