Question

The world would be simpler if the US Tax Code and US GAAP were the same, and thus two sets of books would not be needed. Discuss the reasons they are not and whether or not you think it necessary for the present system to remain as it is

Answer 1

It is only natural that in the corporate world, two sets of books are maintained, one for maintenance of regular accounts & the other for submission to revenue authorities for assessment of taxes.

For the former,standards are set by the Financial Accounting Standards Board (FASB) which is an independent body , responsible for formulating the Generally Accepted Accounting Principle (GAAP),mainly to ensure uniformity in financial statements and accounting methods of companies belonging to variety of industries---- also to reflect true & fair view of the financial state of affairs of the company to the owners/investors and also to any other user of the statements--- and publicly-listed companies are required to file these statements with the Securities & Exchange Commission

while tax rules that give more emphasis for broader public policy concerns rather than only adherence to formal accounting practices, are governed by the Internal Revenue Service & its various Codifications & Publications .

1.GAAP requires that accounts are maintained on accrual basis , so that the corner-stone principle of matching concept of accounting--ie. accruing expenses incurred for generating an income,be recorded in the same period as that revenue. But as IRS opeartes on cash basis --so income not yet received & expenses not yet paid are not consisdered for statements submitted for calculating tax.

2.Again, in the case of depreciation, GAAP insists on consistency over the years & requires any change to be disclosed in the Notes to the Financial statements, very clearly with the purpose and their impact on current Year's profits ---but allows almost any type of depreciation be it straight-line/Double-declining/Units of activity.GAAP is more concerned with justifiable allocation the capital expended over the useful/economic life of the asset.

But IRS almost always allows depreciation as per MACRS rules & are formulated as per the changing needs of public concern of the US Government.It also allows Sec 179 expensing of the full amount of the capital investment ,in the 1st year itself ,when it wants to give some sort of incentive ,to promote sale in any area.Here. larger economic welfare occupies paramount importance.

3. As far as inventory is concerned, GAAP allows both LIFO & FIFO --again consistency in practice is required & any change to be disclosed properly with purpose & impact.

LIFO increases COGS & hence reduces profits as well as taxable income.Ending inventory is at older prices.But this matches latest revenue with latest costs of goods issued to production.

FIFO decreases COGS & hence shows increased profits as well as taxable income .Ending inventory is at the latest prices.But this matches the latest revenue with old & obsolete costs of goods issued to production.

So, IRS requires inventory to be valued at LIFO & reported as such for both income-tax purposes & disclosure to shareholders & others ,even,if following FIFO for their internal purposes.

Thus difference in the methods will result in a permanent tax -difference as per books & IRS.

Items like the one in 1, . (accrual vs cash accounting)--will result in a temporary tax-difference between books & IRS --that will even out with time-may a year or two.

But the other 2 like depreciation & inventory --tax differences arising between books & IRS are permanent & bound to remain.

Thus,it can be seen that in the corporate world,it becomes almost imperative to maintain two sets of books-one for disclosure as per GAAP standards & the other for submission to revenue authorities for assessment & payment of taxes ,on the income earned.