Introducing Income Taxes to Level 1 CFA Candidates
Welcome to the first lesson on income taxes. In this lesson, we will discuss:
- accounting standards and key definitions,
- differences between accounting profit and taxable income,
- deferred tax assets and liabilities,
- the determination of tax base of assets and liabilities,
- the impact of tax rate changes and how to calculate the effective tax rate.
Let’s start with a brief overview of key accounting standards that guide companies on how to account for income taxes and some important definitions.
Defining Accounting Profit, Taxable Income & More
The accounting rules for income taxes are defined in International Financial Reporting Standards (IFRS) in International Accounting Standard (IAS) 12 and in U.S. Generally Accepted Accounting Principles (U.S. GAAP) within FASB ASC Topic 720.
In general, the rules included under both accounting regimes are similar. However, there are certain differences that we are going to discuss in detail in the next lesson.
First, we introduce some definitions that will help you effectively study for the level 1 CFA exam:
Accounting profit (aka. income before taxes or pretax income) is the profit value reported in the company’s income statement.
Taxable income is the income calculated for tax purposes under the tax laws applicable to the company.
Income tax payable is a position reported in the balance sheet and it is calculated as the company’s tax rate multiplied by taxable income. Note that sometimes we also deal with tax recoverable, which is the amount of taxes that will be returned to the company.
Tax expense is a position reported in the income statement which represents the sum of tax payable plus or minus the change in deferred tax assets and liabilities.
Now, what are these deferred tax assets and liabilities?
Deferred tax asset (DTA) / liability (DTL) is created when tax payable and tax expense are not the same in a given reporting period and the company expects that the difference will be covered in future periods.
Deferred tax asset (DTA) arises when a company needs to pay more tax than indicated in its financial statement. This is mainly due to different treatment of certain expenses for accounting vs tax purposes (e.g., the difference in the depreciation method allowed).
Deferred tax liability (DTL) arises when a company needs to pay less tax than indicated in its financial statements.
Have a look at the following examples to better understand the mechanism behind DTA and DTL:
A company’s tax payable and tax expense are equal to USD 30,000 and USD 28,000, respectively. Decide whether the deferred tax asset or liability is created. Assume that the company expects the difference between the tax payable and tax expense to be covered in future periods.
Because the tax payable is greater than the tax expense, it means that the company has to pay more taxes than the income statement reveals. What is more, it is assumed that the company expects to recover the difference. Hence, the company expects that in future periods it will pay fewer taxes than indicated by the value recorded in the income statement. This is why the company should create a deferred tax asset in its balance sheet:
DTA is equal to the difference between the tax payable and the tax expense and amounts to USD 2,000.
Note that thanks to creating this deferred tax asset, the accounting equation still holds.
Now, let’s take a look at another example:
A company’s tax payable and tax expense are equal to USD 25,000 and USD 28,000, respectively. Decide whether the deferred tax asset or liability is created. Assume that the company expects the difference between the tax payable and tax expense to be covered in future periods.
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There are other important definitions we have not yet talked about. Have a look:
- valuation allowance – a reserve created against the deferred tax asset (DTA) to recognize the portion of the DTA that might not be realizable in the future,
- income tax paid – an actual amount of the tax paid to the local tax authorities; it might differ from the income tax payable (e.g., due to refunds or taxes overpaid in previous periods),
- tax base – the value of an asset or a liability established according to tax laws rather than accounting rules (the difference between the tax base and the carrying value of an asset/a liability is one of the reasons why the accounting profit and taxable income differ),
- tax loss carry forward – arises when a company recognizes a loss in a reporting period and is entitled to “use” this loss against the future taxable income.
Now, let’s discuss some common situations that can lead to temporary differences between taxable income and accounting profit.
We noted before that it is common for accounting profit to differ from taxable income during the reporting periods. The list below presents the major reasons why those differences occur:
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This extensive list describes the root causes of differences in the current tax accounting. Let’s now look into another relevant concept, namely the recognition of deferred tax assets (DTA) and deferred tax liabilities (DTL).
Deferred tax assets (DTA) arise due to differences between tax calculated for the net income using tax regulations and accounting regulations. We recognize DTA in the situations when the actual tax paid to the governmental authorities exceeds the tax due calculated using the accounting methods
By analogy with the deferred tax asset:
Deferred tax liabilities (DTL) are recognized in reverse scenarios, so when the financial accounting income tax expense is greater than the regulatory (according to tax laws) income tax.
In both cases, the mechanism is the same and the recognition is usually driven by the timing difference in the recognition of certain business events (different recognition periods for tax and accounting purposes).
A typical example is when the double depreciation method is used for tax purposes and the straight-line depreciation method – for accounting purposes. As the double depreciation method usually means higher depreciation charges recognized in the income statement (in the first years of the asset life) in comparison with the straight-line method, income for tax purposes will be lower than the one calculated for accounting purposes.
