What is accounting for income taxes?
Accounting for income taxes is the process of measuring and reporting the tax consequences of a company's profits in its financial statements. Because tax rules and accounting rules often treat income and expenses differently, the profit in your books rarely matches the taxable profit on your return. The standards close that gap.
Under IFRS the rules sit in IAS 12 Income Taxes; under US GAAP they sit in ASC 740.
Key components
- Current tax expense: the tax payable on this year's taxable profit.
- Deferred tax liability (DTL): tax you will pay later because income was recognised in the books before it is taxed, or tax deductions came first (for example, faster tax depreciation).
- Deferred tax asset (DTA): tax you will save later, such as from carried-forward tax losses or expenses booked before they are deductible.
- Total tax expense = current tax expense + change in deferred tax.
Temporary vs permanent differences
Temporary differences reverse over time (depreciation timing, provisions) and create deferred tax. Permanent differences never reverse (fines that are never deductible, tax-exempt income) and simply change the effective tax rate.
Example
Equipment costing $100,000 is depreciated by $20,000 a year in the books but $25,000 for tax. Taxable profit is $5,000 lower than book profit in year one. At a 30% tax rate, the company records a $1,500 deferred tax liability, which unwinds in later years when tax depreciation runs out.