Tax Reporting vs. Financial Reporting: - Income Tax Expense On The - Income Tax Payable (Or Paid in

Tax Reporting vs.
Financial Reporting
Income Tax Expense on the
income statement is based on
pre-tax income computed using
GAAP (or IFRS)
Financial Statements (Books):
Pre-tax income (per GAAP rules)
x Effective tax rate
.
= Income Tax Expense
Income Tax Payable (or paid in

cash) is based on Taxable Income
using tax code rules
Tax Return:
Taxable income (per IRS rules)
x Statutory tax rate
= Income Tax Payable
The two tax amounts can be DIFFERENT!

Permanent differences
Temporary differences
KNOWLEDGE FOR ACTION
Tax Reporting vs. Financial Reporting

Examples
Interest income from
municipal bonds
Cash advances
from customers
(unearned revenue)
GAAP
Interest revenue increases
pre-tax income
Revenue recognized when
earned (in future)
Tax Code
Does not affect taxable
income (tax-exempt)
Revenue recognized when
cash collected (now)
Bad debt expense
Expense recognized when

sale is made (now)
Depreciation method
chosen by firm
Expense when account is

written-off (in future)
Depreciation schedule
from tax authority
Depreciation
Example
Books
2011
EBITDA
50,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
EBITDA in this example is Earnings before depreciation, municipal

bond interest revenue, and taxes
Example: Permanent Differences

Books
2011
EBITDA
50,000
Muni Interest Revenue
1,000
Tax Return
2012
50,000 EBITDA
1,000 Muni Interest Revenue
2011
2012
50,000
50,000
Permanent Differences
Revenues that are never included in taxable income and expenses that are never
deductible for tax purposes
Examples: Interest on tax-exempt municipal bonds, tax penalties and tax credits, state
and foreign taxes
Do not reverse over time

Cause the Effective Tax Rate to not equal the Statutory Tax Rate
Example: Temporary Differences

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
(10,000) (10,000) Depreciation
Temporary Differences
Revenues or expenses recognized in a different period for tax purposes than for
financial reporting purposes
Examples: book vs. tax depreciation, bad debt expense, unearned revenue
Reverse over time

Stored up in Deferred Tax Assets and Liabilities
Example: Pre-tax Income vs. Taxable Income

Books
2011
EBITDA
50,000

Depreciation
Pre-tax Income
1,000
Tax Return
2012
50,000 EBITDA

41,000
41,000 Taxable income
2011
2012
50,000
50,000
(15,000)
(5,000)
35,000
45,000
Pre-Tax Income: Earnings before taxes under GAAP

Taxable Income: Earnings before taxes under tax rules
Differences between pre-tax income and taxable income arise from permanent
and temporary differences
Example: Income Tax Payable

Books
2011
EBITDA
50,000

Depreciation
Pre-tax Income
1,000
Tax Return
2012
2011
2012
50,000
50,000
(15,000)
(5,000)
35,000
45,000
X Statutory rate
0.35
0.35
12,250
15,750
50,000 EBITDA

41,000
Income Tax Payable
Statutory rate: Tax rate set by the government

Income Tax Payable: Taxes owed to the government
Taxable income x statutory rate
Example: Adjusted Pre-Tax Income

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Remove Perm Diff
(1,000)
(1,000) X Statutory rate
0.35
0.35
Adj. Pre-tax Income
40,000
40,000 Income Tax Payable
12,250
15,750
Adjusted Pre-Tax Income

Used to compute Income Tax Expense for financial reporting purposes
Pre-tax income adjusted for permanent tax differences
Example: Income Tax Expense

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Remove Perm Diff
(1,000)
0.35
0.35
Adj. Pre-tax Income
40,000
12,250
15,750
X Statutory rate
Income Tax Expense
0.35
0.35
14,000
14,000
Income Tax Expense

Number reported on the income statement
Adjusted Pre-Tax Income x Statutory rate
Differs from Income Tax Payable due to Temporary Differences
Example: Income Tax Expense vs. Income Tax Payable

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Remove Perm Diff
(1,000)
0.35
0.35
Adj. Pre-tax Income
40,000
12,250
15,750
X Statutory rate
0.35
0.35
Income Tax Expense
14,000
14,000
IncTaxExpIncTaxPay
1,750
(1,750)

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Remove Perm Diff
(1,000)
0.35
0.35
Adj. Pre-tax Income
40,000
12,250
15,750
5000
(5000)
X Statutory rate
Income Tax Expense
0.35
0.35
14,000
14,000
Book Depr-Tax Depr
IncTaxExp IncTaxPay
1,750
(1,750)

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Remove Perm Diff
(1,000)
0.35
0.35
Adj. Pre-tax Income
40,000
12,250
15,750
5000
(5000)
1,750
(1,750)
X Statutory rate
Income Tax Expense
0.35
0.35
14,000
14,000
Book Depr-Tax Depr
IncTaxExp IncTaxPay
1,750
(1,750) Tax Effect @ 35%
Temporary Differences reverse over time!

