As part of the comprehensive reform of the Internal Revenue Code, the House Ways and Means Committee is examining the differences between tax and financial accounting, differences that can have a profound effect on company financial statements filed with the SEC. In recent testimony before the Committee, Ashby Corum, a KPMG partner, said that the accounting and reporting of income taxes by corporate enterprises in their financial statements is a critical element of their overall reporting. Changes in tax law can have significant effects on a financial statements, he emphasized.
Coterminous with the Committee hearings on the issue, the Joint Committee on Taxation reported on the differences between financial and tax accounting. The report noted that U.S. companies are subject to separate rules for reporting income, gain, losses, and deductions for U.S. tax and financial reporting purposes under US GAAP. The Joint Committee said there would also be differences between financial reporting under IFRS and U.S. tax reporting.
As a result, income reported for U.S. tax purposes differs from income calculated for financial reporting purposes. A primary objective of financial reporting is to provide current and potential investors with an accurate picture of a company’s economic position by matching revenues and expenses. Tax reporting, however, is designed to reflect income as defined in the federal tax code and permit the IRS to verify the same.
Mr. Corum testified that the tax code specifies how an enterprise’s annual federal current income tax liability is determined. Accounting standards provide for the financial accounting and reporting of the effects of income taxes that result from an enterprise’s activities during the current and preceding years, for U.S. GAAP reporting, FASB Accounting Series Codification Topic 740, Income Taxes.
The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, recognize deferred tax liabilities and assets reflecting the future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns, and measure current and deferred tax assets and liabilities based on tax law.
The KPMG partner noted that financial statement pre-tax income for a global enterprise can differ substantially from taxable income in a particular jurisdiction. Most of these differences are attributable to: when income or expense is recognized for tax purposes versus when it is recognized for financial reporting (temporary differences), items of income or expense that are permanently allowed or disallowed for taxable income purposes (permanent differences), and the allocation of income to different jurisdictions around the world with different statutory tax rates (allocation differences).
According to the Joint Committee on Taxation, many U.S. companies own all or part of other U.S. and foreign entities and typically are required to prepare consolidated financial statements for financial reporting purposes and may elect to file a consolidated return for U.S. tax purposes. For financial reporting, the consolidated group generally includes the parent company and all domestic and foreign entities in which the parent has direct or indirect control. See FASB Accounting Standards Codification 810, Consolidation.
An entity is treated as having direct or indirect control in another entity if it has a greater than 50 percent ownership in the other entity and such control is not transitory. In general, if an entity owns between 20 percent and 50 percent of another entity, the owner includes its percentage interest in the net income of that entity under the equity method of accounting. By contrast, a consolidated group for U.S. tax purposes is generally limited to only domestic corporations with which the parent has at least an 80 percent ownership interest by vote and value. The report noted that this fundamental difference in the definition of a consolidated reporting unit, in combination with complex rules addressing intercompany transactions and eliminations, typically results in a significant difference between a U.S. company’s consolidated financial or book income as compared to its consolidated taxable income.
The differing objectives of financial reporting and tax reporting also lead to differences as to when or how certain items are recognized and measured. Some items of income or expense that are reported for book purposes are never reported for tax purposes, said the Joint Committee, and some items of income or expense reported for tax purposes are never reported for book purposes. These are permanent differences. Common examples of permanent differences include interest income from certain municipal bonds, which is recorded for book purposes but not included in U.S. federal taxable income; the domestic production activities deduction under IRC Section 199, which results in an exclusion for tax reporting that does not exist for financial reporting; the 50-percent limit on meals and entertainment expenses that applies solely for tax purposes; and the excess of book basis over tax basis in the stock of a foreign subsidiary for which management has asserted permanent reinvestment of the underlying earnings of such foreign entity.
In general, depreciation for book purposes is guided by the goal of matching production-related expenses with sales revenue. Hence, cost recovery for tangible assets generally requires using the straight-line method of depreciation over an estimate of the each asset’s expected useful life with some residual value. Depreciation of tangible assets for tax purposes, however, is generally accomplished under the more accelerated modified accelerated cost recovery system depreciation rules without any residual value.
Since the basis of the property will be fully recovered either through depreciation or a future disposition for both book and tax purposes, said the JC report, this is considered a temporary difference. Nonetheless, the differences in depreciation method will generally result in greater tax depreciation relative to book depreciation in earlier years with book depreciation exceeding tax depreciation in later years of the asset’s estimated useful life.
According to the Joint Committee, financial accounting accruals make up one of the largest classes of revenue and expense items that result in temporary differences between financial and tax reporting. Sales or services revenue is generally not recognized until it is both realized and earned for book purposes. As a result, a company will not typically recognize revenue until the goods or services have been provided and there is reasonable assurance that payment will be received regardless of when cash payment is received from a customer. In circumstances where cash payments are received in advance of the goods or service being provided to the customer, such an advance payment is treated as unearned revenue which is a liability for book purposes.
For an accrual basis taxpayer, however, the receipt of certain advance payments for services and certain non-services to be rendered in the future that are not security deposits and are received without restriction as to use, are generally income in the year received. An example is prepaid rental income where the rental period extends over more than one year. Accrued expenses for book purposes are deducted when incurred. Additionally,contingent liabilities (other than income taxes) are recorded as a book expense when the contingency is probable and estimable.
In contrast, for an accrual method taxpayer, an expense is generally only deductible when all events have occurred that fixed the fact of the liability, the amount of the liability is determinable with reasonable accuracy, and economic performance has occurred. As a result, many accrued and contingent expenses are reported in a later period for tax reporting as compared to book reporting. Some examples of accruals that are expensed for book purposes in advance of when they would be deducted for tax purposes include vacation pay accrual, bonus accrual, and warranty reserves.