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IFT Notes for Level I CFA® Program

LM09 Income Taxes

Part 1


1.  Introduction

One of the key concepts we will discuss in this reading is deferred tax assets and liabilities. Deferred tax assets and liabilities are created because of differences between how and when transactions are recognized for financial reporting purposes relative to tax reporting.

2.  Differences between Accounting Profit and Taxable Income

Some common terms related to financial reporting are defined below:

  • Accounting profit: It is also known as pretax income or earnings before tax (EBT) and appears on the income statement. In simple terms, this is before taxes are calculated. Accounting profit is based on accounting standards.
  • Income tax expense: Tax expense, or tax benefit, appears on a company’s income statement, which is created using financial reporting standards. It is calculated based on the accounting profit (profit before tax) using a given tax rate.
  • Carrying value: The net value of an asset or liability reported on the balance sheet according to accounting principles.

Some common terms related to tax reporting are defined below:

  • Taxable income: It is the portion of income that is subject to income taxes under the tax laws where the company is operating.
  • Income tax payable: Income tax payable is calculated on a company’s taxable income using the applicable tax rate. This is the amount that is generally paid to the tax authorities and it appears on the balance sheet. Since it results in a cash outflow, firms minimize taxes payable by showing higher expenses and lower taxable income.
  • Tax Base of an Asset: Tax base of an asset is the amount that will be deductible for tax purposes in future periods as economic benefits are realized. It is used to calculate tax payable and is analogous to the carrying amount (net book value) concept. Tax base is the amount allocated to asset for tax purposes whereas carrying amount is based on accounting principles.

3. Current and Deferred Tax Assets and Liabilities

Both report income before deducting tax expense, yet they are different because accounting profit is based on accrual method of accounting (revenues reported when earned and expenses when incurred). On the other hand, taxable income is usually based on cash-basis accounting (revenue recognized when cash is collected and expense reported when cash is paid).

Accounting profit and taxable income differ when:

  • Revenues and expenses are recognized in one period for accounting purposes and a different period for tax purposes.
  • The carrying amount and tax base of assets/liabilities differ.
  • Gain/loss of assets/liabilities in the income statement is different than tax return.
  • Some revenues/expenses recognized in the income statement are not considered for tax purposes.

The following table shows the distinction between accounting profit/ taxable income and income tax expense/taxes payable.

Income Statement for Everest Inc. Tax Return for Everest Inc.
$ million 2011 2012 $ million 2011 2012
Revenue 100 100 Revenue 100 100
Cash Expenses 50 50 Cash Expenses 50 50
Depreciation (SL) 25 25 Depreciation (Acc) 40 10
Accounting profit 25 25 Taxable income 10 40
Income tax expense (40%) 10 10 Taxes payable (40%) 4 16
Profit after tax 15 15 Profit after tax 6 24

Instructor’s Note:

The following table summarizes the analogous financial and tax reporting terms:

Financial reporting Tax Reporting
Accounting profit Taxable income
Tax expense Income tax payable
Carrying amount Tax base

Deferred tax liabilities

Deferred tax liability (DTL) occurs when income tax expense (financial accounting) is greater than income tax payable. It is a liability because we pay less tax now, thereby creating a liability or an obligation to pay more in the future. Since the tax will be paid later, it is deferred.

Such a situation can happen when:

  • Revenue is recognized on income statement before being included on tax return (accrued/unbilled revenue).
  • Expenses are tax deductible before being recognized on income statement.

For example, in the sample income statement and tax return shown for Everest Inc, at the end of 2011, the income tax expense (10) is greater than the income tax payable (4), hence a DTL of 6 (10 – 4) will be recorded on the balance sheet. At the end of 2012, the DTL is reversed and it increases taxes payable by 6.

Deferred Tax Assets

Deferred tax assets (DTA) arise when income tax payable is temporarily greater than income tax expense. In other words, taxable income is higher than accounting profit. Since tax is paid in advance, it is considered an asset; it can be viewed as a prepaid expense.

Such a situation can happen when:

  • Revenue is taxed before being recognized on income statement (unearned revenue).
  • Expense is recognized on the income statement before being tax deductible.

Consider the following income statement and tax return for Atlas Inc.

Income Statement for Atlas Inc. Tax Return for Atlas Inc.
$ million 2011 2012 $ million 2011 2012
Revenue 100 100 Revenue 120 80
Cash Expenses 50 50 Cash Expenses 50 50
Accounting profit 50 50 Taxable income 70 30
Income tax expense (40%) 20 20 Taxes payable (40%) 28 12
Profit after tax 30 30 Profit after tax 42 18

At the end of 2011, since the income tax payable (28) is greater than the income tax expense (20), a DTA of 8 (28 – 20) will be recorded on the balance sheet. At the end of 2012, the DTA is reversed and it brings down taxes payable by 8.

Any deferred tax asset or liability is the result of a temporary difference that is expected to reverse in the future. Deferred tax liability reverses when taxes are paid in the future resulting in cash outflows. Similarly, deferred tax asset reverses when tax benefits are realized in the future resulting in lower cash outflows.

Under IFRS, deferred tax assets and liabilities are classified as non-current.

Under US GAAP, they are classified based on the classification of the respective asset or liability.

Tax Base of an Asset

Asset tax base is the value of an asset according to tax rules and is used to calculate tax payable. Asset tax base is analogous to carrying amount (net book value).


An asset is purchased for 50 and is depreciated over two years. On the financial statements the depreciation is 25 and 25. According to tax rules the depreciation is 40 and 10. Show the carrying amount and tax base at T=0, T=1, and T=2.


Time period Carrying Amount (Financial Reporting) Tax Base (Tax reporting)
T = 0 50 50
T = 1 25 10
T = 2 0 0

Link between Tax Base and DTL

Deferred tax liability = (Carrying amount – Tax base) x Tax rate

Assuming a 40% tax rate for the above example,

At T = 1: DTL = (25 – 10) x 0.4 = 6

At T = 2: DTL = (0 – 0) x 0.4 = 0

Instructor’s Note

If the carrying amount and tax base are the same then DTL is 0. If the carrying amount is greater than the tax base, then there will be a deferred tax liability. If carrying amount is less than the tax base, then there will be a deferred tax asset.

Both DTL and DTA should be measured at the tax rate which is expected to apply when the liability is settled (reversed).

Link between Income Tax Expense, Tax Payable, and DTL

Income tax expense = Income tax payable + Change in net DTL

where net DTL = DTL – DTA and change in net DTL is the ending value of net DTL – beginning value of net DTL.


In 2015, the income tax payable for a certain company is 100. During the year, DTL increased from 20 to 25 and DTA increased from 0 to 10. What is the provision for income tax in 2015?


ITE = ITP + ∆DTL – ∆DTA = 100 + 5 – 10 = 95

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