Overview on Accounting for Income Taxes - US GAAP

ACCOUNTING FOR INCOME TAXES – US GAAP

Companies have to file income tax returns following the guidelines developed by the Internal Revenue Service (IRS). Because GAAP and tax regulations differ in a number of ways, so the pretax financial income and taxable income will also differ. Consequently, the amount that a company reports as tax expense will vary from the amount of taxes payable to the IRS.

Pretax financial income is a financial reporting term. It also is often referred to as income before taxes, income for financial reporting purposes, or income for book purposes. Companies determine pretax financial income according to GAAP Rules. They measure it with the objective of providing useful decision making information to investors and creditors.

Taxable income (income for tax purposes) is a tax accounting term. It indicates the amount used to compute income taxes payable to the tax authorities. Companies determine taxable income according to the Internal Revenue Code (the tax code).

To understand how differences in GAAP and IRS rules may affect financial reporting and taxable income, Let us consider the below example

Under GAAP Reporting: Sand & Co reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations.

Below is the High Level income statement over these three years

Sand & Co – GAAP Reporting
	2012	2013	2014	Total
Revenues	$130000	$130000	$130000
Expenses	60000	60000	60000
Pre-Tax Financial Income	70000	70000	70000	$210,000
Income Tax Expense – ( 40% )	28000	28000	28000	$84,000

Under TAX Reporting: Sand & Co reported the same expenses to the IRS in each of the years. But, Sand & Co reported taxable revenues of $100,000 in 2012, $150,000 in 2013, and $140,000 in 2014..

Sand & Co – TAX Reporting
	2012	2013	2014	Total
Revenues	$100000	$150000	$140000
Expenses	60000	60000	60000
Pre-Tax Financial Income	40000	90000	80000	$210,000
Income Tax Payable – ( 40% )	16000	36000	32000	$84,000

If we observe the above two reporting, the Income tax expense and income taxes payable differed over the three years, but were equal in total in the end. 

Sand & Co – Income Tax Expense and Income Tax Payable
	2012	2013	2014	Total
Income Tax Expense – GAAP	$28000	$28000	$28000	$84000
Income Tax Payable – TAX	16000	36000	32000	$84000
Difference	$12000	$(8000)	$(4000)	$0

The differences between income tax expense and income taxes payable in this example arise for a small reason. For financial reporting, companies use the accrual method to report revenues whereas for the tax purposes, they use a modified cash basis approach. As a result, Sand & Co reports pretax financial income of $70,000 and income tax expense of $28,000 for each of the three years. However, taxable income fluctuates.

For example, in 2012 taxable income is only $40,000, so Sand & Co owes just $16,000 to the IRS that year. Sand & Co classifies the income taxes payable as a current liability Item in the balance sheet.

For the year of 2012, Sand & Co –the $12,000 ($28,000 - $16,000) difference between income tax expense and income taxes payable reflects taxes that it will pay in future periods. This $12,000 difference is often referred to as a deferred tax amount. In this case it is a deferred tax liability. If taxes will be lower in the future, then the Sand & Co will record a deferred tax asset.

A temporary difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements, which will result in taxable amounts or deductible amounts in future years.

The Taxable amounts will increase taxable income in future years where as the Deductible amounts will decrease taxable income in future years.

In this company, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recognized for book purposes. Sand & Co reported accounts receivable at $30,000 in the December 31, 2012, GAAP-basis balance sheet. Whereas the account receivables balance was zero on tax basis.

This created a $30,000 revenue difference in 2012 for Sand & Co. Assuming that Sand & Co expects to collect $20,000 of the receivables in 2013 and $10,000 in 2014, this collection results in future taxable amount of $20,000 in 2013 and $10,000 in 2014. These future taxable amounts will cause taxable income to exceed pretax financial income in both 2013 and 2014.

Company’s GAAP balance sheet assumption is to recover and settle the assets and liabilities at their reported amounts (carrying amounts). This assumption creates a requirement under accrual accounting to recognize currently the deferred tax consequences of temporary differences. That is, companies recognize the amount of income taxes that are payable (or refundable) when they recover and

settle the reported amounts of the assets and liabilities, respectively

Sand & Co has assumed that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. A payment of income tax in both 2013 and 2014 will occur. Sand & Co should therefore record in its books in 2012 the deferred tax consequences of the revenue recognition of the receivables reflected in the 2012 financial statements. Sand & Co performs this by recording a deferred tax liability.

More about Deferred Tax Asset and Liability to be continued…