Accounting profit vs taxable income: temporary and permanent differences

Why does accounting profit differ from taxable income?

Two rule books measure profit. Accounting standards aim to show economic performance; tax law aims to raise revenue. They time some items differently and treat some items differently altogether, so the profit in the accounts rarely equals the profit on the tax return.

Accounting profit (pretax income) is the profit before tax in the income statement. Taxable income is the income on the tax return under tax law. The two meet in the tax numbers below.

Profit before tax in the accounts: accounting profitincome statement, under IFRS or US GAAP

• Taxable income Use it tax return, under tax law
  • Income tax payable Use it tax owed on it; current liability until paid
  • Income tax paid Know the idea cash handed over; cash flow statement
• Income tax expense Use it income statement charge: payable plus the change in deferred taxes

• Income tax payable is the tax owed on this period’s taxable income. It sits on the balance sheet until paid.
• Income tax expense is the charge on the income statement. It equals taxes payable plus the change in deferred taxes (next lesson).
• Income tax paid is the cash actually handed over in the period, shown in the cash flow statement.

Exam tip Payable is a balance sheet word, expense is an income statement word. A question that asks for “the charge in the income statement” wants expense, even if the payable figure is sitting in the table.

What are temporary and permanent differences?

A temporary difference is a timing gap: the item will be recognized in both the accounts and the tax return, only in different periods, so it reverses. A permanent difference is recognized in one but never in the other, so it never reverses.

The standard timing example is depreciation. Over an asset’s life the same total cost is deducted in both books, but tax law may allow most of it early. The gap opens, then closes.

Gap between accounting profit and taxable income

• Temporary difference Memorize reverses later, so deferred tax arises
  • Taxable temporary difference Memorize more tax later: deferred tax liability
  • Deductible temporary difference Memorize less tax later: deferred tax asset
• Permanent difference Memorize never reverses: no deferred tax; moves the effective tax rate
  • Never deductible fines and penalties, some entertainment
  • Never taxable tax-exempt interest income

Typical permanent differences are fines and penalties, tax-exempt interest income and some non-deductible expenses. They create no deferred tax. Their effect shows up in the effective tax rate (see the rates lesson).

How do you find the tax base?

Use it

The tax base is the amount the tax authority attributes to an asset or liability. The carrying amount is the figure in the balance sheet. For an asset, the tax base is the amount still deductible against taxable income when the asset is recovered. For a liability, start from the carrying amount and subtract whatever will be deductible in the future. For revenue received in advance, subtract the part that will not be taxed again.

$$TB_{liability} = CA - \text{amounts deductible in future}$$

A warranty provision of 80 that is deductible only when paid has a tax base of 80 − 80 = 0. Unearned revenue of 120 that was already taxed when the cash arrived has a tax base of 120 − 120 = 0, because none of it will be taxed again when it is earned.

Which differences create a DTL and which a DTA?

Compare the two figures. A taxable temporary difference will increase taxable income in future (more tax later), so it creates a deferred tax liability. A deductible temporary difference will reduce taxable income in future (less tax later), so it creates a deferred tax asset.

	Carrying amount above tax base	Carrying amount below tax base
Asset	Taxable difference: DTL	Deductible difference: DTA
Liability	Deductible difference: DTA	Taxable difference: DTL

$$DT = |\,CA - TB\,| \times t$$

Exam tip Say it as a story. Asset above its tax base: you have booked profit that has not been taxed yet, so tax is owed later. That is a liability. A liability flips the whole table.

Go deeper Loss carryforwards also create a DTA

An unused tax loss has no carrying amount in the balance sheet, but it will cut future taxable income. It therefore gives rise to a deferred tax asset, recognized only if future taxable profit is probable under International Financial Reporting Standards (IFRS) or more likely than not under US generally accepted accounting principles (US GAAP). The next lesson covers that test.

Go deeper Why some countries show fewer differences

Where tax law follows the accounting standards closely, carrying amounts and tax bases rarely differ, so deferred taxes are small. Where the two are far apart (accelerated allowances, tax-only deductions), deferred taxes are large and worth reading.