Question

When accounting for income taxes, the differences between financial accounting and taxation accounting creates permanent and temporary differences between the expenses and liabilities reported under each regime. Why do these differences exist? What are the reasons that explain why we have one system of accounting for financial reporting, and a second for taxation? Please give an in-depth explanation for the various reasons for why there are two systems for this, instead of one.

I am looking for a general explanation for why we have the two systems. Basically I want to know why there is a system for accounting finances and for accounting tax, not just the rules but the meaning for the separation.

Answer 1

Below is the example of few account balances in which we observe difference in financial accounting and taxation:-

1. Depreciation

2. Expenses incurred in businesses but deduction for which is not allowed while filing fedral tax return.

To put it in more simple words an outflow of resources happen when an expense is incurred , resulting the movement in financial position which needs to be captured through statement of financial position to reflect true and fair position of business. However, talking in terms of taxation the government may not allow deduction for a particular expense while calculating taxable income of an asesse. Therefore, taxable income does not get reduced by the amount of expense because that particular expense is non deductible from the perspective of government. But the net income per financial is lesser creating a permanent difference which will not reverse in future.

Taking the case of depreciation expense, the depreciation rates as per GAAP and federal taxes differ. However the amount of depreciation remains constant. Therefore, it is a temporary difference which gets reversed in near future, creating deferred tax asset or deferred tax liability.

We observe differences in taxation and accounting because the purpose of two things is different. Tax is compulsoary extortion of money in the periphary of law. Therefoe, government defines it own rules as to the timing of taxability of income however the purpose of financial reporting under accounting is to present a true and fair view of financial position of business. The finacial staements are prepared by the entity itself in line with GAAP or IFRS, however the taxation laws are framed by government therefore we have permanent and temporary differences.