Introduction to Income Tax

Introduction

A company’s accounting policies (such as depreciation choices, and valuation of assets) can cause differences in taxes reported in financial statements and taxes reported on tax returns. In this reading “Income Taxes” we will learn about several issues relating to deferred taxes.

Accounting Profit Vs. Taxable Income

A company prepares its accounts and financial statements based on the accounting standards such as US GAAP and IFRS. The accounting profit of a company is the net profit before taxes reported in the income statement. However, there are separate income tax laws and regulations that determine the portion of income that is taxable. This is called the taxable income and can significantly differ from the accounting profit. The taxable income forms the basis for the amount of tax the company needs to pay.

Key Terms

Let’s review the key terms related to income tax.

Income tax payable: This is the tax that the company is required to pay based on the taxable income. The term ‘payable’ means that the tax is yet to be paid and is therefore shown as a liability on the balance sheet.

Income tax expense: This is the tax expense recognized in the income statement. It is an aggregate of income tax payable (or recoverable as tax benefit) and changes in deferred tax assets and liabilities.

Deferred tax assets: Deferred tax assets arise when the taxable income is higher than accounting profits. Therefore the actual income tax payable is higher that the income tax expense as per financial reports. An excess amount of income tax is paid and the company expects to recover the excess amount paid in future.

Valuation allowance: This is a reserve created for deferred tax assets based on the probability that these deferred tax assets will be realized in the future.

Deferred tax liabilities: Deferred tax liabilities arise when taxable income is lower than accounting profits and therefore the income tax payable is less than the income tax expense calculated based on financial reports. The company expects to eliminate the deficit in future.

Income tax paid: This is the actual income tax paid during the period. Income tax paid reduces the income tax payable, which is a liability in the balance sheet.