1. Presenter’s name Presenter’s title dd Month yyyy
Chapter 11 Income Taxes
Presenter’s name
Presenter’s title
dd Month yyyy
LEARNING OUTCOMES
Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
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.
Determine the tax base of a company’s assets and liabilities.
Calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate.
Evaluate the impact of tax rate changes on a company’s financial statements and ratios.
Distinguish between temporary and permanent differences in pretax accounting income and taxable income.
Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
Compare a company’s deferred tax items.
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.
Identify the key provisions of and differences between income tax accounting under IFRS and U.S. GAAP.

2. accounting profits and taxable income
Amount reported in accordance with accounting standards (also known as pretax income).
Taxable Income:
Portion of income subject to income taxes under jurisdiction.
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
Pages 568–569
A company’s accounting profit is reported on its income statement in accordance with prevailing accounting standards. Accounting profit (also referred to as income before taxes or pretax income) does not include a provision for income tax expense.
A company’s taxable income is the portion of its income that is subject to income taxes under the tax laws of its jurisdiction.
Because of different guidelines for how income is reported on a company’s financial statements and how it is measured for income tax purposes, accounting profit and taxable income may differ.
Income tax payable (a liability) is calculated based on a company’s taxable income and tax rate. (In some cases, a company may have tax recoverable, an asset.)
Tax expense is an aggregate of the income tax payable (or recoverable in the case of a tax benefit) and any changes in deferred tax assets and liabilities.
Because of different guidelines for how income is reported on financial statements and how it is measured for income tax purposes, accounting profits and taxable income may differ.
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3. accounting profits and taxable income
When taxable income is greater than accounting profit:
Actual income taxes payable will exceed the financial accounting income tax expense.
Deferred tax assets arise.
When accounting profit is greater than taxable income:
Financial accounting income tax expense exceeds income taxes payable.
Deferred tax liabilities arise.
Tax base: Amount at which the asset or liability is valued for tax purposes.
Carrying amount: Amount at which the asset or liability is valued according to accounting principles.
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
LOS. 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.
LOS. Determine the tax base of a company’s assets and liabilities.
Page 569
When a company’s taxable income is greater than its accounting profit, its income taxes payable will be higher than what would have otherwise been the case had the income taxes been determined based on accounting profit.
Deferred tax assets arise when an excess amount is paid for income taxes (taxable income higher than accounting profit) and the company expects to recover the difference during the course of future operations.
Actual income taxes payable will thus exceed the financial accounting income tax expense (which is determined based on accounting profit).
Related to deferred tax assets is a valuation allowance, which is a reserve created against deferred tax assets. The valuation allowance is based on the likelihood of realizing the deferred tax assets in future accounting periods.
When a company’s accounting profit is greater than its taxable income, deferred tax liabilities arise.
In this case, financial accounting income tax expense exceeds income taxes payable.
A deficit amount is paid for income taxes, and the company expects to eliminate the deficit over the course of future operations.
The tax base of an asset or liability is the amount at which the asset or liability is valued for tax purposes, whereas the carrying amount is the amount at which the asset or liability is valued according to accounting principles. Differences between the tax base and the carrying amount also result in differences between accounting profit and taxable income.
Record a deferred tax liability if the book basis of the underlying asset (liability) is greater (less) than the tax basis of the underlying asset (liability).
Record a deferred tax asset if the book basis of the underlying asset (liability) is less (greater) than the tax basis of the underlying asset (liability).
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4. accounting profits and taxable income
Differences between accounting profit and taxable income can occur in several ways:
Revenues and expenses being recognized in one period for accounting purposes and a different period for tax purposes
Specific revenues and expenses being recognized for accounting purposes and not for tax purposes, or not recognized for accounting purposes but recognized for tax purposes
The carrying amount and tax base of assets and/or liabilities differ
Deductibility of gains and losses varying for accounting and income tax purposes
Tax loss carry-forwards
Adjustments of reported financial data from prior years not being recognized equally for accounting and tax purposes or recognized in different periods
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
LOS. 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.
Pages 569–574
Differences in accounting profit and taxable income are the result of the application of different rules. Such differences between accounting profit and taxable income (i.e., book/tax differences) can occur in several ways, including the following:
Revenues and expenses may be recognized in one period for accounting purposes and a different period for tax purposes.
