Income for financial statement purposes is determined under generally accepted accounting principles as
set forth by the accounting profession. Income for tax purposes is determined according to the rules of the Internal Revenue Service which are passed into law by Congress. These rules often do not follow generally accepted accounting principles. Accordingly, differences will arise between accounting income and taxable income.
set forth by the accounting profession. Income for tax purposes is determined according to the rules of the Internal Revenue Service which are passed into law by Congress. These rules often do not follow generally accepted accounting principles. Accordingly, differences will arise between accounting income and taxable income.
These differences may be either temporary or permanent in nature. Temporary differences are referred to as timing differences because, with time, they reverse or “turn around.” Permanent differences are forever—they do not reverse. Let’s first discuss temporary differences.
Temporary differences involve the recognition of revenue or expense items in one year for tax purposes but in a different year for accounting purposes. Overall the total income is the same for both tax and accounting purposes; it is just the timing that is different. For example, under GAAP, revenue is recognized when earned, not when received. Thus if in year 1 a company earns revenue but does not receive it until year 2, it would recognize it as income in year 1. However, for tax purposes, revenue is usually recognized when received. Thus this item would not be reported on the tax return until year 2. Accordingly, in year 1, the income statement reports this revenue while the tax return does not; in year 2, the tax return reports it as revenue while the income statement does not. For both years together, however, the total income is the same—the difference is only in timing. Year 1 is called the year of origination of the difference; year 2 is the year of reversal.