CFA Level I Exam · Analysis of Income Taxes

Income Tax Disclosures and Analyst Adjustments for CFA Level I

Updated 7 October 2026 · Fact-checked

Income tax disclosures are the footnotes that reconcile tax expense to taxes paid and show deferred tax balances. Analysts use them to compare cash taxes with reported expense, judge whether deferred taxes will reverse, and decide whether to treat a deferred tax liability as liability, equity, or neither.

Understand Income Tax Disclosures and Analyst Adjustments

A company reports income tax expense on its income statement under accounting rules. It pays cash taxes to the tax authority under tax rules. The two differ because of temporary differences, tax losses, rate changes and one-off items. The tax footnote explains the gap.

The footnote usually gives four things: the components of tax expense (current and deferred), a reconciliation from the statutory rate to the effective tax rate, the deferred tax assets and liabilities by source, and any valuation allowance and tax loss carryforwards with expiry dates.

Analysts use these to judge earnings quality. If the effective rate is low only because of a one-off benefit, such as a tax holiday ending or a release of a valuation allowance, future earnings will be hit when the benefit goes. If tax expense is far above cash taxes year after year, the company is deferring tax, and that may or may not reverse.

For solvency, the question is how to treat a deferred tax liability (DTL). There are three views. If the DTL will reverse and be paid, treat it as a liability. If it will never reverse, for example because the company keeps growing and buying assets, treat it as equity. If the timing is uncertain and hard to estimate, many analysts ignore it, neither adding it to debt nor to equity. Which view applies depends on the facts, and the exam usually tells you.

IFRS and US GAAP differ in some details. Both use the balance sheet (liability) method for deferred tax. Under IFRS, deferred tax assets and liabilities are classified as non-current. US GAAP also now classifies them all as non-current. A key difference is that IFRS recognizes a deferred tax asset only when it is probable that future taxable profit will be available, while US GAAP recognizes the asset in full and then reduces it with a valuation allowance if it is more likely than not that some portion will not be realized.

Key formulas to remember

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.

How to solve Income Tax Disclosures and Analyst Adjustments questions

Use this method for any question on tax footnotes, cash taxes or deferred tax adjustments.

1Identify what is asked: earnings quality, cash taxes versus expense, or a solvency ratio adjustment.
2Separate current tax expense from deferred tax expense. Current is roughly what is owed for the year; deferred is the timing effect.
3For rate questions, compute effective rate as tax expense ÷ pretax income and compare with the statutory rate and cash rate.
4Read the reconciling items. Decide which are recurring (permanent differences, foreign rates) and which are one-off (valuation allowance release, tax holiday end, rate change).
5For a DTL, decide from the facts whether it will reverse, will not reverse, or is uncertain, and pick liability, equity or ignore.
6Recompute the ratio. Treating DTL as equity: subtract it from liabilities and add it to equity. Ignoring it: subtract it from liabilities only.
7Pick the option that matches the logic, then check direction (does leverage rise or fall?).

Quickest way: Direction check for DTL treatment

When to use it: Use when a question asks how a ratio changes under different DTL treatments and you have little time.

Liability treatment: nothing changes, so it is the base case.
Equity treatment: liabilities fall and equity rises, so debt-to-equity is lowest.
Ignore treatment: liabilities fall but equity does not rise, so debt-to-equity lies between the other two when the DTL is smaller than liabilities.
For equity treatment, remember the total assets stay the same.

Common mistakes in Income Tax Disclosures and Analyst Adjustments

Treating a DTL as equity in every case
Students memorize the equity view as the standard adjustment.
Fix: Choose by facts: reversal expected means liability, no reversal expected means equity, uncertain timing means ignore.
Assuming tax expense equals cash taxes paid
The income statement figure is easy to see, so it is used as cash.
Fix: Remember deferred taxes bridge the two. Use the footnote and cash flow statement disclosure of taxes paid.
Treating a low effective tax rate as sustainable
Students read the rate without looking at the reconciliation.
Fix: Check whether the low rate comes from one-offs. Remove them before forecasting.
Mixing up IFRS and US GAAP on deferred tax assets
Both recognize assets, but by different tests.
Fix: IFRS recognizes a DTA only if future taxable profit is probable. US GAAP recognizes it and then uses a valuation allowance if realization is more likely than not to fail.
Adding a DTL to equity but forgetting to remove it from liabilities
Students adjust only one side of the ratio.
Fix: Always move the amount: liabilities down, equity up.

Worked examples

Example 1

A company reports pretax income of USD 800 million, income tax expense of USD 200 million (current USD 150 million, deferred USD 50 million) and a statutory rate of 30%. Which statement is most accurate? A. The effective tax rate is 18.75% and the company is paying tax deferred. B. The effective tax rate is 25.0% and cash taxes are likely below tax expense. C. The effective tax rate is 25.0% and cash taxes are likely above tax expense.

Show the solution

Effective rate = 200 ÷ 800 = 25.0%.
The deferred expense of 50 is positive, so tax expense exceeds the current amount owed.
Current tax of 150 approximates cash taxes, which is below the expense of 200.
Option A has the wrong rate. Option C has the wrong direction.

Answer: B

Example 2

A company has total liabilities of USD 600 million (including a DTL of USD 100 million) and equity of USD 400 million. The analyst expects the DTL never to reverse. What is the debt-to-equity ratio after treating the DTL as equity? A. 1.00 B. 1.25 C. 1.50

Show the solution

Adjusted liabilities = 600 − 100 = 500.
Adjusted equity = 400 + 100 = 500.
Debt-to-equity = 500 ÷ 500 = 1.00.
Check: unadjusted ratio is 600 ÷ 400 = 1.50, which is option C. Ignoring the DTL would give 500 ÷ 400 = 1.25, option B.

Answer: A

Exam tips

Read the question for the reversal clue. Words like 'growing company' or 'will not reverse' point to the equity treatment.
When ratios are asked, list original liabilities and equity, then adjust both sides. It takes seconds and avoids errors.
Expect a footnote-style item: use the reconciliation to decide which rate drivers are one-off.
Remember the IFRS probable test versus the US GAAP valuation allowance. It is a favorite comparison.
With three options, eliminate any that move the ratio in the wrong direction first.

Practice questions from Analysis of Income Taxes

Income Tax Disclosures and Analyst Adjustments: frequently asked questions

Should a deferred tax liability be treated as equity or liability?

It depends on whether it will reverse. If you expect it to be paid, treat it as a liability. If it will not reverse, treat it as equity. If timing is uncertain, many analysts leave it out of both.

Why do cash taxes paid differ from income tax expense?

Tax rules and accounting rules recognize income and expenses at different times. Deferred taxes, valuation allowance changes, tax credits and rate changes create the gap. The footnote reconciles them.

What is the main IFRS versus US GAAP difference in deferred taxes?

IFRS recognizes a deferred tax asset only when future taxable profit is probable. US GAAP recognizes the asset and reduces it by a valuation allowance if realization is more likely than not to fail.

How do analysts judge earnings quality from tax footnotes?

They check whether the effective rate is sustainable by looking for one-off items in the reconciliation. They also compare cash taxes with expense to see whether deferrals are building up.