Purchase accounting: DTL from asset step-up?
Hi all, struggling to conceptually understand why a DTL gets created as it seems contrary to everything I've learned about deferred taxes. For example, accelerated depreciation causes a DTL because your cash taxes will be less than your GAAP taxes due to increased depreciation expense on the tax books. However, in the case of write-ups, you get no extra depreciation on the tax books, only GAAP. This should lead to paying higher cash taxes than GAAP, which theoretically should create a DTA. Could really use some help wrapping my head around this, thanks.
So I'm also new on learning this stuff but here's what I believe is true. Please correct if I'm horribly mistaken.
First, consider if the purchase is structured as a stock or a asset purchase.
Next, note that we have book (GAAP) accounting and tax accounting. Tax accounting is what you're obliged to owe to government, but book (GAAP) accounting is the tax amount you actually end up paying that year.
For the book accounting: for stock OR asset purchase you have an asset write-up. For tax accounting: for asset purchase you similarly step up the tax basis of the assets (but this is not a 1:1 equivalency to the asset write-up in the book accounting!) whereas for stock purchase you DO NOT step up the tax basis of the assets.
As a result, here's how to think about it. 1) Is the purchase stock or asset? If it's asset purchase we're good, no DTLs created. If stock purchase, go to next step. 2) Since it's a stock purchase there is no step up for tax basis of the assets but there WAS a GAAP accounting (book) write-up of the assets. As a result you have higher book D&A and pay fewer actual taxes. But because tax basis had not step up you are obliged to pay the original amount of taxes. 3) Therefore, for this period, you have underpaid the government for taxes and now you owe them. You record a deferred tax liability (DTL) on your balance sheet under liabilities (current or non-current depending on timing). Some companies may consolidate DTL and DTA into some net DTA line item on the assets side, so have to clarify on that.
Furthermore, in an asset purchase (not stock purchase) goodwill can be amortized over 15 years, so you can create a DTA in that way as well. Luckily, most LBOs are stock purchases so you don't amortize the goodwill (causing a DTA) and instead only care about asset write-ups resulting in increased D&A and therefore DTLs being created.
Hey, here is how it works:
A deferred tax liability represents a difference between the book and tax basis of an asset or liability that will result in additional future taxes.
In a stock acquisition, PPE for example gets a step up to fair market value for books, but not for tax. Thus, book basis will be higher than tax basis, which is why a DTL is required.
Since the book basis is higher than the tax basis, book depreciation will exceed tax depreciation on the PPE, and that additional book depreciation will be reversed when computing taxable income. This is what creates the higher additional cash taxes -- the throw out of the step up depreciation that is not allowed for tax purposes.
Hope that helps.
Thanks for this. I understand why cash taxes will be higher than GAAP (no extra depreciation from step-up), but am struggling to figure out why it creates a DTL instead of a DTA. I keep going back to the example of accelerated depreciation because it has the direct opposite impact, yet also creates a DTL. Accelerated depreciation is only on the tax books, which leads to lower cash taxes than GAAP, yet it results in a DTL just like in a step-up where cash taxes are actually higher. Everything I've learned about accounting says when cash taxes are higher than GAAP, it actually creates a DTA.
Because the increased depreciation from the step-up would make your taxes on your books lower than they would have to be; by decreasing the EBT. therefore, the DTL makes sure to counter-act this effect
In general, the way deferred taxes should be viewed is as the tax effected difference between the book and tax bases of assets / liabilities.
When the book basis of an asset is higher than its tax basis, it creates a DTL. Accelerated depreciation lowers tax basis faster than GAAP depreciation, so book > tax = DTL.
For stock acquisition step up, the step up applies to book but not for tax, so at acquisition, book > tax = DTL.
Intuitively, you should be asking yourself, will the difference in the book vs tax basis lead to paying more or less taxes as that difference reverses itself. If it results in higher taxes, its a liability (DTL). If it saves taxes as it reverses, it is an asset (DTA).
This just cleared everything up for me, thanks so much.
Accelerated depreciation creates a DTL (not a DTA) in the earlier periods because your book (GAAP) accounting for depreciation is higher than the tax depreciation. As a result you actually pay fewer taxes in cash but owe the original amount, so you record a liability in the form of a DTL. See: https://www.investopedia.com/ask/answers/052915/what-are-some-examples-…
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