Specific revenues and expenses may be either recognized for accounting purposes and not for tax purposes, or not recognized for accounting purposes but recognized for tax purposes.
The carrying amount and tax base of assets and/or liabilities may differ.
The deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes.
Subject to tax rules, tax losses of prior years might be used to reduce taxable income in later years, resulting in differences in accounting and taxable income (tax loss carry-forward).
Adjustments of reported financial data from prior years might not be recognized equally for accounting and tax purposes or might be recognized in different periods.
Differences that are temporary give rise to deferred tax assets or liabilities.
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5. accounting profits and taxable income: example
Assume a company owns equipment purchased at the beginning of the fiscal year for £20,000. For simplicity, assume a salvage value of £0 at the end of the equipment’s useful life. Assume a tax rate of 30%.
Accounting standards permit equipment to be depreciated on a straight-line basis over a 10-year period; annual depreciation will be £2,000 (£20,000 ÷ 10).
Tax standards in the jurisdiction specify that equipment should be depreciated on a straight-line basis over a 7-year period; annual depreciation will be £2,857 (£20,000 ÷ 7).
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
LOS. 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.
Page 569–574
The slide is excerpted from Example 11-1, page 571, and illustrates a common reason for book/tax differences.
Each fiscal year the depreciation expense related to the use of the equipment will, therefore, differ for tax and accounting purposes (tax base versus carrying amount), resulting in a difference between accounting profit and taxable income.
In total, the amount of depreciation on the financial statements will equal the amount for taxes. So, over time, the difference will reverse. This example focuses on the first three years, in which a deferred tax liability arises because tax depreciation exceeds accounting depreciation.
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6. accounting profits and taxable income: example
Period Ending 31 March (£ millions)
2006
2005
2004
Accounting profit prior to depreciation expense
£28,700
£17,280
£6,700
Depreciation expense
– 2,000
Profit before tax
26,700
15,280
4,700
Income taxes based on accounting profit before tax
£8,010
£4,584
£1,410
Taxable income prior to depreciation expense
– 2,857
Taxable income
25,843
14,423
3,843
Income taxes payable
7,753
4,327
1,153
Difference
£257
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
LOS. 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.
LOS. Determine the tax base of a company’s assets and liabilities.
Pages 569–574
This slide is excerpted from Example 11-1, page 571.
Assume a company owns equipment purchased at the beginning of the 2004 fiscal year for £20,000. For simplicity, assume a salvage value of £0 at the end of the equipment’s useful life. Assume a tax rate of 30%. For accounting, annual depreciation is £2,000 (£20,000 ÷ 10). For taxes, annual depreciation is £2,857 (£20,000 ÷ 7). Each fiscal year, the depreciation expense related to the use of the equipment will, therefore, differ for tax and accounting purposes (tax base versus carrying amount), resulting in a difference between accounting profit and taxable income.
In this example, the depreciation expense is the only difference between accounting profit and taxable profit.
The amount of the difference each year is £257, which is the 30% tax impact of the accounting depreciation (£2,000) minus tax depreciation (£2,857) = £857 × 30% = £257. In each year shown, the deferred tax liability increases by £257.
As shown, the tax expense based on accounting profit before tax is an aggregate of income tax payable and changes in deferred tax liabilities.
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7. accounting profits and taxable income: example (continued)
(£ millions)
2006
2005
2004
Income tax payable (based on tax accounting)
£7,753
£4,327
£1,153
Change in deferred tax liability
257
Income tax (based on financial accounting)
£8,010
£4,584
£1,410
(£ millions)
2006
2005
2004
Equipment value for accounting purposes (carrying amount)
£14,000
£16,000
£18,000
Equipment value for tax purposes (tax base)
11,429
14,286
17,143
Difference
£2,571
£1,714
£857
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
LOS. 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.
LOS. Determine the tax base of a company’s assets and liabilities.
Pages 569–574
Top table: Income tax based on financial accounting is the aggregate of the income taxes payable and the change in the deferred tax liability.
Bottom table: At each year, the balance of the deferred tax liability is equivalent to the carrying value for accounting purposes minus the tax base times the tax rate.
