Level I · Financial Statement Analysis

Learning Module 9
Analysis of Income Taxes

Key Outcomes Summary & Practice Problems

Learning Outcomes

What you must be able to do

Curriculum Year: 2026

LOS 1

Contrast accounting profit, taxable income, taxes payable, and income tax expense, and temporary versus permanent differences between accounting profit and taxable income.

LOS 2

Explain how deferred tax liabilities and assets are created and the factors that determine how they should be treated for financial analysis purposes.

LOS 3

Calculate, interpret, and contrast an issuer's effective tax rate, statutory tax rate, and cash tax rate.

LOS 4

Analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and explain how this information affects financial statements and ratios.

1 · Accounting Profit vs. Taxable Income

Accounting profit (pretax income) is reported on the income statement under prevailing accounting standards and excludes any tax provision. Taxable income is income subject to tax under the relevant jurisdiction's tax laws — it is the basis for income tax payable (or recoverable), a balance sheet item. The tax base of an asset or liability is its value for tax purposes; the carrying amount is its value on the financial statements. Differences between the two drive the gap between accounting profit and taxable income.

EXHIBIT 1 — TEMPORARY DIFFERENCE MAP

Asset: Carrying amount > tax base → Deferred tax liability
Asset: Carrying amount < tax base → Deferred tax asset
Liability: Carrying amount > tax base → Deferred tax asset
Liability: Carrying amount < tax base → Deferred tax liability

Classic example — accelerated tax depreciation, straight-line book depreciation: both methods fully depreciate the same total cost over the asset's life — only the timing differs. In early years, faster tax depreciation makes the asset's tax base fall below its carrying amount, creating a deferred tax liability (more tax savings now, smaller savings later, when the difference reverses).

WORKED EXAMPLE — RESTON PARTNERS EQUIPMENT (GBP, 10-YR BOOK LIFE VS. 7-YR TAX LIFE)

Item	Year 1	Year 2	Year 3
Carrying amount (SL over 10 yrs)	18,000	16,000	14,000
Tax base (SL over 7 yrs)	17,143	14,286	11,429
Deferred tax liability (× 30%)	257	514	771
Income tax payable (tax accounting)	1,153	4,327	7,753
Income tax expense (book, incl. ΔDTL)	1,410	4,584	8,010

Why this matters for the income statement: because the depreciation difference is temporary, income tax expense on the income statement equals 30% of accounting profit in every year — even though only part of that is actually payable in cash; the rest builds (or draws down) the deferred tax liability. Income tax expense = Income tax payable + Change in deferred tax liability (net of any change in deferred tax assets).

TAXABLE TEMPORARY DIFFERENCE

→ Deferred Tax Liability

Carrying amount of an asset exceeds its tax base, or tax base of a liability exceeds its carrying amount. Example: accelerated tax depreciation vs. straight-line book depreciation on equipment.

DEDUCTIBLE TEMPORARY DIFFERENCE

→ Deferred Tax Asset

Tax base of an asset exceeds its carrying amount, or carrying amount of a liability exceeds its tax base. Example: rent or interest received in advance — taxed now, recognized as accounting income later.

PERMANENT DIFFERENCE

→ No Deferred Tax Item

Never reverses — e.g., non-deductible fines/penalties, non-taxable dividend income, or direct tax credits (solar/EV incentives). Drives a gap between the effective and statutory tax rate instead.

EXAMPLE 1 & 2 — QUICK CLASSIFICATION DRILL (EUR)

Dividends receivable (non-taxable): carrying = tax base → Permanent difference, no DTA/DTL
Development costs capitalized, carrying > tax base by 250,000 → Deferred tax liability
Research costs expensed, carrying 0 vs tax base 375,000 → Deferred tax asset
Rent received in advance, liability carrying 10,000,000 vs tax base 0 → Deferred tax asset
Donations (non-deductible): no temporary difference → Permanent difference

Realizability of deferred tax assets: recognition requires a reasonable expectation of future profits to use the asset. If doubtful — e.g., a company in liquidation — IFRS reverses an existing DTA, while US GAAP establishes a valuation allowance to reduce the DTA to the amount "more likely than not" to be realized.
Rate-change sensitivity: if the statutory tax rate falls (e.g., 35% → 21%), the recorded value of both deferred tax assets and deferred tax liabilities decreases — the future benefit (DTA) and the future obligation (DTL) are both worth less at a lower rate.

