Analysis of Income Taxes

Financial Statement Analysis, LOS weight share 1.1 percent of the 365 Level I learning outcomes.

Financial Statement AnalysisAnalysis of Income Taxes

Every deferred tax balance on the exam is measured at the rate that will apply when it reverses, not the rate printed on this year's return, and forgetting that single word, enacted, is worth more wrong answers than any other mistake on this topic.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. A company uses straight-line depreciation for financial reporting and accelerated depreciation for tax purposes. In Year 1, book depreciation is $20,000 and tax depreciation is $35,000, and the tax rate is 30%. The income tax consequence is best described as:

Answer: B. Taxable income is lower than book income this year because tax depreciation exceeds book depreciation, so the company pays less tax now and more later: a deferred tax liability. DTL = temporary difference x tax rate = ($35,000 - $20,000) x 30% = $4,500.

2. A company accrues $50,000 of warranty expense on its income statement, but tax law permits the deduction only when cash is actually paid. No cash has been paid yet, and the tax rate is 25%. The deferred tax effect is:

Answer: B. Taxable income exceeds book income this year, since the expense is booked but not yet deductible, so the company overpays tax now relative to its income statement and recovers that overpayment later: a deferred tax asset of $50,000 x 25% = $12,500. Warranty timing is a classic temporary, not permanent, difference.

3. A company's pretax income is $500,000, the statutory tax rate is 21%, and reported income tax expense is $130,000. The effective tax rate, and its most likely explanation, are:

Answer: B. Effective tax rate = tax expense / pretax book income = $130,000 / $500,000 = 26.0%, above the 21% statutory rate. An effective rate above statutory typically signals permanent differences that add to taxable income, such as non-deductible fines or expenses, not tax-exempt income, which would pull the rate below statutory.

The lesson

The video lesson for this unit is recorded and waiting to be published. Everything it teaches is written out below.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to contrast accounting profit, taxable income, taxes payable and income tax expense, explain how a temporary difference creates a deferred tax asset or liability, calculate and contrast the effective, statutory and cash tax rates, and analyze what the tax footnote disclosures reveal about a company's real tax position.

Four numbers describe a company's tax position, and they are not the same number wearing different labels. Accounting profit is computed under financial reporting rules. Taxable income is computed under tax law, and the two diverge through temporary and permanent differences. Taxes payable is taxable income multiplied by the current tax rate, the actual cash owed to the tax authority. Income tax expense, the figure on the income statement, equals taxes payable adjusted for the period's change in deferred tax balances.

A temporary difference eventually reverses; a permanent difference never does, and only temporary differences create a deferred tax balance at all. When accelerated tax depreciation makes today's taxable income lower than book income, the company is paying less tax now and more later, which is a deferred tax liability, a tab it will settle down the road. When a book expense such as a warranty accrual has not yet become tax-deductible, taxable income sits above book income today, the company has effectively overpaid, and it recovers that overpayment later as a deferred tax asset, a deposit it will draw on. A permanent difference, tax-exempt municipal bond interest or a non-deductible fine, never equalizes over the company's life. It moves the effective tax rate away from the statutory rate but creates no deferred tax balance on the balance sheet at all.

Every deferred tax balance is measured at the tax rate expected to apply when it reverses, not the rate printed on this year's return. Whenever a new rate is actually enacted into law, every existing deferred tax asset and liability is immediately remeasured at that new rate, with the adjustment running straight through income tax expense in the period of enactment. Forgetting that single word, enacted, and reaching for the current rate instead of the newly enacted one, is the single most repeated error on this module.

Three tax rates measure three different things. The statutory rate is the legal rate set by tax law. The effective tax rate is income tax expense divided by pretax book income, never taxable income. It diverges from the statutory rate whenever permanent differences or tax credits are present. An effective rate above statutory signals non-deductible items; a rate below statutory signals tax-exempt income or credits. The cash tax rate is actual cash taxes paid divided by pretax income, and it diverges from the effective rate whenever deferred tax balances change during the period. The footnote's effective tax rate reconciliation starts from the statutory rate and itemizes each adjustment that gets to the reported rate. Reading it tells an analyst whether a low effective rate reflects a durable advantage or a one-time item.

