Time Differences between financial reporting and tax accounting

Hi, I am starting to look into Reading 38: Analysis of Income Tax and feel puzzled over the following questions: (The book didn’t explain as if it expects me to know already) 1) Why is that the Income tax reporting could be so different from financial report? On page 425, Income tax reporting reports that a machine is depreciated over two years, but the financial statment depreciates it over three years. Is this allowed in actual practise? 2) I don’t get the calculation shown on page 430: The financial statment charges itself with $975 of income tax expenses while the reported income tax has a “income tax payable” of only $800. Why would a company charges itself with higher income tax expenses, which will lower its net income?

you might want to post the actual problem for #2 so that some of the smarter charterholders like cpk (who don’t have the reading material) can help you out

It’s tough to post the complete problem mentioned in #2 as it involves rows of balance sheets and income statment numbers. But here is the gist of it: a) A firm purchases a machine costing $6,000 with a three-year estimated service life and no salvage value. For financial reporting purposes, the firm uses staight-line depreciation with a three-year life ($2,000 depreciation expenses yearly). For income tax report, the machine is depreciated straight line over two year ($3,000 depreciation expenses for year 1 and 2 only). The machine will generate annual revenue of $5,000 for three years. b) The firm also recognizes a warranty expenses of $1,500 for three years, speading $500 each year in the financial statement. But in income tax reporting, It reports $0 for year 1 and 2, but $1,500 in year three. c) The corporate tax rate has been 40%. But then IRS reduced the corporate tax rate to 35% for year 2. This new tax rate was enacted before the year 1 financial statements were prepared. SFAS 109 requires adjustment to deferred tax assets and liabilities to reflect the impact of a change in tax rates ----> so is this why the firm charge itself with $975 of income tax expenses instead of $800? year 1 income tax reporting looks like this: revenue 5000 Depreciation expense 3,000 Warranty expense 0 taxable income 2,000 taxes payable at 40% 800 Net Income 1,200 So here is the page 430 calculation shown: year 1: 35% * $1000 (the prepaid depreciation expenses to IRS) - 35% * 500 (the deferred warranty expenses ) + 40% * 2,000 (taxable income as reported in Income Tax reporting) = 350 - 175 + 800 = $975 And here is the accounting entry in Year 1: Income tax expenses 975 Deferred tax assets 175 Deferred tax liability 350 Taxes payable 800

The short answer is that corporate books and income taxes are just not very connected. And that’s so for publicly traded and audited books. Imagine what it’s like for small business America…

Key point is that by doing whatever the company does, do not think they are cheating on their taxes, or that they are avoiding paying some of the taxes. No matter how you report it, i.e. depreciate over 2 years for taxes and 3 years for financial statements, the company still pays the same amount of taxes (disregarding TVM). However, firms sometimes prefer to pay more or less taxes in early years or later years, etc, and they resort to this kind of arrangement. When you depreciate using straight line or accelerated methods, do you end up charging more or less in depreciation expense? Of course you charge the exact same amount, it’s just you spread it differently over the years.

Book depreciation is based on the concept of matching the expense (cost) of an asset with the periods in which it will help you generate revenues. Tax laws factor in things such as the government’s economic policies. In order to incent companies to invest in capital assets the IRS created these accelerated depreciation methods to return some of the cash invested to the corporate world faster.

JoeyDVivre Wrote: ------------------------------------------------------- > The short answer is that corporate books and > income taxes are just not very connected. And > that’s so for publicly traded and audited books. > Imagine what it’s like for small business > America… lol I work as a management accountant in a fairly small firm in France with sub in Miami, I can confirm that for both countries !!

i 123 study, your first question it is allowed, yes different depreciation treatement are allowed under the US GAAP. This the primary reason why we have differed tax liability i.e. low depreciatin results into high pre tax income and high tax expense. On a different note in terms of stock valuation you can not use different valuation methods i.e. it not allowed to use different stock treatement for financial reporting and tax report. if you chose LIFO you have to use it for both.