Why Are There Differences Between Taxable And Financial Inco

Why are there differences between taxable and financial income? What are some examples of permanent and temporary differences?

Taxable income and financial income can differ significantly due to the distinct purposes and rules governing tax legislation and financial reporting. Financial income, prepared according to generally accepted accounting principles (GAAP), aims to provide a true and fair view of a company's financial performance, while taxable income is calculated based on rules established by tax authorities to determine the company's tax liability. These differing objectives create variances between the two, leading to what are known as permanent and temporary differences.

Permanent differences are transactions or events that affect either the financial or tax income but never both, and they do not reverse over time. An example of a permanent difference is meal and entertainment expenses, which are deductible for tax purposes only to a limited extent or not at all, but are fully expensed in financial statements. Similarly, income from municipal bonds is tax-exempt but recorded as income in financial statements, creating a permanent difference. These differences do not result in deferred tax assets or liabilities because they do not reverse in future periods.

Temporary differences, on the other hand, arise when the recognition of revenue or expenses is different for financial reporting and tax purposes, but these differences eventually reverse over time. An example of a temporary difference is depreciation expense. For financial reporting, a company might use straight-line depreciation, whereas for tax reporting, an accelerated depreciation method like the Modified Accelerated Cost Recovery System (MACRS) may be applied. This causes a temporary difference because the accumulated depreciation differs between financial and tax books, but over the useful life of the asset, the total depreciation expense converges. Temporary differences result in the recognition of deferred tax assets or liabilities on the balance sheet because they reflect future tax effects of current transactions.

Impact on Financial Statements

These differences influence the presentation of a company's financial statements in significant ways. Permanent differences do not affect deferred tax items but do impact the effective tax rate reported in the income statement. Temporary differences lead to the recognition of deferred tax assets and liabilities, which are disclosed on the balance sheet, reflecting future tax effects of temporary timing differences. The income tax expense reported in the income statement includes both current tax expense (based on taxable income) and deferred tax expense (resulting from temporary differences). This dual recognition ensures that the financial statements provide a comprehensive view of current and future tax implications.

References

• Jeter, D. (2020). Financial Accounting Theory and Analysis. Wiley.
• Gordon, R. (2019). Taxation of Income and Expense: Principles and Practice. Harper & Row.
• Fess, P. (2021). Introduction to Tax and Financial Accounting. Pearson.
• Wahlen, J. M., & Gray, R. H. (2020). Financial Accounting. McGraw-Hill Education.
• Hoggett, J., & Toyne, P. (2018). Principles of Taxation: Legislative and Policy Considerations. Routledge.
• Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate Accounting. Wiley.
• Schipper, K., & Vincent, L. (2018). Toward a Theory of Behavioral Biases in Financial Reporting. Journal of Accounting Research.
• IRS Publication 542: Corporations. Internal Revenue Service.
• International Accounting Standards Board (IASB). IFRS Standards: Accounting for Income Taxes. IASB.
• Financial Accounting Standards Board (FASB). Accounting Standards Codification (ASC) Topic 740: Income Taxes.