Explain what the reconciliation of the effective tax rate shows
The idea
The effective tax rate is total tax expense divided by pre-tax accounting profit, and it rarely equals the statutory rate. The reconciliation in the notes explains the difference item by item: income earned in lower-rate jurisdictions, permanently non-deductible expenses, tax credits, changes in valuation allowances and adjustments to prior-year estimates. It is one of the most useful notes in a set of accounts, because a low effective rate driven by a recurring structural feature is sustainable while one driven by a one-off credit or a released allowance is not, and forecasts built on the reported rate get this wrong.
A practice question
How is the effective tax rate calculated?
- Current tax expense divided by taxable incomeWhy not: That is close to the rate the tax authority actually applies. The effective rate uses *total* tax expense over *accounting* profit, which is why it can differ from both.
- Total tax expense divided by pre-tax accounting profit — correct
- The statutory rate applied to net incomeWhy not: That computes an amount from a rate rather than deriving a rate from the figures. Net income is also already after tax.
It uses the reported figures from the income statement, which is why it can differ substantially from both the statutory rate and the cash tax actually paid.
A harder one
Which item would explain a sustainably low effective tax rate?
- A substantial share of profit earned in a lower-rate jurisdiction — correct
- A one-off release of a valuation allowanceWhy not: A single-period remeasurement. It depresses this year's rate and will not repeat.
- A favourable settlement of a prior-year tax disputeWhy not: Also a one-off, and one relating to an earlier period rather than to how this business is structured.
A structural feature of where the company operates persists. The other two are single-period items that will not repeat.
The hardest tier
A company's effective rate has been 12% for three years thanks to a manufacturing location. What should a forecast assume?
- The statutory rate, since low rates never persistWhy not: Structural advantages often persist for many years. Three years of consistency is evidence for, not against.
- Zero tax, since the rate is fallingWhy not: Nothing in the question says the rate is falling — it has been steady at 12%.
- A rate near 12%, while checking whether the incentive has an expiry date — correct
A structural feature is forecastable; the risk is not that it is temporary by nature but that it may have a stated end.
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