Book Versus Tax Accounting

Patrick Killeavy

Income Tax II
Professor Key
April 19, 2015

Introduction: The principal objective of a business is usually to earn a large amount of net income. Business income is essentially the total amount of profit or loss left over after deducting expenses from sales or revenue. There are a number of reporting methods to define and account for income in a business. The two main systems to measure income which a company incurs in a year are corporate income (tax reporting/accounting) and Book (accounting) income. A number of countries impose corporate tax on the amount of profits that a company earns each year. This tax is imposed using a rate based upon the amount of taxable income earned each year. The higher the company’s income the more tax it will have to pay. The amount of income for U.S. companies is reported on IRS Form 1120 each year. The rules for determining income and expenses are governed by federal tax law. In addition to filing federal income tax returns, all publicly traded corporations and some privately held corporations must provide financial statements each year to its users. The users of the financial statements are generally investors, creditors, lenders, suppliers, financial institutions and the general public. The financial statements provide information to the users about a company’s financial strength and solvency. The rules for deciding what and how to report certain items in the financial statements are governed by generally accepted accounting principles or (GAAP). Since GAAP and federal tax law contain different rules, this will create many differences when reporting income. A corporation may be motivated to report low income on its tax return to the IRS resulting in less income tax due but conversely, may desire to display high income on its income statement in order to gain the confidence of investors. The differences that arise between the reporting of book and accounting income can affect the amounts ultimately recorded as income and the timing for when income is recorded.
Corporate Income: Corporate income tax is enforced by the United States for all companies set up as a corporation at the federal, state, and local level. Each corporation will file a Form 1120 to the IRS every year disclosing amounts such as business income, dividends, deductions and taxes. Federal corporate tax returns and payments are due by March 15th for most entities. The determination of taxable income is calculated by included business income minus allowed deductions. Each company’s income tax liability will be computed by taking a certain percentage of the corporation’s taxable income. The higher the taxable income the higher the rate and taxes due to the government. The tax return reflects gross receipts and subtracts cost of goods sold to arrive at gross profit. Once gross profit is determined, certain gains and interest must be added such as capital gains, and interest income to arrive at total income. Once income is determined the company’s financial officers or accountants determine which expenses or losses can be deductible on the tax return. A number of deductions and losses contain certain restrictions. For example, a corporation’s charitable deductions cannot exceed 10% of its AGI. In addition, certain losses such as capital losses must be offset by capital gains and only shown on the tax return as a capital gain or as no gain or loss. The losses will be carried forward to future years when future income can be generated to offset the losses. The criteria for determining which amounts are included as income or allowed as a deduction are found in the Internal Revenue Code which is administered by the IRS. Management will try to deduct as much as they can to arrive at a low taxable income. After this amount is determined, the corporation looks at the rate category in which they fall. For example, if the corporation recorded taxable income below