16.2: Differences Between Accounting and Taxable Profit

There are a variety of causes of the differences between accounting profit and taxable profit. These can be summarized as follows:

Let's look at each of these situations.

Permanent Differences

These differences arise when an item is included in one type of reporting (accounting or tax) but is permanently excluded from the other type of reporting. Items that are included in the determination of accounting profit but not taxable profit can be both revenue and expense items. An example of a revenue item would be a dividend received from another company that is not taxed in the reporting jurisdiction. Many jurisdictions allow this tax-free flow of inter-corporate dividends. In this case, the dividend would be reported on the company's statement of profit, but would never be taxed. An example of an expense item would be a sports club membership for the company's executive officers. Many businesses consider this type of item to be an appropriate form of promotion and business development, but many tax authorities do not allow this to be deducted when calculating taxable profit. Items that are included in taxable profit but never in accounting profit are less common. These include such items as certain depletion allowances allowed for natural resources and certain types of capital taxes that are not based on income.

The accounting treatment for permanent differences is quite straightforward. Because these items do not affect future periods, there is no effect on future taxes. Thus, the amount is simply included (or excluded) in the determination of current taxable profit and the resulting tax payable is reported as a liability.

Temporary Differences

We can further classify temporary differences as follows:

Note that the items are classified as being either taxable or deductible. This feature refers to the item's effect on future tax calculations: taxable temporary differences increase future tax payable while deductible temporary differences decrease future tax payable. For example, a warranty expense to reflect the cost of future repairs may be accrued for accounting purposes, but the appropriate tax law does not allow any deduction in determining taxable profit until the repairs are actually made. In this case, the expense is a deductible temporary difference because it will allow for a deduction against taxable profit in a future period when the repairs actually occur.

The following are some common examples of deductible and taxable temporary differences:

	Revenue Item	Expense Item
Taxable	Construction revenue	Capital allowance in excess of depreciation
	Instalment sales	Pension funding in excess of expense
	Unrealized holding gains	Certain prepaid expenses
Deductible	Subscriptions paid in advance	Capital allowance less than depreciation
	Royalties and rent paid in advance	Pension expense in excess of funding
	Sale and leaseback gains	Warranty accruals
		Litigation accruals
		Unrealized holding losses

These examples only represent a sample of the types of items that can result in temporary differences. In determining the tax expense for the year, the accountant must consider the effect on all items for which the accounting treatment and the tax treatment are different. For example, with construction revenue, the company will normally choose the percentage of completion method to recognize revenue for accounting purposes. However, many tax jurisdictions will allow the company to defer the recognition of revenue on a long-term construction contract until the project is completed. This will result in a future taxable amount, as future revenue for tax purposes will be greater since the revenue has already been recognized for accounting purposes.