Accounting Profit and Taxable Income

Accounting profit, also known as income before taxes, is reported on a company’s income statement according to prevailing accounting standards. By definition, accounting profit does not account for income tax expense.

Taxable income is the portion of a company’s income subject to income taxes following the jurisdiction’s tax laws within which a company operates. Taxable income determines the company’s income tax payable (a liability) or recoverable (an asset), which is reflected on the balance sheet. Consequently, the income tax paid during a period is the actual cash amount paid for income taxes, reducing the income tax payable.

The tax base of an asset or liability is the amount at which it is valued for tax purposes. In contrast, the carrying amount is the amount at which it is valued according to accounting principles. Differences between the tax base and carrying amount result in differences between the accounting profit and taxable income.

The tax base of an asset or liability is the amount assigned to it for tax purposes, while the carrying amount is the value recorded in the financial statements. Differences between the tax bases and carrying amounts can arise due to variations in accounting standards and tax laws. Common differences include:

• Timing Differences: Revenues and expenses may be recognized in one accounting period and in another for tax purposes.
• Recognition Differences: Certain revenues and expenses may be recognized for accounting purposes but not for tax purposes, or vice versa.
• Deductibility Differences: The deductibility of gains and losses on assets and liabilities may differ for accounting and tax purposes.
• Tax Loss Carryforwards: Subject to tax rules, tax losses from prior years might be used to reduce taxable income in future years, leading to differences between accounting income and taxable income.
• Adjustment Differences: Adjustments of reported financial data from previous years may not be recognized equally for accounting and tax purposes or may be recognized in different periods.

Differences between the tax base and the carrying amount of liabilities (and, consequently, between taxable income and accounting profit) can be categorized as either temporary or permanent.

Taxable Temporary Differences

Temporary differences are divided into two categories: taxable temporary differences and deductible temporary differences.

Taxable Temporary Differences

Taxable temporary differences occur when the carrying amount of an asset exceeds its tax base, or when the tax base of a liability exceeds its carrying amount. For example, this might happen with accelerated depreciation, where the asset’s carrying amount is higher than its tax base at the end of the year. Taxable temporary differences lead to the recognition of deferred tax liabilities.

Deductible Temporary Differences

Deductible temporary differences are those that will reduce taxable income in future periods when the related balance sheet item is recovered or settled. These differences create a deferred tax asset when the tax base of an asset is higher than its carrying amount or when the carrying amount of liability exceeds its tax base. Recognition of a deferred tax asset is only permitted if it is likely that there will be future profits against which the asset or liability can be settled or recovered.

To determine if there will be sufficient future profits to utilize the deferred tax asset, the following must be considered:

1. There must be enough taxable temporary differences associated with the same tax authority and taxable entity.
2. The taxable temporary differences should be expected to reverse in the same periods as the deductible temporary differences.

The following table summarizes the differences between the tax bases and carrying amounts of assets and liabilities result in deferred tax assets or deferred tax liabilities:

$$
\begin{array}{l|c|c}
\textbf { Balance Sheet} & \textbf { Carrying Amount} & \textbf { Deferred Tax }\\ \textbf{ Item }&\textbf{vs. Tax Base }&\textbf{Asset or Liability}\\ \hline \text { Asset } & \text { Carrying amount }>\text { tax base } & \text { Deferred tax liability } \\ \hline\text { Asset } & \text { Carrying amount }<\text { tax base } & \text { Deferred tax asset } \\\hline \text { Liability } & \text { Carrying amount }>\text { tax base } & \text { Deferred tax asset } \\\hline
\text { Liability } & \text { Carrying amount }<\text { tax base } & \text { Deferred tax liability } \\
\end{array}$$

Permanent Differences

Permanent differences are discrepancies between tax laws and accounting standards that will not be reversed in the future. Since these differences do not reverse, they do not lead to deferred tax but rather result in a disparity between the company’s effective tax rate and the statutory corporate income tax rate.

Examples of permanent differences include:

• Income or expense items not permitted by tax laws, such as penalties and fines that are recognized as expenses in financial reporting but are not tax-deductible.
• Tax credits for certain expenditures that reduce taxes directly, such as credits for purchasing solar power systems or electric vehicles, are provided by tax authorities to incentivize these purchases.

Example: Demonstrating Taxable Temporary Differences and Permanent Differences

Consider the following assets and liabilities of a company, with their current amounts, tax bases and temporary differences where applicable:

$$\begin{array}{l|c|c|c|c}&&&&\textbf { Will it }\\&&&& \textbf{Result}\\&&&& \textbf{in}\\&&&& \textbf{Deferred}\\&&&&\textbf{Tax}\\&\textbf{Carrying} &&\textbf { Temporary }&\textbf {Asset}\\&\textbf{Amount}&\textbf{Tax Base}&\textbf{Difference}&\textbf{or}\\\textbf{Item}&\textbf{(euros)}&\textbf{(euros)}&\textbf{(euros)}&\textbf{Liability}\\\hline \text { 1. Loan (capital) } & 600,000 & 600,000 & 0 & ? \\\hline \text { 2. Interest paid } & 0 & 0 & 0 & ? \\\hline \text { 3. Development } & 2,750,000 & 2,500,000 & 250,000 & \text { ? } \\
\text { costs } & & & & \\\hline
\text { 4. Research costs } & 0 & 400,000 & (400,000) & \text { ?} \\\hline
\text { 5. Accounts } & 1,600,000 & 1,300,000 & 300,000 & \text { ? } \\
\text { receivable } & & & & \\\hline
\text { 6. Donations } & 0 & 0 & 0 & ? \\\hline
\text { 7. Interest received } & 350,000 & 0 & (350,000) & \text { ? } \\\hline
\text { in advance } & & & & \\
\text { 8. Rent received  } & 11,000,000 & 0 & (11,000,000) & \text { ? } \\\hline
\text { in advance } & & & & \\
\text { 9. Dividends } & 1,200,000 & 1,200,000 & 0 & \text { ?}\\
\text { receivable } & & & & \\
\end{array}$$