2 · Deferred Tax Assets and Liabilities

At each reporting date, deferred tax assets and liabilities are recalculated by comparing tax bases and carrying amounts across the balance sheet. Only the change in these balances flows into the period's income tax expense — not the full balance.

EXHIBIT 10 — NET DEFERRED TAX POSITION (USD THOUSANDS)

Item	Year 3	Year 2
Deferred tax assets (gross)	18,851	16,917
Valuation allowance	(1,245)	(1,360)
Net deferred tax assets	17,606	15,557
Deferred tax liabilities	(32,639)	(39,040)
Net deferred tax liability	(15,033)	(23,483)

Reading the net liability shrinking ($23,483 → $15,033 thousand): a smaller net DTL in Year 3 means the company paid taxes in cash that exceeded its income tax provision that year — it settled some of the deferral built up in prior periods, so the cash tax rate exceeded the effective tax rate for the year. A reduction in the statutory tax rate would benefit both the income statement (higher net income) and the balance sheet (smaller net liability) for a company in a net DTL position.

Analyst treatment of deferred tax liabilities — three cases: treat as a true liability if it's expected to reverse with a future cash tax payment; treat as equity if it's not expected to reverse (no future cash outflow expected); exclude from both debt and equity if both the amount and timing of any reversal are genuinely uncertain.
Valuation allowance changes are a real income statement lever: an increase in the valuation allowance increases income tax expense (even though no cash tax changes), while a decrease reduces it — purely a financial-reporting effect with no cash tax impact at the time of the adjustment.
M&A implication of net operating loss (NOL) carryforwards: a target's unused NOLs are more valuable to an acquirer that is highly profitable and faces a high tax rate — such an acquirer can use the NOLs sooner and at greater tax savings, so it can rationally pay a higher price than a less profitable, lower-tax-rate acquirer.

3 · Corporate Income Tax Rates

Three tax rates matter to analysts, each serving a different forecasting purpose.

THREE TAX RATES

Statutory tax rate = the corporate income tax rate in the company's country of domicile
Effective tax rate = Income tax expense (income statement) ÷ Pretax income — used to project earnings
Cash tax rate = Cash taxes actually paid ÷ Pretax income — used to project cash flow

Why the effective rate diverges from the statutory rate: tax credits, dividend withholding tax, prior-year adjustments, non-deductible expenses, and — especially — operating in multiple tax jurisdictions. A multinational's effective rate is a profit-weighted blend of each jurisdiction's rate: more profit shifted toward a low-tax country pulls the blended rate down over time, even with no change in any single statutory rate.

EXAMPLE 4 — BLENDED RATE DRIFTS AS COUNTRY MIX SHIFTS (COUNTRY A: 40%, COUNTRY B: 10%)

Year	PBT — Country A	PBT — Country B	Total Tax	Effective Rate
0 (base)	100	100	50	25%
1 (B grows 15%/yr)	100	115	52	24%
3	100	152	55	22%

Cash tax rate vs. effective tax rate with deferral (Example 4, part 2): if Country A allows accelerated deductions that cut Year 0 cash taxes by 50% (clawed back in Year 1), the effective tax rate is completely unaffected by the timing shift — but the cash tax rate drops sharply in Year 0 (to 15%) before rebounding. The deferral is a one-time cash-timing event; the underlying economics (and the effective rate analysts use for earnings) don't change.