DTA and DTL are recognized due to *temporary differences*and there is an expectation that they will eventually offset as time passes.
Companies are expected to recognize the changes in DTA and DTL between reporting periods in the income statement by adding them to the income tax payable to determine the income tax expense for the period.
Additionally, companies are required to perform the following actions:
- at the end of the fiscal year DTA and DTL positions need to be recalculated by comparing the tax base and carrying value of assets,
- then, if differences are observed, the company needs to assess whether the difference will bring future economic benefits for the company,
- if there is any doubt about the company being able to benefit from the difference in the future, a valuation allowance (under U.S. GAAP) or reversal of DTA/DTL (under IFRS) needs to be applied.
As you might remember, the determination of the tax base for assets and liabilities is crucial while dealing with current and temporary tax differences. Let’s now deep dive into how the tax base is determined.
Let’s begin by reminding the definition of the tax base.
Tax base is the value of an asset or a liability established according to the tax laws rather than accounting rules. Differences between the tax base and carrying value of an asset and liability are one of the reasons why the accounting profit and taxable income differ.
The best way to explain the concept of how the tax base is determined and also recap the other concepts we have discussed in this lesson is to tackle the following example:
In the table below, you can see some financial data related to Plush, Co.
| 31 December 2019 | |
|---|---|
| Revenue | USD 1,000,000 |
| Cost of goods sold (COGS) | USD 800,000 |
| Pretax income | USD 200,000 |
| Deferred tax liability | USD 0 |
On 1 January 2020, the company bought a piece of equipment for USD 100,000. This equipment is depreciated for 2 years according to tax regulations and for 4 years according to accounting rules. We assume the straight-line depreciation method and the residual value of the equipment to be USD 0.
Our goal is:
- to calculate the taxable income and accounting profit in each year,
- to compute the carrying amount and tax base of the equipment in each year,
- to find the difference between the carrying amount and tax base in each year,
- to compute the deferred tax asset or liability in each year, and
- to compute the tax payable and tax expense in each year assuming a tax rate of 20%.
For the sake of simplicity, we assume that the revenue and all expenses apart from the depreciation expense are the same in all years and amount to USD 1 million and USD 800,000, respectively.
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We hope that the example will help you to better understand the mechanism of how current and deferred tax calculations work. Let’s now consider what happens when the tax rate that the company is subject to changes.
Now, we will analyze the situation in which the tax rate changes.
In general, the measurement of deferred tax assets and liabilities is based on the current tax rate defined by the tax law. However, if the tax rate changes, deferred tax assets and liabilities should be adjusted. The change should be reflected in the current accounting profit.
A rise in the tax rate results in an increase in deferred tax assets, which translates into an increase in the current tax expense. If expenses increase, the net income decreases.
The effect of a tax rate increase on deferred tax liabilities is very similar. An increase in deferred tax liabilities translates into an increase in the current tax expense, which translates into lower net income reported in the income statement.
Differences between the tax base and carrying value of the equipment for Plush, Co. are given in the table:
| Year | Carrying amount | Tax base | Difference |
|---|---|---|---|
| 2020 | USD 75,000 | USD 50,000 | USD 25,000 |
| 2021 | USD 50,000 | USD 0 | USD 5,0000 |
| 2022 | USD 25,000 | USD 0 | USD 25,000 |
| 2023 | USD 0 | USD 0 | USD 0 |
Compute the deferred tax liability under the 20% tax rate and then assume that tax authorities have changed the tax rate to 30%. Decide how is the deferred tax liability going to change under the new tax rate.
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Let’s now explain the concept of an effective tax rate using the following formula:
Have a look at this example:
The following information was gathered from the financial statement of None, Inc. What is the company’s effective tax rate?
| Revenue | USD 100,000 |
| Expenses | USD 70,000 |
| Pretax income | USD 30,000 |
| Tax expense | USD 6,000 |
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- Accounting profit is reported in the company’s income statement.
- Taxable income is the income that is calculated for tax purposes. Tax payable is calculated based on taxable income.
- Tax expense is tax payable plus or minus the change in deferred tax assets and liabilities and is computed based on accounting profit.
- When tax payable and tax expense in a given period are not the same and the company expects the difference to be covered in future periods, the deferred tax asset or liability is created.
- Tax base is defined as the value at which a balance sheet item is valued for tax purposes. The difference between the tax base and the carrying amount usually leads to different values of tax expense and tax payable.
- Changes in the tax rate impact the deferred tax assets and liabilities so that when the tax rate increases, deferred tax assets and liabilities increase as well. This translates into an increase in the current tax expense. If expenses increase, the net income decreases.