There are fundamental differences in the amount of income and expenses reported for GAAP and income tax purposes. The objective for GAAP reporting is to report the economic activities of the entity. The objective for income tax purposes is for the government to raise revenue. There are two terms that identify the types of income subject to tax under each reporting system. Firstly, pretax financial income is determined using GAAP. It is the amount of income on which income tax is computed for financial statement purposed.
It is formally presented in the income statement as income before taxes. Secondly is taxable income where they are determined in accordance with prescribed tax regulations. It is the amount of income on which the entity will actually pay income tax in the current accounting period. Deferred taxes arise as a result of temporary difference between income tax expense and income tax payable. A temporary difference is the difference between the book value of an asset or liability and the tax of an asset or liability and the tax basis of the same asset or liability.
If the income tax expense in the income statement is larger than the current income tax liability the difference is called a deferred tax liability. If the tax expense in the income statement is smaller than the current income tax liability the difference is called a deferred tax asset. There are two categories of differences between financial income and tax income: (1) permanent differences and (2) temporary differences. Permanent differences results from item that enter into pretax financial income but never into taxable income or enter into taxable income but never into pretax financial income.
Non-taxable revenues and non-deductible expenses are never included in the computation of taxable income for tax return purposes but are included in the computation of financial income on the income statement. Thus permanent differences cause no particular accounting problems. On the other hand, temporary differences arise from timing differences as to the reporting of income or the deducting of expenses. These temporary differences create deferred tax liabilities for future taxable amounts and deferred tax assets for future deductible amounts.