© 2019. Michael Minnis. Please do not reproduce without permission.
How do we handle Taxes?
Items above the “Income tax expense” line item are
of tax, while all
items below “Income tax expense” are reported
Therefore, you do not need to consider tax effects when reclassifying
items below the Income tax expense line.
If the firm has Net Financial Obligations (NFO) with related financing
expenses (e.g., Interest expense), then the “Income tax expense”
underreports the amount of taxes related to operations.
Interest tax shield = Net interest expense x Tax rate
The marginal tax rate on interest income/expense is usually 35%
The goal is to allocate the “Income tax expense” line item to operating and
Usually easiest to identify the Net Financing Expense (usually interest
expense – interest income) and multiply by marginal tax rate on NFE
(usually 35%, though you may want to also consider state income taxes)
Usually results in a negative tax expense (i.e., tax benefit) for financing and
a positive tax expense for operating.