Income Tax

Income Tax Financial Modeling

Income Tax Expense on the Income Statement

All companies calculate their income taxes using two sets of rules:

  • Accounting Rules (IFRS or US GAAP, depending on where the company is based)
  • Tax Rules (these are set by each country’s government tax agency)

The Income Tax Expense line on the Income Statement represents the amount of tax that a company reports for accounting purposes. It is calculated based on accounting rules that dictate how a company needs to recognize revenues and expenses. These accounting rules can be quite different from the rules used to calculate how much tax a company has to pay to the government in cash during a given period. This latter set of rules is determined by the governments of various countries where a company has operations and pays tax.

Under these two different sets of rules, differences will often occur because revenues and expenses are recognized at different times. These differences are commonly called “timing differences.”

Income Tax Timing Differences

There are many items that can cause timing differences between accounting tax and government tax.

For many companies, depreciation expense can cause a big difference between taxable income for accounting purposes and for government purposes. Under accounting rules, many fixed assets are depreciated on a straight-line basis over their estimated useful lives. However, for government purposes (in many countries), fixed assets are depreciated on an accelerated basis. This means that the company can deduct more of the asset’s cost earlier in the asset’s life for tax purposes. Governments around the world allow this type of pattern of deduction to incentivize investment. The incentive happens because as companies buy fixed assets, they record a large depreciation expense on their government tax return in the early years of the investment which reduces their government taxable income and therefore the amount of cash tax paid.

Note that the full cost of the asset will eventually get expensed through depreciation on both the accounting and government books - the difference relates to the timing of the expenses over time. These timing differences are therefore called “temporary”.

Below is a simple example of the differences in the accounting value versus government tax value for a fixed asset after 1 period where the government tax depreciation exceeds the accounting depreciation: