FINANCIAL STATEMENT

CFA LEVEL 1 ANALYSIS

CHAPTER 9
“CRAFTING YOUR
CFA TRIUMPH
WITH EFFECTIVE
SUMMARIES.”
CONCEPT NOTES
Income Taxes
-Tax return terminology 1
-Financial reporting terminology 2

-Deferred tax asset (DTA) 3

-Deferred tax liability (DTL) 4

-Tax base of assets 5

-Tax base of liabilities 7

-Change in tax rates 8

-Permanent differences 9

-Valuation allowance 11
-Deferred tax disclosures 12
-Effective tax rate reconciliation 14

TABLE OF
CONTENTS
Income Taxes
What is tax return terminology?
Taxable Income: Taxable income is the portion of a person's or business's
total income that is subject to taxation by the government. It's calculated by
subtracting allowable deductions and exemptions from the total income.
Taxable income is the amount on which the tax liability is determined.
Taxes Payable: Taxes payable refer to the amount of taxes that a person or
business owes to the government for a specific tax period. This is the actual
tax liability that must be paid by the taxpayer, typically calculated based on
their taxable income and applicable tax rates.
Income Tax Paid: Income tax paid represents the total amount of income
tax that an individual or entity has already remitted to the government
during a specific tax year. It includes any tax payments made through
withholding, estimated tax payments, or other methods.
Tax Loss Carryforward: Tax loss carryforward, also known as a tax loss
carryover, is a provision in tax law that allows individuals or businesses to
offset their current taxable income with prior years' losses. If a taxpayer
experiences a net operating loss (NOL) in one year, they can use that NOL to
reduce their taxable income in future years, thereby reducing their tax
liability.
Tax Base: The tax base is the specific value, item, or event that is subject to
taxation. It can vary depending on the type of tax being applied. For
example, in income tax, the tax base is typically the taxable income. In
property tax, the tax base is the assessed value of the property.
Understanding the tax base is essential for calculating the tax liability
accurately.

"Tax returns are the financial scorecards of

our civic duty, where we tally what we owe
to society and what it owes us in return."

1 | CFA L1 NOTES
What is financial reporting terminology?
Accounting Profit: Accounting profit refers to the profit reported on a
company's income statement. It is calculated by subtracting all expenses
from a company's total revenue. It may differ from taxable income due to
differences in accounting rules and tax regulations.
Income Tax Expense: Income tax expense is the amount a company
records in its financial statements to account for the taxes it is expected to
pay during a specific accounting period. This expense is based on the
company's taxable income and tax rates.
Deferred Tax Liabilities: Deferred tax liabilities represent future tax
obligations that arise due to temporary differences between the accounting
and tax treatment of certain items. These differences result in a tax liability
that will be paid in the future.
Deferred Tax Assets: Deferred tax assets are future tax benefits that arise
from temporary differences. These assets can be used to reduce future tax
liabilities. For example, if a company has tax losses that can be carried
forward to offset future taxable income, it creates a deferred tax asset.
Valuation Allowance: A valuation allowance is established when it is
more likely than not that a portion of a deferred tax asset will not be realized.
This allowance reduces the recorded value of the deferred tax asset to reflect
its expected future recovery accurately.
Carrying Value: The carrying value is the amount at which an asset or
liability is reported on the balance sheet. It is typically the original cost
minus accumulated depreciation for assets or the original amount of the
liability. It represents the book value of an item.
Permanent Difference: A permanent difference is a difference between
accounting income and taxable income that will not reverse in the future.
These differences do not create deferred tax assets or liabilities because they
do not affect future tax obligations.
Temporary Difference: A temporary difference is a difference between
accounting income and taxable income that is expected to reverse in the
future. Temporary differences give rise to deferred tax assets or liabilities
because they affect future tax obligations.

