Change in enacted tax rate

Definition

A change in enacted tax rate refers to the modification of the legal tax rate that is applied to taxable income, impacting both current and deferred tax liabilities. This change can arise from new legislation or amendments to existing tax laws, and it affects how companies account for their income taxes, particularly concerning valuation allowances and the measurement of deferred tax assets and liabilities.

5 Must Know Facts For Your Next Test

1. A change in enacted tax rate can affect a company's financial statements by requiring adjustments to deferred tax assets and liabilities.
2. When an increase in the enacted tax rate occurs, companies may need to increase their valuation allowance if it becomes less likely that they will realize certain deferred tax assets.
3. Conversely, a decrease in the enacted tax rate may lead to a reduction in the valuation allowance as the likelihood of realizing deferred tax assets improves.
4. Companies must account for changes in enacted tax rates in the period when the change is substantively enacted, regardless of when it becomes effective.
5. The impact of a change in enacted tax rate is reflected in the income statement as an adjustment to tax expense for the period in which the change occurs.

Review Questions

• How does a change in enacted tax rate influence the calculation of deferred tax assets and liabilities?
  • A change in enacted tax rate directly impacts the measurement of deferred tax assets and liabilities. When a new tax rate is enacted, companies must re-evaluate their deferred tax accounts to reflect this change. For instance, if the enacted rate increases, it may necessitate an increase in deferred tax liabilities due to higher future taxable income. Conversely, a decrease in the rate could reduce these liabilities while potentially allowing for more recognition of deferred tax assets, depending on the realizability assessment.
• Discuss how a company would adjust its valuation allowance in response to a change in enacted tax rate and why this is important.
  • When there is a change in enacted tax rate, it is crucial for a company to adjust its valuation allowance accordingly. An increase in the tax rate might lead to a greater risk that certain deferred tax assets won't be utilized, requiring an adjustment upward of the valuation allowance. Conversely, if the rate decreases, it might become more likely that these assets will be utilized, leading to a reduction in the allowance. These adjustments are significant as they ensure that financial statements accurately reflect the potential future tax benefits and liabilities based on current laws.
• Evaluate the broader implications of changes in enacted tax rates on corporate financial strategy and investor perceptions.
  • Changes in enacted tax rates can significantly influence corporate financial strategies and shape investor perceptions. An increase in rates may lead companies to reassess their operational structures, potentially resulting in cost-cutting measures or shifts in investment strategies to mitigate higher tax burdens. This recalibration can affect cash flow projections and ultimately influence stock valuations. Investors closely monitor such changes as they directly impact profitability and growth potential; therefore, understanding these dynamics becomes essential for making informed investment decisions.

Related terms

Deferred Tax Assets:

Assets on a company's balance sheet that represent the expected reduction in future taxes payable due to deductible temporary differences and carryforwards.

Valuation Allowance:

A reserve established to reduce the carrying amount of deferred tax assets to the amount that is more likely than not to be realized.

Effective Tax Rate:

The average rate at which a corporation's pre-tax profits are taxed, calculated by dividing total tax expense by pre-tax income.