Can’t get my head around this topic and I really need to understand this topic in order to pass😭
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OK, at the most basic level you should understand that taxable income, and financial statement income are not the same. IF you’re this far along in a class this statement is likely obvious to you.
On your financial statements you will report lots of information but always remember that the reason accountants create financial statements is so that people can read the statements and gain important information about the company. Investors, bankers, any financial statement users should be able to read the statements and get a relevant picture of the state of the company.
But taxes are trickery because the tax authority has it’s own rule set that companies need to follow. So what do you do when the accounting standards of how a transaction is treated is different than the tax standards of that transaction?
The core problem there is this. If you follow accounting standards only for the transaction then it gives the readers an incorrect picture of what the taxes are of that transaction. That picture might be in either direction btw.
Perhaps we are giving the reader the impression that we are tax wizards and are able to report loads of revenue and not have any taxes owing. Or perhaps they might get the impression that we have an incomponent tax accountant and that we are paying way to much in taxes given our current revenue situation.
Both of those readers impressions are wrong and financial statements are supposed to provide clear and relevant information to readers, not misleading and unclear information.
So enter the concept of deferred tax assets or liabilities. All this is intended to do is to tell the statement readers that while financial statement income is X, with a tax expense of Y, in reality those events have created a future impact that we will not be able to avoid and we need to tell you about that.
So lets say that you have some kind of odd business situation that allows you to recognize revenue today for financial statements, but not for income tax. That’s misleading since a reader might assume it’s some kind of tax free income when it’s not. So you need to find a way to communicate that, and that would be a future tax liability.
On the other hand, perhaps you prepaid some large expense and for tax you need to deduct it right away but on financial statements it’s a prepaid. In that case a financial statement reader might think you are overpaying your taxes, but that’s untrue. The following year you are going to not have this big tax deduction when it will be on the financial statements next year as an expense.
This is the idea that future tax liabilities or assets is intended to solve. Really, the income tax expense should follow the revenue that generated that tax payable (per the basic principle of matching revenues and expenses). But since that tax is not part of your current year tax payable, how are you going to record that?
In terms of understanding the concept always think that what shows on the financial statements is intended to reflect the actual reality of the business’s operations. It must paint a clear picture for the reader of the statements. Tax assets and liabilities exist to show the readers that there is a difference between taxable income and financial statement income, but that difference is temporary.
Temporary is a key word there, while there are other differences between financial statement income and taxable income that are not temporary. So those non-temporary differences in the 2 incomes don’t create a tax asset or liability. It’s only differences that are temporary that create the future tax impact problem.
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