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CFA Level I · CFA Level I Exam

Analysis of Income Taxes for CFA Level I

Analysis of income taxes explains why tax expense in the income statement differs from tax paid. You compare accounting profit with taxable income, find the tax base and carrying amount of each asset and liability, and book deferred tax on the temporary differences. Then you test the result for rate changes and valuation allowances.

What this chapter covers

This chapter sits inside Financial Statement Analysis. It answers one question: why does the income tax expense a company reports differ from the tax it pays this year? The answer is that accounting rules and tax rules measure profit differently. Some differences reverse over time. Others never reverse.

You will learn the vocabulary first: taxable income, income tax payable, income tax expense, deferred tax asset (DTA) and deferred tax liability (DTL). Then you learn the balance sheet method. For each asset and liability you compare the carrying amount with the tax base. The gap is a temporary difference, and the tax rate turns it into a DTA or DTL.

The chapter links to several other areas. It builds on income statement and balance sheet mechanics, and it links to long-term assets (depreciation methods), leases, and employee benefits. It also feeds into financial reporting quality and ratio analysis, because tax items change net income, equity and cash flow. Under IFRS the rules are in IAS 12. US GAAP differs in some points, so read the question for any mention of US GAAP.

Financial Statement Analysis carries a large share of the exam, and income taxes is a compact chapter where the same few ideas are tested again and again. The questions are mostly rule-based or short calculations, so they are very winnable if you have a clear method. With 180 questions, no penalty for wrong answers and about 90 seconds per question, you cannot afford to derive the logic from scratch in the exam. If you can quickly classify a difference, state the direction of the DTA or DTL, and read a rate reconciliation, you pick up reliable marks and save time for harder items.

Analysis of Income Taxes: topics in the order to study them

  1. 1Accounting Profit vs Taxable IncomeStart here because everything else explains the gap between these two numbers and between tax expense and tax payable.
  2. 2Tax Base and Carrying Amount of Assets and LiabilitiesThe balance sheet method needs you to find the tax base and carrying amount before you can measure any deferred tax.
  3. 3Deferred Tax Assets and LiabilitiesOnce you can compare tax base with carrying amount, you can decide which differences create a DTA and which create a DTL.
  4. 4Temporary vs Permanent DifferencesThis sorts differences into those that create deferred tax and those that do not, which sharpens the previous topic.
  5. 5Valuation Allowance and Tax Loss CarryforwardsIt adds judgment on whether a DTA will be used, so you need the DTA basics first.
  6. 6Tax Rate Changes and Effective Tax Rate ReconciliationRate changes remeasure existing balances, and the reconciliation pulls together all earlier ideas.
  7. 7Income Tax Disclosures and Analyst AdjustmentsFinish with how an analyst reads the notes and adjusts ratios, which only makes sense once the mechanics are clear.

How to prepare Analysis of Income Taxes

Treat this chapter as one method applied many times. Learn the method, then drill it until classification is automatic.

  1. Write the core identity on one page: income tax expense = income tax payable (current tax) + increase in DTL − increase in DTA. Equivalently, it is current tax + deferred tax expense. Know what each part means and which way each sign goes.
  2. Learn the balance sheet method. For an asset, a DTL arises when carrying amount is above tax base; a DTA arises when carrying amount is below tax base. For a liability, it is the reverse. Practise with depreciation, provisions and revenue received in advance.
  3. Do a short list of drills on each type of difference: faster tax depreciation, warranty provisions, unused tax losses, and items that are never taxed or never deductible. Label each as temporary or permanent and as DTA or DTL.
  4. Work through valuation allowance questions. Ask whether future taxable profit is likely enough to use the asset, and note the effect on net income when the allowance changes.
  5. Practise rate changes: remeasure the existing deferred balance at the new rate and see how it moves tax expense. Then read a statutory-to-effective rate reconciliation and name the cause of each line.
  6. Finish with disclosure-based questions. Analysts commonly adjust for the timing of a DTL: treat it as a liability if it is expected to reverse, as equity if it is not expected to reverse (for example, because capital spending keeps growing), and decide case by case (often excluding it from both) if the timing is uncertain. This is an analyst adjustment, not a reporting rule. Then do timed mixed sets at about 90 seconds per question and review every wrong answer.

Common mistakes in Analysis of Income Taxes

  • Mixing up the direction of DTA and DTL for liabilities.

    Fix: Think about the future tax effect. If the liability will let you deduct more later than the books suggest, you get a DTA. Check with a one-line story each time.

  • Treating every difference between book and tax as a deferred tax item.

    Fix: Ask whether the difference will reverse. If it never will, it is permanent, so no deferred tax is recorded, and it only affects the effective tax rate.

  • Confusing income tax payable with income tax expense.

    Fix: Payable comes from taxable income. Expense is payable plus the increase in DTL minus the increase in DTA. Write the identity before you start any question.

  • Applying the wrong rate when remeasuring deferred balances.

    Fix: Deferred balances use the rate expected to apply when they reverse. After a rate change, restate the opening balance and put the change through tax expense.

  • Ignoring the valuation allowance effect on earnings.

    Fix: Remember that raising an allowance increases tax expense and lowers net income, and that releasing it does the opposite. Note that the recognition approach differs: US GAAP records the DTA and then deducts a valuation allowance if realisation is not more likely than not, while IFRS recognises a DTA only to the extent future taxable profit is probable.

  • Reading the effective tax rate reconciliation in the wrong order.

    Fix: Start from the statutory rate, then add or subtract each reconciling item. Ask whether it is a one-off or recurring before judging the quality of earnings.

Last-day revision: Analysis of Income Taxes

  • 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.

Analysis of Income Taxes practice questions

Analysis of Income Taxes in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Analysis of Income Taxes: frequently asked questions

Is Analysis of Income Taxes hard for CFA Level I?

It is conceptual, but it uses a small set of repeating ideas. Once you can compare carrying amount with tax base and decide DTA or DTL, most questions become quick. Practise the classification until it feels automatic.

Do I need a calculator for this chapter?

Only for simple arithmetic such as differences multiplied by a tax rate and effective tax rate. Your TI BA II Plus or HP 12C is enough, and many questions need only mental maths.

What is the difference between a temporary and a permanent difference?

A temporary difference arises from different timing in accounting and tax, and it reverses in the future, so it creates deferred tax. A permanent difference never reverses, so it creates no deferred tax but changes the effective tax rate.

Are IFRS and US GAAP different on income taxes?

Yes, in some points. For example, US GAAP recognises the full DTA and then reduces it with a valuation allowance if realisation is not more likely than not. IFRS has no allowance account and recognises a DTA only to the extent future taxable profit is probable. Questions follow IFRS unless they say US GAAP, so apply the framework the question names.