Master CFA Level I deferred tax questions with worked examples covering tax bases, temporary differences, and when to recognize deferred tax assets or liabilities.

How to Solve CFA Level I Deferred Tax Questions: Tax Bases, Temporary Differences, and DTA or DTL

If you understand the income statement and balance sheet but get confused about whether a difference creates a deferred tax asset or liability, you're not alone. CFA Level I deferred tax questions consistently trip up candidates who haven't mastered the mechanical approach to identifying taxable versus deductible temporary differences.

This tutorial walks through five concrete points that will help you solve these questions systematically: defining carrying amounts and tax bases with reliable sign rules, distinguishing temporary from permanent differences, working through common scenarios like accelerated depreciation, reconciling tax expense components, and handling reversals and rate changes.

The CFA Institute's 2026 curriculum emphasizes that candidates must be able to "contrast accounting profit, taxable income, taxes payable, and income tax expense and temporary versus permanent differences," making this a crucial skill for exam success.

Understanding Carrying Amount and Tax Base: The Foundation

Defining Carrying Amount and Tax Base

The carrying amount (also called book value) is an asset's or liability's value on the financial statements under accounting standards. The tax base is the amount attributed to that same asset or liability for tax purposes.

For assets, the tax base represents the amount that will be deductible against future taxable income when the asset's economic benefits are realized. If those benefits aren't taxable, the tax base equals the carrying amount.

For liabilities, the tax base is the carrying amount minus any amounts that will be deductible for tax purposes in future periods.

Reliable Sign Table for Temporary Differences

Here's the systematic approach to determine whether a temporary difference creates a deferred tax asset (DTA) or deferred tax liability (DTL):

Item Type	Condition	Result
Assets	Carrying Amount > Tax Base	DTL (Taxable temporary difference)
Assets	Tax Base > Carrying Amount	DTA (Deductible temporary difference)
Liabilities	Tax Base > Carrying Amount	DTL (Taxable temporary difference)
Liabilities	Carrying Amount > Tax Base	DTA (Deductible temporary difference)

Memory aid: For assets, if the book value is higher than the tax base, you'll owe more tax in the future (DTL). For liabilities, if you can deduct more for tax purposes (higher tax base), you'll owe more tax later (DTL).

The calculation is always: Temporary Difference × Tax Rate = DTA or DTL

Worked Example: Equipment Depreciation

IFRS Framework Assumptions: Equipment cost €100,000, 5-year useful life, 25% tax rate.

Accounting: Straight-line depreciation = €20,000 per year
Tax: Accelerated depreciation = €30,000 in Year 1

End of Year 1:

Carrying amount: €100,000 - €20,000 = €80,000
Tax base: €100,000 - €30,000 = €70,000
Temporary difference: €80,000 - €70,000 = €10,000 (Carrying amount > Tax base for asset)
Result: DTL = €10,000 × 25% = €2,500

This makes economic sense: you took €10,000 more depreciation for tax purposes than accounting, so you'll have less tax depreciation available in future years, leading to higher future taxable income.

Distinguishing Permanent from Temporary Differences

Temporary Differences

Temporary differences arise when the tax base of an asset or liability differs from its carrying amount, and these differences will reverse in future periods. They create deferred tax assets or liabilities because the tax effects occur in different periods. Common examples:

Different depreciation methods (accelerated tax vs. straight-line accounting)
Warranty provisions (expensed immediately for accounting, deductible when paid for tax)
Bad debt provisions (estimated for accounting, deductible when written off for tax)
Accrued expenses deductible only when paid

Permanent Differences

Permanent differences arise when income or expenses are recognized for either accounting or tax purposes, but never both. They affect the effective tax rate but create no deferred tax effects. Original examples:

Municipal bond interest: €10,000 interest income appears in accounting profit but is never taxable under most tax codes
Entertainment expenses: €5,000 client entertainment expense reduces accounting profit but is permanently non-deductible for tax
Tax penalties: €2,000 penalty expense reduces accounting profit but cannot be deducted for tax purposes
Life insurance premiums on key employees where the company is the beneficiary

Impact on Effective Tax Rate

Example with permanent differences:

Pretax accounting income: €100,000
Add: Non-deductible entertainment: €5,000
Less: Tax-exempt interest: €10,000
Taxable income: €95,000
Tax at 25% statutory rate: €23,750
Effective tax rate: €23,750 ÷ €100,000 = 23.75% (differs from 25% statutory rate)

The permanent differences changed the effective rate, but created no deferred tax assets or liabilities.