In each fiscal year, the carrying amount of the equipment exceeds its tax base. For tax purposes, therefore, the asset tax base is less than its carrying value under financial accounting principles. The difference results in a deferred tax liability.
The comparison of the tax base and carrying amount of equipment shows what the deferred tax liability should be on a particular balance sheet date.
2004: £(18,000 – 17,143) × 30% = £257
2005: £(16,000 – 14,286) × 30% = £514
2006: £(14,000 – 11,429) × 30% = £771
In each fiscal year, only the change in the deferred tax liability is included in the calculation of the income tax expense reported on the income statement prepared for accounting purposes.
£2,571
× 30% = £771
£1,714
× 30% = £514
£857
× 30% = £257
Amount of deferred tax liability
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8. Tax base of asset: example solution
Company ABC capitalized development costs of €3 million and amortized €500,000 of this amount during the year. For tax purposes, amortization of 25% per year is allowed.
Carrying amount is (€3,000,000 – €500,000) = €2,500,000.
Tax base is [€3,000,000 – (25% × €3,000,000)] = €2,250,000.
Company ABC incurred €500,000 in research costs, all of which were expensed in the current fiscal year for financial reporting purposes. Assume that applicable tax legislation requires research costs to be expensed over a four-year period rather than all in one year.
Carrying amount is €0.
Tax base is (€500,000 – €500,000/4) = €375,000.
LOS. Determine the tax base of a company’s assets and liabilities.
Pages 574–576
The tax base of an asset is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized and the company recovers the carrying amount of the asset.
The slide follows Example 11-2, page 574, in text.
In the first case, the amortization allowed by the tax authorities exceeds the amortization accounted for based on accounting rules. Therefore, the carrying amount of the asset exceeds its tax base.
The carrying amount is (€3,000,000 – €500,000) = €2,500,000.
The tax base is [€3,000,000 – (25% × €3,000,000)] = €2,250,000.
This example is similar to the previous example using accelerated versus straight-line depreciation.
The second case assumes that research costs will result in future economic benefits for the company; if this were not the case, creation of a deferred tax asset or liability would not be allowed.
The carrying amount is €0 because the full amount has been expensed for financial reporting purposes in the year in which it was incurred.
The tax base of the asset is (€500,000 – €500,000/4) = €375,000.
The tax base of research costs exceeds their carrying amount.
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9. Tax base of liability: example
Company ABC received in advance interest of €300,000. The applicable tax legislation requires that interest be recognized as part of taxable income on the date of receipt of payment.
Company ABC recognized €10 million for rent received in advance from a lessee for an unused warehouse building. Rent received in advance is deferred for accounting purposes but taxed on a cash basis.
Company ABC made donations of €100,000 in the current fiscal year. The donations were expensed for financial reporting purposes but are not tax deductible based on applicable tax legislation.
Question: What are the tax base and carrying amounts for each item?
LOS. Determine the tax base of a company’s assets and liabilities.
Pages 576–578
The tax base of liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future. With respect to payments from customers received in advance of providing the goods and services, the tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in future.
The slide follows Example 11-3, page 576. The order has been changed to present the two examples of temporary book/tax differences first.
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10. Tax base of liability: example solution
Company ABC received in advance interest of €300,000. The applicable tax legislation requires that interest be recognized as part of taxable income on the date of receipt of payment.
Carrying amount of the liability is €300,000.
Tax base is €0.
Company ABC recognized €10 million for rent received in advance from a lessee for an unused warehouse building. Rent received in advance is deferred for accounting purposes but taxed on a cash basis.
Carrying amount of the liability is €10 million.
Company ABC made donations of €100,000 in the current fiscal year. The donations were expensed for financial reporting purposes but are not tax deductible based on applicable tax legislation.
No liability, tax base is €0, difference is permanent.
LOS. Determine the tax base of a company’s assets and liabilities.
Pages 576–578
The tax base of liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future. With respect to payments from customers received in advance of providing the goods and services, the tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in future.
The slide follows Example 11-3, page 576, in text. The order has been changed to present the two examples of temporary book/tax differences first.