Given the values of the table, for each asset or liability, determine whether the temporary differences will lead to deferred tax asset or liability.

Solution

Here is the completed table and discussions:

$$\begin{array}{l|c|c|c|c}&&&&\textbf { Will it }\\&&&& \textbf{Result}\\&&&& \textbf{in}\\&&&& \textbf{Deferred}\\&&&&\textbf{Tax}\\& &&\textbf { Temporary }&\textbf {Asset}\\&\textbf{Amount}&\textbf{Tax Base}&\textbf{Difference}&\textbf{or}\\\textbf{Item}&\textbf{(euros)}&\textbf{(euros)}&\textbf{(euros)}&\textbf{Liability}\\\hline \text { 1. Loan (capital) } & 600,000 & 600,000 & 0 & \text { N/A} \\\hline \text { 2. Interest paid } & 0 & 0 & 0 & \text { N/A} \\\hline \text { 3. Development } & 2,750,000 & 2,500,000 & 250,000 & \text { DTL } \\\hline
\text { costs } & & & & \\
\text { 4. Research costs } & 0 & 400,000 & (400,000) & \text {DTA} \\\hline
\text { 5. Accounts } & 1,600,000 & 1,300,000 & 300,000 & \text { DTL } \\
\text { receivable } & & & & \\\hline
\text { 6. Donations } & 0 & 0 & 0 & \text { N/A} \\\hline
\text { 7. Interest received } & 350,000 & 0 & (350,000) & \text {DTA} \\
\text { in advance } & & & & \\\hline
\text { 8. Rent received  } & 11,000,000 & 0 & (11,000,000) & \text {DTA} \\
\text { in advance } & & & & \\\hline
\text { 9. Dividends } & 1,200,000 & 1,200,000 & 0 & \text {N/A}\\
\text { receivable } & & & & \\
\end{array}$$

• Loan: No temporary differences arise from the loan or interest paid; hence, no deferred tax items are recognized.
• Interest paid: No temporary differences result from interest paid, and therefore, no deferred tax asset or liability is recognized.
• Development costs: The discrepancy between the carrying amount and tax base represents a temporary difference that will eventually reverse, creating a deferred tax liability for this fiscal period.
• Research costs: The variation between the carrying amount and tax base generates a temporary difference, resulting in a deferred tax asset. A deferred tax asset occurs when more taxes are paid upfront than necessary (when taxable income exceeds accounting profit), with the expectation of recovery in future periods. According to accounting standards, the entire amount was deducted, thus lowering the accounting profit, while taxable income remains higher due to reduced expenses.
• Accounts receivable: The difference between the asset’s carrying amount and tax base is a temporary difference that results in a deferred tax liability.
• Donations: It is assumed that tax laws do not permit deductions for donations, leading to no temporary difference. This is considered a permanent difference, and thus, no deferred tax asset or liability is recognized.
• Interest received in advance: This situation creates a temporary difference, resulting in a deferred tax asset. Deferred tax asset forms due to excess tax payments (when taxable income is higher than accounting profit) are anticipated to be recuperated in future periods.
• Rent received in advance: The difference between the carrying amount and tax base creates a temporary difference, leading to the recognition of a deferred tax asset.
• Dividends receivable: Since dividends are non-taxable, their carrying amount is equal to their tax base, which creates a permanent difference. This does not result in the recognition of a deferred tax asset or liability. Permanent differences are not reversed over time and arise from specific tax legislation that excludes certain incomes, like dividends from a subsidiary, from being taxed. Consequently, the dividends received do not affect the taxable income, resulting in a permanent disparity between taxable income and accounting profit.

Tax Expense (Provision for Income Taxes)

A company’s tax expense is reported on its income statement and includes both the income tax payable (or recoverable in the case of a tax benefit) and any changes in deferred tax assets and liabilities. This method adheres to the matching principle, ensuring that the tax effects of all current period activities are reported rather than only the income taxes actually paid.

Question

Which of the following statements accurately describes an occurrence of a difference between accounting profit and taxable income?

1. The tax base and carrying amount of assets and liabilities are the same.
2. The tax losses of previous years cannot be used to reduce the taxable income in later years.
3. Revenues and expenses may be recognized in one reporting period for accounting purposes and in another period for tax purposes.

Solution

The correct answer is C.

The statement, “revenues and expenses may be recognized in one reporting period for accounting purposes and in another for tax purposes,” provides an example of a difference between accounting profit and taxable income.