Taxation.  The tax code is a mismatch of government policy and revenue collection that is constantly changing and is difficult to understand.  Even when you know what you owe, when you pay is a large issue (this example does not deal with tax payments per se, as they are essentially A/R and A/P).  As such, accountants have stuck with reflecting economic tax on the income statement.  This is generally accounting income times the tax rate.  What you actually pay is based on the tax code, which does not coordinate with the accountants in several areas, including depreciation.  An accountant might give an asset a 15 year economic life for depreciation, where the government might let you depreciate it using 5 year Modified Accelerated Cost Recovery System (“MACRS”) ( tables, which fully depreciate the asset in 6 years (not 5 total because the government assumes assets are purchased in the middle of the first year of depreciation).  Since tax is levied on income after depreciation, a 15 year life and a 6 year life will net dramatically different tax values.  However, over the life of the asset, the total tax will generally be the same (the shelter is 100% of the value in each case).  The difference between levied tax and accounting tax is tracked in deferred tax assets and deferred tax liabilities on the balance sheet.  The cash flow statement provides the reconciliation between the accounting income and the actual cash.  It “uses” the tax assets and liabilities to determine the amounts.   There are more reasons for tax differentials than depreciation, but this example focuses on depreciation, as it is the most common modeling reason for a difference, and it can have a dramatic impact.  For more complicated tax situations, get a tax professional (always a good idea, you will be surprised how many times a simple situation will have goofy tax) to walk you through the results.  However, the basic math with accounting / cash differences and the use of assets and liabilities will be the same.

Simple Example.  In the simple example, your tax professionals have given you the deferred tax assets and liabilities so you do not have to determine them.  The “Simple” tab of the free taxation Excel spreadsheet download Taxation tracks through this example and how it is reflected in a model.  The simple model shows how to integrate changes in tax assets and liabilities into the balance sheet and income statement. 

On row 18 and 20, the deferred tax assets and liabilities are entered by your friendly accountant.  These are reflected in the cash flow statement just like other assets and liabilities.  Often, it can be helpful to model tax only on one line as a net number (positive or negative) on the asset or liability side of the balance sheet.  This is not proper accounting, and can mask the workings of the tax statement, but can make for much easier modeling. 

What is an example of a deferred tax liability?  When tax depreciation is faster than GAAP, the tax amount on the income statement is too high vs. what was actually paid.  From an accounting standpoint though, the company will eventually owe that tax.  Further, the tax will be owed later when the company is recording a lower-than-cash tax amount on its income statement.  The difference between (higher) GAAP and (lower) cash tax is a liability of the company.  Making it a liability from a modeling standpoint means that it “generates” cash on the cash flow statement to make up for the “over-charge” for tax on the income statement. 

Deferred tax assets can arise in instances where a company has paid (or owes) tax on taxable income that is not accounting income.  Your friends at the IRS are more concerned with what actually happened than are accountants, who are trying to reflect economics and protect investors.  Often, deferred tax assets can occur in a loss contract situation.  When a company (using the percentage completion method) forecasts a loss on a contract/project, GAAP requires recognizing all of the loss now.  The federal government thinks that is nice (from an SEC standpoint) but is not going to write a check (i.e. give you a tax deduction) until you actually experience the losses (otherwise what a fraud bucket this would be – need a tax rebate?  Hmm… I think this project is going to lose money).  When a loss contract happens, the accounting income is low (from “fake” accelerated losses) making the income statement tax low, but taxes actually owed / paid are higher because the IRS does not recognize the accounting loss.  Therefore, an asset has been created.  You have (when compared to your income statement) paid taxes where you did not have an economic profit.  In the future, when the losses actually happen, you will have higher accounting income (because you took the loss in a prior period), but lower tax (because you paid it earlier, and are now “enjoying” the cash loss).  If this example is confusing, do not worry, it is not necessary to understand for general modeling.  Deferred tax assets can also occur in certain pre-paid or deposit situations.

Complex Example.  Calculating and reflecting tax and GAAP differences.  In this example, tax depreciation and GAAP depreciation is calculated.  Row 9 contains the inputs from the MACRS table that can be had from your tax specialist or the IRS.  Row 12 carries over the capital expenditures as an input.  In an actual model, you would pull your inputs from the same, primary, source to make tracing of inputs easier for the user.  Here, the only source available is the secondary one on the depreciation schedule included for reference. 

