Income tax expense can differ from the cash you pay because of deferred taxes and payment timing. Temporary differences between book and taxable income can create deferred tax assets and liabilities on the balance sheet. Permanent differences move the effective tax rate but create no deferred balance. By themselves, they affect current tax and income tax expense equally.
Companies live in two parallel accounting worlds. The financial reporting world produces accounting profit (pretax income) using generally accepted accounting principles (GAAP) or IFRS. The tax world produces taxable income using the tax code. The two systems use different depreciation lives, different revenue timing, and different allowable expenses.
KEY: Accounting profit drives reported earnings. Taxable income drives the cash tax bill. They almost never match.
Taxes payable is the tax owed to the tax authority for the period: taxable income times the statutory rate, less any tax credits. (Strictly, that amount is current tax expense, and only the unpaid part stays on the balance sheet as a payable.
Common mistakes
- Confusing income tax expense with taxes payable. Tax expense is the GAAP charge. Taxes payable is the legal liability. They differ by the change in deferred items. Trap: assuming the income statement number equals the check written to the tax authority.
- Creating a DTL/DTA for a permanent difference. Municipal interest, fines, and certain dividend deductions never reverse. They flow through the effective rate reconciliation only. Trap: setting up a DTA for non-deductible fines.
- Reversing the DTL/DTA trigger. DTL arises when book income exceeds taxable income today (pay more tax later). DTA arises when book income is below taxable income today (pay less tax later). Trap: assigning a DTA to accelerated tax depreciation, which actually creates a DTL.
Bottom line
- Accounting profit follows GAAP/IFRS; taxable income follows the tax code. Income tax expense = taxes payable + change in DTL − change in DTA.
- Temporary differences reverse and create DTL/DTA. Permanent differences never reverse and only affect the effective tax rate.
- DTL when book income exceeds taxable income (deferred outflow). DTA when book income is below taxable income (deferred inflow, if realizable). Either balance = temporary difference × tax rate.
- A valuation allowance reduces a DTA when realization is doubtful; a rising allowance signals a weakening profitability outlook.
Exam shortcut
For DTL vs. DTA direction, remember "Book High = DTL, Book Low = DTA" relative to taxable income. For permanent vs. temporary, ask whether the item ever reverses. If never, it touches only the effective rate. For the three rates, remember SEC: Statutory (law), Effective (P&L), Cash (cash flow). When the question asks whether to treat a DTL as debt or equity, the trigger is whether reversal is realistically expected.
The full lesson (about 4,088 words, 27 min read) adds 7 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- analysis of income taxes
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