2 | CFA L1 NOTES
What is a deferred tax asset (DTA)?
A Deferred Tax Asset (DTA) is an accounting concept that represents a future tax
benefit a company expects to realize in its financial statements due to temporary
differences between its accounting and tax treatments of certain items. It arises
in situations where a company pays less in taxes in the future because of these
temporary differences.
Creation of Deferred Tax Asset (DTA): Deferred Tax Assets are created in
situations where a company reports expenses or losses on its financial
statements (accounting income) before they are recognized for tax purposes
(taxable income), resulting in a future tax benefit. Common scenarios that create
DTAs include:
Accrued Expenses: When a company records an expense in its financial
statements before it's deductible for tax purposes. For example, warranty
expenses that will be deducted when claims are paid.
Depreciation: If a company uses different depreciation methods or lives
for accounting and tax purposes, it can create a DTA. This happens when
depreciation expense is recognized earlier for financial reporting.
Tax Loss Carryforwards: If a company incurs a net operating loss (NOL)
in one year, it can carry forward that loss to offset future taxable income,
creating a DTA.
Reversal of Deferred Tax Asset: Deferred Tax Assets are reversed when the
temporary differences that initially created them reverse. This can happen in
several ways:
Income Recognition: When the expenses or losses that created the DTA
are recognized for tax purposes and can be deducted, the DTA is reversed.
Change in Tax Laws: If there is a change in tax laws that reduces the
benefit a company can get from a DTA, it may need to reverse a portion of
the DTA.
Expiration of Carryforwards: If a company has NOL carryforwards that
have a limited shelf life (e.g., they expire after a certain number of years), the
DTA associated with those carryforwards will be reversed when they expire.

3 | CFA L1 NOTES
It's important to note that the reversal of a DTA means the company will pay
higher taxes in the future, reducing its future tax expense. DTAs are subject to
rigorous assessment to determine whether it is more likely than not that they
will be realized. If it's uncertain, a valuation allowance is established to offset the
DTA until there's sufficient evidence to support its realization. Deferred tax
accounting can be complex, and it's typically handled by accounting and tax
professionals to ensure accurate reporting and compliance with accounting
standards.

"Deferred tax assets are the echoes of

financial prudence, waiting in the balance
to harmonize a brighter tax future."

What is a deferred tax liability (DTL)?

A Deferred Tax Liability (DTL) is an accounting concept that represents a future
tax obligation a company expects to pay in its financial statements due to
temporary differences between its accounting and tax treatments of certain
items. It arises in situations where a company will pay more in taxes in the
future because of these temporary differences.
Creation of Deferred Tax Liability (DTL): Deferred Tax Liabilities are
created in situations where a company reports income or gains on its financial
statements (accounting income) before they are recognized for tax purposes
(taxable income), resulting in a future tax obligation. Common scenarios that
create DTLs include:
Accelerated Depreciation: When a company uses accelerated
depreciation methods for accounting purposes, but straight-line
depreciation for tax purposes, it results in lower depreciation expense on the
tax return, which creates a DTL.
Revenue Recognition: If a company recognizes revenue for accounting
purposes before it's included in taxable income (e.g., recognizing sales for
financial reporting before they are taxable for tax purposes), it creates a
DTL.

4 | CFA L1 NOTES
 Asset Revaluations: When a company revalues its assets, and the
increase in value is included in accounting income but not yet taxed, it leads
to a DTL.
Reversal of Deferred Tax Liability: Deferred Tax Liabilities are reversed
when the temporary differences that initially created them reverse. This can
happen in several ways:
Income Recognition: When the income or gains that created the DTL are
recognized for tax purposes and become taxable, the DTL is reversed.
Change in Tax Laws: If there is a change in tax laws that increases the tax
obligation on a previously recognized DTL, the DTL may need to be adjusted
upward.
Change in Depreciation Methods: If the company changes its
depreciation methods to align with the accounting treatment, it may reverse
the DTL associated with depreciation.
It's important to note that the reversal of a DTL means the company will pay
higher taxes in the future, increasing its future tax expense. DTLs are subject to
rigorous assessment to determine when and how they will reverse. Accounting
for deferred taxes can be complex, and it's typically handled by accounting and
tax professionals to ensure accurate reporting and compliance with accounting
standards.

