CFA Level I · CFA Level I Exam

Analysis of Income Taxes: formula sheet

Full chapter guide

Key formulas

Income tax payable (current tax): Income tax payable = Taxable income × Tax rate; This is the cash tax owed to the authority for the period, based on the tax return.
Income tax expense: Income tax expense = Income tax payable + ΔDTL − ΔDTA; ΔDTL is the increase in deferred tax liability. ΔDTA is the increase in deferred tax asset. A decrease reverses the sign.
Income tax expense (alternative): Income tax expense = Current tax expense + Deferred tax expense; Deferred tax expense = ΔDTL − ΔDTA.
Tax on accounting profit: Pre-tax income × Tax rate; Equals income tax expense only when there are no deferred tax effects (no temporary differences, and no tax rate change).
Effective tax rate: Effective tax rate = Income tax expense ÷ Pre-tax income; Compare with the statutory rate to see the effect of permanent differences and other items.
Deferred tax balance: Deferred tax = temporary difference × enacted tax rate; Use the rate expected to apply when the difference reverses.
Asset test: Asset: carrying amount > tax base → DTL; carrying amount < tax base → DTA; Temporary difference = |carrying amount − tax base|.
Liability test: Liability: carrying amount > tax base → DTA; carrying amount < tax base → DTL; Opposite direction to the asset test.
Income tax expense: Income tax expense = income tax payable + increase in DTL − increase in DTA; Payable is taxable income × tax rate. Use net changes in the balances. The DTA change is net of any reduction for amounts that are not recoverable. Under IFRS, the DTA carrying amount is reduced to the amount that is probable to be recovered. A separate valuation allowance is a US GAAP mechanism.
Income tax payable: Income tax payable = taxable income × tax rate; This is the cash tax for the period, before deferred items.
Temporary difference for an asset: Temporary difference = Carrying amount − Tax base; Positive for an asset means a taxable temporary difference (deferred tax liability). Negative means deductible (deferred tax asset).
Temporary difference for a liability: Temporary difference = Tax base − Carrying amount; The order is reversed so the signs match the asset formula: positive means taxable (deferred tax liability); negative means deductible (deferred tax asset). A liability with carrying amount above tax base gives a negative result, which is a deductible difference.
Deferred tax amount: Deferred tax = Temporary difference × Enacted tax rate; Use the rate expected to apply when the difference reverses, based on enacted or substantively enacted law.
Effective tax rate: Effective tax rate = Income tax expense ÷ Pre-tax income; Permanent differences push this away from the statutory rate. Temporary differences do not, because deferred tax is included in tax expense.
Classification rule: Reverses = temporary (deferred tax). Never reverses = permanent (no deferred tax).; Permanent items affect only the effective rate.
US GAAP valuation allowance test: Allowance required if P(DTA not realized) > 50% (more likely than not); Allowance = the portion of the DTA not expected to be realized. Reported DTA = gross DTA − valuation allowance.
IFRS recognition test: Recognize DTA only to the extent future taxable profit is probable; No separate allowance account. The asset is reduced directly, and the reduction can be reversed.
Deferred tax asset from a tax loss: DTA = unused tax loss × enacted tax rate; Use the rate expected to apply when the loss is used.
Effect on income: Increase in allowance → higher tax expense → lower net income; A decrease (reversal) has the opposite effect. Cash taxes paid do not change.
Effective tax rate: Effective tax rate = Income tax expense ÷ Pretax income; Compare with the statutory rate. Use the reconciliation in the footnote to explain the difference.
Income tax expense: Income tax expense = Current tax expense + Deferred tax expense; Deferred tax expense = increase in DTL minus increase in DTA (net change), before items booked to equity or OCI.
Cash tax rate: Cash tax rate = Cash taxes paid ÷ Pretax income; A cash rate well below the effective rate points to deferral or credits that may reverse.
Adjusted equity when DTL is treated as equity: Adjusted equity = Reported equity + DTL; Debt-to-equity falls because liabilities fall by the DTL and equity rises by the same amount.
Adjusted liabilities when DTL is treated as liability: No adjustment: DTL stays in liabilities; Use when reversal is expected. If ignoring the DTL, remove it from liabilities and do not add it to equity.