EXAMPLE 5 — JOHNSON & JOHNSON 2021 EFFECTIVE TAX RATE RECONCILIATION

Component	2021	2020	2019
US statutory rate	21.0%	21.0%	21.0%
International operations	(16.4)	(9.9)	(5.9)
US taxes on international income	6.7	2.7	1.8
Effective tax rate	8.3%	10.8%	12.7%

WORKED EXAMPLE — WALMART FY2022 (USD MILLIONS)

Total income before taxes: 18,696 · Total tax provision: 4,756 · Current tax provision: 5,515

Effective tax rate = 4,756 / 18,696 = 25.4%
Cash tax rate = 5,515 / 18,696 = 29.5%

Cash rate > effective rate here → company paid more in cash taxes than its income-statement provision, drawing down deferred tax liabilities

WORKED EXAMPLE — MULTI-JURISDICTION BLEND (NEUTRINO CORP.)

US (21%) + Ireland (12%), USD1,000 profit each → blended rate = 16.5%

Add South Korea (25%) in Year 2, all bases +25%: US 1,250 + Ireland 1,250 + Korea 500
Tax = (1,250×21%) + (1,250×12%) + (500×25%) = 262.50+150.00+125.00 = 537.50
Effective rate = 537.50 / 3,000 = 17.9% (adding a high-tax jurisdiction pulled the blend up)

Forecasting tip: a good starting point for future tax expense is a normalized rate based on operating income, excluding equity-method investee income and one-time/special items — especially when those items are volatile, since including them distorts the run-rate estimate.
An effective rate persistently below peers isn't necessarily a red flag, but it warrants closer attention when forecasting — check the tax reconciliation note for the specific drivers (jurisdictional mix, credits, valuation allowance changes) and assess their durability

4 · Presentation and Disclosure

Income tax notes are typically among the most extensive disclosures in a company's financial statements — covering the income statement provision breakdown, the statutory-to-effective rate reconciliation, and the full deferred tax asset/liability roll-forward.

EXHIBIT 20 — MICRON TECHNOLOGY FY2017 TAX PROVISION BUILD (USD MILLIONS)

Line	2017
Income before taxes	5,196
US federal tax at statutory rate (35%)	(1,819)
Foreign tax rate differential	1,571
Change in valuation allowance	64
Income tax provision (reported)	(114)

MICRON'S DEFERRED TAX POSITION (USD MILLIONS, FY2017)

Gross deferred tax assets: 3,782 (incl. USD3,426M in NOL/credit carryforwards)
Less valuation allowance: (2,321) — substantially all of US net DTAs
Net deferred tax assets: 1,461
Deferred tax liabilities: (712)
Net deferred tax position: USD749 million asset

NOL/credit carryforwards expire 2018–2037; aggregate US NOLs ≈ USD3.88 billion

Reading a large valuation allowance: a USD2,321 million allowance against USD3,782 million of gross DTAs doesn't necessarily signal pessimism about all future profits — it reflects the specific expiration schedule (2018–2037) and historical earnings volatility. As a company matures and sustains profitability, the allowance can be released, which reduces reported income tax expense in the release year — a real but non-recurring earnings boost analysts should flag.

Balance sheet placement: deferred tax assets are typically shown as a distinct noncurrent asset line; deferred tax liabilities are often folded into "other noncurrent liabilities" rather than broken out — always check the tax note for the full gross breakdown, since the face of the balance sheet may only show the net position or bury the liability in an aggregate line.
Indefinitely reinvested foreign earnings: companies (like Micron, with USD12.91 billion as of FY2017) can elect not to recognize a deferred tax liability on undistributed foreign earnings management intends to permanently reinvest abroad — a meaningful off-balance-sheet tax exposure if that intent ever changes.
Decomposing effective rate by geography: when a company discloses domestic vs. foreign pretax income and tax separately, analysts can back out each region's effective rate — useful for spotting structurally lower-taxed foreign operations or unusual swings driven by one jurisdiction.