Updated for the 2026-2027 CFA® Level I curriculum.
A deferred tax asset or liability exists because accounting rules and tax rules do not always recognize revenue and expenses in the same period. These gaps create temporary differences between the carrying amount of an asset or liability and its tax base. The CFA Level I exam tests whether you can identify which type of balance a temporary difference creates, measure it correctly, and judge whether it belongs on the balance sheet at full value.
Quick Answer
A deferred tax liability (DTL) arises when a company will pay more tax in the future than its current financial statements suggest. A deferred tax asset (DTA) arises when a company will pay less tax in the future. US GAAP uses enacted rates expected at reversal; IFRS also permits substantively enacted rates. US GAAP uses a valuation allowance for amounts not more likely than not to be realized. IFRS recognizes a DTA only to the extent that realization is probable, rather than reporting a separate valuation allowance.
Key Takeaways
A DTL arises when the carrying amount of an asset exceeds its tax base, or a liability's carrying amount is less than its tax base.
A DTA arises when the carrying amount of an asset is less than its tax base, or a liability's carrying amount exceeds its tax base.
Both items are measured using the tax rate expected to apply in the period the temporary difference reverses, not the current rate.
When an enacted tax rate changes, existing DTA and DTL balances are remeasured, and the adjustment flows through income tax expense.
A valuation allowance reduces a DTA when it is not more likely than not that the full benefit will be realized. It never applies to a DTL.
What You Need to Know for CFA Level I
The LOS asks you to explain how DTAs and DTLs are created and how analysts should treat them, so expect conceptual and applied questions rather than journal entries.
Focus on matching a temporary difference to the correct balance (DTA or DTL) and recognizing the measurement rate.
You need to recalculate DTA and DTL balances after a tax rate change and identify the income statement effect.
Know the boundary with the sibling note on tax bases: that note explains why a temporary difference exists, this note explains what balance it creates and how to treat it.
The most common trap is assuming a tax rate decrease always helps net income. It helps if the company has a net DTL position but hurts if it has a net DTA position.
How Deferred Tax Liabilities and Assets Are Created
A temporary difference is created whenever the carrying amount of an asset or liability on the financial statements differs from its tax base. The direction of the difference determines whether it produces a DTL or a DTA.
Scenario | Carrying Amount vs. Tax Base | Result |
|---|---|---|
Asset carrying amount exceeds tax base | Future taxable amounts increase | Deferred tax liability |
Asset carrying amount is less than tax base | Future taxable amounts decrease | Deferred tax asset |
Liability carrying amount is less than tax base | Future taxable amounts increase | Deferred tax liability |
Liability carrying amount exceeds tax base | Future taxable amounts decrease | Deferred tax asset |
A common example of a DTL is accelerated depreciation for tax purposes combined with straight-line depreciation for financial reporting. The asset's carrying amount exceeds its tax base, so the company will owe more tax later as the difference reverses.
A common example of a DTA is a warranty liability. The company recognizes the expense and liability on its financial statements before it is tax deductible. The liability's carrying amount exceeds its tax base, so the company will pay less tax later when it takes the deduction.
Measuring Current Deferred Tax Items
DTAs and DTLs are not measured at the current tax rate by default. They are measured at the enacted tax rate expected to apply when the temporary difference reverses. If a new rate has been enacted but is not yet effective, that enacted rate is still used for measurement.
DTA or DTL = Temporary Difference × Enacted Future Tax Rate
where:
Temporary difference: the dollar gap between the carrying amount and the tax base of the asset or liability,
Enacted future tax rate: the tax rate that has been legally enacted and is expected to apply in the period the difference reverses.
Using the enacted rate, rather than the current rate, matters most when a rate change has already been passed into law but has not taken effect yet.
How Changes in the Tax Rate Affect Deferred Tax Balances
When a government enacts a new tax rate, companies must remeasure existing DTA and DTL balances using the new rate. For US GAAP amounts recognized in profit or loss, the adjustment enters tax expense when the rate change is enacted. IFRS also considers substantive enactment and can allocate effects outside profit or loss when the underlying item was recorded there.
∆Income tax expense = (New rate - Old rate) × (Taxable temporary differences - Deductible temporary differences)
This simplified formula assumes one applicable rate change, unchanged temporary differences, fully recognized DTAs, and remeasurement entirely in profit or loss. An increase in DTL raises tax expense; an increase in DTA lowers it. Assess changes in DTA realizability and amounts recorded outside profit or loss separately. The direction therefore depends on the relevant net DTA or DTL position.
Position | Rate Increase | Rate Decrease |
|---|---|---|
Net deferred tax liability | DTL increases, tax expense increases | DTL decreases, tax expense decreases |
Net deferred tax asset | DTA increases, tax expense decreases | DTA decreases, tax expense increases |
This is the part candidates most often get backward. A lower future tax rate is good news for a company with a net DTL, because it owes less tax later. It is bad news for a company with a net DTA, because the future tax savings are worth less.
Valuation Allowance for Deferred Tax Assets
A DTA represents a future tax benefit, but that benefit only has value if the company expects to generate enough future taxable income to use it. Under US GAAP, a company must reduce a DTA with a valuation allowance when it is more likely than not (a probability greater than 50%) that some or all of the asset will not be realized.
