The computation of income taxes poses problems in financial reporting. The major problems arise because current period taxable income is measured using different rules than those used in accounting for pretax income.

Taxes are paid based on tax reporting, but from a financial reporting standpoint, the tax expense in the income statement (IS) is based on the matching principle and is computed on pretax accounting income. In order to achieve matching between taxes based on taxable income and taxes based on pretax income for accounting purposes, deferred tax entries are put through the accounting books.

The differences between the tax expense for tax and the accounting tax expense create deferred tax liabilities (credits) and deferred tax assets (debits or prepaid taxes).

Here are key terms based on tax return:

• Taxable income: Income subject to tax based on the tax code.

• Taxes payable: Tax return liability resulting from current period taxable income. (U.S.) SFAS 109 calls this "current tax expense or benefit."

• Income tax paid: Actual cash flow for income taxes, including payments (refunds) for other years.

• Tax loss carry forward: Tax return loss that can be used to reduce taxable income in future years.

• The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

Here are key terms based on financial reporting:

• Pretax income or accounting profit: Income before income tax expense.

• The carrying amount is the amount at which the asset or liability is valued according to accounting principles.

• Income tax expense: Expense resulting from current period pretax income; this includes taxes payable (from the tax return) and deferred income tax expense. It is reported in the income statement.

• Deferred income tax expense: Accrual of income tax expense expected to be paid (or recovered) in future years (difference between taxes payable and income tax expense). Under (U.S.) SAAS 109, this results from changes in deferred tax assets and liabilities.

• Deferred tax asset: Balance sheet item that results from a temporary excess of taxes payable over income taxes expense. It is expected to be recovered from future operations; it is not created if the excess is a permanent difference.

• Deferred tax liability: Balance sheet item that results from a temporary excess of income taxes expense over taxes payable. It is expected to result in future cash outflows; it is not created if the excess is a permanent difference.

• Valuation allowance: Reserve against deferred tax assets based on likelihood that those assets will be realized.

• Timing difference: The result of the tax return treatment (timing or amount) of a transaction that differs from the financial reporting treatment.

• Temporary difference: Difference between tax reporting and financial reporting that will affect taxable income when those differences reverse. This is similar to but slightly broader than timing difference. It also considers other events that result in differences between the tax bases of assets and liabilities and their carrying amounts in financial statements.

• Permanent difference: Differences between tax reporting and financial reporting that will not reverse in the future.