Differences exist between the generally accepted accounting principles (GAAP) and the provisions of the Internal Revenue Code (IRC). These differences arise due to the varying objectives of GAAP and the IRC.
The objectives of GAAP are aimed at providing investors and other users of financial statements with reliable and relevant financial information.
The objectives of the tax law contained in the IRC include social equity, ease of administration, political considerations, and ensuring that individuals and corporations are taxed when they have the ability to pay.
Furthermore, there are many cases when the management of a firm will use one accounting method, such as straight-line depreciation, for accounting purposes and another method, such as ACRS-based depreciation, for tax purposes.
Therefore, prudent management will often select those accounting methods by the IRC that will minimize the firm’s taxable income and, thus, reduce its cash outflow due to taxes.
On the other hand, the same management may select a different set of accounting principles for financial reporting purposes.
Sources of Differences Between Accounting and Taxable Income
Differences between accounting income and taxable income can be classified into permanent and timing differences.
Permanent differences enter into the determination of accounting income but never into the determination of taxable income. They are, in effect, statutory differences between GAAP and the IRC.
An example of a permanent difference is interest on state and local bonds.
Although interest on these items represents revenue from an accounting perspective, it is not included in taxable income in either the year received or the year earned.
In the US, Congress did this in order to make it easier for states and local governments to raise revenues by making the interest on their obligations nontaxable. Since these differences are indeed permanent, we are not concerned with them.
Timing differences are the other reason that accounting income in any year may differ from taxable income.
Timing differences result from the fact that some transactions affect taxable income in a different period from when they affect pre-tax accounting income.
However, over the life of a particular transaction, the amount of income or expense for accounting and tax purposes is the same; it is just that it is different within the various periods.
An example of a timing difference is the use of straight-line depreciation based on the asset’s economic life for financial reporting purposes and the use of ACRS depreciation for tax purposes.
Generally, in the first few years of the asset’s life, ACRS depreciation exceeds straight-line depreciation, and pre-tax accounting income is reduced to less than taxable income as a result of depreciation.
However, in later years, the timing difference reverses. Straight-line depreciation now exceeds ACRS depreciation, causing a greater reduction in accounting income than in taxable income as a result of differences in depreciation.
To illustrate, suppose that a company purchases a light truck at the beginning of 2019 for $10,000 and decides to use straight-line depreciation for accounting purposes, with a 5-year life and no salvage value.
The firm takes an entire year’s depreciation in the first year, meaning that annual depreciation is $2,000, or $10,000 + 5 years.
For tax purposes, the asset has a 3-year class life, and under ACRS the depreciation percentages are 25% in the first year, 38% in the second year, and 37% in the third year.
The following table compares the annual and total depreciation under each method:
As the table shows, over the life of the asset—in both cases—the total depreciation is $10,000.
In the first three years, ACRS depreciation exceeds straight-line depreciation, but in the last two years, straight-line depreciation exceeds ACRS depreciation, which is reduced to zero.
There are several other timing differences between taxable income and accounting income. Some of the more important ones are summarized in the below example.
You should remember two points. Timing differences affect two or more periods: the period in which the timing difference originates and the later periods when it turns around or reverses.
However, over the life of a single transaction, the amount of accounting and taxable income or expense related to that transaction will be the same. It is just a question of when timing differences affect accounting and taxable income.