The Tax versus Book Accounting Gap

Phil Kenkel

Bill Fitzwater Cooperative Chair

Financial accounting and tax accounting have different goals. The tax code is created to raise money for the government. Legislators use the tax code to provide economic incentives for targeted activities. Financial accounting strives to provide owners and managers with an accurate picture of the firm’s economic position. These differences create a gap between book and tax measures of earnings. One difference, which I discussed last week, isdepreciation. This is an example of a temporary difference between tax and book accounting. The entire expense of the fixed asset is eventually realized by both methods. It is also generally classified as a favorable difference as tax accounting allows the deduction to be realized sooner rather than later.

Temporary differences also often occur in the treatment of reserves and accrued expenses. For example, book based accounting recognized a bad debt reserve as an expense while tax accounting recognized bad debt expense only when it is written off. Similarly, tax accounting does not allow a deduction for deferred compensation until the payments actually occur. These temporary differences are often referred to as unfavorable differences since they postpone the timing of deductable expenses.

There are also permanent differences between tax and book accounting. Payments for meals and entertainment, charitable andpolitical contributions are not deductible or only partially deductible for tax purposes. These conventions create permanent differencesbetween the net income shown for tax purposes and book based net income. These permanent differences are also classified as unfavorable since they result in lower expense deductions and higher taxes for the firm.

Tax and accounting experts continue to debate the ever widening gap between tax and book accounting values and whether it matters. Tax and book differences have unique implications for cooperative firms because they impact the amount and timing of patronage refunds. More on that point in the next newsletter.

8-1-2012