LOS F requires us to:
describe the valuation allowance for deferred tax assets—when it is required and what effect it has on financial statements.
The temporary difference is the difference between the carrying value and tax base of assets and liabilities. However, the permanent differences are those differences that occur due to the existence of certain items of income and expense that can be recognized in one statement and not on the other (i.e. income statement and tax return). These are the differences that cannot be reversed at some future point.
We have seen the examples of items that can cause the temporary differences, but some examples of permanent differences are non-taxable revenues such as government grants, etc., non-tax-deductible expenses such as fines, penalties, etc.
With permanent differences, there is no corresponding deferred tax asset or liability created. These result in differences in the effective and the statutory tax rates. The effective tax rate can be calculated by dividing the income tax expense with the pre-tax income, i.e.
The temporary differences, on the other hand, are of two types:
a. Taxable Temporary Differences. These are the temporary differences that result in the creation of deferred tax liability.
b. Deductible Temporary Differences. These are the temporary differences that result in the creation of deferred tax assets.
There must, however, be reasonable expectations of future profits in order to carry the deferred tax assets or liabilities. Otherwise, these may be written down or use valuation reserve under GAAP.