Example: Effective Tax Rate

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Remove Perm Diff
(1,000)
0.35
0.35
Adj. Pre-tax Income
40,000
12,250
15,750
X Statutory rate
0.35
0.35
Income Tax Expense
14,000
14,000
Effective Tax Rate
34.1%
34.1%
Effective Tax Rate = Income Tax Expense / Pre-Tax Income

Does not equal 35% (Statutory Rate) because of Permanent Differences
Does not reverse
Tax Expense Calculation: Summary

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Income Tax Expense
14,000
12,250
15,750
Pre-Tax Income
41,000
+/- Permanent Diff
- 1,000
Adjusted Pre-Tax Inc X Statutory rate = Income Tax Expense
40,000
+/- Temporary Diff
-5,000
Taxable Income
X Statutory rate = Income Tax Payable
35,000
2011
X 0.35 = 14,000
X 0.35 = 12,250
Tax Expense Calculation: Summary

Books
2011
EBITDA
50,000

Depreciation
1,000
Tax Return
2012
50,000 EBITDA
2011
2012
50,000
50,000
(15,000)
(5,000)
Pre-tax Income
41,000
35,000
45,000
Income Tax Expense
14,000
12,250
15,750
Pre-Tax Income
41,000
+/- Permanent Diff
- 1,000
Adjusted Pre-Tax Inc X Statutory rate = Income Tax Expense
40,000
+/- Temporary Diff
+5,000
Taxable Income
X Statutory rate = Income Tax Payable
45,000
2012
X 0.35 = 14,000
X 0.35 = 15,750

Tax Reporting vs. Financial Reporting: - Income Tax Expense On The - Income Tax Payable (Or Paid in

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Tax Reporting vs. Financial Reporting: - Income Tax Expense On The - Income Tax Payable (Or Paid in

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Tax Reporting vs.

Income Tax Payable (or paid in

The two tax amounts can be DIFFERENT!

Tax Reporting vs. Financial Reporting

Bad debt expense

Expense recognized when

Expense when account is

KNOWLEDGE FOR ACTION

EBITDA in this example is Earnings before depreciation, municipal

KNOWLEDGE FOR ACTION

Example: Permanent Differences

Muni Interest Revenue

Do not reverse over time

KNOWLEDGE FOR ACTION

Example: Temporary Differences

Muni Interest Revenue

1,000 Muni Interest Revenue

(10,000) (10,000) Depreciation

Reverse over time

KNOWLEDGE FOR ACTION

Example: Pre-tax Income vs. Taxable Income

Muni Interest Revenue

(10,000) (10,000) Depreciation

41,000 Taxable income

Pre-Tax Income: Earnings before taxes under GAAP

KNOWLEDGE FOR ACTION

Example: Income Tax Payable

Muni Interest Revenue

41,000 Taxable income

(10,000) (10,000) Depreciation

Income Tax Payable

Statutory rate: Tax rate set by the government

KNOWLEDGE FOR ACTION

Example: Adjusted Pre-Tax Income

Muni Interest Revenue

1,000 Muni Interest Revenue

(10,000) (10,000) Depreciation

41,000 Taxable income

Remove Perm Diff

(1,000) X Statutory rate

Adj. Pre-tax Income

40,000 Income Tax Payable

Adjusted Pre-Tax Income

KNOWLEDGE FOR ACTION

Example: Income Tax Expense

Muni Interest Revenue

(10,000) (10,000) Depreciation

41,000 Taxable income

Remove Perm Diff

(1,000) X Statutory rate

Adj. Pre-tax Income

40,000 Income Tax Payable

Income Tax Expense

Example: Income Tax Expense vs. Income Tax Payable

Muni Interest Revenue

(10,000) (10,000) Depreciation

41,000 Taxable income

Remove Perm Diff

(1,000) X Statutory rate

Adj. Pre-tax Income

40,000 Income Tax Payable

Income Tax Expense