Working Through Common Scenarios

Scenario 1: Accelerated Tax Depreciation (US GAAP Framework)

Assumptions: Equipment cost $120,000, 3-year life, 30% tax rate. Year 1:

Accounting depreciation (straight-line): $40,000
Tax depreciation (accelerated): $60,000

Calculations:

Carrying amount end of Year 1: $80,000
Tax base end of Year 1: $60,000
Temporary difference: $20,000 (Carrying amount > Tax base)
DTL created: $20,000 × 30% = $6,000

Why this creates a DTL: The company received $20,000 more tax depreciation than accounting depreciation in Year 1. In future years, tax depreciation will be $20,000 less than accounting depreciation, creating additional taxable income and higher tax payments.

Scenario 2: Accrued Expense Deductible on Payment (IFRS Framework)

Assumptions: €50,000 warranty provision accrued, 25% tax rate. Warranty costs are deductible for tax only when actually paid. Year 1 (Provision created):

Accounting: €50,000 warranty expense reduces profit
Tax: €0 deduction allowed (not yet paid)
Liability carrying amount: €50,000
Liability tax base: €50,000 - €50,000 (future deductible) = €0
Temporary difference: €50,000 (Carrying amount > Tax base for liability)
DTA created: €50,000 × 25% = €12,500

Year 2 (Warranty claims paid):

Accounting: €35,000 cash paid reduces liability to €15,000
Tax: €35,000 deduction taken
The DTA reverses by €35,000 × 25% = €8,750

Why this creates a DTA: The company took the accounting expense early but can't deduct it for tax until paid. This creates a future tax benefit when the cash outflow occurs and becomes tax-deductible.

Reconciling Current Tax, Deferred Tax, and Total Income Tax Expense

Understanding how the three components of tax expense work together is essential for mastering deferred tax calculations, especially when combined with other Financial Statement Analysis topics you'll encounter in your 6-week FSA study plan.

The Three Components

Total Income Tax Expense = Current Tax Expense + Deferred Tax Expense (Net)

Where:

Current Tax Expense = Taxable Income × Tax Rate
Deferred Tax Expense = Increase in DTL - Increase in DTA

Comprehensive Example (US GAAP Framework)

Company ABC Year 1 Facts:

Pretax accounting income: $200,000
Tax depreciation exceeds accounting by: $30,000
Warranty provision (not yet paid): $20,000
Tax rate: 30%

Step 1: Calculate Taxable Income

Pretax accounting income: $200,000
Add: Warranty provision (not deductible yet): $20,000
Less: Excess tax depreciation: $30,000
Taxable income: $190,000

Step 2: Calculate Current Tax

Current tax payable = $190,000 × 30% = $57,000

Step 3: Calculate Deferred Tax Effects

Depreciation temporary difference: $30,000 → DTL = $9,000
Warranty temporary difference: $20,000 → DTA = $6,000
Net deferred tax expense = $9,000 - $6,000 = $3,000

Step 4: Calculate Total Tax Expense

Total income tax expense = $57,000 + $3,000 = $60,000

Verification:

If there were no temporary differences, tax expense would be $200,000 × 30% = $60,000 ✓

