Deferred Tax Liabilities

As I continue to study for the CFA Level I exam, I am seeing the concepts come alive in this global recession. Granted, it hasn't been 'declared' a recession, but those that know the signals realise it's a full blown recession, possibly a global one.

I'd like to flesh a few things out about Deferred Tax Liabilities.

I'm learning that fnancial analyzers should add continuous DTL's to equity. This assumes continued acquisition of assets, accumulating more DTL's, coupled with constant growth, assuming general inflation.

However, what does this mean?

Deferred Tax Liabilities are essentially taxes owed coming from the difference in taxable income reported to the IRS (tax return use) and pretax income reporting on Financial Statements (investor use).

Why is there a difference? There is a difference because firms may prefer to depreciate their equipment in an accelerated manner when reporting to the IRS. Why? This lowers taxable income, which lowers the tax! Conversely, firms may prefer to depreciate their equipment in a straight-line fashion, which comforts investors and 'smooths' earnings.

When this happens, a Deferred Tax Liability results.

Up until now, we've seen general inflation, market growth, and continued acquisition of products & equipment by corporations. As a result, these DTL's have been disregarded by financial analysts, and have been actually added to stockholder's equity! (eg treat this as the 'bottom line'). So, we practically went from a liability to your asset....interesting accounting move, eh?

Now, it makes sense, assuming efficient markets, and assuming the market is constantly going up.

What happens in a deflationary recession?

...We're about to find out.

What happens to the company's DTL's & balance sheet when Governments increase corporate tax rates in order to pay for deficit spending?

...We're about to find out.

What happens when companies cease their acquisition phase and actually reduce capacity and downsize?

....We're about to find out.

This is where the general principle of continuous DTL's falls apart, I believe. The problem is, no one has talked about it. Companies with large DTL's may find their share prices plumetting after these consequences take affect. This might be next year, or more likely, the year afterwards (taking into account potential increased corporate tax).

What's a financial guy to do? Well, if I was part of a company, I might recommend realising some of the DTL right now somehow. Granted, there may be other ways to offset the potentially increasing DTL, and I simply just don't know them right now. But, it would seem to be a potential issue, one that might merit discussion among financial officers. Balance sheets might appear to have too many liabilities, which could have an adverse affect on solvency ratios...not good at a time when credit is expensive for those with AAA ratings.

That's about all I know right now, future studies might result in me switching my views because of alternative accounting methods that allow further ways to offset increasing DTL's...but that remains to be seen.