Employee compensation and income taxes - Deferred taxes reco...

Learning Outcomes

This article explains the recognition, measurement, and presentation of deferred taxes arising from employee compensation within the CFA Level 2 curriculum, including:

• distinguishing temporary differences created by share-based payments and post-employment benefits from permanent differences that never give rise to deferred tax items
• determining the tax base of employee compensation-related assets and liabilities and reconciling accounting expense with deductible amounts
• calculating deferred tax assets and liabilities when the timing of tax deductions differs from the recognition of compensation expense
• assessing when it is probable that deferred tax assets will be realized and when valuation allowances (or equivalent IFRS reductions) are required
• recording initial recognition, subsequent changes, and reversals of deferred tax balances in both the income statement and statement of financial position
• analyzing how excess tax deductions or shortfalls on share-based compensation affect equity, income tax expense, and effective tax rates
• interpreting common disclosure notes related to employee compensation, deferred tax assets, and valuation allowances in exam-style financial statement excerpts
• evaluating the impact of changes in assumptions about future taxable income on the quality and sustainability of reported earnings.

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are expected to understand the accounting and tax implications of employee compensation, especially how they create deferred tax items, with a focus on the following syllabus points:

• Recognize how employee compensation (including share-based and post-employment benefits) creates temporary differences leading to deferred tax assets and liabilities
• Explain the difference between temporary and permanent differences
• Understand the measurement and recognition of deferred tax assets and liabilities for employee compensation
• Apply the concept of valuation allowances when it is more likely than not that deferred tax assets will not be realized
• Analyze disclosures and assess the quality of reported income tax amounts

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which type of difference between accounting profit and taxable income gives rise to a deferred tax asset:
   1. Permanent difference
   2. Temporary difference
   3. Valuation allowance

2. When do firms recognize a valuation allowance against a deferred tax asset related to stock-based compensation?

3. True or false? A tax deduction for vested share-based compensation that exceeds the cumulative expense recognized under IFRS results in a deferred tax asset.

4. What immediate effect does a valuation allowance have on the statement of financial position?

Introduction

Employee compensation—in particular, share-based payments and post-employment benefits—can generate significant differences between the accounting profit reported to shareholders and taxable profit recognized by tax authorities. These differences lead to deferred tax assets or liabilities, influencing both the measurement of income and the quality of reported financial statements. Understanding when those tax implications arise and how valuation allowances are applied is essential for CFA Level 2 candidates.

Key Term: Temporary Difference
A difference between the carrying amount of an asset or liability for accounting purposes and its tax base, which will result in taxable or deductible amounts in the future.

Key Term: Deferred Tax Asset (DTA)
An amount recognized for deductible temporary differences (or unused tax losses/credits) expected to reduce future taxable income.

Key Term: Deferred Tax Liability (DTL)
An amount recognized for taxable temporary differences that will result in higher taxable income in the future.

Key Term: Valuation Allowance
A reserve against a deferred tax asset, reducing its carrying value if it is more likely than not that part or all of the asset will not be realized.

EMPLOYEE COMPENSATION AND TEMPORARY DIFFERENCES

Employee compensation expenses, such as share-based payments (e.g., stock options) or defined benefit pension costs, are typically deducted from accounting profit as they are earned or vested according to accounting standards. However, tax deductibility often follows different rules, usually tied to when compensation is exercised or paid, not when it is earned or accrued.

Recognition of Deferred Taxes

When the timing of expense recognition differs for tax and accounting purposes, a temporary difference arises:

• If expense is recognized sooner for accounting than for tax (e.g., pension expense accrued before payment), a deferred tax asset is created.
• If tax deduction occurs before the expense is recognized in the financial statements, a deferred tax liability is recorded.

Example Scenarios

• Share-Based Compensation: Under IFRS and US GAAP, the expense for employee stock options is recognized over the vesting period, even though a tax deduction is typically only permitted at exercise. The difference between cumulative book expense and tax deduction causes a temporary difference and results in a deferred tax asset.
• Post-Employment Benefits: Companies accrue pension or other benefit costs for accounting, while the tax deduction is recognized when the cash contribution is made, again creating a deferred tax asset.

Key Term: Permanent Difference
A difference between accounting profit and taxable profit that will never reverse. Permanent differences do not generate deferred tax assets or liabilities.

VALUATION ALLOWANCES ON DEFERRED TAX ASSETS

Accounting standards require that a deferred tax asset is recorded only to the extent that it is probable (more likely than not) that future taxable profit will be available to utilize the deductions. If recovery is uncertain, firms recognize a valuation allowance (US GAAP) or reduce the balance of the DTA directly (IFRS).

A valuation allowance reduces the deferred tax asset and increases income tax expense in the period it is set or increased. Typical situations requiring a valuation allowance include losses from operations, insufficient future taxable income, or expiration of stock options/loss carryforwards before use.

Worked Example 1.1

A firm grants equity-settled share options to employees, vesting over three years. Accounting expense recognized over vesting totals $500,000, but at exercise, the tax deduction is $400,000. Corporate tax rate is 25%. At the reporting date, future taxable income is uncertain.

Question: How do these temporary differences affect deferred tax balances, and when should a valuation allowance be recognized?

Answer:
As at the reporting date, a deferred tax asset of ($500,000 accounting expense – $400,000 tax deduction) × 25% = $25,000 should be recognized for the future expected benefit if sufficient taxable income is expected. If management determines it is more likely than not that $10,000 of the DTA will not be realized, a valuation allowance of $10,000 is recorded, reducing both the DTA and net income.

Exam Warning

A common mistake is to record deferred tax assets for permanent differences (such as expenses never deductible for tax), or to overlook the need for a valuation allowance when the company's ability to use future deductions is in doubt. Only temporary differences can generate deferred tax balances. Regularly assess whether deferred tax assets are recoverable.

Worked Example 1.2

A company accrues $200,000 of pension expense in the financial statements during the year, but only $100,000 of pension contributions are deductible for tax purposes that year. Corporate tax rate is 30%. The company projects sufficient profits in the future.

Question: What deferred tax item arises, and how is it measured?

Answer:
The company recognizes a deferred tax asset for the temporary difference of $100,000 ($200,000 accrued - $100,000 deductible). DTA = $100,000 × 30% = $30,000.

Revision Tip

Assess the likelihood of utilizing deferred tax assets via regular comparison of forecasted taxable income against available deductions or credits. Consider valuation allowances at each reporting date, especially for firms with recent losses.

Summary

Temporary differences between the tax treatment and accounting recognition of employee compensation give rise to deferred tax assets or liabilities. Share-based payments and post-employment benefits most commonly generate deferred tax assets, as accounting expense is recognized before the tax deduction is permitted. When there is uncertainty about future profits, a valuation allowance (under US GAAP) or a direct reduction (under IFRS) may be required, reducing the recognized deferred tax benefit. Only temporary, not permanent, differences are eligible for deferred tax recognition.

Key Point Checklist

This article has covered the following key knowledge points:

• Employee compensation can create temporary differences resulting in deferred tax assets or liabilities
• Temporary differences arise when accounting profit and taxable income differ in timing but not permanently
• Share-based payments and post-employment benefits most commonly result in deferred tax assets
• Deferred tax assets must be reviewed for recoverability; a valuation allowance is recognized if it is more likely than not that all or part will not be realized
• Permanent differences never generate deferred tax assets or liabilities

Key Terms and Concepts

• Temporary Difference
• Deferred Tax Asset (DTA)
• Deferred Tax Liability (DTL)
• Valuation Allowance
• Permanent Difference