Question

Explain the different treatments, options, methods and practices between tax legislation and accounting standards, for recording and reporting expenses/deductions, benefits and depreciation

Answer 1

There has been a flurry of sensational press accounts in recent months about the taxes paid by large corporations. These stories have reignited an ongoing debate over the different ways in which a company’s profits and tax liability are presented to shareholders on financial statements and what is reported to the IRS on a company’s tax return.

While the differences between book and tax accounting are no doubt confusing to many, it is entirely reasonable that there be considerable differences between the two practices. After all, corporate accounting standards are typically set by the independent Financial Accounting Standards Board (FASB), while the Internal Revenue Code is a product of the political process between Congress and the While House. Tax rules are driven by broader public policy concerns rather than adherence to formal accounting practices.

So while Generally Accepted Accounting Principles[1] (GAAP) are intended to insure uniformity of companies’ financial statements and accounting methods, similar activities may be treated very differently for tax purposes.[2] Therefore, it is possible for the financial reports of a company to differ from the tax returns prepared for the IRS because of the different accounting methods.

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.

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.

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..