A deferred tax liability that keeps growing every year, replaced by a larger one before the old one ever reverses, functions more like equity than debt for analytical purposes. A company that keeps buying new depreciable assets can carry a growing DTL from accelerated depreciation indefinitely; when reversal is not realistically foreseeable, an analyst may treat that portion of the DTL as equity-like in a leverage ratio rather than as a near-term cash obligation.

Worked in full

A company uses straight-line depreciation for financial reporting and accelerated depreciation for tax. In the current year, book depreciation is $80,000 and tax depreciation is $140,000. The enacted tax rate for future years, just signed into law, is 27 percent, down from the current 32 percent. What deferred tax balance is created this year, and at what rate is it measured? Tax depreciation exceeds book depreciation, so taxable income is lower than book income this year: the company pays less tax now and more later, a deferred tax liability. The temporary difference = $140,000 - $80,000 = $60,000. Because the new 27 percent rate is already enacted, it applies, not the current 32 percent rate: DTL created = $60,000 x 0.27 = $16,200.

The same problem, one step removed

Same facts: book depreciation $80,000, tax depreciation $140,000, current tax rate 32 percent, newly enacted future rate 27 percent. Determine the temporary difference and whether it creates a DTA or DTL, then apply the correct rate yourself.

The trap

A question supplying both a current tax rate and a newly enacted rate is testing exactly one thing: the enacted future rate always applies to measuring deferred tax balances, and any existing balance is remeasured immediately when the new rate is enacted, never held at the rate in effect when the difference first arose.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. contrast accounting profit, taxable income, taxes payable, and income tax expense and temporary versus permanent differences between accounting profit and taxable income
  2. explain how deferred tax liabilities and assets are created and the factors that determine how a company's deferred tax liabilities and assets should be treated for the purposes of financial analysis
  3. calculate, interpret, and contrast an issuer's effective tax rate, statutory tax rate, and cash tax rate
  4. analyze disclosures relating to deferred tax items and the effective tax rate reconciliation and explain how information included in these disclosures affects a company's financial statements and financial ratios

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 01

Accounting profit, taxable income, taxes payable and tax expense are four related but distinct numbers

Accounting (pretax) profit is computed under financial reporting rules; taxable income is computed under tax law and can differ from it through temporary and permanent differences; taxes payable is taxable income times the current tax rate, the actual cash-basis liability to the tax authority; income tax expense on the income statement equals taxes payable adjusted for the period's changes in deferred tax balances, and so is generally not equal to taxes payable in any given year.

LOS 01

A temporary difference eventually reverses; a permanent difference never does, and only temporary differences create deferred tax

A temporary difference, such as accelerated tax depreciation or an accrued but not-yet-paid warranty expense, will equalize between book and tax treatment at some future point, which is exactly what a deferred tax asset or liability represents: the future tax consequence of that eventual reversal. A permanent difference, such as tax-exempt municipal bond interest or a non-deductible fine, never reverses and therefore creates no deferred tax balance at all, even though it does move the effective tax rate away from the statutory rate.

LOS 02

Taxable income below book income today creates a deferred tax liability; taxable income above book income today creates a deferred tax asset

When accelerated tax depreciation or a similar item makes today's taxable income lower than book income, the company is paying less tax now and will pay more later, which is a deferred tax liability. When a book expense such as a warranty accrual has not yet become tax-deductible, taxable income is higher than book income today, the company has effectively overpaid, and will recover that overpayment later, which is a deferred tax asset.

LOS 02

Deferred tax balances are measured at the enacted rate expected to apply when they reverse, not at today's rate

Whenever a new tax rate is enacted into law, every existing deferred tax asset and liability must be immediately remeasured at that new rate, with the adjustment flowing through income tax expense in the period of enactment; the rate used is always the one expected to apply at reversal, never the rate in effect when the temporary difference first arose.

LOS 02

A deferred tax liability that keeps growing every year, with no sign of reversing, functions more like equity than debt for analytical purposes

A continuously growing company that keeps adding new depreciable assets can see its aggregate deferred tax liability from depreciation grow indefinitely, since new temporary differences keep replacing ones that reverse; when reversal is not realistically foreseeable, an analyst may treat that portion of the DTL as equity-like in leverage ratios rather than as a near-term cash obligation, a judgment call the exam expects a candidate to be able to reason through, not merely recite.

