How Corporate Finance Rules Your Life
Conflicts between Stockholders and Managers
Why Budgeting is Important in Cost Accounting

Financial Income versus Taxable Income

In addition to using different standards for financial income (also known as book income) versus taxable income, the entities and individuals interested in financial accounting and taxable income are different.

The users of taxable income are usually governmental, whereas the users of financial income are typically individuals or businesses.

  • Governmental: Any local, state, or federal taxing agency. Most of the time, though, whenever you think about taxes, the image of good old Uncle Sam and the IRS immediately jumps into your head.

  • Individuals/businesses: This class of user includes stock exchanges if the business is publicly traded, which means anyone with the money and desire can purchase shares of company stock in an open marketplace.

    This category includes investors like you and me interested in finding a safe bet to invest our leftover cash, as well as creditors who closely scrutinize the financial statements to make sure the company likely will be able to pay back any loans eventually made.

Financial income

You show financial income on the income statement. All earned and recognizable revenue minus all allowable expenses per GAAP gives you income before taxes. Income before taxes gives users of the financial statements a clear picture on how well the company performs during the financial period. After all, taxes are a somewhat involuntary disbursement of income instead of an accounting event that causes income.

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Income before taxes is also known as pretax financial income or income for financial reporting purposes.

Now, you may be thinking, “Okay, but what about income tax expense and the bottom-line net income?” Well, don’t start rustling around in your intermediate accounting textbook to find the magic GAAP income tax formula. You figure income tax for financial reporting using the same tables as you do for tax reporting.

Because the goal of this chapter is not to test your ability to accurately figure income tax expense using the IRC income tax tables, I use a constant tax rate of 40 percent in all examples (your intermediate accounting textbook uses a constant tax rate, too).

Using a constant tax rate of 40 percent, income tax expense for the income before taxes is $34,000 ($85,000 x .40).

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Taxable income

Using IRC as your guide, you figure how much total income to include and which expenses are allowable to reduce the total income. Taxable income is that bottom-line number you report on the appropriate tax return.

Most companies report different financial and taxable income, for this reason: Accounting management prepares the financial books using a full accrual method but, for the tax return, uses a modified cash method, which uses some elements of GAAP and some elements of the cash method. For example, the company may accelerate asset depreciation.

Using the cash method of accounting, total income is recorded when it’s received. In other words, money changes hands and the company doesn’t have an accounts receivable. Ditto for expenses: The company records expenses only when the expenses paid — the company doesn’t have an accounts payable.

The gap between book and tax income generally results from three categories of differences: temporary, permanent, and loss carryforwards/carrybacks. Yikes, not sure how the three differ? Let’s take a look.

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