deferred tax liability from asset write-up

I was going through some merger model videos, and it said that the PP&E write up creates a deferred tax liability because the pre-tax income on GAAP basis is lower than the pre-tax income on the tax book (because of higher D&A). Therefore, the taxes payable on your income statement is lower than what you pay in the tax book.

I referred to some of the old forum posts, but I was still unclear on the concept (cannot attach links because I am considered a new user)

Investopedia says - "A deferred tax liability occurs when taxable income is smaller than the income reported on the income statements" -

This statement by investopedia contradicts the videos I watched. Based on investopedia's definition, the write-up creates a deferred tax asset.

Could someone please shed some more light on how deferred taxes occur in an acquisition?

Thanks in advance!!

Comments (42)

Jan 3, 2015

Yeah so lets take for example and acquisition in which some of the assets BV's are significantly different that their Market Values. So in this hypothetical case the company doing the acquiring will write up the assets from their previous lower BV. However it is important to note that this write up only effects the company's accounting books and is not counted in anyway in tax accounting. This causes the taxes being paid on the book accounting and tax accounting to differ and that is when DTA/DTL's come into play.

So if you had a write up on assets, that will increase the amount of Depreciation on you income statement therefore reducing the amount of taxes that you pay. But since this is not accounted for in tax accounting, the actual taxes you must pay in your book accounting are less than the taxes on cash tax accounting. Hence the creation of a differed tax liability since you are recording a lesser amount of taxes but you are in reality paying more in taxes.

This DTL is created to capture this difference and normalize the tax and book accounting over time. Hope this helps, I have been going hard for my ib interviews lol

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Jan 3, 2015

Thanks! I understood your explanation of the need to normalize the tax and book accounting. But I'm still thrown off by investopedia's definition of DTL, since it suggests that a DTA is created.

Jan 3, 2015

Thanks! I understood your explanation of the need to normalize the tax and book accounting. But I'm still thrown off by investopedia's definition of DTL, since it suggests that a DTA is created.

Jan 4, 2015

I honestly have no idea why they would say that the DTA and DTL accounts count different things. For example in the DTA account, you also include things like nol's. This is too accounting intensive so I can't go that deep into this stuff. If you are preping for interviews as a SA I think the above explanation should be sufficient. If you find out why let me know!

Feb 17, 2017

Hello there.

Would just like to clarify regarding your point on "recording a lesser amount of taxes but in reality paying more in taxes". Isn't it that there is higher D&A in the current period --> paying less in taxes in current period --> DTL is created and you have to pay more in cash taxes in the future?

Thanks buddy

Apr 3, 2019

so your cash goes down by the amount you pay cash taxes , DTL goes up on the Liability and Equity side. How does the equation balance then? It doesn't make any sense..

Most Helpful
Apr 3, 2019

I wanted to clarify on a few points that were brought up in this post, since it looks like people have additional questions. Here is the process:

In a stock acquisition, say the target's PP&E had a net book and tax value of $100, but the fair market value is $150. Assuming a 20% tax rate, a DTL of $10 will be established ($50 x 20%), and goodwill will be increased by $10.

In a stock acquisition, the tax basis is carried over from the old owners, but the book basis is adjusted to fair market value. As such, there will be $50 of incremental book depreciation that will be recorded over the remaining useful life of the PP&E, but no incremental tax depreciation (the $100 of tax basis that was originally there will simply be depreciated).

This incremental book depreciation will lower pre-tax book income, but have no impact on taxable income -- so cash taxes will never be reduced due to the book basis being higher by $50 due to purchase accounting. That is what the DTL is reflecting, the fact that the additional book depreciation will not be deductible for tax purposes, and cash taxes will be higher because that additional depreciation never lowers taxable income.

I hope this helps. Let me know if any follow ups.

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Apr 3, 2019

Thanks for your comment. I understand you logic but i am just so confused because so many sources say that "A deferred tax liability occurs when taxable income is smaller (for example due to accelerated depreciation ) than the pre-tax income reported on the income statement"
But in the example you described, pre-tax book income is lower than taxable income due to additional depreciation which seems to be a contradiction. What am i missing? Also, in your example, it seems like the difference between book and tax is permanent, then i thought that no DTL or DTA should be created?

Jan 4, 2015

I honestly have no idea why they would say that the DTA and DTL accounts count different things. For example in the DTA account, you also include things like nol's. This is too accounting intensive so I can't go that deep into this stuff. If you are preping for interviews as a SA I think the above explanation should be sufficient. If you find out why let me know!

Jan 4, 2015

Here is how it works:

-DTL = (Intangible Asset Write-Up + Tangible Asset Write-Up) * Buyer Tax Rate

However in an asset or 338(h)(10) purchase the DTL is $0 because the tax basis of the acquired assets matches what's on the books, so there's no temporary tax difference.

