3 2 Income Taxes Explained

Key Concepts

• Taxable Income
• Income Tax Expense
• Deferred Tax Assets and Liabilities
• Temporary and Permanent Differences
• Tax Rate Changes

Taxable Income

Taxable income is the amount of income subject to taxation by tax authorities. It is calculated by adjusting the accounting income (as reported in the financial statements) for items that are taxable or deductible under tax laws.

Example: A company reports $1,000,000 in accounting income. However, it has $50,000 in non-deductible expenses for tax purposes. The taxable income would be $1,050,000 ($1,000,000 + $50,000).

Income Tax Expense

Income tax expense is the total amount of taxes a company is required to pay based on its taxable income. It is reported in the income statement and is calculated using the applicable tax rates.

Example: If the applicable tax rate is 25%, the income tax expense for a company with $1,050,000 in taxable income would be $262,500 ($1,050,000 * 25%).

Deferred Tax Assets and Liabilities

Deferred tax assets (DTAs) and deferred tax liabilities (DTLs) arise from temporary differences between the accounting income and taxable income. DTAs represent future tax benefits, while DTLs represent future tax obligations.

Example: A company uses straight-line depreciation for financial reporting and accelerated depreciation for tax purposes. This creates a temporary difference that results in a deferred tax liability.

Temporary and Permanent Differences

Temporary differences are differences between the tax basis and accounting basis of an asset or liability that will reverse in the future. Permanent differences are differences that will not reverse and do not result in deferred taxes.

Example: A company has $100,000 in tax-exempt interest income, which is a permanent difference because it will never be taxable. On the other hand, depreciation methods create temporary differences that will reverse over time.

Tax Rate Changes

Tax rate changes affect the calculation of income tax expense and the revaluation of deferred tax assets and liabilities. When tax rates change, companies must adjust their deferred taxes to reflect the new rates.

Example: If a company has a deferred tax liability of $50,000 based on a 25% tax rate, and the tax rate increases to 30%, the deferred tax liability would be adjusted to $60,000 ($50,000 / 25% * 30%).

Examples and Analogies

Consider taxable income as the "taxable portion" of a company's earnings, similar to the taxable portion of an individual's salary. Income tax expense is like the "tax bill" that a company must pay based on its taxable income.

Deferred tax assets and liabilities are like "future tax credits and debts" that arise from differences in how income is reported for financial and tax purposes. Temporary differences are like "temporary loans" that will be repaid, while permanent differences are like "one-time gifts" that do not need to be repaid.

Tax rate changes are like "interest rate changes" on a loan, affecting the total amount owed and requiring adjustments to the deferred tax balances.