Analysis of Income Taxes

The tax line on the income statement rarely equals the cash a company pays to tax authorities, and the gap can be large, persistent and revealing. This module explains why accounting profit and taxable income differ, how those differences create deferred tax liabilities and assets, how rate changes and valuation allowances move reported earnings, and how to read the tax note to judge whether a company's tax burden is sustainable.

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What you will learn

1. Distinguish accounting profit, taxable income, taxes payable and income tax expense, and classify book-tax differences as temporary or permanent.

Taxes payable = taxable income x tax rate; income tax expense = taxes payable + deferred tax expense.
Compare carrying amount with tax base for each asset and liability to find temporary differences.
Asset carrying amount > tax base, or liability carrying amount < tax base: DTL.
Asset carrying amount < tax base, or liability carrying amount > tax base: DTA. Loss carryforwards also create DTAs.
Permanent differences create no deferred tax; they make the effective rate differ from the statutory rate.

2. Explain how deferred tax liabilities and assets are created and calculate income tax expense from taxes payable and the change in deferred tax balances.

IAS 12 and ASC 740 both use the balance-sheet (temporary-difference) approach.
Accelerated tax depreciation is the textbook source of a DTL; provisions and loss carryforwards are typical sources of DTAs.
Income tax expense = taxes payable + increase in DTL - increase in DTA.
Deferred taxes change timing only; over an asset's life total tax expense equals total tax paid.
Deferred tax expense is non-cash and is added back in the indirect-method operating cash flow.

3. Explain how changes in tax rates and in the expected recoverability of deferred tax assets affect deferred tax balances, income tax expense and financial analysis.

Rate changes remeasure all DTLs and DTAs; the effect normally flows through income tax expense.
US GAAP: enacted rates; IFRS: enacted or substantively enacted rates.
Rate cut: net DTL holders gain, net DTA holders lose. Rate rise: the reverse.
US GAAP valuation allowance when realization is not more likely than not; IFRS recognizes a DTA only to the extent recovery is probable.
Valuation allowance changes are judgmental and can be used to manage earnings.

4. Calculate and interpret the effective and cash tax rates and use the tax rate reconciliation to judge how sustainable a company's tax burden is.

ETR = income tax expense / pretax income; cash tax rate = cash taxes paid / pretax income.
Permanent differences, foreign rate differences, credits and allowance changes explain ETR versus statutory rate.
Temporary differences explain the gap between the ETR and the cash tax rate.
Separate recurring reconciling items from one-time items and forecast with a normalized rate.
A low ETR from favorable jurisdictions is exposed to tax-law changes such as the 15% Pillar Two minimum tax.

5. Evaluate how analysts should treat deferred tax liabilities and assets, and identify the main IFRS and US GAAP differences in income tax accounting and presentation.

DTL expected to reverse: liability. Not expected to reverse: equity. Uncertain: exclude from both.
Deferred taxes are undiscounted, so book DTLs overstate their economic burden.
DTAs need future taxable profit; treat large loss-based DTAs with caution.
IFRS: probable recognition, substantively enacted rates. US GAAP: valuation allowance, enacted rates.
Both frameworks present deferred taxes as non-current.

Module at a glance

Income tax expense = taxes payable + increase in DTL - increase in DTA.
Taxable temporary differences create DTLs; deductible differences and loss carryforwards create DTAs.
Permanent differences create no deferred tax but move the effective rate away from the statutory rate.
Rate changes remeasure all deferred balances; net DTL holders gain from rate cuts.
US GAAP uses a valuation allowance (more likely than not); IFRS recognizes DTAs only when recovery is probable.
Use the rate reconciliation to separate recurring from one-time items and forecast with a normalized rate.
Analysts treat a DTL as a liability, as equity or exclude it, depending on whether and when it will reverse.

This free module has 5 lessons, 14 practice questions with full explanations.

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