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LM09 Analysis of Income Taxes 2025 Level I Notes © IFT. All rights reserved 1 LM09 Analysis of Income Taxes 1. Introduction ........................................................................................................................................................... 2 2. Differences Between Accounting Profit and Taxable Income ............................................................ 2 3. Deferred Tax Assets and Liabilities .............................................................................................................. 3 4. Corporate Income Tax Rates ........................................................................................................................... 8 5. Presentation and Disclosure ........................................................................................................................... 8 Summary ...................................................................................................................................................................11 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM09 Analysis of Income Taxes 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction One of the key concepts we will discuss in this learning module 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. Why are accounting profit and taxable income different? 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
LM09 Analysis of Income Taxes 2025 Level I Notes © IFT. All rights reserved 3 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 3. Deferred Tax Assets and Liabilities 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
LM09 Analysis of Income Taxes 2025 Level I Notes © IFT. All rights reserved 4 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. Realizability of Deferred Tax Assets A DTA may be created only if the company expects to be able to realize the economic benefit of the deferred tax asset in the future. If it is uncertain whether future economic benefits will be realized from a temporary difference (for example, if the company is being liquidated), the temporary difference will not result in the recognition of a DTA. If a DTA was previously recognized, but now there is sufficient doubt about whether the economic benefits will be realized, then, under IFRS, the DTA would be reversed. Under US