Companies have to file tax returns that are in accordance with tax regulations and rules developed by the Internal Revenue Service (IRS). The amounts reported under taxable income and financial income differs. These amounts are different because financial income is based on Generally Accepted Accounting Principles (GAAP) which uses the accrual method to report revenues. Taxable income on the other hand, which is determined by rules and regulations of the IRS, follow a modified cash basis to determine revenue. Therefore, it can be seen that these amounts differ because of the differences between tax regulations and GAAP.
The majorities of financial advisers do not have a formal accounting or tax background and thus have some challenges to overcome when reading tax returns of their clients. However they are still asked to help their clients in future planning. Since most accounting is to be done based on compliance with GAAP it would make sense to think that tax accounting should also be done this way, however both the IRS and the courts have stated that compliance with GAAP is of little significance when dealing with the objectives of tax accounting. The objectives of both accounting methods are simply different, because the primary goal of financial accounting is to provide useful information to all stakeholders and the primary goal of the income tax system is the equitable collection of revenue. Because of these differences it can be said that the users of accounting information are different for both methods. The assumption for financial accounting is the going-concern and the tax accounting system ignores this assumption. These differences give us the concept of timing differences and permanent differences. Understanding these differences is the goal of the financial advisor in the pursuit of their career, or at least it should be Brinker Jr., (2005).
These differences may cause variances between taxes payable and income tax expense. This difference occurs when there is a temporary difference between book and tax amounts. According to Kieso, Weygandt & Warfield “a temporary difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements, which will result in taxable amounts or deductible amounts in future years. Taxable amounts increase taxable income in future years. Deductible amounts decrease taxable income in future years” (2012). Therefore, temporary differences are timing differences and will eventually be recognized both under GAAP and the IRS. Temporary differences include depreciation, prepaid expenses, unearned revenue, warranty liability/expense, contingency accruals, and accounts receivable/cash receipts. There are two consequences for temporary differences. One consequence is a deferred tax liability and the other is a deferred tax asset.
Currently deferred taxes are accounted for based on the asset-liability method and with the convergence...