Question

"Financial Accounting Income vs. Taxable Income"

• Your new client, Barbara, has just formed a new corporation that provides consulting services to couples contemplating marriage. Help Barbara understand her company’s financial situation better by identifying two items of income and two items of expense that cause a company’s financial income to be different than its taxable income. Explain to her how her tax return reporting should be done as well as how tax obligations will need to be handled.

Answer 1

As mentioned in the question, Barbara has recently started the new company. At the end of the year, for computing the tax payable by her, certain considerations need to be taken care by her so that she reports the actual taxable profits made by the company and pays the right amount of tax on it.

Usually, while computing the taxable profits, the companies start from the accounting profits shown by the profit and loss statement (income statement) and make adjustments to it. The major adjustments are made for such incomes and expenses which has a different way of reporting as required under Income Tax Act.

The following are the incomes that differs from each other while computing accounting profits and taxable profits:

1. Accrued incomes

2. Unearned revenue

Accrued Income:

Accounting profit may exceed taxable income in certain reporting periods due to accrued revenues. Using the accrual method of financial accounting, companies report revenues when earned in the reporting period even though customers have not paid for the revenue-related sales. Consequently, such revenue recognition increases the accounting profit. On the other hand, using the cash method of tax accounting, companies don’t report any revenues unless they have collected cash from customers for the sales. As a result, the taxable income in the same period is potentially lower than the accounting profit.

Unearned Revenue:

Accounting profit may be lower than taxable income in certain reporting periods due to unearned revenues. Unearned revenues are cash receipts from customers for receiving goods or services over time through multiple periods. Using the accrual method of financial accounting, companies report only a portion of the total unearned revenues as the revenue earned in the current period, potentially having a lower accounting profit. Using the cash method of tax accounting, companies report the full amount of cash receipts as the revenue in the current period, increasing taxable income.

Also, in the expense side, the following need an adjustment:

1. Prepaid Expense

2. Accrued expense

3. Depreciation

Prepaid expense :

Accounting profit may also exceed taxable income in certain reporting periods due to prepaid expenses. Prepaid expenses are cash expenditures for future expenses but paid in the current reporting period. Using the accrual method of financial accounting, companies report expenses when incurred. As a result, only a portion of the prepaid expenses is reported as the expense incurred in the current period. Thus, the less expense reported in financial reporting, the higher the accounting profit. Using the cash method of tax accounting, companies report the full amount of cash expenditures as the expense in the current period, lowering taxable income.

Accrued Expense:

Accounting profit may also be lower than taxable income in certain reporting periods due to accrued expenses. Using the accrual method of financial accounting, companies accrue and report expenses when incurred rather than when paid. As a result, the more accrued expenses, the lower the accounting profit. Using the cash method of tax accounting, companies don’t report any expenses for tax filing in a period unless cash has been paid for related expense items. Thus, with less expenses reported, the taxable income is potentially higher than the accounting profit in the same period.

Depreciation:

Under accounting, the company follows a depreciation method depending on the useful life, salvage value and cost of the asset. But, when it comes to depreciation computed under taxable profits, the useful life selected changes, the method used changes and few other changes also can happen. In that case, the amount of depreciation changes under both computation methods. Hence, adjustment need to be done.