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CFA Level I · CFA Level I Exam · Analysis of Income Taxes

A company pays a regulatory fine that is recognized as an expense in its income statement but is never deductible for tax purposes. The effect of this item on the company's effective tax rate relative to the statutory rate is most likely:

The fine raises the effective tax rate above the statutory rate. It is a permanent difference: it lowers pretax accounting profit but not taxable income, so income tax expense is large relative to pretax profit, and no deferred tax is recorded.

  1. Ano effect, because a deferred tax liability is recognized
  2. Bto raise the effective tax rate above the statutory rateCorrect
  3. Cto lower the effective tax rate below the statutory rate

Explanation

A non-deductible fine is a permanent difference. It reduces accounting profit but not taxable income, so tax expense is high relative to pretax profit. No deferred tax is recognized because the difference never reverses.

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