Quick revision

Income tax expense = income tax payable (current tax) + increase in DTL − increase in DTA (equivalently, current tax + deferred tax expense).
Taxable income follows the tax return; accounting profit follows the financial statements.
DTL: the company pays less tax now and more later.
DTA: a future tax saving. It arises when taxable income exceeds accounting profit because of a timing difference, so tax paid is higher than tax expense. The cumulative amount is recognised as a DTA and is recovered through lower future taxes. Unused tax losses and credits also create DTAs.
Asset: carrying amount above tax base gives a DTL; below gives a DTA.
Liability: carrying amount above tax base gives a DTA; below gives a DTL.
Permanent differences create no deferred tax but change the effective tax rate.
Temporary differences reverse and create deferred tax.
US GAAP recognises the full DTA, then reduces it with a valuation allowance if it is more likely than not that some will not be realised. IFRS has no allowance account: it recognises a DTA only to the extent future taxable profit is probable, and reviews this each period.
A rate cut reduces both DTAs and DTLs; a rise increases both.
Effective tax rate = income tax expense ÷ pretax income.
Check the notes and judge the timing of a DTL. Analysts commonly adjust for it: treat the DTL as a liability if it is expected to reverse, as equity if it is not expected to reverse (for example, because of continued growth in capital spending), and decide case by case (often excluding it from both) if the timing is uncertain. This is an analyst adjustment, not a reporting rule.

Common mistakes

Applying the tax rate to taxable income and calling it income tax expense. Fix: Taxable income × rate is tax payable. Add the change in DTL and subtract the change in DTA to get tax expense.
Getting the sign of the deferred tax adjustment wrong. Fix: A rising DTL means taxable income is lower than pre-tax income now, so tax payable is below the tax on book profit and the tax is deferred to later. Tax expense is therefore higher than tax payable. A rising DTA lowers expense below tax payable.
Reversing the asset and liability rules Fix: For assets, higher carrying amount gives a DTL. For liabilities, higher carrying amount gives a DTA. Think of future tax effect instead.
Creating deferred tax for permanent differences Fix: Only temporary differences reverse. Items never taxed or never deductible create no deferred tax.
Recording deferred tax on a permanent difference. Fix: Only reversing differences create deferred tax. Permanent items change the effective tax rate only.
Reversing the rule for liabilities. Fix: For a liability, carrying amount above tax base is deductible and gives a deferred tax asset. Example: a warranty provision not yet deductible for tax.
Saying a valuation allowance reduces cash taxes paid or cash flow. Fix: The allowance is a non-cash accounting entry. It changes tax expense and the DTA, not taxes paid.
Applying the allowance when the chance of non-realization is exactly 50% or just below. Fix: The US GAAP test is more likely than not, meaning above 50%. At 50% or less, no allowance is required.
Treating a DTL as equity in every case Fix: Choose by facts: reversal expected means liability, no reversal expected means equity, uncertain timing means ignore.
Assuming tax expense equals cash taxes paid Fix: Remember deferred taxes bridge the two. Use the footnote and cash flow statement disclosure of taxes paid.

Exam tips

Questions are standalone three-option MCQs. Compute tax payable first, then adjust for deferred taxes, and eliminate options that skip this step.
Read whether the question gives taxable income or pre-tax income. The rate is applied to taxable income for tax payable.
Watch for the words temporary and permanent. Permanent differences never create deferred tax.
Expect conceptual items too: why taxable income can be higher or lower than pre-tax income, and which direction the deferred item moves.
Most questions test direction first. Decide DTA or DTL before doing any arithmetic.
Watch for a tax rate change in the stem. Remeasure the deferred balance at the new enacted rate.
Check whether the question says IFRS. Deferred tax is not discounted, and DTAs need probable future profit.
Link this topic to unrecoverable DTAs and tax loss carryforwards. Under IFRS, a DTA is written down to the probable recoverable amount. Under US GAAP, a valuation allowance does this job. In both cases, a larger reduction signals doubts about future profits.