Case Study #1 – Financial vs. Taxes
The following is an excerpt from a conversation between two employees at WXRT Technologies, Nolan and Stacy. Nolan is the accounts payable clerk and Stacy is the manager of the cashier department.
Nolan: Stacy, could I get your opinion on something?
Stacy: Sure, Nolan.
Nolan: Do you know Rita, the fixed asset clerk?
Stacy: I know who she is, but I don’t know her personally.
Nolan: Well, I was talking with her and she mentioned something about having to keep two sets of books – one for taxes and one for financial statements. That can’t be good accounting, can it? What do you think?
Stacy: Two sets of books? It doesn’t sound right.
Nolan: It doesn’t sound right to me either. I was always taught that you have to use generally accepted accounting principles. How can there be two sets of books? What can be the difference between the two?
How would you respond to Nolan and Stacy if you were Rita?
You will be graded according the the following rubric:
Case Study Rubric
Excellent: 4 points Evaluation
Content: accounting issues Covers topic completely and in-depth. Complete accurate information and issues identified from the case.
connects case to key accounting issue- Demonstrates insight into the case and details appropriate accounting connections. Proper Accounting Terminology.
-Grammar, spelling, punctuation, capitalization are correct. No errors in the text.
Action plan- Supports action to resolve case that are clear and detailed and organized
conclusion- Communicates accurate, effective readable results and conclusions of accounting needed on case
solution:
Indeed it is true that we have to use the generally accepted accounting principles (GAAP) while preparing the financial statements.But, there is federal tax also, which does not accept the financials prepared as per GAAP. It has its own methods for computation of income,suitable as per the convenience of the tax rules of the state.That is why income for federal tax purposes is computed in accordance with the prevailing tax laws, whereas financial accounting income is determined in accordance with GAAP. And, they frequently differ.There are basically two types of differences between pretax GAAP financial income and taxable income.All differences are either permanent differences or temporary differences.
Permanent differences: These are items of revenue and expense that either, come into pretax GAAP financial income , but never come into taxable income. Or come into taxable income but never come pretax GAAP financial income.It means it is a transaction taht affects only income per books or taxable income, but not both.Income tax expense for a period is calculated only on taxable items. For example, tax exempt interest is included in financial income, but is excluded in computing income tax expense. So, permanent differences creates the differences between taxable income and financial accounting income, that will never reverse. Its examples include:
a) Tax exempt interest
b) Other non deductible expenses. (like ceratin portion of meal & entertaiinment expense)
c) Dividends received deduction for corporations.
Temporary differences: These are items of revenue and expense that may come into pretax GAAP financial income in a period before they come into taxable income, or that may come into pretax GAAP financial income in a period after they enter into taxable income.It means these are differences between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled. Its examples include:
a) All prepaid expenes like prepiad rent, prepaid interest etc. These expenses come into taxable income first but get deducted from the financial income in later years.
b) Allowance accounts: Allowances are deducted from the accounting income first and in later years when the bad debt or related allowance expense happens, they come into taxable income.
c) Depreciation expense: There can be different methods or rates of computing the depreciation expense as per financial books and as per taxable income. Due to this, differences arise in the computation of income under both books.
