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Tell current tax expense apart from deferred tax

CFA® Level I · Financial Statement Analysis · Analysis of Income Taxes · FSA.9.a

The idea

Tax expense reported in the income statement has two parts. Current tax is the amount payable on the period's taxable income under the tax rules. Deferred tax arises because accounting rules and tax rules recognise items in different periods: the same depreciation, provision or revenue can be taken at different times in each. Where a difference will reverse in future it creates a deferred tax asset or liability. Permanent differences, such as income that is never taxable, do not create deferred tax; they simply change the effective tax rate.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is current tax expense?

  1. The tax payable on the period's taxable income under the tax rules — correct
  2. The cumulative tax paid since inceptionWhy not: A running total over the company's life, not a charge for the period. The income statement reports one period at a time.
  3. The tax that will be payable in future periodsWhy not: That is deferred tax. The two together make up total tax expense, and separating them is the point of the distinction.

It is the period's actual liability to the tax authority, computed on taxable income rather than on accounting profit.

A harder one

Why does a temporary difference create deferred tax while a permanent difference does not?

  1. Because permanent differences are largerWhy not: Size is irrelevant. A tiny temporary difference creates deferred tax and a large permanent one does not.
  2. Because a temporary difference will reverse — correct
  3. Because permanent differences are not disclosedWhy not: They are disclosed, in the effective tax rate reconciliation, which exists largely to explain them.

The reversal creates a future tax consequence; a permanent difference never reverses, so there is nothing to record. Deferred tax exists to capture that future consequence, and where none exists there is only a gap between the statutory and effective rates.

The hardest tier

A company uses accelerated depreciation for tax and straight line for reporting. What arises in the early years?

  1. A deferred tax asset, because more tax was paid than the accounting profit impliesWhy not: The reverse — accelerated tax depreciation means *less* tax is paid early, so tax is owed later rather than prepaid.
  2. No deferred tax, since total depreciation is identicalWhy not: The totals do match over the asset's life, which is precisely what makes the difference temporary and therefore deferrable.
  3. A deferred tax liability, because taxable income is below accounting profit and the difference will reverse — correct

Tax is deferred rather than avoided. Later years reverse the position, and a company that keeps investing can carry the liability indefinitely without it ever being paid.

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