1.6 Income Taxes

The fourth basic flavor of accounting is income tax accounting. Let’s start with this provocative question: How many sets of books does a large corporation keep? We're not talking about doing anything shady here. Legitimately, how many sets of books does a large company keep?  The answer is that any large company in the world keeps three sets of books. Of course, there is one underlying bookkeeping system that captures all the data, but then those raw data are used in different systems to prepare reports and analyses satisfying different purposes.

First there are the financial accounting records. Those are the reports that are provided to outsiders: banks and potential investors.  Next there are the managerial accounting data that we use every single day, those detailed data that we use to make internal decisions.  Third, we use the same raw bookkeeping data to fill out the tax reports to be in compliance with the law of our local governments. These income tax records can be said to be a third set of books.

Let me illustrate the difference between taxable income and financial accounting income. Financial accounting income is an attempt to get as close to economic income as we can. We call the set of procedures to accomplish this “accrual accounting.”  Let me give you an example of this idea of accrual accounting. Let's say I earned $20,000 this year, but I'm not going to collect that $20,000 in cash until next year. I earned it this year. I did the work this year. But I'm not going to collect the cash until next year.  Well, do I report the income this year or next year? This year when I did the work, or next year when I collect the cash? The idea of financial accounting income, accrual income, is that you don't follow the cash, the money. Instead, you follow the effort. So for your financial accounting records, you would report the income this year when you actually did the work.

Taxable income, on the other hand, is closer to cash flow. Typically, taxable income is reported when you collect the cash. You have probably experienced this as you have filled out your own tax return: income is taxed when you collect it in cash.  Why would taxable income be closer to the objective cash flow rather than to subjective economic income? Well, because taxable income it's a legal report, and a person wants to be able to tell whether she or he has obeyed the law. Good laws are objective, clear, easily understood.  If we're measuring subjective economic values, it's hard to tell who's right and who's wrong. In contrast, cash flow is very straightforward so that people can tell whether they're obeying the law.

Also, there's the idea of the ability to pay. I should pay tax when I have the cash to pay the tax. Yes, I earned the income this year, but I can't pay the tax this year because I haven't collected the cash yet. Wait until next year when I collect the cash, then I can pay the tax. Income tax reporting rules generally are built around this idea of taxing a person when she or he has received the cash to be able to pay the tax.

To summarize, financial accounting income is an ECONOMIC measure. Income tax income is typically based on cash flow so that the computation of the taxable income amount is straightforward and objective and so that income is taxed when the taxpayer has the cash with which to pay the tax.