Companies are required to report their earnings in accordance with generally accepted accounting principles (GAAP). They are also required to report their earnings to the IRS and pay taxes as appropriate. However, sometimes a company will report one amount on its financial statements and another amount on its tax return. Taxable income is calculated by adhering to IRS rules, while pre-tax financial income is calculated by following GAAP.
Taxable income versus pre-tax financial income
Taxable income is the amount of income a company must pay taxes on, while pre-tax financial income is the amount a company makes before taxes are factored in. It's important for companies to present their pre-tax financial income to investors, as this gives them a more accurate picture of how well the company has performed. Companies sometimes include income on their financial statements that isn't part of their taxable income so that investors can see that the income in question was indeed earned.
Permanent differences between them
Certain types of corporate income are always exempt from taxes, and any income that falls into those categories constitutes a permanent difference between taxable and pre-tax income. One common example is the interest received on municipal bonds. If a company receives tax-free interest, it should include that income on its financial statements. However, it does not have to include that interest in its tax filing or pay taxes on it.
Temporary differences between them
Because the tax code and GAAP differ, a company might record a difference between taxable income and pre-tax income at a specific point in time only. One common example of this is depreciation. Depreciation is the reduction in an asset's value over time. Businesses are allowed to deduct depreciation expenses against their income.
Usually, for accounting purposes, companies use what's known as the straight line method of depreciation, which involves writing off an asset evenly over time. So if a company buys a piece of equipment for $10,000 with a five-year lifespan, under the straight line method, it would deduct $2,000 per year in depreciation. However, the tax code sometimes allows for accelerated depreciation, in which case a company might write off more of an asset's cost up front. Using our example, with accelerated depreciation, the company might write off $4,000 after the first year of owning that equipment for the immediate tax benefit.
As a result, a company's financial statement might show one rate of depreciation, and its tax return might show another at a specific point in time, producing two different net income figures. Eventually, however, the equipment will be depreciated in its entirety, and both the financial statement and tax return will reflect the same total depreciation.
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