-Goodwill = Equity Purchase Price of Seller - Seller Book Value + Seller's Goodwill (It's written off completely) - Intangible Asset Write-Up - Tangible Asset Write-Up - Write-Off of Seller's Existing DTL + Write-Down of Seller's Existing DTA + New DTL Created.

So to answer your question, if the goodwill before the DTL is $100 and the DTL is $20, the goodwill with the DTL factored in would be $120. New DTL getting created should raise the goodwill.

Think about it like this: DTL is a liability. If liabilities go up by $20, you need another $20 on the Assets side to balance it... so Goodwill needs to go up by $20 to plug the hole.

A couple other notes:

-As far as I know, existing DTLs are always written down to $0 regardless of the transaction type (Asset vs. Stock vs. 338(h)(10) ). I don't know if this is a hard-and-fast accounting rule but this is how you see it in models and how I do it in models as well.

-DTAs are written down by the Buyer Tax Rate * Seller's nol Write-Down. In an asset or 338(h)(10) purchase you assume the entire NOL balance is written down to $0, but in a stock purchase you only write down the NOLs that you CANNOT use post-transaction, i.e. the existing balance minus the allowed annual usage * NOL expiration years. If that number is negative, you just assume $0 for the write-down because you're going to use up all the NOLs anyway.

Hope this helps.

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Jan 4, 2015

Thanks dosk17. Appreciate the help. If anyone knows the reasoning behind DTL writedowns, please share. Thanks!

Jan 4, 2015

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Jan 4, 2015

I also understand the concepts behind new DTL creation and write down of existing DTAs related to NOLs.
However, similarly to freeforall, I don't understand why Target's Existing DTL is entirely writen down.
Is there any accountant or tax specialist that could explain us why does this happen?

Appreciate the help.

Jan 4, 2015

Here is my thought:
DTL exist because there is a difference between the target's tax-base and the IRS's. After M&A, the assets of the target are re-evaluated at a fair market price so the previous difference is reconciled. Therefore, the DTL of the target should be completely written off.

Jan 4, 2015

Anyone?!?!?

Jan 4, 2015

Assuming that the purchaser can somehow make use of a deferred tax liability of say $50 million, he still won't pay for the net savings since there needs to be margin to be worth it. Is there any history whether this typically might be 20% or 30% or any other number?

Jan 4, 2015

In an asset sale theoretically the asset which was depreciated on an accelerated basis will result in taxable gain and the basis will be written up to fair market value since the gain was calculated on that basis. That logic doesn't apply to all types of DTA and DTL sources.

Jan 4, 2015
  1. Combine all the major line items, ie. Revenues, Operating Expenses Etc. Adjust Pre-Tax Income for Foregone Interest on Cash; Additional Interest Expense from New Debt; Sometimes additional amortization from intangibles created during acquisition. Tax rate would be buyer's tax rate
    Changes in shares outstanding for new shares issued for calculating new EPS;
  2. I would say that commonly, market value of assets tends to be higher than book value (historical value), which would create deferred tax liabilities as these assets have to be written up during the acquisition.

Not 100% on these, maybe someone could weigh in....

Jan 4, 2015

My thoughts would be as follows:

1. The gain on disposal on your tax books would be larger than on your reporting books so that would reverse the DTL. As for the exact accounting treatment, I think you reclass the DTL to a current liability account like current tax liability.

2. If the source of the DTL is a difference in depreciation between tax and reporting purposes, then if the asset has been fully depreciated, the DTL balance must be 0, since deferred tax assets/liabilities are temporary and will be reversed naturally once the asset has been fully depreciated in both books.

Just my 2 cents, but for more insight maybe check out FAS 109 for USGAAP or IAS 12 for IFRS.

Jan 4, 2015

1. I think I get the jist of what you're saying, but if someone can show me how it strings together using the numbers in the example I gave, that would give me more detail.

2. Maybe I'm misunderstanding things, but in the case of an asset write-up, the difference in depreciation is permanent, right? Aren't we starting with a higher depreciation base on the accrual books, which means that over the assets life there will be more total depreciation (which means a greater tax shield in total)? I don't see how all of the DTL will get reversed out...I just see it accumulating over time until the asset is sold.

Feb 18, 2017

The key is understanding difference between asset purchase and stock purchase. When you do a public company merger / acquisition, you are buying the shares of the company. The company in turn owns a bunch of assets, but for tax purposes the ownership of those assets never changed - they've been owned by the company the whole time. Therefore the tax basis in the assets (what you can deduct from your tax bill) never changes (because no change in raw asset ownership). But GAAP accounting requires you to mark up/down the value of the assets on your balance sheet to FV (in many cases up) resulting in an increased discrepancy between book and tax depreciation -- there may already be a discrepancy (probably is), but it jsut got bigger. This results in a deferred tax liability that decreases each year as you pay more cash taxes than your book D&A might otherwise indicate (because the tax d&a has not in fact changed).

