Module 17

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Module 17

• Differences Between Financial and Tax Accounting

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Module Topics

• Overview of differences between financial and tax
  accounting
• Temporary differences
• Permanent differences
• Reconciling financial income to tax income
• Deferred taxes

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Overview of Differences Financial vs Tax
Accounting

• Key Learning Objectives
• Recognize the importance of transactions to all
  accounting disciplines
• Understand why the reports produced by financial,
  managerial, and tax accountants from the same
  transactions-based information are different

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Transactions-Based Accounting

• Transactions provide the raw data for all
  accounting activity
• Financial, managerial, and tax accountants use
  the same basic data to compile reports
• Reports differ because of different information
  needs of users

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Comparing the Accounting Disciplines

• Financial accounting
• Provide useful information for external investors
  and creditors
• Managerial/cost accounting
• Provide useful information for internal managers
• Tax accounting
• Provide useful information for tax authorities

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Justifying Differences Between Financial and Tax
Accounting

• Different Goals Exist
• Financial
• Provide useful information to decision makers
  external to a firm
• Tax
• Generate revenues to fund government
• Implement social and economic policy
• Reward valued electoral constituencies

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Research Query One Method of Accounting?

• Is there a uniform method of tax accounting that
  is prescribed for all taxpayers?

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Solution-- Research Query One Method of
Accounting?

• No uniform method of accounting is prescribed for
  all taxpayers
• Taxpayers may adopt the forms and systems that
  are, in their judgment, best suited for their
  needs
• However, no method of accounting is acceptable
  unless it clearly reflects incomeReg
  1.446-1(a)(2)

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Research Query What Code Rules

• Which provisions in the Code and Regs govern
  record keeping requirements?

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Solution--Research Query What Code Rules (1)

• Taxpayers must maintain those accounting records
  that will enable them to file correct returns of
  their taxable income each year
• Accounting records include the regular books of
  account and whatever other records and data may
  be necessary to support the entries on their
  books of account and on their returns, e.g., a
  reconciliation of any differences between the
  books and their returnsReg 1.446-1(a)(4)

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Solution-- Research Query What Code Rules (2)

• Every person subject to the income tax must keep
  permanent books of account or records, including
  inventories, sufficient to establish the amount
  of gross income, deductions, credits and other
  items shown on the income tax returnCode Sec.
  6001 Reg 1.6001-1(a)

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Reconciling Differences Between Financial and Tax
Accounting

• Financial accounting income
• Adjustments
• Tax accounting income
• Adjustments can be due to
• Temporary differences
• Permanent differences

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Temporary Differences

• Key Learning Objectives
• Why temporary differences exist between financial
  and tax accounting income
• Identify transactions that create differences

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Temporary Differencesa.k.a. Timing Differences

• How much revenue or expense is recognized in each
  time period
• Over time, same amount of revenue or expense is
  recognized by both

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Temporary DifferencesDepreciation Example
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Temporary DifferencesGross Income Examples

• Prepaid income of accrual basis taxpayer
• Positive adjustment in year cash received
• Negative adjustment in year services provided
• Installment sales
• Negative adjustment in year of sale
• Positive adjustment in later years

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Temporary DifferencesExpense Examples

• Common Positive Adjustments
• Excess capital losses
• Book depreciation in excess of tax depreciation
• Charitable contributions gt 10 limit

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Temporary DifferencesExpense Examples

• Common Negative Adjustments
• Capital loss carryovers
• Tax depreciation in excess of book depreciation
• Charitable contribution carryovers
• NOL carryovers

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Compliance Query Installment Sale

• T reported a 50,000 gain for tax purposes
• Using the installment method
• Gain reported in year 1 15,000
• Gain reported in year 2 25,000
• Gain reported in year 3 10,000
• What adjustments to financial records are
  necessary each year?

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Solution-- Compliance Query Installment Sale

• Year 1 35,000 negative adjustment
• Tax - book income (15,000 - 50,000)
• Year 2 25,000 positive adjustment
• Tax - book income (25,000 - 0)
• Year 3 10,000 positive adjustment
• Tax - book income (10,000 - 0)

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Permanent Differences

• Key Learning Objectives
• Why permanent differences exist between financial
  and tax accounting income
• Identify transactions that create differences

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Permanent Differences

• Over time, the two systems do NOT recognize the
  same amount of revenue or expense
• Generally due to differences in goals between the
  systems

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Permanent DifferencesCommon Adjustments

• Negative Adjustment Income Items
• Municipal bond interest
• Proceeds from key person life insurance

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Permanent DifferencesCommon Adjustments

• Positive Adjustment Expense Items
• Related to producing tax exempt income
• Key person life insurance premiums
• Related party losses
• 50 of meals and entertainment
• Political contributions

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Reconciling Financial Income to Tax Income

• Key Learning Objectives
• Reconcile the differences between financial and
  tax return income
• Analyze changes in the equity accounts of
• C corporations
• S corporations
• Partnerships

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Reconciling Formula

• Income for books
• Taxable income not recognized for book
• Book expenses not deductible for tax
• - Book income not subject to tax
• - Tax deductible expenses not claimed for books
• Income for tax
• (Similar to Schedule M-1)

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Analyzing Equity AccountsGeneral Formula

• Balance, beginning of the year
• Income earned during the year
• - Deductions and losses incurred during the year
• - Distributions to owners
• Balance, end of the year
• (Similar to Schedule M-2)

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Deferred Taxes

• Key Learning Objective
• Nature of the deferred tax accounts and
• Relationship to the differences between financial
  and tax accounting income

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Deferred TaxesIntroduction

• Arise because of temporary differences between
• Taxable income per GAAP
• Taxable income per tax law

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Deferred Taxes--FASB Statement 109

• Identify timing and amount of temporary
  differences
• Measure current and noncurrent
• Deferred tax liabilities
• Deferred tax assets
• Adjust valuation allowance for deferred assets
  (50 rule)
• Provide adequate disclosure