When the tax laws change, which rate is used to value deferred tax assets and liabilities?Multiple choice question.
The average rate of the years before the timing difference reverses.
The enacted rate in the year the timing difference reverses.
The effective rate in the current year.
The enacted rate in the current year.
The correct answer and explanation is:
Correct Answer: The enacted rate in the year the timing difference reverses.
Explanation:
Deferred tax assets (DTAs) and deferred tax liabilities (DTLs) arise from temporary differences between the book value of assets and liabilities for financial reporting purposes and their tax bases for tax purposes. When tax laws change — such as a change in the corporate tax rate — these deferred tax amounts must be re-evaluated.
According to Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), deferred tax assets and liabilities must be valued using the tax rate that is enacted at the time the temporary difference is expected to reverse, not the rate in effect at the reporting date.
This approach aligns with the principle that deferred taxes are future obligations or benefits — and thus, they should be measured based on the tax rate that will be in effect in the future when the tax impact is actually realized.
For example, if a company has a deferred tax liability expected to reverse in 2026, and in 2025 the government passes legislation changing the tax rate to 25% effective from 2026, then 25% (the enacted rate at reversal) will be used to calculate the deferred tax liability, even if the current year’s rate is different.
This rule ensures that financial statements reflect the true economic value of tax positions based on actual, legally binding future tax rates. Estimates or average historical rates are not used, as they do not accurately predict future tax consequences. Likewise, the effective tax rate, which is an average of actual taxes paid relative to earnings, is not used for valuing deferred taxes.
Summary:
- Use the enacted tax rate that will apply in the year the timing difference reverses.
- This provides a more accurate and compliant measurement of deferred tax positions under GAAP/IFRS.