Interest received in advance:
For accounting, interest is recognized in income in the financial period in which it is deemed to have been earned. Interest received in advance gives rise to liability (unearned income) until the period in which it is earned.
Based on the information provided, for tax purposes, interest is included in taxable income in the financial year received. Because the full €300,000 is included in taxable income in the current fiscal year, the tax base is €300,000 – 300,000 = €0.
Rent received in advance:
Similar to interest received in advance, the carrying amount of rent received in advance would be €10,000,000 reported as a liability (unearned rent revenue). The tax base is €0 because the full amount is included in taxable income in the current fiscal year.
Donations:
The amount of €100,000 was immediately expensed on ABC’s income statement; therefore, there is no liability. Carrying amount is €0. Tax legislation does not allow donations to be deducted for tax purposes, so the tax base of the donations equals the carrying amount. Note that although the carrying amount and tax base are the same, the difference in the treatment of donations for accounting and tax purposes (expensed for accounting purposes, but not deductible for tax purposes) represents a permanent difference (a difference that will not be reversed in future).
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11. tax rate changes
Measurement of deferred tax assets and liabilities is based on current tax law.
If there are subsequent changes in tax laws or new income tax rates, existing deferred tax assets and liabilities must be adjusted for the effects of these changes.
Resulting effects of the changes are included in determining accounting profit in the period of change.
LOS. Evaluate the impact of tax rate changes on a company’s financial statements and ratios.
Pages 578–579
The measurement of deferred tax assets and liabilities is based on current tax law.
If there are subsequent changes in tax laws or new income tax rates, existing deferred tax assets and liabilities must be adjusted for the effects of these changes.
The resulting effects of the changes are also included in determining accounting profit in the period of change.
When income tax rates change, the deferred tax assets and liabilities are adjusted to the new tax rate.
If income tax rates increase, deferred taxes (that is, the deferred tax assets and liabilities) will also increase.
Likewise, if income tax rates decrease, deferred taxes will decrease.
A decrease in tax rates decreases deferred tax liabilities, which reduces future tax payments to the taxing authorities.
A decrease in tax rates will also decrease deferred tax assets, which reduces their value toward the offset of future tax payments to the taxing authorities.
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12. tax rate changes: Example
(£ Millions)
2006
2005
2004
Equipment value for accounting purposes (carrying amount)
£14,000
£16,000
£18,000
Equipment value for tax purposes (tax base)
11,429
14,286
17,143
Difference
£2,571
£1,714
£857
Amount of deferred tax liability
£2,571
× 30% = £771
£1,714
× 30% = £514
£857
× 30% = £257
LOS. Evaluate the impact of tax rate changes on a company’s financial statements and ratios.
Pages 578–579
This example modifies the first example from earlier in this presentation.
At each year, the balance of the deferred tax liability is equivalent to the carrying value for accounting purposes minus the tax base times the tax rate.
In each fiscal year, the carrying amount of the equipment exceeds its tax base. For tax purposes, therefore, the asset tax base is less than its carrying value under financial accounting principles. The difference results in a deferred tax liability.
The comparison of the tax base and carrying amount of equipment shows what the deferred tax liability should be on a particular balance sheet date.
After the tax rate change in 2006, the amount of the deferred tax liability is (£14,000 – £11,429) × 25% = £643.
The amount of the reduction is £128, rounded (£771 – £643).
The company’s provision for income tax expense is also affected by the change in tax rates. Taxable income for 2006 will now be taxed at a rate of 25%. The benefit of the 2006 accelerated depreciation tax shield is now only £214 (£857 × 25%) instead of the previous £257 (a reduction of £43). In addition, the reduction in the beginning carrying value of the deferred tax liability for 2006 (the year of change) further reduces the income tax expense for The reduction in income tax expense attributable to the change in tax rate is £85: (30% – 25%) × £1,714 = £85. Note that these two components together account for the reduction in the deferred tax liability (£43 + £85 = £128).
Assume that the taxing authority changed the income tax rate to 25% for 2006.
Amount of deferred tax liability
£2,571 × 25% = £643
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13. temporary and permanent differences
Creation of a deferred tax asset or liability occurs
Only if the book/tax difference is temporary (i.e., if it reverses itself at some future date) and
Only to such an extent that the balance sheet item is expected to create future economic benefits or costs for the company.
