A manufacturing company reports $100M of pre-tax book income. Its tax depreciation exceeds book depreciation by $40M. The statutory tax rate is 25%. Compute the deferred tax liability increase for the year. Explain why this DTL does not represent a near-term cash outflow for the company.
AdvancedModel answer
The increase in the deferred tax liability is the temporary difference multiplied by the tax rate: $40M × 25% = $10M. This DTL arises because the company paid $10M less in cash taxes today than the book tax expense; it will be paid in future periods when the asset becomes fully depreciated for tax while book depreciation continues. For a growing company that consistently invests in new PP&E, new originating differences can exceed reversing differences, causing the DTL balance to grow or remain stable, effectively acting as a permanent, interest-free source of financing. It is not a current payable, and the exact timing of reversal may be years away.
Follow-up pressure:
- If the tax rate were to decrease to 21% next year, how would the existing DTL balance be adjusted? Walk me through the income statement impact.
- Suppose the company's capital expenditures slow dramatically and it stops acquiring new assets. Walk me through what happens to the DTL balance over the following three years.
- Would a valuation allowance ever be recorded against a DTL? Why or why not?
This is an advanced Superday-level question with a full model answer, part of IB Atlas's practice bank.
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