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- Traditionally Income taxes has been provided for, by using tax payable method which required providing for income tax payable in a particular accounting period in the Profit and Loss Account. However, we have moved from tax payable method of providing income taxes to tax effect accounting method.
- Since the fundamental objectives of financial reporting and those of taxing authorities are not the same, the tax payable as per GAAP differs from tax payable as per tax rules. 'Timing Differences' are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.
- The concept of 'temporary differences' which is more comprehensive than timing differences, was introduced consistent with the balance sheet orientation of GAAP. Temporary difference refers to the events that result in differences in the tax bases. Permanent differences are those differences between taxable income and accounting income which originate in one period and do not reverse subsequently.
- If book income exceeds taxable income, then tax expense exceeds tax payable, resulting in a deferred tax liability (credit). The deferred tax liability may also be calculated by multiplying the temporary difference by the applicable tax rate. If book income is less than taxable income, then tax expense, is less than tax payable, causing a deferred tax asset (Debit). The deferred tax asset equals the temporary difference multiplied by the tax rate scheduled to be in effect when the difference reverses.