Permanent differences between tax and financial reporting of revenue (expenses) are differences that will not be reversed at some future date.
They do not give rise to deferred tax.
They result in a difference between the company’s effective tax rate and statutory tax rate.
Permanent differences typically include
Income or expense items not allowed by tax legislation
Tax credits for some expenditures that directly reduce taxes.
LOS. Distinguish between temporary and permanent differences in pretax accounting income and taxable income.
Pages 579–584
The creation of a deferred tax asset or liability occurs only if the book/tax difference is temporary (i.e., if it reverses itself at some future date) and to such an extent that the balance sheet item is expected to create future economic benefits for the company.
IFRS and U.S. GAAP both prescribe the balance sheet method for recognition of deferred tax. This balance sheet method focuses on the recognition of a deferred tax asset or liability should there be a temporary difference between the carrying amount and tax base of balance sheet items.
Permanent differences are differences between tax and financial reporting of revenue (expenses) that will not be reversed at some future date (e.g., interest on municipal bonds in the United States is included in accounting income but is not taxed).
Because they will not be reversed at a future date, these differences do not give rise to deferred tax. These items typically include
Income or expense items not allowed by tax legislation and
Tax credits for some expenditures that directly reduce taxes.
Because no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s effective tax rate and statutory tax rate.
Copyright © 2013 CFA Institute

14. temporary and permanent differences: examples
Reason for Difference
Type of Difference?
Items of income recognized in financial reports are not taxable.
Permanent
Expenses recognized in financial reports are not deductible for tax purposes.
Rate of depreciation or amortization differs between financial reports and taxes.
Temporary
Timing of expensing an expenditure differs between financial reports and taxes.
Timing of recognizing revenue differs between financial reports and taxes.
LOS. Distinguish between temporary and permanent differences in pretax accounting income and taxable income.
Pages 574–578, 581–583
Items of income recognized in financial reports are not taxable—for example, dividends from a subsidiary are not taxable.
Expenses recognized in financial reports are not deductible for tax purposes.
For example, tax deduction allowed for bad debt expense is less than recognized in financial reports.
For example, donations recognized as expense in financial report are not tax deductible.
Rate of depreciation or amortization differs between financial reports and taxes. For example, development costs are amortized more slowly for financial reporting.
Timing of expensing an expenditure differs between financial reports and taxes. For example, research costs are expensed for financial reports but recognized over a period of time for taxes.
Timing of recognizing revenue differs between financial reports and taxes. For example, revenue is taxable when cash is received but it is recognized in the financial reports when it is earned.
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15. Treatment of Temporary Differences
Balance Sheet Item
Carrying Amount vs. Tax Base
Results in Deferred Tax Asset/Liability
Asset
Carrying amount > Tax base
Deferred tax liability
Carrying amount < Tax base
Deferred tax asset
Liability
LOS. Describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.
LOS. 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.
Page 581
The slide shows Exhibit 11-1, page 581.
The slide summarizes how differences between the tax bases and carrying amounts of assets and liabilities give rise to deferred tax assets or deferred tax liabilities.
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16. Valuation allowance Valuation allowance A contra-asset account.
A reserve created against deferred tax assets based on the likelihood of realizing the benefit of the deferred tax assets in future accounting periods.
Will realize the benefit if in a tax-paying position.
Deferred tax assets must be assessed at each balance sheet date
If there are doubts that the benefits will be realized, then the carrying amount is reduced to the expected recoverable amount.
Reduces deferred tax asset
Reduces income
Should circumstances subsequently change and suggest that the future will lead to recovery of the deferral, the reduction may be reversed.
Reversal increases deferred tax asset and income.
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
Pages 569, 586
Related to deferred tax assets is a valuation allowance, which is a reserve created against deferred tax assets. The valuation allowance is based on the likelihood of realizing the deferred tax assets in future accounting periods.
Deferred tax assets must be assessed at each balance sheet date.
If there is any doubt whether the deferral will be recovered, then the carrying amount should be reduced to the expected recoverable amount.
Should circumstances subsequently change and suggest the future will lead to recovery of the deferral, the reduction may be reversed.