Net DTA = Gross DTA - Valuation Allowance
where:
Gross DTA: the full deferred tax asset calculated from temporary differences before any realizability adjustment,
Valuation allowance: a contra-asset account that reduces the DTA to the amount expected to be realized.
A valuation allowance is reassessed every reporting period. A company with a history of losses or uncertain future profitability is more likely to need one. The allowance never applies to a DTL, because a liability does not require future income to be "realized."
Working Example
Vantage Corp reports under US GAAP. Assume all illustrated tax adjustments are recognized in profit or loss, all temporary differences reverse after the new rate takes effect, and no netting requirements are being assessed. It reports:
A warranty liability of $200,000 on its balance sheet. The tax base of this liability is $0, because warranty costs are deductible only when paid.
Equipment with a carrying amount of $500,000 and a tax base of $350,000, due to accelerated tax depreciation.
The current enacted tax rate is 25%.
Step 1: Identify the balances created.
The warranty liability's carrying amount exceeds its tax base, creating a deductible temporary difference and a DTA.
The equipment's carrying amount exceeds its tax base, creating a taxable temporary difference and a DTL.
Step 2: Measure at the current enacted rate.
DTA = $200,000 × 25% = $50,000.
DTL = $150,000 × 25% = $37,500.
Step 3: Apply a tax rate change.
The government enacts a new tax rate of 21%, effective next year. Vantage remeasures both balances this year.
New DTA = $200,000 × 21% = $42,000.
New DTL = $150,000 × 21% = $31,500.
The DTA fell by $8,000. Since the DTA produces less future benefit at the lower rate, tax expense increases by $8,000.
The DTL fell by $6,000. Since the company now owes less future tax, tax expense decreases by $6,000.
Step 4: Apply a valuation allowance.
After two years of weak earnings, management concludes it is more likely than not that only 60% of the DTA will be realized.
Valuation Allowance = 40% × $42,000 = $16,800.
New DTA = $42,000 - $16,800 = $25,200.
Vantage reports a net DTA of $25,200 and a DTL of $31,500 on its balance sheet. The rate decrease helped the company on the liability side but hurt it on the asset side. The valuation allowance signals that management has doubts about future profitability, a detail analysts should weigh when judging earnings quality.
Common Exam Traps
Reversing the DTA and DTL creation rule
Candidates often mix up which direction of the carrying amount versus tax base gap creates an asset versus a liability. Anchor the rule to the warranty (DTA) and accelerated depreciation (DTL) examples.
Using the current tax rate instead of the enacted future rate
If a new rate has been enacted but is not yet effective, the exam expects you to use the new rate for measurement, not the rate currently in force.
Assuming a tax rate decrease always helps net income
A rate decrease reduces tax expense for a net DTL position but increases tax expense for a net DTA position. Always check which position the company holds before you can say if a rate change is favorable.
Forgetting that valuation allowances apply only to assets
A DTL is never adjusted for a valuation allowance because it does not depend on future taxable income to be settled.
Treating the valuation allowance as a permanent, one-time entry
Companies reassess realizability every period. A previously recorded allowance can be reduced or reversed if future profitability improves.
Practice Question
Rolfe Industries reports under US GAAP and has a gross deferred tax asset of $80,000 related to deductible temporary differences from accrued compensation. After three consecutive years of losses, management determines it is more likely than not that only $50,000 of this deferred tax asset will be realized.
What valuation allowance should Rolfe recognize, and what net deferred tax asset should appear on its balance sheet?
Valuation allowance of $30,000; net DTA of $50,000
Valuation allowance of $50,000; net DTA of $30,000
Valuation allowance of $80,000; net DTA of $0
Correct Answer: A
Explanation: The valuation allowance equals the gross DTA minus the amount expected to be realized: $80,000 - $50,000 = $30,000. The net DTA reported is the realizable amount, $50,000.
Option B: Reverses the valuation allowance and the realizable amount.
Option C: Incorrectly assumes the entire DTA is unrealizable, ignoring that management still expects to realize $50,000 of the benefit.
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FAQs About Deferred Tax Assets and Liabilities
What is the difference between a deferred tax asset and a deferred tax liability?
A deferred tax asset means a company expects to pay less tax in the future because of a temporary difference. A deferred tax liability means it expects to pay more tax in the future. The direction depends on whether the carrying amount of the related asset or liability is above or below its tax base.
When should a company recognize a valuation allowance for deferred tax assets?
A company recognizes a valuation allowance when it is more likely than not, meaning a probability over 50%, that some or all of a deferred tax asset will not be realized. This usually happens when a company has a history of losses or uncertain future taxable income.
How does a change in the tax rate affect existing deferred tax balances?
Existing deferred tax asset and liability balances are remeasured using the newly enacted rate, and the adjustment is recorded in income tax expense in the period the rate change is enacted, even if the new rate is not yet effective.
What tax rate should be used to measure deferred tax assets and liabilities?
Use the enacted tax rate expected to apply in the period the temporary difference is expected to reverse, not necessarily the rate currently in effect.
Does a deferred tax liability always represent a real future cash outflow?
Not necessarily. Some deferred tax liabilities may never reverse if a company continues to grow and replace assets, which is a consideration covered in the sibling note on deferred tax disclosures.