Tax Part 2

Quick reference

• 00:04 Continuing with tax.
• 00:07 What I want to do is continue the conversation with tax expense and
• 00:10 how we calculate that as part of the control account as we systematically work
• 00:15 our way down the income statement we've got there.
• 00:18 We've got almost to the bottom of the smallest of the three financial
• 00:21 statements.
• 00:22 But we are more than a third of the way through because we've been
• 00:25 actually putting things into the income statement, the balance sheet, and
• 00:27 the cash flow statement all at the same time.
• 00:30 So we're in good shape.
• 00:32 Let's carry on.
• 00:33 Now, I talked about tax expense and making adjustments for
• 00:36 permanent differences last time.
• 00:38 And I also talked about the idea of tax losses, which we will model, too.
• 00:42 I want to also explain another issue, deferred tax.
• 00:45 And the best way to do that is to consider a control account.
• 00:49 And surprisingly, I'm gonna start off with interest.
• 00:53 So if you recall when we were going through the interest calculations,
• 00:57 we had opening interest payable, we added on interest expense,
• 01:01 we deducted interest paid, gave us our closing interest payable.
• 01:05 So far, so good.
• 01:06 Let's change this to tax.
• 01:09 Not too much of a challenge there.
• 01:12 Seems to make complete sense, just one problem.
• 01:16 10 + 20- 10 = 37, what on Earth is going here?
• 01:21 Well let me explain how this might be by considering depreciation
• 01:26 which is a common cause of differed tax issues.
• 01:30 Let's start off with accounting depreciation.
• 01:34 So we'll have a four-year economic life.
• 01:37 Assuming we're going to spread the cost evenly over the four years, that's gonna
• 01:41 be 25% of the cost spread in each of the years, what we call straight line.
• 01:44 So let's have an opening of net book value of 100.
• 01:47 At the end of year 1, 25% of that depreciation will come off.
• 01:50 It's 25, will give me a net book value at the end of the year of 75.
• 01:55 Similarly, in year 2 we'll have a further 25 depreciation.
• 01:59 We'll make my net book value 50.
• 02:01 Deduct again.
• 02:02 At the end of year 3, we have 25.
• 02:04 And in the final year of the term,
• 02:06 we subtract the remaining depreciation off to give us a net book value of 0.
• 02:11 So if we were to plot this on a chart,
• 02:13 net book value against time, we'd get something that looked like this.
• 02:17 A straight line.
• 02:18 This is why it's called straight line depreciation.
• 02:21 Right, now let's consider tax.
• 02:24 In many territories around the world, the US, Australia, the UK and others,
• 02:28 they'll actually let you have what's called a declining balance approach.
• 02:32 Which is where they'll actually dictate to you what the life is,
• 02:35 which may not be the economic life,
• 02:37 it's just this is stipulated by the tax rules and regulations.
• 02:40 Coincidentally, to keep this simple, let's say it's also four years, but
• 02:44 they'll give you a multiplier, and it also tells you is that will be two times.
• 02:48 So in the US, for instance,
• 02:50 the declining balance method is known as the double declining balance method.
• 02:53 Because what you do is you actually work out the depreciation rate,
• 02:57 which on four years will be 1 over 4, who's 25% and double it, so it's 50.
• 03:02 But then you take 50% of what's left,
• 03:06 not of the original balance like you do in straight line.
• 03:08 So to demonstrate that,
• 03:10 we don't call it net book value when we talk about it for tax.
• 03:13 It's called tax written down value or TWDV.
• 03:17 So the opening tax written down value will be 100.
• 03:20 Half of that will be 50, will leave me with 50 at the end of the first year.
• 03:24 Half of that in year 2 will be 25, would leave me with 25 at the end of year 2.
• 03:30 Half of that in year 3 would be 12.5, leaving me with the same at year 3.
• 03:34 And so on and so on.
• 03:35 At the end of the four year life, it's not fully written down, and
• 03:39 you can actually pull these assets, just keep going on forever.
• 03:43 And the chart might look something like this.
• 03:45 Nice red chart where you can see the actual tax break.
• 03:49 You're getting a bigger amount of depreciation to start off with,
• 03:52 which is good because that depresses your profits and you pay tax on your profits.
• 03:57 So you pay less tax under the taxation method.
• 04:00 This is known as an accelerated capital allowance.
• 04:04 Why on Earth would the tax authorities give you this?
• 04:08 Well what they're trying to do is they're trying to get you to spend more on capital
• 04:12 expenditure.
• 04:13 That means spending more money in the territory or jurisdiction of the tax
• 04:17 authority, which will create capital investment and hopefully more jobs.
• 04:20 Then they can tax everybody, so don't feel too sorry for them.
• 04:24 Now before I explain the concept of deferred tax completely,
• 04:28 I'm just going to actually modify the taxation calculation slightly, so
• 04:32 that my depreciation in the final year, write it off completely.
• 04:36 Which is what would happen if you just had one big asset.
• 04:39 So let's just make that adjustment first of all.
• 04:41 There we go, bang, it's 0 too.
• 04:43 Now, let's compare accounting and tax again.
• 04:46 So let's just tidy this up a bit.
• 04:48 I made a bit of mess with this piece of paper.
• 04:50 So, tidying it up for accounting, here's the numbers we had.
• 04:56 For tax, here's the numbers we have.
• 04:59 Now what I want to do is calculate the taxable timing difference, the TTD.
• 05:03 So for the year 1, the actual depreciation charge on the account is $25 and
• 05:08 under tax, it's $50.
• 05:10 That's a benefit of 25 because you're depressing the profits down.
• 05:15 In the second year, there's no difference.
• 05:17 In the third year it's 12.5 worse the other way.
• 05:20 And in the final year, it's 12.5 worse the other way to recoup it back to 0.
• 05:24 So it's a timing difference only.
• 05:26 But remember what I said, it's the tax effect that's the key thing.
• 05:29 What you're looking at on the balance sheet, the tax effect there.
• 05:33 So in tax effected, what I've got to do is multiply these numbers by the tax rate so
• 05:38 I can show them in the balance sheet.
• 05:41 Let's assume the tax rate's 30%.
• 05:43 So 30% of 25 is $7.50, still 0 here.
• 05:47 And then it will be $3.75 the other way to still give me a timing difference of 0.
• 05:53 This is what we would show in the balance sheet then.
• 05:56 We would actually show this benefit of $7.50,
• 05:59 which would then be written down over future years.
• 06:03 This is beneficial to a company anyway because any positive cost of capital,
• 06:08 it's worth deferring the tax payments to later on
• 06:11 because effectively you're paying less in real terms.
• 06:15 We'll gonna talk more about deferred tax next time, but
• 06:18 just let that sink in for a second.

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