Difference Between Book and Tax Income

Definitions

• Book Income
  • Also known as pre-tax financial income
  • Computed according to GAAP (Generally Accepted Accounting Principles) in the US
  • Appears on the income statement and financial statements used by investors and creditors
• Tax Income
  • Income computed for the corporation's tax return to be filed with the IRS
  • Reported on Form 1120 for corporate income taxes
  • Information used by IRS, not accessible to investors and creditors

Differences in Purpose

• Objective of Book Income
  • Calculated on an accrual basis
  • Tracks changes in the firm’s wealth
  • Used by investors and creditors to predict the timing and certainty of future cash flows
• Objective of Taxable Income
  • Based on the ability to pay doctrine
  • Used by the IRS to raise money for the US government
  • Not disclosed to investors and creditors

Example

• Prepaid Rent Scenario
  • Tenant pays $800 rent in advance
  • Book Income (accrual accounting): Rent is not recognized as revenue until earned
  • Taxable Income (modified cash basis): Rent is recognized immediately when received

Accounting Bases

• Accrual Basis (Book Income)
  • Revenue is recognized when earned, not when cash is received
• Modified Cash Basis (Taxable Income)
  • Revenue may be recognized when cash is received

Differences Between Book and Tax Income

• Maintaining two sets of books
• Differences can be Temporary or Permanent

Temporary Differences

• These differences reverse over time
• Example: Depreciation

Permanent Differences

• These differences do not reverse over time
• Example: Life insurance proceeds from the death of a CEO
  • Counted in book income but not taxable income

Upcoming Topics

• Further details on temporary and permanent differences