LOS 03

Effective, statutory, and cash tax rates measure three different things and can move independently

The statutory rate is the legal rate set by tax law; the effective tax rate is reported income tax expense divided by pretax book income, and diverges from the statutory rate whenever permanent differences or tax credits are present; the cash tax rate is actual cash taxes paid divided by pretax income, and diverges from the effective rate whenever deferred tax balances change during the period, since a growing DTL means the company is paying less cash tax than its reported expense implies.

LOS 04

The effective tax rate reconciliation in the footnotes shows exactly which permanent items moved the rate away from statutory

Public filers disclose a reconciliation starting from the statutory rate and itemizing each adjustment, non-deductible expenses, tax-exempt income, tax credits, that produces the reported effective rate; reading this reconciliation, rather than only comparing the two headline rates, tells an analyst whether a low effective rate reflects a durable tax advantage (a foreign tax structure, a credit) or a one-time item unlikely to recur.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

DTL: defer to later. DTA: down payment on tax

A deferred tax liability means the company deferred paying tax to a later period. A deferred tax asset means the company has effectively made a down payment on future tax it will recover.

Always the enacted future rate, never the current rate

Whenever a question supplies both a current rate and a newly enacted rate for deferred tax measurement, the enacted rate is always the one that applies, and the remeasurement of existing balances hits income tax expense the moment the new rate is enacted.

A permanent difference moves the effective rate but never touches the balance sheet

Only ask whether the difference will ever reverse. If never, it is permanent: it changes the effective tax rate relative to statutory, but it creates no deferred tax asset or liability.

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. Determine whether a given book-versus-tax difference is temporary (will reverse) or permanent (never reverses) before deciding whether it creates a deferred tax balance at all.
  2. For a temporary difference, compare current taxable income to current book income: lower taxable income now signals a deferred tax liability, higher taxable income now signals a deferred tax asset.
  3. Apply the enacted rate expected at reversal, not the current rate, and remeasure any existing balances immediately upon a rate change, running the adjustment through tax expense.
  4. Compute effective tax rate as tax expense over pretax book income, and compare it to the statutory rate to infer whether non-deductible items (rate above statutory) or tax-exempt income and credits (rate below statutory) are present.
  5. For a persistent, growing deferred tax liability with no plausible reversal date, consider whether it should be treated as equity-like rather than as near-term debt in a leverage analysis.

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

A company uses straight-line depreciation for financial reporting and accelerated depreciation for tax purposes. In Year 1, book depreciation is $20,000 and tax depreciation is $35,000. The tax rate is 30%. Which of the following best describes the income tax consequence in Year 1?

How sure are you?

Correct: B. Accelerated tax depreciation means taxable income is lower than book income in Year 1. The company pays less tax now than its income statement expense implies. The difference will be paid later when tax depreciation falls below book depreciation. DTL = ($35,000 - $20,000) x 30% = $4,500.
A. Tax depreciation exceeds book depreciation this year, so the company pays LESS tax now, not more. That is a future obligation to pay more later (a liability), not an asset.
C. $15,000 is the pre-tax timing difference ($35,000 - $20,000), not the tax effect. The difference must be multiplied by the 30% tax rate: $15,000 x 30% = $4,500.

Unit: analysis-of-income-taxes

Question 2Exam level

A company accrues warranty expense of $50,000 on its income statement. Tax law only permits a deduction when warranty costs are actually paid. No cash has been paid yet. Tax rate is 25%. What is most likely the deferred tax impact?

How sure are you?

Correct: B. Taxable income is HIGHER than book income because the $50,000 expense is recognized on the income statement but not yet deductible for tax. The company overpays tax now and will get the deduction later when cash is paid. DTA = $50,000 x 25% = $12,500.
A. Choosing A might tempt you if you think the company owes more taxes due to the accrued expense, but this confuses the timing difference with a liability; the accrued expense creates a future tax benefit, not a liability, because you will deduct these costs later when paid, leading to a deferred tax asset instead.
C. A permanent difference never reverses, but this one does: the company will get its tax deduction later, once the warranty costs are actually paid in cash. That reversing pattern is the definition of a temporary, timing difference, not a permanent one, and every temporary difference between book and taxable income creates a deferred tax balance, here a deferred tax asset of $12,500, not the absence of one.