"Deferred tax liabilities are the financial

promises to future fiscal realities, a reflection
of tomorrow's tax obligations cast in today's
accounting shadows."

What is a tax base of asset?

The tax base of an asset is the value or amount that serves as the basis for
calculating the tax liability associated with that asset. It represents the asset's
value for tax purposes, which may differ from its book or financial statement
value. The tax base is used to determine the amount of taxable income or gain
when the asset is sold or disposed of, and subsequently, the amount of tax owed.

5 | CFA L1 NOTES
The tax base of assets is typically determined by the tax laws and regulations in a
specific jurisdiction. It may involve various adjustments, deductions, or
exemptions. Here are a few examples of how the tax base of assets can be
calculated:
Real Property (Real Estate): In many jurisdictions, the tax base for real
property is the assessed value, which is determined by local tax authorities.
This assessed value may be lower than the property's market value, and it
often serves as the basis for property tax calculations.
Depreciable Assets: For depreciable assets like machinery, vehicles, or
equipment, the tax base is usually determined based on the asset's cost
minus any applicable depreciation or amortization. Tax laws may specify the
depreciation method and rates to be used.
Inventory: The tax base for inventory is often the lower of cost or market
value. Companies need to follow specific rules regarding how inventory costs
are calculated for tax purposes, which can differ from their financial
reporting methods.
Securities and Investments: The tax base for stocks, bonds, and other
investments may be the original purchase price. When these assets are sold,
the tax is typically calculated based on the capital gains or losses, which can
be a key component of the tax base.
Intangible Assets: Intangible assets like patents, copyrights, or
trademarks may have their tax base determined based on their acquisition
cost, amortized value, or other rules specified by tax authorities.
It's important to note that tax bases can change over time due to various factors
such as changes in tax laws, depreciation or amortization, and adjustments
made for specific circumstances. Accurate determination of the tax base is
crucial for calculating the correct amount of tax when assets are disposed of or
transferred. It's also important for financial and tax planning to minimize tax
liabilities legally. For this reason, many businesses and individuals rely on tax
professionals or accountants to ensure compliance with tax regulations and
optimize their tax positions.

6 | CFA L1 NOTES
What is a tax base of liability?
The tax base of liabilities refers to the amount that serves as the basis for
calculating the tax impact associated with certain liabilities. It represents the
value of a liability for tax purposes and is used to determine the tax
consequences of those liabilities. The tax base for liabilities can vary depending
on tax laws and regulations, and it often differs from the book or financial
statement value of the liability. Here are some examples of how the tax base of
liabilities can be calculated:
Debt Liabilities: The tax base for debt liabilities is typically the principal
amount of the debt. Interest expenses may be deductible for tax purposes, so
the interest portion of the liability is not included in the tax base. For
example, if a company has a loan with a principal amount of $100,000, the
tax base for that debt liability is $100,000.
Deferred Tax Liabilities: Deferred tax liabilities are created when a
company recognizes income for tax purposes before it's recognized in its
financial statements. The tax base for deferred tax liabilities is the amount of
income that has been recognized for tax purposes but not yet for financial
reporting. For example, if a company recognizes $10,000 of income for tax
purposes that is not yet included in its financial statements, it would create a
deferred tax liability of $10,000.
Accrued Liabilities: Accrued liabilities, such as accrued expenses or
wages payable, may have a tax base equal to the amount that has been
accrued but not yet paid at the end of the tax year. For example, if a
company has accrued $5,000 in unpaid wages at the end of the tax year, the
tax base for that liability is $5,000.
Contingent Liabilities: Contingent liabilities, which are potential
obligations that depend on the outcome of future events, may not have a
specific tax base until they become actual liabilities. When contingent
liabilities become actual liabilities, their tax base is determined based on tax
laws and regulations.
It's essential to understand that tax laws can be complex, and the tax base for
specific liabilities may be subject to various rules and regulations. Accurate
calculation of the tax base is crucial for determining the correct amount of tax
liability and ensuring compliance with tax laws.

