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Lesson 1 of 7 · 12 min

Accounting profit, taxable income and the tax base

A company keeps two sets of rules, one for its financial statements and one for the tax authority, so its accounting profit and its taxable income are rarely the same number.

In short

Accounting profit (pretax income) follows accounting standards; taxable income follows tax law.
Income taxes payable is the tax owed on taxable income: a balance sheet liability. Income tax paid is the cash that settles it.
Income tax expense (the provision for income taxes) is the income statement charge: taxes payable plus the change in deferred taxes.
The tax base is what an asset or liability is worth for tax purposes; the carrying amount is what it is worth in the financial statements.
Differences come from timing, items that only one system recognises, different treatment of gains and losses, tax loss carryforwards and prior-year adjustments.

Four amounts that sound alike

The financial statements are prepared under accounting standards such as IFRS or US GAAP. The tax return is prepared under the tax law of each jurisdiction. Because the two rule books have different goals, the same year can produce two different profit figures.

Accounting profit is income before taxes on the income statement. It contains no tax charge yet. Taxable income is the income on which the tax authority levies tax.

Taxable income times the tax rate gives income taxes payable, a liability on the balance sheet (or a tax recoverable, an asset, if the company is owed a refund). When the company pays, the cash outflow reduces that liability and shows up on the cash flow statement.

Income tax expense is the tax line on the income statement. It is not simply the tax bill: it also includes the change in deferred tax balances, so that the tax effects of everything recognised this period are matched to this period.

Keep the four apart
Term	Rule book	Where it appears
Accounting profit (pretax income)	Accounting standards	Income statement, before the tax line
Taxable income	Tax law	Tax return
Income taxes payable	Tax law × tax rate	Balance sheet liability
Income tax expense (provision)	Accounting standards	Income statement tax line

One year, three tax numbers: Brekke's expense (225) follows accounting profit, the amount owed (200) follows taxable income, and cash paid (150) is whatever was settled before year-end, leaving 50 still payable.

Tax base versus carrying amount

Every asset and liability has two values. The carrying amount (book value) is the figure in the financial statements. The tax base (or tax basis, the usual US term) is the figure the tax authority recognises.

When the two values differ, the profits of the two systems differ too, because the gap has to flow through income in one system before the other. Comparing tax base and carrying amount, item by item, at every balance sheet date is how deferred taxes are measured.

Depreciation is the classic case. A company may depreciate a machine straight line in its accounts while the tax law allows a much larger deduction in the early years. Both methods write off the full cost over time; they just do it at different speeds.

Brekke's machine after Year 1: the books have deducted 100 and the tax return 200, so the tax base sits 100 below the carrying amount, exactly the extra tax depreciation taken so far.

Think of the tax base as the 'tax authority's balance sheet'. If the tax authority has already let you deduct more of a machine than your accounts have, its value for tax is lower than its book value.

Where the differences come from

The reading lists five common sources. Each one makes accounting profit and taxable income diverge in a given year, and some of them reverse later while others never do.

Timing: revenue or expense recognised in one period for accounting and in another for tax (accelerated tax depreciation, warranty costs deductible only when paid).
One system only: items recognised for accounting but never for tax, or the reverse (non-deductible fines, tax-exempt dividends).
Gains and losses: the deductibility of gains and losses on assets and liabilities can differ.
Tax loss carryforwards: tax law may let losses from earlier years reduce taxable income in later years.
Prior-year adjustments: restated figures may be treated differently, or in different periods, for tax and accounting.

Formulas

Income taxes payable: $\text{Taxes payable} = \text{Taxable income} \times t$
t = statutory tax rate. Taxes payable is the current tax for the period.
Income tax expense: $\text{Income tax expense} = \text{Taxes payable} + \Delta\text{DTL} - \Delta\text{DTA}$
Previewed here; built step by step in the deferred tax lesson. DTL/DTA = deferred tax liability/asset.

Worked examples

Example 1 Two depreciation schedules, two profits

Brekke Maskin AS buys a machine for NOK 600,000 at the start of Year 1. Its accounts depreciate it straight line over six years; tax law allows NOK 200,000 in Year 1. Profit before depreciation is NOK 1,000,000 and the tax rate is 25%. What are accounting profit, taxable income, taxes payable, and the machine's carrying amount and tax base at the end of Year 1?

Example 2 Which amount is which?

For Brekke Maskin's Year 1, income tax expense turns out to be NOK 225,000, and the company pays NOK 150,000 of its tax bill in cash before year-end. Identify the taxes payable at year-end, the income tax expense and the income tax paid.

On the exam

Expect definitional questions that test whether you can tell taxes payable (balance sheet, from taxable income) from income tax expense (income statement), and simple calculations of taxable income and taxes payable when tax and book depreciation differ.

Calling income tax expense 'the tax bill'. The bill is taxes payable; expense also includes deferred tax changes.
Multiplying accounting profit, not taxable income, by the tax rate to get taxes payable.
Mixing up tax base (tax value) and carrying amount (book value) when reading a table.

Check yourself

Q1Which amount is a balance sheet liability calculated from the company's taxable income?
Q2Accounting profit is EUR 900,000. Tax depreciation exceeds book depreciation by EUR 120,000, and there are no other differences. At a 25% tax rate, taxes payable are closest to:
Q3The tax base of an asset is the amount at which the asset is:
Q4Tax law lets a company use a loss from two years ago to reduce this year's taxable income. This is best described as a:
Q5A machine costs GBP 400,000. Book depreciation is straight line over 8 years; tax depreciation in Year 1 is 25% of cost. At the end of Year 1, carrying amount minus tax base is closest to:

0/5Check yourself

Answer the 5 questions: +10 XP for each one you get right first time.

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