As explained in Lesson 51 the bookkeeper keeps track of both schedules and the differences as a part of their daily activities. In this lesson I explain how the profit is calculated using both book and tax depreciation and their respective benefits. This lesson is designed to provide business insight and knowledge about the subject matter so that you can answer questions posed to you in regards to this matter. To assist you in understanding the relationships, I’ll explain business and tax difference fundamentals, how tax depreciation works and finally how the bookkeeper keeps track of these tax timing amounts.
Business and Tax Fundamentals
Ironically these two business aspects are diametrically opposed to each other. In business, owners want the highest profit possible whereas with taxable income, they covet low income to minimize tax obligations. Often the tax goals of low profit drive very poor decisions by management; specifically, spending earnings needlessly or inefficiently.
To help small businesses address this dilemma the U.S. Congress changed the tax code to provide tax preferences to small business. Interestingly they didn’t reduce the tax rate, they simply allow more deductions. These additional deductions include:
- Cash Adjustments for Revenue
- Cash Adjustments for Expenses
- Accelerated Depreciation
- Charitable Giving
- Unrealized Gain Deferral
This article focuses on depreciation to illustrate the effect.
Let’s take a look at a small business income statement for both book income, tax income and the associated income tax effect with greater tax depreciation.
Comparative Income Statement
Book and Tax Purposes
For the Year Ending December 31, 2015
Book Tax Difference
Revenue $1,350,000 $1,350,000 -0-
Cost of Sales 865,000 865,000 -0-
Gross Profit 485,000 485,000 -0-
Expenses w/o Deprec. 210,000 210,000 -0-
Operational Profit 275,000 275,000
Costs of Capital:
-Interest 62,000 118,000 -0-
-Depreciation 81,000 7,000 $37,000
-Amortization 7,000 7,000 -0-
Profit Before Taxes $125,000 $88,000 $37,000
Taxes @ 21% 26,250 18,840 (7,770)
Net Profit $98,750 $69,520 $29,230
Notice two distinct differences between the two forms of income. In the tax column, the additional depreciation of $37,000 decreases the net profit for tax purposes the same amount. Therefore the additional $37,000 deduction saved the owners $7,770 in income taxes (15% at the federal level and 6% at the state level for at total of 21%). The income tax savings or deferred tax is equal to a $37,000 tax preference item of depreciation times 21%.
There are several reasons these two different reports are so important to understand. I’ll start with the book income statement.
The goal of book income is to present a FAIR and reasonable understanding of actual results of operations. This is essential for management to make good decisions. In accounting there is a saying that goes “…good accounting data into the books of record, means good information out and the maximum possibility of good decisions by management”.
In this case the only difference between the book and tax income statements is depreciation. Assuming the company used proper depreciation as explained in Lesson 50, the profit reflects actual business operations. This allows management to explore areas of improvement. More importantly the financial statements inform third-party creditors such as vendors and the bank the actual performance of the company.
Imagine presenting the taxable income statement as the ‘Fair Presentation’ of business performance. The $37,000 difference in profit would weigh negatively in a bank’s decision model for lending money in the future. This is why banks request both book (Generally Accepted Accounting Principles based financial statements) and tax financial reports when applying for a loan.
In general, book income statements have a higher profitability, are more accurate and easier to understand than tax based income statements.
The actual income tax is a draw on cash in the business. Small businesses need cash to grow and expand operations. Growth usually creates jobs and benefits the community. With the example above, the tax difference is $7,770 in reduce liability as a result of a $37,000 tax preference item; in this case, accelerated depreciation.
Tax Depreciation Principle
In Lesson 51 I explained that small businesses use a modified accelerated cost recovery system (MACRS) to accelerate depreciation in earlier years. But in later years, this system has less depreciation than straight line and therefore taxable income increases.
To understand this principle, lets look at a schedule of book and tax income over five years. Stay attuned to the tax amounts paid per year and the tax deferred balance.
Tax Preference Balance
5 Year Asset
2015 – 2020 (6 years)
Accel. Deprec. Taxable Tax Savings Tax Preference
Year Book Income > or < S/L Income @ 21% Balance
2015 $125,000 $37,000 $88,000 $7,770 $7,770
2016 125,000 48,000 77,000 10,080 17,850
2017 125,000 19,000 106,000 3,990 21,840
2018 125,000 (29,000) 154,000 (6,080) 15,750
2019 125,000 (43,000) 168,000 (9,030) 6,720
2020 125,000 (32,000) 157,000 (6,720) -0-
$750,000 -0- $750,000 -0- -0-
Notes ‘1’ ‘2’ ‘1’ ‘2’ ‘3’
Take note of the following:
- After the six years of depreciation (half-year convention under tax rules) the book income equals taxable income as the asset is depreciated for both book and tax purposes.
- In the earlier years the tax depreciation is greater than straight line used to determine book income resulting in tax savings. In the later years, tax depreciation exists but is less than straight line by the amount indicated resulting in more taxable income. This requires more tax payments by the amount indicated in parenthesis over the $26,250 tax obligation on $125,000 of net income. Therefore in year 2019, the company will owe $35,280 ($26,250 on $125,000 plus $9,030 on $43,000 of lower depreciation).
- This is the running tax savings balance during the six-year period. The savings peak in 2017 and are paid back reducing the savings by the end of the depreciation time period.
The goal of accelerated depreciation for tax purposes is to save tax dollars for the business in hopes the business will use the proceeds to invest in the growth of the business. With growth comes extra income and therefore more profit to satisfy the tax obligation.
A function of the bookkeeper’s job is to track this tax preference value. Don’t forget to remind management of the potential tax implication pending in future years.
Tracing Tax Preference Values
In Lesson 51 I illustrated how depreciation schedules are generated for both book and tax purposes. In addition I illustrated a tax preference schedule for each asset. A summary schedule for each group and finally a master set of schedules in summation for all assets.
The tax preference schedule identifies the preference amount and from this amount you create a tax benefit or cost schedule depending on the aggregate accelerated depreciation values as illustrated above. This schedule is updated regularly based on any changed in fixed assets and information provided by the CPA.
What is interesting is that there are other tax preference items and their tracking is explained in other articles under the advanced issues section of bookkeeping.
Summary – Book and Tax Depreciation
Under Code Section 168 Congress allows small businesses to take advantage of the tax savings offered via accelerated depreciation. Accelerated depreciation is called a tax preference item and can be substantial in tax savings in earlier years of its use. In later years, the depreciation is always less than book depreciation causing additional taxable income.
The bookkeeper is responsible to understand the difference between book and taxable income. Book income provides a fair representation of actual income. Taxable income is often different due to many tax preference items including depreciation. A good bookkeeper keeps track of these tax preference items and their corresponding impact on taxes. Act on Knowledge.