7 | CFA L1 NOTES
What is the effect of change in tax rates?
A change in tax rates can have significant effects on a company's financial
statements and financial ratios. The impact largely depends on whether tax rates
increase or decrease. Here's how it can affect various financial aspects:
Income Statement:
Net Income: A higher tax rate will lead to a decrease in net income as
more profits are allocated to taxes, all else being equal. Conversely, a
lower tax rate will result in higher net income.
Earnings Per Share (EPS): Changes in net income can affect EPS,
which is an important metric for investors. Higher taxes reduce EPS,
while lower taxes increase it.
Balance Sheet:
Deferred Tax Assets and Liabilities: Changes in tax rates can
impact the valuation of deferred tax assets and liabilities. If tax rates
increase, deferred tax assets (e.g., tax credits) become less valuable,
leading to a reduction in assets. Conversely, lower tax rates can increase
the value of these assets.
Income Tax Payable: The company's tax liability on the balance sheet
may need to be adjusted to reflect the new tax rate.
Cash Flow Statement:
Cash Taxes Paid: Higher tax rates will increase the cash taxes paid,
while lower rates will reduce it. This affects the cash flow from operating
activities.
Ratios:
Profit Margin: Higher taxes result in a lower profit margin, while
lower taxes lead to a higher margin.
Return on Assets (ROA): A change in net income can impact ROA,
which is calculated by dividing net income by total assets. Higher taxes
will reduce ROA, and lower taxes will increase it.
Return on Equity (ROE): Similarly, ROE can be affected. Higher
taxes lower ROE, while lower taxes increase it.

8 | CFA L1 NOTES
It's important to note that changes in tax rates can also affect a company's
overall financial health and decision-making. For instance, lower tax rates might
incentivize investment and expansion, while higher tax rates can lead to cost-
cutting measures.
Additionally, changes in tax rates can have an impact on the valuation of a
company's shares in the stock market. Investors often react to changes in tax
rates, which can influence stock prices.
In summary, changes in tax rates have a cascading effect on a company's
financial statements and ratios. These changes can impact a company's
profitability, financial position, and ability to generate returns for shareholders,
making them a crucial consideration for investors and financial analysts.

Income Tax Expense

Taxes Payable

Change in DTL

Change in DTA

What are permanent tax differences?

Permanent tax differences and temporary tax differences are two concepts in
accounting and taxation that relate to how a company accounts for and reports
its financial and tax information. They arise due to the differences between
accounting rules (GAAP or IFRS) and tax laws.
(1) Permanent Tax Differences:
Permanent tax differences are differences between a company's taxable income
and its accounting income that will never reverse in the future. These differences
arise because certain items are recognized differently for tax purposes than they
are for financial reporting purposes. Here are some common examples of
permanent tax differences:

9 | CFA L1 NOTES
 Nontaxable Income: Certain types of income, like municipal bond
interest or life insurance proceeds, are not subject to taxation. These items
create a permanent tax difference because they are never taxed.
Non-Deductible Expenses: Some expenses, such as fines and penalties,
are not deductible for tax purposes but are recognized as expenses in the
financial statements. This creates a permanent difference because these
expenses are not deductible for tax purposes.
Tax Credits: Tax credits, such as research and development credits or
investment tax credits, may reduce a company's tax liability. These credits
create permanent differences because they affect tax expenses but not
accounting income.
(2) Temporary Tax Differences:
Temporary tax differences, on the other hand, are differences between taxable
income and accounting income that will eventually reverse in the future. These
differences arise because of the timing of when certain items are recognized for
tax and accounting purposes. Common examples of temporary tax differences
include:
Depreciation: Companies may use different methods for calculating
depreciation for tax and accounting purposes. Over time, these differences
result in temporary tax differences because the total depreciation expense
will eventually match for both tax and accounting purposes when the asset is
fully depreciated.
Accruals and Deferrals: Items like revenue or expenses that are
recognized in the financial statements before they are recognized for tax
purposes create temporary differences. For example, a company may
recognize revenue when it is earned (accrual basis) for financial reporting,
but for tax purposes, it may be recognized when cash is received.
Reserve for Bad Debts: Companies may have different policies for
estimating bad debt expenses for tax and accounting purposes. Over time,
these differences result in temporary tax differences because the actual bad
debts may not match the estimated amounts.