Journal Entry

``` Dr. Income Tax Expense $60,000 Cr. Taxes Payable $57,000 Cr. Deferred Tax Liability $9,000 Dr. Deferred Tax Asset $6,000 ```

Tax Rate Changes and Reversal Effects

Impact of Tax Rate Changes

When enacted tax rates change, existing deferred tax assets and liabilities must be remeasured immediately. The adjustment flows through continuing operations tax expense.

Under IFRS IAS 12, entities can use substantively enacted rates, while US GAAP requires fully enacted rates. This difference can affect the timing of when rate changes are reflected in the financial statements.

Example (IFRS Framework):

Existing DTL at 25% rate: €20,000 × 25% = €5,000
New enacted rate: 30%
Remeasured DTL: €20,000 × 30% = €6,000
Additional tax expense: €1,000

Framework differences:

IFRS: Uses enacted or substantively enacted rates
US GAAP: Uses only enacted rates

Reversal Pattern Example

3-Year Equipment Depreciation (IFRS Framework, 25% tax rate):

Year	Accounting Depreciation	Tax Depreciation	Temporary Difference	DTL Balance	Change in DTL
1	€10,000	€15,000	€5,000	€1,250	+€1,250
2	€10,000	€10,000	€0	€1,250	€0
3	€10,000	€5,000	-€5,000	€0	-€1,250

Tax expense impact:

Year 1: Increases tax expense by €1,250 (DTL creation)
Year 2: No effect on tax expense
Year 3: Reduces tax expense by €1,250 (DTL reversal)

Multiple Choice Practice Questions

Question 1

A company uses straight-line depreciation for financial reporting and accelerated depreciation for tax purposes. In Year 1, accounting depreciation was $40,000 and tax depreciation was $60,000. The tax rate is 25%. What is the deferred tax effect?

A) $5,000 deferred tax asset
B) $5,000 deferred tax liability
C) $15,000 deferred tax asset
D) $15,000 deferred tax liability

Answer: B) $5,000 deferred tax liability Explanation: Temporary difference = $60,000 - $40,000 = $20,000. Tax depreciation > Accounting depreciation means carrying amount > tax base, creating a DTL = $20,000 × 25% = $5,000. Distractors: A assumes the sign is wrong. C and D use the wrong base ($60,000 × 25%).

Question 2

Under IFRS, a company recognizes a €30,000 warranty provision. Warranty costs are tax-deductible only when paid. The tax rate is 30%. What deferred tax effect results?

A) €9,000 deferred tax asset
B) €9,000 deferred tax liability
C) €21,000 deferred tax asset
D) No deferred tax effect

Answer: A) €9,000 deferred tax asset Explanation: Liability carrying amount (€30,000) > tax base (€0), creating a deductible temporary difference and DTA = €30,000 × 30% = €9,000. Distractors: B reverses the sign. C uses the wrong base (€30,000 - €9,000). D ignores that this creates a temporary difference.

Question 3

A company has pretax income of $100,000, including $10,000 of municipal bond interest that is permanently non-taxable. Tax depreciation exceeds book depreciation by $15,000. The tax rate is 35%. What is the current tax payable?

A) $29,750
B) $26,250
C) $31,500
D) $35,000

Answer: B) $26,250 Explanation: Taxable income = $100,000 - $10,000 (non-taxable) - $15,000 (excess tax depreciation) = $75,000. Current tax = $75,000 × 35% = $26,250. Distractors: A uses pretax income without adjustments. C ignores the municipal bond interest. D applies the tax rate to pretax income.

Question 4

If the tax rate increases from 25% to 30%, what happens to an existing deferred tax liability with an underlying temporary difference of $80,000?

A) It decreases by $1,000
B) It increases by $1,000
C) It decreases by $4,000
D) It increases by $4,000

Answer: D) It increases by $4,000 Explanation: Original DTL: $80,000 × 25% = $20,000. New DTL: $80,000 × 30% = $24,000. Increase = $4,000. Distractors: A and C assume a decrease. B uses the change in rate (5%) rather than recalculating the full amount.

Question 5

Which of the following creates a permanent difference?

A) Using different depreciation methods for tax versus financial reporting
B) Accruing warranty expenses that are deductible when paid
C) Receiving tax-exempt municipal bond interest income
D) Creating bad debt provisions deductible when accounts are written off

Answer: C) Receiving tax-exempt municipal bond interest income Explanation: Municipal bond interest is included in accounting income but is permanently exempt from taxation, creating a permanent difference that affects the effective tax rate but creates no deferred tax. Distractors: A, B, and D all create temporary differences that reverse over time.

These practice questions align with the analytical approach you'll need across all CFA Level I topics. Consider building similar problem-solving skills in Quantitative Methods and Ethics to create a comprehensive study foundation.

Frequently Asked Questions

How do I remember whether to create a DTA or DTL?

Focus on the economic reality: if you'll pay more tax in the future due to the difference, it's a DTL. If you'll pay less tax in the future, it's a DTA. For assets, when book value exceeds tax base, you have "less depreciation left" for tax purposes, meaning higher future taxable income and a DTL.

What's the difference between IFRS and US GAAP for deferred taxes?

The key differences are: (1) IFRS uses enacted or substantively enacted tax rates while US GAAP requires enacted rates, (2) IFRS recognizes DTAs only when realization is probable while US GAAP recognizes the full DTA then applies a valuation allowance if realization is not "more likely than not," and (3) all deferred taxes are classified as non-current under IFRS while US GAAP classifies based on the underlying asset or liability.

Why don't permanent differences create deferred taxes?

Permanent differences never reverse—the tax treatment difference is permanent. Since deferred taxes represent future tax consequences of current differences, and permanent differences have no future reversal, they create no deferred tax assets or liabilities. They only affect the current period's effective tax rate.

How do rate changes affect existing deferred tax balances?

When tax rates change, all existing DTAs and DTLs must be remeasured using the new enacted rate, with the adjustment flowing through tax expense in the current period. This can create significant one-time impacts when rates change substantially.

Should I memorize the formulas or understand the concepts?

Understand the concepts first, then use the mechanical rules as backup. The economic logic (future tax consequences) helps you solve complex scenarios, while the sign table gives you quick answers for straightforward questions. Both approaches complement each other in CFA Level I deferred tax questions.

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