Unit: analysis-of-income-taxes

Question 3Exam level

Which of the following is MOST LIKELY a permanent difference for income tax purposes?

How sure are you?

Correct: B. Municipal bond interest is tax-exempt permanently. It will never be taxed. It is recognized as income on the financial statements but never appears in taxable income at any point. A and C are temporary differences: they reverse over time.
A. You might be tempted by the estimated warranty liability because it seems like an expense not yet paid, but this is a temporary difference since the expense will be deductible when paid, unlike the permanently non-taxable nature of municipal bond interest.
C. You might be tempted by accelerated depreciation because it seems like it should be permanent since it affects the tax basis of assets, but remember, this is a temporary difference as the depreciation methods will converge over the asset's life, unlike the permanent non-taxability of municipal bond interest.

Unit: analysis-of-income-taxes

Question 4Exam level

A company's income tax expense is $180,000 and taxes payable is $210,000. Which of the following occurred during the period, most likely?

How sure are you?

Correct: B. Tax expense < taxes payable means the company paid MORE tax than its income statement expense. The excess cash tax paid ($30,000) is a prepaid tax benefit. A deferred tax asset. Income tax expense = taxes payable + change in DTL - change in DTA. $180k = $210k - $30k DTA increase.
A. Choosing A might seem logical if you assume an increase in taxes payable requires a corresponding increase in deferred tax liability, but this overlooks the fact that a higher taxes payable than tax expense indicates a future tax benefit, thus a deferred tax asset, not a liability, would increase.
C. Choosing C might seem logical if you think a decrease in deferred tax liability would reduce the tax expense, but this violates the relationship where a higher taxes payable than tax expense indicates a future tax benefit, thus increasing a deferred tax asset instead of decreasing a deferred tax liability.

Unit: analysis-of-income-taxes

Question 5Exam level

Under GAAP, a company records a $400,000 deferred tax asset but believes it is 'more likely than not' that only $300,000 will be realized. The net deferred tax asset reported on the balance sheet is closest to:

How sure are you?

Correct: B. Under US GAAP (ASC 740), all DTAs are first recognized in full. A valuation allowance is then established for the amount 'more likely than not' (>50% probability) to not be realized. Valuation allowance = $400,000 - $300,000 = $100,000. Net DTA = $400,000 - $100,000 = $300,000.
A. Choosing $400,000 might seem logical if you think the full deferred tax asset is always reported, but under ASC 740, you must account for the valuation allowance for the portion of the DTA that is not expected to be realized, which in this case reduces the net DTA to $300,000.
C. Choosing $100,000 might seem logical if you think it represents the amount of the deferred tax asset that will not be realized, but this overlooks the requirement to report the net realizable value of the deferred tax asset, which is $300,000 after applying the valuation allowance.

Unit: analysis-of-income-taxes

Question 6Exam level

A company has pretax income of $500,000. The statutory tax rate is 21%. Tax expense reported is $130,000. The effective tax rate is closest to:

How sure are you?

Correct: B. Effective tax rate = Income tax expense / Pretax income = $130,000 / $500,000 = 26.0%. This exceeds the statutory rate of 21%, suggesting the company has permanent differences that INCREASE taxable income relative to book income (e.g., non-deductible fines, non-deductible meals). An ETR > statutory rate is a red flag for analysts.
A. Choosing 21.0% might seem logical if you assume the effective tax rate equals the statutory rate, but this ignores the actual tax expense reported, which indicates a higher effective rate due to factors that increase taxable income beyond the statutory rate.
C. Choosing 9.0% might tempt you if you mistakenly divide the tax expense by the statutory rate, but this approach violates the formula for calculating the effective tax rate, which requires dividing the tax expense by pretax income, leading to the correct rate of 26.0%.

Unit: analysis-of-income-taxes

Question 7Exam level

Which of the following changes would most likely INCREASE a company's deferred tax liability?

How sure are you?

