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Book and Tax Differences in Financial Accounting

Because of these differing objectives, revenue and expense measurements that are used to determine taxable income may differ from those used in financial reporting. Accountants in these cases distinguish between book and tax measurements in that book measurements are used for financial reporting purposes, while tax measurements must comply with income tax laws.

In most cases, differences between book and tax measurements are temporary in nature. In order to stimulate purchases of property, plant, and equipment, for example, the U.S. government allows firms to depreciate such assets quickly for tax purposes. Firms can thereby reduce their income taxes in the earlier years after purchasing such assets. This accelerated depreciation usually exceeds the amount of depreciation expense that is used for financial accounting measurements of income. In later years, however, the situation is reversed. Financial statements continue to report depreciation expense, although the asset is already fully depreciated for tax purposes.

Accounting standards for reporting income tax expenses and liabilities reflect a basic premise: all events that affect the tax impact of temporary differences should be recognized currently in the financial statements. Broadly, two types of events can affect these expected tax impacts: (1) a change in the amount of temporary differences between the book and the tax bases of a firm’s assets (or liabilities) and (2) a change in tax rates that will apply to those temporary differences.

To illustrate the measurement of income tax expenses and liabilities, consider the information provided in Figure 9.3 about the financial statement and income tax accounting used by Dorian Company to account for its plant and equipment. As shown in Figure 9.3, Dorian uses the straight-line method of depreciation for financial reporting purposes and an accelerated method of depreciation for income tax purposes. As a result, the financial statement carrying value, or book basis, of these assets is $700 million at December 31, 2000, and the tax basis of these assets is $300 million. The book and tax bases of Dorian’s plant and equipment differ by $400 million:

Deferred Tax Liability Because temporary differences such as those resulting from accelerated tax depreciation only allow a firm to postpone its tax payments to later years, the postponed taxes will be paid eventually. For this reason, accounting standards require that firms recognize a liability for such future income taxes.

Figure 8.3 - Depreciation for Book and Tax Purposes

The liability for future income taxes is referred to as a deferred income tax liability. The measurement of a firm’s deferred income tax liability is obtained by multiplying the difference between the asset’s book and tax bases by the appropriate income tax rate.

Dorian Company’s income tax rate is expected to be 35% over the relevant future. Consequently, Dorian’s deferred tax liability at December 31, 2000, is $140 million, computed as follows:

Income tax expense reported in the financial statements is computed in the following manner:

To illustrate, refer again to Figure 8.3, which shows that during 2001 Dorian’s tax depreciation exceeds the book depreciation of the plant and equipment by $90 million ($150 million - $60 million). As a result, the difference between the tax and book bases of these assets has increased by $90 million, and the amount of the deferred tax liability has increased by $31.5 million, computed as follows:

Dorian’s 2001 income tax expense is the sum of the amount actually payable, $35 million (shown in Figure 8.3), and the increase in the deferred tax liability during 2001 computed above:

This tax expense would affect Dorian’s financial statements in the following manner:

Note that the income tax expense of $66.5 million is equal to 35% of Dorian’s reported pre-tax income of $190 million. This relationship occurs because our example assumes that tax rates remain stable at 35%. On the other hand, the percentage relationship of the income tax actually payable, $35 million, to Dorian’s pre-tax income is just 18.4% ($35 million / $190 million). If this amount were to be reported as income tax expense on the income statement, investors might be misled about Dorian’s true tax burden. For this reason, deferred tax accounting appears to provide a better matching of expenses on the income statement, at least when tax rates are expected to be stable over time. Case study 8.3 illustrates the relationships between income tax expenses, tax payments, and effective tax rates for a large U.S. firm.

Case Study 8.3

The Aluminum Company of America (Alcoa) includes the following information in its 1997 Financial Report:

Required

Based solely on the information provided above

a. Determine Alcoa’s effective income tax rate during 1997.

b. Determine the percentage relation between Alcoa’s actual tax payments and income before taxes during 1997.

c. Provide a likely reason for the difference between the percentages determined in parts a and b above.

d. Assume that Alcoa’s statutory tax rate is 35 percent. What would you estimate as the difference between the tax basis and the book basis of Alcoa’s depreciable assets at the end of 1997?

Solution

a. Alcoa’s effective tax rate during 1997 is the percentage relation of the provision for income tax ($528.7 million) to income before income tax ($1,601.7 million), or 33% ($528.7/$1,601.7).

b. Alcoa’s tax payments of $445.5 million are 27.8 percent of income before taxes ($445.5/$1,601.7).

c. A likely reason for the fact that Alcoa’s effective tax rate exceeds the percentage of income actually paid in income taxes during 1997 is that Alcoa’s taxable income is below the amount of income recognized in Alcoa’s financial statements.

This may be due to timing differences in recognizing revenues (such as lower revenues recognized for tax purposes) or in recognizing expenses (such as higher expenses recognized for tax purposes).

d. If Alcoa’s statutory tax rate is 35%, the differences between the tax and book bases of the depreciating assets may be estimated as follows:

Historically, tax rates in the U.S. have been relatively stable. In the third quarter of 1993, however, a new deficit-reduction law raised the corporate tax rate from 34 to 35%. This apparently minor adjustment in tax rates required that firms revalue their deferred tax liabilities upward by about 2.9% (1% rate increase/34% old rate). Because accounting standards require this adjustment to be included in the calculation of tax expense for the quarter in which the new tax law is signed, many firms experienced a considerable drop in the forecast for third-quarter profits. As examples, International Paper’s profit forecast fell by 50.8%, and Georgia Pacific’s forecasted profits were revised to a forecasted loss.

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