Under U.S. GAAP, deferred tax assets are reduced by creating a valuation allowance.
Establishing a valuation allowance reduces the deferred tax asset and income in the period in which the allowance is established.
Should circumstances change to such an extent that a deferred tax asset valuation allowance may be reduced, the reversal will increase the deferred tax asset and operating income. Because of the subjective judgment involved, an analyst should carefully scrutinize any such changes.
Copyright © 2013 CFA Institute

17. Valuation allowance: example disclosure
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
LOS. 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.
Pages
Slide shows excerpt from Micron Technology Inc.’s footnote to its financial statements presenting its deferred tax assets.
This slide is part of Exhibit 11-3, page 590.
As shown, the company discloses a valuation allowance of $915 million against total deferred tax assets of $1,547 million in 2006.
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18. Valuation allowance: example disclosure
“The Company has a valuation allowance against substantially all of its U.S. net deferred tax assets. As of August 31, 2006, the Company had aggregate U.S. tax net operating loss carryforwards of $1.7 billion and unused U.S. tax credit carryforwards of $164 million. The Company also has unused state tax net operating loss carryforwards of $1.4 billion and unused state tax credits of $163 million. During 2006, the Company utilized approximately $1.1 billion of its U.S. tax net operating loss carryforwards as a result of IMFT, MP Mask and related transactions. Substantially all of the net operating loss carryforwards expire in 2022 to 2025 and substantially all of the tax credit carryforwards expire in 2013 to 2026.” Excerpt from notes to financial statements Micron Technology (2006), 10-K
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
LOS. 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.
Pages
The slide shows an excerpt from Micron Technology Inc.’s (MU) footnote to its financial statements presenting its deferred tax assets.
This slide is part of Exhibit 11-4, page 591.
Does the existence of the valuation allowance have any implications concerning MU’s future earning prospects?
It possibly indicates that the company does not expect to generate enough taxable profits to utilize the deferred tax assets; however, the company has been profitable in recent years.
The note discloses that it utilized approximately $1.1 billion of net operating loss carry-forward.
MU’s deferred tax assets expire 2022–2025 for the net operating loss carry-forwards and 2013–2026 for the tax credit carry-forwards.
Because the company is relatively young, it is likely that most of these expirations occur toward the end of that period.
Because cumulative federal net operating loss carry-forwards total $1.7 billion, the valuation allowance could imply that MU is not reasonably expected to earn $1.7 billion over the next 20 years.
However, the company was profitable in 2006 and the reduction in the valuation allowance from 2005 to 2006 may signal improved expectations.
How did the reduction in the valuation allowance impact the financial statements? See next slide.
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19. Valuation allowance: example disclosure
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
LOS. 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.
Pages 591–595
The slide shows an excerpt from Micron Technology Inc.’s (MU) footnote to its financial statements presenting the reconciliation between its statutory tax rate and the amount of the income tax provision shown on its income statement.
This slide is an excerpt from Exhibit 11-4, page 591.
How did the reduction in the valuation allowance impact the financial statements?
The disclosure shows that in 2006, the reduction in the valuation allowance reduced the income tax provision as reported on the income statement by $103 million.
A lower income tax provision results in higher reported net income.
Actual taxable income and income taxes are not affected by a valuation allowance. The valuation allowance is established for financial reporting.
Additional potential reductions in the valuation allowance could similarly reduce reported income taxes in future years.
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20. income statement: Example
Portions omitted
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
LOS. 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.
Pages 594–595
The slide shows an excerpt from Micron Technology Inc.’s income statement.
A lower income tax provision results in higher reported net income on the financial statements.
Actual taxable income and income taxes are not affected by a valuation allowance. The valuation allowance is established for financial reporting.
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21. Valuation allowance: example disclosure
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
LOS. 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.
Pages , 594–595
The slide is a repeat of an earlier slide, moving the discussion to the net deferred tax assets.
The slide shows an excerpt from Micron Technology Inc.’s footnote to its financial statements presenting its deferred tax assets.
This excerpt is part of Exhibit 11-3, page 590.
As shown, the company’s net deferred tax assets were $47 million at the end of Where does this appear on the company’s balance sheet? See next slide.
