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

The following are just three of the most common textbook differences between book and tax accounting:

1) Cash-Based vs. Accrual-Based Accounting

While certain activities of a corporation may be recorded on a cash basis for tax accounting, most activities accounted for in its financial statements are done so using what is known as the accrual method. For example, when a company receives payment for a service or product, it is immediately taxable income in the view of the IRS (unless it is deferred income[3]). However, on a financial statement, the matching principle must be used under U.S. GAAP rules. This principle, used in book accounting, ensures that the income generated by an output and the expense incurred for that output are recognized in the same period. The following simple example is illustrative:

A magazine company is selling year-long subscriptions to its publication. The cost of printing each issue is $2 and the revenue generated by each issue sold is $5. A consumer buys a year-long subscription on August 1st and the company immediately receives $60. In the eyes of the IRS, this is immediately taxable income in the current year. However, for book accounting purposes, the company (using US GAAP) matches the revenue of each month’s issue with the cost associated with that copy. In this manner, the company will only have made a $15 profit by the end of the year. They must, however, pay income tax on the full $36 profit of the initial transaction.

In this case, a $21 difference exists between book and tax profit. This difference results in a lower income tax liability on the company’s financial statement than what is actually owed to the IRS. Accrual-based accounting can be used by any company for internal bookkeeping; however, it is mandatory if a business has sales of more than $5 million or inventory and sales of $1 million on an annual basis.

2) Treatment of Depreciation

Depreciation is technically defined as “a method of allocating the cost of a tangible asset over its useful life. Businesses depreciate long-term assets for both tax and accounting purposes.

Companies generally use two main types of depreciation, although variations of each exist: straight line and accelerated.examples of straight line and accelerated depreciation of an asset originally valued at $100,000, with an expected salvage value (the price for which it can reasonably be sold at the end of its use by the firm) of $10,000 after 10 years.

In the case of straight-line depreciation, an identical percentage of the difference between initial and salvage value is depreciated every year (in this case $9,000/year, 10 percent of ($100,000-$10,000=$90,000)), resulting in a book value equal to salvage value at the end of the asset’s useful period. Using this method, 20 percent of the asset’s book value is depreciated each year.

The U.S. tax code and GAAP allow both of these methods. However, GAAP rules require that the rate of depreciation be consistent with the expected wear and tear of the asset depending on its characteristics. This difference allows corporations to depreciate these assets on their financial statements in a way that truly reflects the use and growing obsolescence of some capital investments.

This method currently allows businesses to legally deduct a much larger percentage of an asset in the first year than U.S. GAAP allows under the rules’ “period of usefulness” provision. This capital investment is theoretically incentivized because depreciation is tax-deductible; thus when a proprietor can use 100 percent of a capital outlay to reduce their tax liability, the investment immediately becomes more attractive. This is one clear example of how changes in tax law can cause differences between book and tax numbers.

3) Treatment of Inventory

Two principal methods are used when accounting for inventory for book and tax purposes. The first is the last-in, first-out (LIFO) method. Using this method, the cost of inputs purchased for production in a given period is matched with the revenues generated by items sold in the same period. This method is used regardless of whether the inputs are physically used to produce anything during that time. The IRS has stipulated that businesses using LIFO to account for inventory on their tax returns must also use LIFO when reporting taxable income on financial statements:

Section 472(c) of the [Internal Revenue] Code imposes the condition that a taxpayer electing the LIFO method for income tax reporting purposes must also use the LIFO method for financial reporting to shareholders, partner, other proprietors, or beneficiaries, or for credit purposes.

U.S. GAAP allow businesses to claim income using either the LIFO or FIFO (first-in, first-out) system. Contrary to LIFO, FIFO matches the cost of the oldest inputs with the revenue of goods sold in a given period.

For all practical purposes, U.S. corporations must keep two sets of books: one set to comply with Generally Accepted Accounting Practices and the other to comply with the Internal Revenue Code. GAAP rules are intended to promote uniform statements that accurately convey the financial history, health, and prospects of a business, while the tax code is intended to generate revenues for the government but also achieve certain public policy goals. It is only natural that these two methods frequently produce very different results.

Companies are required to report their earnings in accordance with generally accepted accounting principles (GAAP). They are also required to report their earnings to the IRS and pay taxes as appropriate.

However, sometimes a company will report one amount on its financial statements and another amount on its tax return. Taxable income is calculated by adhering to IRS rules, while pre-tax financial income is calculated by following GAAP.

Before you can understand what pretax income is, you need to understand the difference between revenue and income.

Revenue is money earned for goods and services. For instance, if you sell a leather wallet for $75, the revenue received is $75. Revenue does not take into account the cost of the item that you sold, nor the overhead expenses it took to get that wallet to your customer, which includes payroll, shipping, and utilities, to name a few.

Pretax income, also known as earnings before taxes, is the income earned by your business after subtracting common operating expenses, but before deducting any taxes due. Pretax income gives you and your investors a much better idea of what the business is earning.

In order to calculate pretax income, you will need to take total revenue and then subtract operating expenses such as rent, utilities, and payroll. You will also need to subtract any non-cash expenses that impact your business such as depreciation, as well as any interest expense on loans or notes payable you may have. When calculating your pretax income, you’ll also want to add in any interest income you may have received throughout the year.

Taxable income is the amount of income a company must pay taxes on, while pretax financial income is the amount a company makes before taxes are factored in.

It's important for companies to present their pretax financial income to investors, as this gives them a more accurate picture of how well the company has performed. Companies sometimes include income on their financial statements that isn't part of their taxable income so that investors can see that the income in question was indeed earned.

Permanent differences between them

Certain types of corporate income are always exempt from taxes, and any income that falls into those categories constitutes a permanent difference between taxable and pre-tax income.

One common example is the interest received on municipal bonds. If a company receives tax-free interest, it should include that income on its financial statements. However, it does not have to include that interest in its tax filing or pay taxes on it.

Temporary differences between them

Because the tax code and GAAP differ, a company might record a difference between taxable income and pre-tax income at a specific point in time only. One common example of this is depreciation. Depreciation is the reduction in an asset's value over time. Businesses are allowed to deduct depreciation expenses against their income.

Usually, for accounting purposes, companies use what's known as the straight line method of depreciation, which involves writing off an asset evenly over time. So if a company buys a piece of equipment for $10,000 with a five-year lifespan, under the straight line method, it would deduct $2,000 per year in depreciation.

However, the tax code sometimes allows for accelerated depreciation, in which case a company might write off more of an asset's cost up front. Using our example, with accelerated depreciation, the company might write off $4,000 after the first year of owning that equipment for the immediate tax benefit.

As a result, a company's financial statement might show one rate of depreciation, and its tax return might show another at a specific point in time, producing two different net income figures.

Eventually, however, the equipment will be depreciated in its entirety, and both the financial statement and tax return will reflect the same total depreciation.