A company’s accounting profit is reported on its income statement in accordance with prevailing accounting standards. Accounting profit (also referred to as income before taxes or pretax income) does not include a provision for income tax expense.
A company’s taxable income is its income subject to income taxes under the tax laws of the relevant jurisdiction. A company’s taxable income is the basis for its income tax payable (a liability) or recoverable (an asset), which appears on its balance sheet.
Income tax paid in a period is the cash amount paid for income and reduces the income tax payable.
The tax base of an asset or liability is the amount at which the asset or liability is valued for tax purposes, whereas the carrying amount is the amount at which the asset or liability is recorded in the financial statements. The tax bases and carrying amounts of assets and liabilities can differ based on differences in accounting standards and the relevant tax laws. Common differences are as follows:
- Revenues and expenses may be recognised in one period for accounting purposes and a different period for tax purposes.
- Specific revenues and expenses may be either recognised for accounting purposes and not at all for tax purposes, or vice versa.
- The deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes.
- Subject to tax rules, tax losses in prior years might be used to reduce taxable income in later years, resulting in differences in accounting and taxable income (tax loss carryforward).
- Adjustments of reported financial data from prior years might not be recognised equally for accounting and tax purposes or might be recognised in different periods.
Taxable Temporary Differences
Temporary differences are further divided into two categories, namely taxable temporary differences and deductible temporary differences. Taxable temporary differences result from the carrying amount of an asset exceeding its tax base (like the aforementioned accelerated depreciation example at the end of Year 1) or when the tax base of a liability exceeds its carrying amount. Taxable temporary differences result in the recognition of deferred tax liabilities.
Deductible Temporary Differences
Deductible temporary differences are temporary differences that result in a reduction or deduction of taxable income in a future period when the balance sheet item is recovered or settled. Deductible temporary differences result in a deferred tax asset when the tax base of an asset exceeds its carrying amount and, in the case of a liability, when the carrying amount of the liability exceeds its tax base. The recognition of a deferred tax asset is allowed only to the extent there is a reasonable expectation of future profits against which the asset or liability (that gave rise to the deferred tax asset) can be recovered or settled.
To determine the probability of sufficient future profits for utilisation, one must consider the following:
- (1) sufficient taxable temporary differences must exist that are related to the same tax authority and the same taxable entity; and
- (2) the taxable temporary differences that are expected to reverse in the same periods as expected for the reversal of the deductible temporary differences.
Taxable and Deductible Temporary Differences
Permanent Differences
Permanent differences are differences between tax laws and accounting standards that will not be reversed at some future date. Because they will not be reversed at a future date, these differences do not give rise to deferred tax. These items typically include the following:
- income or expense items not allowed by tax legislation, such as penalties and fines that are considered expenses for financial reporting purposes, but are not deductible for tax purposes; and
- tax credits for some expenditures that directly reduce taxes. An example is tax credits provided by tax authorities to encourage the purchase of solar power or an electric vehicle.
Because no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s tax rate and its statutory corporate income tax rate.
Tax Expense
A company’s tax expense or its provision for income taxes, appears on its income statement and is an aggregate of its income tax payable (or recoverable in the case of a tax benefit) and any changes in deferred tax assets and liabilities.