Correct: C. When tax depreciation exceeds book depreciation, taxable income falls below book income. The company pays less tax now but will pay more later. A deferred tax liability. DTL increases by $200,000 x applicable tax rate. Option A would DECREASE DTL (lower rate on same temporary difference). Option B creates a DTA (taxes paid now, deduction later).
A. You might think a lower tax rate increases deferred tax liability by reducing current tax payments, but in reality, a decrease in the tax rate from 25% to 21% reduces the future tax liability on existing temporary differences, thus decreasing deferred tax liability rather than increasing it.
B. You might think that accruing restructuring charges creates a deferred tax liability because it seems like a future tax benefit, but in reality, it creates a deferred tax asset as the tax deduction will be claimed in the future, reducing future tax payments, which is the opposite of what increases a deferred tax liability.

Unit: analysis-of-income-taxes

Question 8Harder

A company's deferred tax liability has been growing for 10 consecutive years with no sign of reversal. How should an analyst treat this DTL for financial analysis purposes, most likely?

How sure are you?

Correct: B. When a company continuously grows and adds new assets, old DTLs from depreciation reverse but new, larger DTLs replace them. If the DTL balance has grown every year for a decade, it functionally never requires cash payment. Analysts reclassify it as equity-like in ratio analysis (e.g., removing from debt in leverage ratios). This is the 'Tax Rate Trap' concept for financial analysis.
A. Choosing A might seem logical if you think all deferred tax liabilities will reverse eventually, but this overlooks the "Tax Rate Trap" concept, where continuously growing DTLs effectively become permanent, thus should be treated as equity rather than a liability that will reverse and require cash payment.
C. Ignoring DTLs because they always reverse is a common misconception; in reality, if DTLs from depreciation consistently grow without reversing, they effectively become a permanent benefit, akin to equity, rather than a liability that will require cash outflow.

Unit: analysis-of-income-taxes

Question 9Above the exam

A company has a deferred tax asset of $200,000 related to warranty expense accruals not yet deductible for tax purposes. Management determines that, based on a history of losses, it is more likely than not that only 40% of this deferred tax asset will actually be realized. Combining the valuation allowance concept with its effect on the balance sheet and income statement, the company should most likely:

How sure are you?

Correct: B. When it is more likely than not that a portion of a deferred tax asset will NOT be realized, a valuation allowance must be recorded to reduce the asset to its expected realizable amount. If only 40% ($80,000) is expected to be realized, a valuation allowance of 60% x $200,000 = $120,000 is recorded, reducing the net deferred tax asset to $80,000; recording the allowance increases income tax expense (reduces net income) in the period it is established.
A. Leaving the deferred tax asset unchanged ignores the required valuation allowance assessment; accounting standards specifically require a valuation allowance whenever it is more likely than not that some or all of a deferred tax asset will not be realized, which is exactly the situation described.
C. A valuation allowance reduces the NET carrying amount of the deferred tax asset; it does not eliminate the gross deferred tax asset from the accounting records entirely, and it certainly does not create an unrelated tax refund receivable, which is not part of this mechanism at all.

Unit: analysis-of-income-taxes

Question 10Above the exam

A company has a temporary difference that creates a deferred tax liability, and the government has just enacted a change in the statutory tax rate from 25% to 21%, effective immediately. Combining the treatment of enacted (not merely proposed) tax rate changes with the deferred tax liability's balance, the company should most likely:

How sure are you?

Correct: B. Deferred tax assets and liabilities must be remeasured whenever a new tax rate is ENACTED (not merely proposed), using the rate expected to apply when the temporary difference reverses. The remeasurement is recognized immediately, in the period the rate change is enacted, as an adjustment to income tax expense, not deferred until the rate is actually paid in cash.
A. Deferred tax balances are remeasured at the point of ENACTMENT, not deferred until cash actually changes hands; waiting for the future cash payment ignores the accounting requirement to reflect the best available (now enacted) rate immediately.
C. Deferred tax balances are explicitly NOT fixed at the historical rate that applied when the temporary difference originated; they must be remeasured for enacted rate changes, which is precisely the scenario and requirement this LOS tests.

Unit: analysis-of-income-taxes

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