Copyright © 2013 CFA Institute

22. Valuation allowance: example disclosure
LOS. Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.
LOS. 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.
Pages 590–591, 594–595
The slide shows an excerpt from Micron Technology Inc.’s footnote to its financial statements presenting its deferred tax assets. This disclosure follows immediately from the previous slide.
This excerpt is part of Exhibit 11-3, page 590.
As shown, the company’s net deferred tax assets were $47 million at the end of The disclosure shows where they are reported (i.e., $26 million as current deferred tax assets, etc.).
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23. balance sheet: Example
LOS. 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.
Pages 589–595
The slide shows the asset portion of Micron’s balance sheet, which includes, as was indicated in the footnote, $26 million of current deferred tax assets in 2006 and $49 million noncurrent deferred income tax assets.
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24. balance sheet: example (CONTINUED)
LOS. 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.
Pages 589–595
The slide shows the liabilities and equity portion of Micron’s balance sheet, which includes, as was indicated in the footnote, $28 million of noncurrent deferred income tax liabilities.
Under what circumstances should the analyst consider MU’s deferred tax liability as debt or as equity? Under what circumstances should the analyst exclude MU’s deferred tax liability from both debt and equity when calculating the debt-to-equity ratio?
The analyst should classify the deferred tax liability as debt if the liability is expected to reverse with subsequent tax payment.
If the liability is not expected to reverse, there is no expectation of a cash outflow and the liability should be treated as equity. By way of example, future company losses may preclude the payment of any income taxes or changes in tax laws could result in taxes that are never paid.
The deferred tax liability should be excluded from both debt and equity when both the amounts and timing of tax payments resulting from the reversals of temporary differences are uncertain.
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25. Comparison of IFRS and U.S. GAAP
Topic
IFRS
U.S. GAAP
Revaluation of plant, property, and equipment and intangible assets
Deferred tax recognized in equity
Not applicable because revaluation is prohibited.
Measurement of deferred taxes
Tax rates and tax laws that have been enacted or substantively enacted
Use of substantively enacted rates is not permitted. Tax rate and tax laws used must have been enacted
LOS. Identify the key provisions of and differences between income tax accounting under IFRS and U.S. GAAP.
Pages 595–598
Although IFRS and U.S. GAAP follow similar conventions on many tax issues, there are some notable differences.
This slide highlights a difference with respect to a particular application (revaluation) and with respect to measurement of deferred taxes.
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26. Comparison of IFRS and U.S. GAAP
Topic
IFRS
U.S. GAAP
Recognition of deferred tax assets
Recognized if it is probable (more likely than not) that sufficient taxable profit will be available against which the temporary difference can be utilized
Recognized in full but is then reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized
Presentation of deferred tax assets and liabilities: Current vs. noncurrent
Classified net as noncurrent on the balance sheet, with supplemental note disclosure
Classified as either current or noncurrent, based on the classification of the related nontax asset or liability for financial reporting
LOS. Identify the key provisions of and differences between income tax accounting under IFRS and U.S. GAAP.
Pages 595–598
Although IFRS and U.S. GAAP follow similar conventions on many tax issues, there are some notable differences.
This slide highlights a difference with respect to recognition of deferred tax assets and presentation of deferred tax assets.
For the current/noncurrent presentation:
IFRS supplemental note disclosure includes (1) the components of the temporary differences and (2) amounts expected to be recovered within 12 months and more than 12 months from the balance sheet date.
Under U.S. GAAP, tax assets or liabilities not associated with an underlying asset or liability are classified based on the expected reversal period.
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27. Summary
Differences between the recognition of revenue and expenses for tax and accounting purposes may result in taxable income differing from accounting profit.
Temporary differences between accounting profit and taxable income (i.e., differences that will reverse over time) give rise to deferred tax assets and/or liabilities.
Permanent differences between accounting profit and taxable income (i.e., differences that will not be reversed at some future date) do not give rise to a deferred tax asset or liability.
Deferred tax assets must be assessed for their prospective recoverability. If it is probable that they will not be recovered at all or partly, the carrying amount is reduced.
Under U.S. GAAP, reduction of deferred tax assets is done through the use of a valuation allowance (a contra-account), with potential for subsequent reversal.
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