10 | CFA L1 NOTES
The key difference between permanent and temporary tax differences is that
permanent differences do not reverse in the future, whereas temporary
differences are expected to reverse, either increasing or decreasing future tax
liabilities. Temporary differences give rise to deferred tax assets or deferred tax
liabilities, which are recognized on the balance sheet and represent future tax
consequences.
It's essential for companies to manage these differences effectively for tax
planning and financial reporting purposes. Additionally, understanding these
differences is crucial for financial analysts and investors when analyzing a
company's financial statements and evaluating its tax liabilities.

“Company XYZ, following a recent corporate tax rate

reduction from 35% to 21%, experienced a significant
boost in after-tax profits. This tax cut led to an increase
in net income and, consequently, higher earnings per
share, positively impacting shareholder returns.”

What is valuation allowance?

A valuation allowance for deferred tax assets is an accounting provision used to
reduce or eliminate the carrying amount of deferred tax assets when it is more
likely than not that some or all of the deferred tax assets will not be realized.
Let's break down the concept in detail:
Need for Valuation Allowance: Deferred tax assets are recorded on the
balance sheet when it's more likely than not that they will be realized.
However, sometimes, it becomes uncertain whether these assets will be fully
realized due to factors like a history of losses, uncertain future profitability,
or significant changes in tax laws.
Establishing a Valuation Allowance: When there is uncertainty about
the realization of deferred tax assets, accounting standards, such as
Generally Accepted Accounting Principles (GAAP) in the United States,
require the company to establish a valuation allowance. This allowance is a
contra-account, meaning it reduces the carrying amount of deferred tax
assets on the balance sheet.

11 | CFA L1 NOTES
 Assessment of Realization: The company must make a judgment about
whether it is more likely than not that the deferred tax assets will be realized.
This typically means that there should be a greater than 50% probability that
the assets will be realized.
Factors Considered: When determining the need for a valuation
allowance, the company considers factors such as its historical and projected
future profitability, tax planning strategies, and any changes in tax laws that
could impact the utilization of these assets.
Impact on Financial Statements: Establishing a valuation allowance
reduces the net value of deferred tax assets on the balance sheet, which in
turn decreases shareholders' equity. It also increases the income tax expense
on the income statement. As a result, it can lead to a lower reported net
income.
Reversal of Valuation Allowance: If circumstances change, and it
becomes more likely that deferred tax assets will be realized, the valuation
allowance is reduced or reversed, and this has a positive impact on the
company's financial statements and income tax expense.

"Valuation allowance for deferred tax assets is a

prudent accounting practice, ensuring that financial
statements accurately reflect potential tax benefits only
when it's more likely than not that they will be
realized."

What are deferred tax disclosures?

Deferred tax disclosures under both International Financial Reporting
Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP)
require companies to provide information about their deferred tax assets and
liabilities. These disclosures help users of financial statements understand the
future tax consequences of transactions and events. While there are many
similarities between IFRS and U.S. GAAP, there are some key differences in the
specific requirements for deferred tax disclosures:

12 | CFA L1 NOTES
(1) IFRS Deferred Tax Disclosures:
Nature and Composition of Deferred Tax Balances: IFRS requires
companies to disclose the nature and amounts of deferred tax assets and
liabilities, and the circumstances under which they are expected to be
realized or settled.
Reconciliation: IFRS mandates a reconciliation between the tax expense
(or benefit) and the product of the accounting profit multiplied by the
applicable tax rate(s). This reconciliation explains the differences between
the expected tax expense based on the statutory tax rate and the actual tax
expense in the financial statements.
Origination and Reversal of Temporary Differences: Companies
must provide information about the origination and reversal of temporary
differences, as well as the reasons for changes in deferred tax balances.
Unrecognized Deferred Tax Assets: Companies must disclose the
existence of unrecognizable deferred tax assets, such as tax loss
carryforwards, and the reasons for their non-recognition. They should also
disclose when they expect to recover these assets.
(2) U.S. GAAP Deferred Tax Disclosures:
Components of Income Tax Expense: U.S. GAAP requires companies
to provide a reconciliation of the total income tax expense, separating it into
the current tax expense and the deferred tax expense. This explains the
differences between the statutory tax rate and the effective tax rate.
Origination and Reversal of Temporary Differences: Similar to
IFRS, U.S. GAAP requires the disclosure of the origination and reversal of
temporary differences, as well as the reasons for changes in deferred tax
balances.
Valuation Allowance: Companies must disclose information about any
valuation allowance recorded against deferred tax assets, including the
reasons for the allowance and changes in the allowance amount.
Uncertain Tax Positions: Under U.S. GAAP, companies must disclose
information about uncertain tax positions, including a description of the tax
position, the years that remain subject to examination, and the amount of
unrecognized tax benefits.

13 | CFA L1 NOTES
What is effective tax rate reconciliation?
The effective tax rate reconciliation is a financial statement disclosure that
provides a detailed breakdown of how a company's statutory or nominal tax rate
differs from its actual effective tax rate. It is an essential part of a company's
financial reporting, allowing stakeholders to understand the factors that
influence the company's overall tax rate. Here's a detailed explanation of what an
effective tax rate reconciliation entails:
Statutory Tax Rate: This is the tax rate determined by the tax laws and
regulations of the jurisdiction in which the company operates. It serves as a
reference point for calculating taxes and is often the starting point for the
reconciliation.
Pre-Tax Income: The effective tax rate reconciliation begins with the
company's pre-tax income or accounting profit before income tax. This
figure is a starting point for calculating the tax expense and reflects the
income on which taxes are based.
Tax Expense: The next step is to calculate the company's total tax expense
for the reporting period, which is the amount the company is obligated to
pay according to tax laws. This is often calculated by applying the statutory
tax rate to the pre-tax income.
Permanent Differences: The reconciliation identifies permanent
differences between accounting income and taxable income. Permanent
differences are items that affect taxable income differently from accounting
income and include items like tax-exempt income, non-deductible expenses,
or tax credits. These differences are generally not expected to reverse in the
future.
Temporary Differences: Temporary differences arise from timing
discrepancies in recognizing items for financial reporting and tax purposes.
For example, depreciation methods, revenue recognition, or bad debt
allowances can be recognized differently for tax and accounting purposes.
These differences are expected to reverse in the future.
Rate Changes: The effective tax rate reconciliation takes into account any
changes in tax rates that occurred during the reporting period. It explains
how these rate changes impacted the company's tax expense.

14 | CFA L1 NOTES
 Uncertain Tax Positions: If the company has uncertain tax positions, the
reconciliation may disclose this information. These positions involve
potential disputes with tax authorities, and the company may record a
liability for uncertain tax benefits.
Other Items: The reconciliation can include explanations for any other
significant items that impact the effective tax rate, such as tax provisions,
penalties, or interest.
By providing a comprehensive breakdown of the factors affecting the effective
tax rate, the reconciliation helps investors, analysts, and other stakeholders
better understand the company's tax position and the relationship between
accounting profit and income tax. It enhances transparency in financial
reporting and enables a more accurate assessment of a company's financial
performance and tax management strategies.

"The effective tax rate reconciliation unveils the

intricate interplay of accounting, tax, and regulatory
factors that shape a company's true tax burden, offering
a transparent window into its financial strategies and
obligations."

15 | CFA L1 NOTES
CFA L1 Notes

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Published: October 2023