Chapter 9: Income Taxes

1

INTRODUCTION TO INCOME TAX ACCOUNTING

A company's financial statements are prepared using accounting principles (like IFRS or U.S. GAAP), while its tax obligations are determined by tax laws set by the government. These two sets of rules are often different, leading to discrepancies between the profit a company reports to investors and the income on which it actually pays taxes.

            Key Concepts:
            Tax vs. Accounting Rules: This difference is the root cause of all income tax accounting complexities.
Temporary vs. Permanent Differences: Some discrepancies will reverse over time (temporary), creating deferred tax items. Others will not (permanent).
Effective Tax Rate: This rate reflects a company's actual tax burden and is a key metric for analyzing profitability after taxes.
Disclosures: Companies provide detailed notes in their financial statements to explain their tax accounting and reconcile these differences.

          

2

KEY DIFFERENCES: ACCOUNTING PROFIT VS. TAXABLE INCOME

Understanding the following core terms is essential for income tax analysis:

Term	Definition
Accounting Profit	The pre-tax profit reported on a company's income statement, calculated according to accounting standards (IFRS/GAAP).
Taxable Income	The profit subject to income tax, calculated according to the rules set by tax authorities. This is the amount used to determine the actual tax payable for the period.
Tax Expense	The total tax reported on the income statement. It includes both the current tax payable and changes in deferred tax assets/liabilities.
Taxes Payable	The actual amount of tax that a company must pay to the tax authorities for the current period.
Deferred Taxes	The difference between the tax expense and the tax payable, arising from timing differences.
Temporary Differences	Differences between the carrying amount of an asset or liability on the balance sheet and its tax base. These differences will reverse in future periods.
Permanent Differences	Differences between accounting and tax rules that will never reverse. Examples include non-deductible expenses or non-taxable income.

Tax Rate Definitions

Statutory Tax Rate

The official corporate income tax rate enacted by law in a specific jurisdiction.

Effective Tax Rate

Effective Tax Rate = Tax Expense ÷ Accounting Profit

This represents the company's actual tax burden on its reported profit.

3

DEFERRED TAX ASSETS AND LIABILITIES (DTAS AND DTLS)

Deferred taxes arise from temporary differences between accounting profit and taxable income. They represent future tax effects of transactions that have already been recognized in the financial statements.

Core Idea: The goal of deferred tax accounting is to match the tax expense with the accounting profit in the period it is earned, regardless of when the tax is actually paid.

Feature	Deferred Tax Liability (DTL)	Deferred Tax Asset (DTA)
What is it?	An obligation to pay more tax in the future.	A right to pay less tax in the future.
When does it arise?	When accounting profit is less than taxable income now, but will be higher in the future. This happens when: The carrying amount of an asset > its tax base. The tax base of a liability > its carrying amount.	When accounting profit is greater than taxable income now, but will be lower in the future. This happens when: The tax base of an asset > its carrying amount. The carrying amount of a liability > its tax base.
Common Causes	Accelerated Depreciation for Tax: A company gets larger tax deductions for an asset upfront than the depreciation expense it reports on its income statement. Unrealized Gains: Gains on investments are reported on the income statement but are not taxed until the investment is sold.	Warranty Expenses: A company estimates and expenses future warranty costs on its income statement, but can only deduct them for tax purposes when the costs are actually paid. Unrealized Losses: Losses on investments are reported on the income statement but are not tax-deductible until the investment is sold. Tax Loss Carryforwards: When a company has a net loss for tax purposes, it can often use that loss to reduce taxable income in future years.
Effect on Future Taxes	Increases future taxes payable	Decreases future taxes payable

Recognizing Deferred Tax Assets

Important: While DTLs are generally always recognized, a DTA is only recognized if it is probable that the company will have sufficient future taxable profit to actually use the asset (i.e., to realize the future tax deduction). This involves management judgment about future profitability.

