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As an investor, you should know that most companies keep two sets of books, but not for any nefarious reasons. One set reflects the requirements of financial reporting, while the other keeps track of accounts from the point of view of the Internal Revenue Service. Corporations periodically report economic activities, some of which create income. A corporation’s pretax financial income stems from income recognized under generally accepted account principles, or GAAP, whereas its taxable income is the amount on which it will pay tax in the current period according to IRS rules.
Tax Payable Under GAAP
The bulk of tax payable may be income tax, but others types include state sales tax, payroll tax and local property tax. Income tax payable is based on the amount of pretax finance income for the period. The corporation recognizes an income tax obligation by recording an expense for the tax amount and assigning this amount to income tax payable. When the corporation gets around to writing the tax check, it reduces the income tax payable account and the cash account by the amount on the check.
Source of Differences
Corporations record the book value of assets and liabilities on one set of books and the tax value of the same items in their tax books. A deferred tax liability results from differences between the two books. Book value is based on GAAP rather than IRS rules. For example, suppose XYZ Corp. sells merchandise on installment that will eventually create $300,000 of pretax income. GAAP requires XYZ to immediately recognize the full $300,000 as pretax financial income. However, the IRS only taxes the amount of profit earned on installment payments received during the year, which in this example is $100,000. The temporary difference between the two books is $200,000 in taxable income.
Deferred Tax Liability
XYZ is in the 25 percent tax bracket. On the tax books, it must pay 25 percent tax on the $100,000 profit actually received during the year, or $25,000. XYZ assigns this amount to income tax payable.
On the financial books, the income statement shows a total tax expense of $75,000 for the year, derived from 25 percent of the total $300,000 profit recognized this year under GAAP. The unpaid tax on the $200,000 not yet received creates a deferred tax liability of $50,000.
In Year 2, XYZ receives the remaining $200,000 in profit from the previous year’s installment sales. The 25 percent tax on this amount is $50,000, the same amount as the deferred tax liability. On the GAAP books, XYZ reverses the $50,000 from the deferred tax liability and adds it to income tax payable. When XYZ pays the tax, it reduces cash and income tax payable by $50,000.
On the tax books, XYZ records the payment of $50,000 in taxes against the income of $200,000 it books in Year 2. Both books now reflect $300,000 in taxable income from sales and $75,000 in tax payments. XYZ thus reconciles the Year 1 temporary difference between the two corporate books.
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