IB Manual – Balance Sheet Taxes and Pensions

The amount payable on income (taxes) and the amount invested for the future benefit of an employee (pensions)

Balance Sheet Taxes and Pensions

As a financial analyst, it’s important to gain a solid understanding of how taxes and pensions are accounted for on a company’s balance sheet. This guide will walk you through how to account for pensions and taxes as an analyst would in investment banking, private equity, or equity research.


Considerations for investment banking: Taxes


Deferred tax

A deferred tax is a probable tax inflow (asset) or outflow (liability) deferred until a later date.



Deferred tax liabilities

Deferred tax liabilities are the amounts of income taxes payable in future periods.

Deferred tax assets

Deferred tax assets are the amounts of income taxes recoverable in future periods, such as deductible temporary differences, carryforward of unused tax losses, and carryforward of unused tax credits.


Balance Sheet – Taxes




Temporary differences

Temporary differences are differences between the amount at which an asset or liability is recognized in financial statements and its tax base (the amount that will be deductible or taxable in respect to the asset or liability in the future).

The entity should provide for the unavoidable tax consequences of recovering the carrying values of assets or settling liabilities at the amounts shown on the accounts. The carrying value of an asset that will generate (pre-tax) cash flows will be at least equal to that carrying value.  Any tax payable on generating those cash flows is a liability of the entity.


Taxable temporary differences

A deferred tax liability is recognized for all taxable temporary differences unless the liability arises from:

  • Goodwill, where amortization is not deductible for tax purposes
  • The initial recognition of an asset or liability in a transaction that is not a business combination and that, at the time of the transaction, affects neither accounting profit nor taxable profit


Deductible temporary differences

A deferred tax asset is recognized for all deductible temporary differences where it is probable that taxable profit will be available against which the deductible temporary difference can be utilized. This is true unless the deferred tax asset arises from:

  • Negative goodwill
  • The initial recognition of an asset in a transaction that is not a business combination and that, at the time of the transaction, affects neither accounting profit nor taxable profit


Unutilized tax losses

A deferred tax asset is recognized for the carry forward of unused tax losses (and unused tax credits) to the extent that it is probable that future taxable profit will be available against which the unused tax losses (and unused tax credits) can be utilized.


Taxes – Measurement

Deferred tax assets and liabilities are measured at the tax rates expected to apply to the period when the asset is realized or the liability is settled, based on tax rates that have been enacted or substantively enacted by the balance sheet date.

Deferred tax assets and liabilities are not discounted.




Defined contribution schemes

In these schemes, the company pays an additional amount (often a percentage of salary) to the employee, to be invested for the benefit of the employee when they retire.  Essentially, the employee enjoys a personal pension that grows over time.

For the company, it is simply treated as an extra benefit paid out to staff, so the accounting for each payment is a decrease in cash and a corresponding income statement expense.


Defined benefit schemes

A defined benefit scheme is essentially a promise. The employer promises to pay a pension to the employee in retirement. The size of the payment(s) is typically related to the number of years of service and the salary of the employee during the years of service.

This promise immediately creates an obligation for the company that needs to be recognized on the balance sheet as a liability. There are two types of defined benefit schemes:

  • Funded: Company ring-fences some financial assets to help settle the obligation in the future
  • Unfunded: No ring-fenced assets are set aside, but there is usually a regulatory requirement to take out insurance against company bankruptcy


The explanations that follow relate to a funded scheme, though the same rules apply for an unfunded scheme. The unfunded scheme would be simpler, as there would be no pension assets on the balance sheet. For a funded scheme, there is both a pension asset and a pension liability on the balance sheet.


Pension asset

The pension asset on the balance sheet is the fair value of the pool of assets at the balance sheet date. The three main reasons why the pool of financial assets might move over time are:

  • Actual return on assets: These pension assets are a pool of investments, held for the long-term benefit of the employees, and their value moves with the market.
  • Employer contributions: The company may top up the pool of assets with its own cash, perhaps to fill a deficit and match the pension asset to pension obligation. It may also be a regular contribution.
  • Payments: There may be one-off payments out to transfer the value of an individual’s benefit to their next of kin in the event of death. These payments represent a continual outflow of assets from the pool.


Movement in pension obligation

A pension liability is the result of an actuarial calculation with a number of inputs such as mortality rates, salary rates, and other economic assumptions. The four main reasons why the obligation moves over time are:

  • Service cost: The increase of a future obligation results from staff working for the year. More years worked means the value of the pension increases.
  • Interest cost: The company does not actually incur interest on the liability but there is a notional interest cost from discounting as time passes. Each year, future cash flows are discounted one year less than the previous year, so the present value will increase.
  • Changes in actuarial assumptions: If the actuaries change their assumptions for the actuarial calculation, there will be a positive or negative change in the value of the obligation.
  • Payments: In the same way that payments to retired people decrease the pension asset, they will also decrease the pension obligation.


Dual effects and the income statement

There are seven reasons why the net pension position (asset minus liability) might move over time. Each of these results in a dual effect to balance the balance sheet:

  • Actual return on assets: A long-term expected return on assets is taken to the income statement as a gain and any difference between expected and actual is treated as an actuarial gain/loss.
  • Employee contributions: Cash falls and pension asset increases by the same amount.
  • Payments: Pension asset falls, and pension liability falls by the same amount.
  • Service cost: Obligation increases, matching expense on the income statement.
  • Interest cost: Obligation increases, matching expense on the income statement.
  • Changes in actuarial assumptions: Treated as actuarial gain or loss.
  • Payments: Pension obligation falls; pension asset falls by the same amount.


Balance Sheet – Pensions


Actuarial gains and losses

The difference between actual and expected return on assets and the impact of changes in actuarial assumptions are referred to as actuarial gains and losses. Read our full Investment Banking Manual for the detailed accounting treatment of actuarial gains and losses for IFRS and US GAAP.


Considerations for investment banking: Pensions


Cleaning up the income statement

There are two main income statement issues:

  • Some of the pension cost may be in the wrong part of the income statement.
  • There are some questionable items included in the income statement.

The issues arise with the treatment and location of:

  • Interest costs
  • Expected gains or losses on plan assets
  • Actuarial gains and losses

An additional problem associated with the income statement impact of pensions is that most companies preparing their accounts only disclose a detailed breakdown of the income statement changes in the annual report. It is, therefore, difficult for analysts to examine the income statement impact of these changes in the quarterly results.



The pension service cost represents the present value of the additional pension entitlement earned by an employee working for another year for the organization. It is an operating cost and gets charged to EBITDA. The most appropriate approach to adjusting the EBITDA metrics is to strip out all other pension accounting – interest costs, expected gains/losses on plan assets, and actuarial gains and losses that are financial in nature. Financial items MUST be taken below the EBITDA line.


Balance Sheet – EBIT and EBITDA Illustration


Additional Resources

Thank you for reading this section of CFI’s free investment banking book on balance sheet taxes and pensions. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Balance Sheet Liabilities
  • Deferred Tax Liability or Asset
  • Pension Accounting
  • Tax Shield

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Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!

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