Financial Reporting and Analysis III
Reading 27. Income Taxes
Learning Outcome Statements
a. describe the differences between accounting profit and taxable income and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense;
CFA Curriculum, 2020, Volume 3
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Subject 1. Key Terms
Taxes are paid based on tax reporting, but from a financial reporting standpoint, the tax expense in the income statement (IS) is based on the matching principle and is computed on pretax accounting income. In order to achieve matching between taxes based on taxable income and taxes based on pretax income for accounting purposes, deferred tax entries are put through the accounting books.
The differences between the tax expense for tax and the accounting tax expense create deferred tax liabilities (credits) and deferred tax assets (debits or prepaid taxes).
Here are key terms based on tax return:
- Taxable income: Income subject to tax based on the tax code.
- Taxes payable: Tax return liability resulting from current period taxable income. (U.S.) SFAS 109 calls this "current tax expense or benefit."
- Income tax paid: Actual cash flow for income taxes, including payments (refunds) for other years.
- Tax loss carry forward: Tax return loss that can be used to reduce taxable income in future years.
- The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
Here are key terms based on financial reporting:
- Pretax income or accounting profit: Income before income tax expense.
- The carrying amount is the amount at which the asset or liability is valued according to accounting principles.
- Income tax expense: Expense resulting from current period pretax income; this includes taxes payable (from the tax return) and deferred income tax expense. It is reported in the income statement.
- Deferred income tax expense: Accrual of income tax expense expected to be paid (or recovered) in future years (difference between taxes payable and income tax expense). Under (U.S.) SAAS 109, this results from changes in deferred tax assets and liabilities.
- Deferred tax asset: Balance sheet item that results from a temporary excess of taxes payable over income taxes expense. It is expected to be recovered from future operations; it is not created if the excess is a permanent difference.
- Deferred tax liability: Balance sheet item that results from a temporary excess of income taxes expense over taxes payable. It is expected to result in future cash outflows; it is not created if the excess is a permanent difference.
- Valuation allowance: Reserve against deferred tax assets based on likelihood that those assets will be realized.
- Timing difference: The result of the tax return treatment (timing or amount) of a transaction that differs from the financial reporting treatment.
- Temporary difference: Difference between tax reporting and financial reporting that will affect taxable income when those differences reverse. This is similar to but slightly broader than timing difference. It also considers other events that result in differences between the tax bases of assets and liabilities and their carrying amounts in financial statements.
- Permanent difference: Differences between tax reporting and financial reporting that will not reverse in the future.
User Contributed Comments 8You need to log in first to add your comment.
The difference between timing differences and temorary differences is not very clear. I may need more clarity.
Tax expense is therefore the product of tax rate and pretax income.
Timing difference happens when a certain tax amount is shown in different time intervals for the Income Tax returns and the Financial statements. Depriciation is a good example. If one buys a machine for $100,000 whose life is 5 years with zero salvage value . One uses the double-declining method of depriciation in their tax returns and straight line method in their Financial statements. The depriciation expense each year will differ between the Tax returns and the financial statements. But the total depriciation expense will be same for both the methods if we add all the five years.
A permenant difference happens when a certain type of income is exempt from the Income Tax return but is present in Financial statements. The interest on Tax free municipal bonds is a good example.
thanks wirelessguy :)
Good explanation. Thanks a lot mywirelesskit.
i guess the difference asked was between 'timing' and 'temporary' ... not 'timing' and 'permanent'
What is the difference between 'timing' and temporary differences?
could somebody please explain difference between timing and temporary? thank you!
The timing difference creates the temporary difference. They are closely related. accounting statements vs tax statements may have timing differences on reporting. Over time if the difference will correct itself or balance out then it is only a temporary difference.