In this video, we walk through 4 FAR practice questions teaching about preparing income tax basis financial statements. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Preparing Income Tax Basis Financial Statements
What is the Income Tax Basis of Accounting?
The income tax basis of accounting is a special purpose framework that prepares financial statements using the methods and principles utilized in preparing an income tax return. This approach allows for a clear reflection of the company’s taxable income, aligning the financial statements more closely with tax reporting requirements than with Generally Accepted Accounting Principles (GAAP). It’s particularly useful for companies with complex operations or those seeking consistency between their financial statements and their tax returns.
Key Differences from Cash and Accrual Basis Accounting
Unlike cash basis accounting, which recognizes revenue and expenses only when cash is exchanged, and accrual basis accounting, which records transactions when they are earned or incurred, the income tax basis of accounting follows the tax code. This means that some items of revenue and expense are treated differently:
- Nontaxable income and expenses are recognized differently. They are not included in taxable income but may be shown as separate line items, additions or deductions to net income, or disclosed in the notes to the financial statements.
- For cash basis taxpayers, revenue and expenses are recognized in the period received or paid.
- For accrual basis taxpayers, they are recognized in the period accrued, subject to the tax rules.
Nontaxable Income and Expenses
One of the distinctive features of the income tax basis of accounting is its treatment of nontaxable income and expenses. Examples include municipal bond interest and life insurance proceeds and the expenses associated with them. While these items do not affect taxable income, they can be presented as separate line items in the revenue section, as additions or deductions to net income, or disclosed in the notes to provide clarity to users of the financial statements.
Permanent vs. Temporary Differences
The income tax basis of accounting involves understanding the difference between permanent and temporary differences:
- Permanent Differences: These are items that are recognized in financial accounting but are never included in taxable income. Examples include nontaxable income like municipal bond interest. These items do not reverse over time and will never affect taxable income.
- Temporary Differences: These differences occur when an item is recognized in one period for financial accounting purposes but in another period for tax purposes. A common example is depreciation, where the method used for tax purposes (e.g., accelerated depreciation) may differ from the method used for financial reporting (e.g., straight-line depreciation). These differences will reverse over time, meaning that the total amount recognized for both financial and tax purposes will ultimately be the same.
Presentation of Financial Statements
Financial statements prepared on the income tax basis of accounting are often labeled to indicate that they follow a special purpose framework. For example:
- Statement of Assets, Liabilities, and Equity (Income Tax Basis)
- Statement of Revenues and Expenses (Income Tax Basis)
This explicit labeling informs users that the financial statements were prepared using the tax return’s methods and principles, which may result in differences from statements prepared under GAAP.
Why Use the Income Tax Basis of Accounting?
The income tax basis of accounting is beneficial for companies with complex operations seeking alignment between their financial statements and tax returns. It simplifies the process by using the same methods and principles, reducing the need for adjustments or reconciliations between book and tax records. This basis is also particularly useful for closely-held businesses where tax efficiency is a primary concern.
However, it’s important to note that the income tax basis of accounting may not provide as complete a picture of a company’s financial performance and position as GAAP does, given its focus on tax compliance. Therefore, while it serves a useful purpose, especially for tax planning and compliance, it may not be suitable for all users, particularly those who need more comprehensive financial information.
Conclusion
The income tax basis of accounting provides a tax-centric view of a company’s financial performance and position. By aligning with tax rules, it offers simplicity and consistency for businesses seeking to streamline their financial reporting with their tax obligations.