A confusing topic to be sure -- macabacus has good articles / demos on the topic.

Jun 14, 2018

I'll chime in and try and synthesize what others have pointed out with varying clarity:

It's all about tax-basis - and thus about whether the merger is a stock or asset deal. In an asset deal, the buyer receives a step-up basis both re. GAAP and tax statements. Thus, the larger depreciation is tax deductible and has an actual cash flow impact.
In a stock deal, the step-up basis is only re. GAAP and not re. the tax statement. Thus, the tax benefit from the larger GAAP depreciation does not really manifest itself in actual cash benefits (via lower taxes). To take this into consideration, a Deferred Tax Liability is created to adjust for this permanent difference - for the fact that our Taxes Payable (what we will actually have to pay in taxes) will be larger than our Tax Expense from the GAAP statement. Each year, the Deferred Tax Liability account will be debited exactly delta between the Tax Payable and the Tax Expense. Eventually, the DTL will go to zero.

Hope this helps.

Jun 14, 2018

the step up D&A expense is included as a tax shield on a GAAP income statement regardless of whether it's stock sale vs asset sale/338h. If it's a stock sale, that's when you create the DTL and amortize it to cancel out the tax shield effects from the cash flow statement since you don't actually get cash tax benefits for the step up. Asset sales/338h10 structures have real tax shield effects, so there wouldn't be a DTL

Jun 14, 2018

Think this helps explain it pretty well: http://macabacus.com/accounting/purchase-price-all...

Jun 14, 2018

Correct me if I am wrong, but I don't think GAAP allows for amortizing intangibles past 200X (2008?) - intangibles must be periodically assessed and written-down as needed. If that were the case, book=tax and no DT_s. However, if anything, only book would allow for amortization, so you are correct that this would typically result in a DTA. But I am not an accountant.

Jun 14, 2018

thanks for the link bernake, i'm still confused though.

again, it says your book taxes will be lower than your taxable income for tax purposes, but isn't this a DTA?

don't you calculate tax based on your tax books, not GAAP books?

i'm still not understand why if cash taxes are higher than book taxes, how that's a DTL. Isn't it a DTA because you're paying more tax than your books say you should?

i guess the point i'm getting to here is, the taxes you actually pay, are they calculated from your GAAP records or tax records?

Jun 14, 2018

bump

Jun 14, 2018

Would you be asked a question like this in an entry level interview?

Jun 14, 2018

As Bernake23 mentioned, the link provides a good explanation.

Alternatively an easier way to make sense of things will be:
Remember the accounting equation:

A = L + E

So when u have a asset write, A increases.
There has to be a corresponding increase in either L or E.

So having a DTA is def out of the question.

Jun 14, 2018

It's a DTL b/c for book purposes, your taxes are LOWER - and yet for tax purposes, they are HIGHER. In other words, you show LESS than what you really HAVE to pay. This is a classic definition of a liability - owing more than what you show. And there needs to be an account for that - since there's a cash outflow of an extra tax expense that you don't record on your income statement (and yet you need to reconcile your B.S. for cash).

It'll be an asset if it's the opposite, i.e. you have pre-paid (or paid more than you should've) in taxes, but showed a smaller tax expense on books. So that's like a pre-paid asset. This is why all pre-paid expenses (i.e. deferred charges) are really assets, because when you pay for something in advance, you don't have to pay for it in the future. And this is why stuff like deferred revenue is a liability - you've received cash for your services/products, but you haven't yet delivered them (and thus haven't recorded them). So it's someone else who pre-paid you; and you need (i.e. OWE) to deliver them your products (or in the example of IRS, you need to deliver them higher taxes).

One more point about DTL's - DTL's are basically the SUM of ALL future book/tax discrepancies. In other words, every year you show less tax than what you really pay in cash, so you "tap" into that DTL, and that DTL becomes smaller BY THAT AMOUNT. Eventually that DTL gets completely depleted.

As far as amortization of intangibles (replying to Dr Joe above): you can still amortize intangibles (go to a 10-K of... say, Broadcom, who acquires like 10 companies per year. You'll see a full purchase price allocation for all of their deals in 2009, 2010, etc. - they give a breakout of what actually goes into acquired intangible assets and for how long are they amortized for). You're confusing acquired intangibles with goodwill; as of 2008, you can't amortize goodwill and do an annual impairment test to it.

Dec 23, 2018
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Apr 3, 2019