Valuation Allowances for DTAs

If it's not probable that a DTA will be realized, a valuation allowance is created as a contra-asset. Increases in the valuation allowance signal deteriorating profit expectations and increase tax expense.

4

CORPORATE INCOME TAX RATES FOR ANALYSIS

Analysts use different tax rates to evaluate a company's earnings and cash flows:

Tax Rate	How to Calculate	What it Tells an Analyst
Statutory Tax Rate	The official rate in the company's home country.	The baseline rate before any adjustments. A starting point for analysis.
Effective Tax Rate	Effective Tax Rate = Tax Expense ÷ Pre-Tax Income	Shows the actual tax burden on reported profits. It is crucial for forecasting future earnings. A rate consistently different from the statutory rate requires investigation.
Cash Tax Rate	Cash Tax Rate = Cash Taxes Paid ÷ Pre-Tax Income	Measures the actual cash that went out the door for taxes. This is vital for cash flow modeling and valuation.

Analysis Note: The effective tax rate often differs from the statutory rate due to factors like tax credits, permanent differences, and different tax rates in various countries where the company operates (geographic mix of profits).

5

PRESENTATION AND DISCLOSURE IN FINANCIAL STATEMENTS

Classification on the Balance Sheet

IFRS

Requires companies to present DTAs and DTLs as separate line items. It also requires a breakdown of components and their recovery timing (e.g., reversing in more or less than 12 months).

U.S. GAAP

Generally classifies all DTAs and DTLs as non-current on the balance sheet.

Offsetting DTAs and DTLs

A company can only present a single net deferred tax asset or liability if specific conditions are met:

The entity must have a legally enforceable right to offset current tax assets and liabilities.
The deferred tax items must relate to the same tax authority (e.g., both are federal taxes in the same country).

Reconciliation of Income Tax Expense

Companies must provide a reconciliation to explain why their reported income tax expense is different from the amount that would result from applying the statutory tax rate to their accounting profit.

IFRS Requirements:

Required for both public and private companies
Allows two formats: monetary amounts or tax rates
Can compare average effective rate to applicable rate

U.S. GAAP Requirements:

Required only for public companies
Must use domestic federal statutory tax rate
Reconciliation shows specific adjustments

6

EXAM FOCUS & KEY FORMULAS

Exam Weight & High-Yield Topics

Income taxes typically account for 2-3 questions on the CFA Level I exam. Focus on:

Calculating income tax expense from current tax and changes in deferred taxes
Identifying situations that create DTAs vs. DTLs
Distinguishing temporary from permanent differences
Effective tax rate calculations and interpretation
Impact of tax rate changes on deferred tax balances

ESSENTIAL FORMULAS

1. Income Tax Expense

Income Tax Expense = Current Tax Payable + ΔDTL - ΔDTA

where Δ = Change in deferred tax asset or liability during the period

2. Effective Tax Rate (ETR)

ETR = Income Tax Expense / Pre-Tax Income

Shows actual tax burden on reported profits

3. Current Tax Payable

Current Tax Payable = Taxable Income × Statutory Tax Rate

Actual cash tax owed to tax authorities

4. Deferred Tax Liability or Asset

DTL or DTA = Temporary Difference × Tax Rate

DTL when accounting income < taxable income; DTA when accounting income > taxable income

5. Cash Tax Rate

Cash Tax Rate = Cash Taxes Paid / Pre-Tax Income

More relevant for cash flow modeling than ETR

            Critical Exam Concepts
            DTA Recognition: DTAs require probable future taxable income. Increases in valuation allowances signal deteriorating prospects.
Tax Rate Changes: When tax rates change, existing DTAs and DTLs must be revalued using the new rate. Rate increase DTL increases (expense), DTA increases (income).
Permanent vs. Temporary: Permanent differences affect only ETR, not deferred taxes. Temporary differences reverse over time and create DTAs/DTLs.
Cash Flow Impact: Deferred taxes are non-cash items. Increases in DTLs are added back to net income in operating cash flow.

          

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