IFRS and US GAAP reporting guidelines often differ from the income tax regulations which leads to differences in the income tax expense recognized in the income statement and income taxes actually owed, thus leading to creation of deferred tax assets and deferred tax liabilities.
Differences in timing in recognizing transactions on the financial statements and recognizing them for tax reporting leads to differences in tax expense recognized. To reconcile these differences companies create deferred tax assets and deferred tax liabilities on the balance sheet.
Deferred tax assets are income taxes that have been recognized for tax reporting purposes but have not yet been recognized on the income statement. Deferred tax liabilities are income taxes that have been recognized on the income statement but have not actually been paid yet.
Differences between Accounting Profit and Taxable Income
Accounting profit, also known as pretax income or income before taxes, differs from taxable income because of different accounting and tax guidelines regarding how transactions (revenues and expenses) are reported on the income statement and how and when they recognized for income tax purposes.
A company’s taxable income is the basis for its tax payable (a liability) or recoverable (asset). Tax payable is also known as current tax expense. It is not to be confused with income tax expense. Income Tax expense is recognized on the income statement and includes tax payable (current tax expense) and changes in deferred tax assets and liabilities.
When a company’s taxable income (tax laws) is higher than pretax income (reported income), the taxes payable will be higher than income tax expense recognized on the income statement. This is called deferred tax asset as an excess amount has been paid in taxes which will result in less tax outflow over future periods, thus creating an asset.
Similarly, when taxable income is lower than pretax income, taxes paid are lower than that recognized on the income statement, thus creating a tax liability that is payable in future periods.
Other Income taxes related terminologies that you should know
Tax base of an asset or liability is the amount at which the asset or liability is valued for tax purposes.
The amount at which an asset or liability is valued for accounting purposes.
It is a reserve created against deferred tax assets based on the likelihood the assets will not be realized.
Tax loss carryforward:
A current or past loss that can be used to reduce future taxable income. It can lead to the creation of a deferred tax asset.
Reasons for Differences in Taxable Income and pretax income
- Differences in timing in recognition of revenues and expenses for accounting purposes and income tax purposes.
- Specific revenues or expenses may be recognized for tax purposes and not for accounting purposes or the other way round.
- Carrying amount and tax base may differ.
- Tax losses carried forward may reduce the taxable income, thus creating differences in the taxable income and pretax income.
- Adjustments made to reported data from prior years, will create differences between pretax income and taxable income.
Deferred tax assets and Deferred tax liabilities
Deferred tax assets
Deferred tax assets represent taxes that have already been paid but have not yet been recognized on the income statement. It is based on temporary differences due to excess taxes paid that the company expects to recover over future periods. It is treated as an asset as it reduces the future tax outflow. Deferred tax assets can occur when;
- Revenues are taxable before they are recognized on the income statement
- Expenses are recognized on the income statement before they become taxable.
- Tax loss carryforwards are created.
As already discussed deferred tax assets are created through temporary differences which are expected to reverse in future.
Deferred tax liabilities
Deferred tax liability is created when income tax expense is greater than taxes payable. Like deferred tax assets it too is a result of temporary differences leading to deficit in taxes paid, thus creating deferred liabilities that the company expects to pay in future periods. Deferred tax liability can occur when;
- Revenues are recognized on the income statement before they become taxable.
- Expenses become taxable before they are recognized on the income statement.
Like deferred tax assets, deferred tax liabilities are also expected to reverse in future when taxes are paid.
For solved examples please refer to the CFA Institute books or CFA study materials. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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