Rows 15 through 28 contain a wedge for calculating tax depreciation.  This wedge is similar in concept to the depreciation wedge, except that each new batch of capital expenditure must be multiplied by the differing MACRS percentages according to the age of the asset (rather than one percentage in depreciation).  There are many ways to construct this wedge.  I have included this “automatic” calculation for reference only.  You could build a corresponding wedge of MACRS data to related to a wedge of plain formulas (space is generally “free” in a modern spreadsheet).  Or, you could hand code each row by modifying the references, etc.  The formula here looks up the current year in the capital spending table and returns the appropriate year’s spending.  It then looks up the MACRS % based on the age of the asset (current year-start year) and multiplies them together.  If you have a mix of asset MACRS treatment (such as buildings and equipment) you could easily build two wedges with different MACRS tables feeding off of the same capex, as was done here, or you could increase the complexity of the first wedge by combining both classes of property.  C13 contains the ratio between the asset classes.  Copying the wedge is easy, even if duplicating the capital expenditure line is somewhat sloppy.  The automatic wedge formula is also somewhat sloppy in that it contains many null set cells, where there will never be information (such as the zeros ahead of the year 2023 on row 28).  But, the formula need only be coded once in one cell and the wedge does provide more flexibility in setting the dates that are across and down (especially with the automatic calculation feature).

Row 31 contains the historic tax depreciation that is the same in concept to the historic depreciation in the GAAP table.  Here, it is set equal to the historic GAAP depreciation only for illustrative purposes.  In reality, it will most often be of shorter duration.  Your tax advisors / department should be able to quickly prepare a projection of the tax depreciation for historic assets.

Now that you have both sets of depreciation, you can strike a difference, apply the tax rate, and calculate the difference between the cash* and accounting taxes (*cash in the sense of taxes owed, not necessarily taxes paid.  Paid taxes depend on filing deadlines, and other tax rules – again not a focus of this discussion).  The difference is shown on row 68.

With this difference, you can now create a tax liability or asset by accumulating the annual differences.  Then, as in the simple tax example, use the tax assets and liabilities to drive the cash flow statement.  Often, these are combined on one line for ease of modeling.  If your audience likes their balance sheets to look correct (no negative assets) use a positive / negative separation as on rows 72 and 73.

This example was set up to illustrate the modeling technique, but also the logic in the tax calculation.  First set cell C13 (portion of 7 year property) to 100%.  Look at the first few years.  The IRS depreciation is higher than the GAAP depreciation in the early years of an asset’s life.  This means that your book/ GAAP/ income statement taxes will be higher than your cash* taxes early on.  You can see this through the increase in the deferred tax liability (you having not paid taxes that you booked) which will cause the cash flow statement to “generate” cash.  Note that this does not really generate cash, it is adjusting for reality.  Then look at the latter years.  Here, for tax purposes, the assets are fully depreciated.  When you file your return, you will get no reduction in income for these assets.  However, the longer, straight, GAAP depreciation remains.  This means that your cash* taxes will be higher than your GAAP taxes.  You will pay the IRS more than the expense you have on your books.  Your liability is coming home to roost.  As it is reduced (because you are literally paying it down) the cash flow statement will show a use of cash, reflecting the difference between GAAP and IRS.  Note that in the final year the liability is gone.  All of the assets (at least the new ones) are fully depreciated for book / GAAP and tax purposes.  Now the timing differences have worked themselves out.  The tax “paid” in total under GAAP and tax is, of course, the same.

Now, change cell C13 back to 90%.  Look at the difference in the final years.  Now, you have very long lived tax property that reduces tax depreciation.  GAAP depreciation in the final years is higher than tax (IRS) depreciation.  This generates a tax asset because you have pre-paid (in cash) for taxes that you will “owe” on your income statement later because your GAAP depreciation has run out.  In the final year, column O, this begins to happen when the tax bill is lower than the GAAP taxes.

Tax modeling can be confusing, but remember that you are just reflecting the differences between the accountant’s method of depreciation and the tax person’s method of depreciation.  Your tax bill will basically never match the tax on the income statement.  If you do not adjust for this in your cash flow model, you may dramatically over or under state cash flow.

Tax loss carry forward values also operate via the balance sheet.  Simply apply current period taxes (you will need to calculate actual taxes using the tax difference to GAAP) against the prior period loss being mindful of limitations and exhausting the loss.