Module 17

1. Module 17 Differences Between Financial and Tax Accounting

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

3. 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

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

6. 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

7. 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

8. Research Query: One Method of Accounting? • Is there a uniform method of tax accounting that is prescribed for all taxpayers?

9. 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)

10. Research Query: What Code Rules • Which provisions in the Code and Regs govern record keeping requirements?

11. 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)

12. 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)

13. Reconciling Differences Between Financial and Tax Accounting Financial accounting income ± Adjustments Tax accounting income Adjustments can be due to • Temporary differences • Permanent differences

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

15. 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

16. Temporary DifferencesDepreciation Example

17. 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

18. Temporary DifferencesExpense Examples Common Positive Adjustments • Excess capital losses • Book depreciation in excess of tax depreciation • Charitable contributions > 10% limit

19. Temporary DifferencesExpense Examples Common Negative Adjustments • Capital loss carryovers • Tax depreciation in excess of book depreciation • Charitable contribution carryovers • NOL carryovers

20. 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?

21. 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)

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

23. 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

24. Permanent DifferencesCommon Adjustments Negative Adjustment Income Items • Municipal bond interest • Proceeds from key person life insurance

25. 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

26. 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

27. 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)

29. 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)

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

32. Deferred TaxesIntroduction • Arise because of temporary differences between: • Taxable income per GAAP • Taxable income per tax law

33. 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