Learning Goal
Today you will learn why financial accounting income and taxable income are not always the same.
This lesson addresses Michigan Finance competency A4.
By the end of the lesson, you should be able to:
- Explain the purpose of GAAP.
- Explain the purpose of income-tax law.
- Explain why book income and taxable income may differ.
- Identify basic book-tax differences.
- Complete a simple book-to-tax reconciliation.
The original lesson plan specifically uses depreciation, deductible versus nondeductible expenses, tax-exempt income, and timing differences as examples. Accounting_A_A3_A4_Tax_Complian…
Warm-Up
Is profit shown on a company's financial statements always the same as its taxable income? Why or why not?
What Is GAAP?
GAAP stands for Generally Accepted Accounting Principles.
GAAP is used in financial accounting to help businesses prepare useful and comparable financial information.
Financial statements may be used by:
- Owners
- Managers
- Investors
- Lenders
- Creditors
- Other users of financial information
The primary goal is to communicate the financial condition and operating results of a business.
What Is Income Tax Law?
Income-tax law is used to determine:
- Taxable income
- Deductions
- Credits
- Tax liability
- Tax-reporting requirements
Tax accounting follows applicable tax laws, regulations, and guidance.
Its purpose is different from the purpose of financial accounting.
GAAP vs. Income Tax Law
Topic GAAP / Financial Accounting Income Tax Law
Primary purpose Provide useful, comparable financial information Determine taxable income and tax liability
Rules Financial-reporting framework, including GAAP Federal and state tax statutes, regulations, and guidance
Income/expense timing Recognition follows financial-reporting rules Recognition or deduction may occur in a different period
Result Book income and financial statements Taxable income and tax return
Differences May create book-tax differences May create permanent or temporary differences
This comparison comes directly from the student reference material for the module. Accounting_A_A3_A4_Tax_Complian…
Why Can Book Income and Taxable Income Differ?
Financial accounting and tax accounting may use different rules.
Differences may involve:
- Depreciation
- Deductible expenses
- Nondeductible expenses
- Tax-exempt income
- Timing of income recognition
- Timing of expense recognition
Therefore:
Book Income does not always equal Taxable Income.
Example 1 — Nondeductible Expense
Assume a business reports:
Book Income: $52,000
The business recorded:
$2,000 of expense that is not deductible for tax purposes
Because the expense reduced book income but is not deductible for taxes:
$52,000 + $2,000 = $54,000 taxable income
So:
Book Income: $52,000
Taxable Income: $54,000 Accounting_A_A3_A4_Tax_Complian…
Example 2 — Depreciation Difference
Assume:
Book depreciation: $6,000
Tax depreciation: $9,000
Difference:
$9,000 − $6,000 = $3,000
Tax depreciation is $3,000 greater.
Therefore, taxable income would be $3,000 lower than book income, assuming no other differences. Accounting_A_A3_A4_Tax_Complian…
Permanent Differences
A permanent difference does not reverse in a later period.
Financial accounting and tax accounting permanently treat the item differently.
Temporary Differences
A temporary difference occurs when financial accounting and tax accounting recognize an item at different times.
The difference may reverse in a later period.
Accounting_A_A3_A4_Tax_Complian…
Activity — GAAP, Tax Law, Both, or Neither
For each statement, decide whether it relates primarily to:
GAAP
Tax Law
Both
Neither
Examples:
1. Preparing a balance sheet for investors
2. Determining whether an expense is deductible on a tax return
3. Maintaining accurate source documents
4. Determining taxable income
Be prepared to explain your choices.
Guided Book-to-Tax Reconciliation
Starting with book income:
1. Identify an item treated differently for tax purposes.
2. Determine whether it should be added to or subtracted from book income.
3. Calculate taxable income.
4. Explain why the adjustment was needed.
Exit Ticket
In your own words:
1. What is the main purpose of GAAP?
2. What is the main purpose of income-tax law?
3. Why might book income and taxable income be different?