GAAP to Non - GAAP
Companies typically prepare 2 sets of accounts. One set is prepared for investors and shareholders using relevant accounting rules such as US GAAP or IFRS. The other set is prepared for relevant tax authorities using applicable tax rules and the aim is to calculate corporate taxes that are owed to the government.
The tax expense on the income statement is based on GAAP or IFRS, which require companies to recognize revenues and expenses on an accrual basis. But companies pay taxes to the government based on their tax liability using applicable tax rules. The goal of the tax authorities is to maximize tax collection.
There are differences in revenue and expense recognition between GAAP accounting and tax accounting, since they have different goals. This results in differences between GAAP or book taxes and actual taxes. These differences may be temporary or permanent in nature. Temporary differences result in creation of deferred taxes and these are reversed in the future. Deferred taxes can be in the form of either Deferred Tax Assets (DTA’s) or Deferred Tax Liabilities (DTL’s).
As a simple example, if a company reports GAAP taxes of $1,000 and its actual taxes based on tax rules are $1,400 then this company will recognize DTA on its books worth $400. The logic is that since this company has paid higher actual taxes of $1,400, it will be making lower tax payments in the future. Let’s turn around these numbers. If this company reports GAAP taxes of $1,400 and pays actual taxes of $1,000 based on tax rules, then it will recognize DTL worth $400. The reason being that it has paid lower taxes today and will have to make higher tax payments in the future.
DEFERRED TAX LIBILITIES (DTL’s)
ABC inc’s income before depreciation is $80,000 in Year 1; $90,000 in Year 2; $90,000 in Year 3 and $100,000 in Year 4. It has a fixed asset worth $60,000 which has no salvage value and a useful life of 4 years. ABC Inc follows straight line depreciation and expenses this cost equally over the asset’s life. After subtracting depreciation expense of $15,000 every year, the company generates profit before taxes of $65,000 in Year 1; $75,000 in Year 2; $75,000 in Year 3 and $85,000 in Year 4. Applying a 40% tax rate, GAAP tax expense comes to $26,000 in Year 1; $30,000 in Year 2; $30,000 in Year 3 and $34,000 in Year 4. This is the summary based on GAAP.
Under tax accounting, ABC Inc’s income before depreciation is the same as before. But as per tax accounting rules, it uses an accelerated method to recognize depreciation. This gives a higher depreciation charge in the initial periods. Depreciation expense is $25,000 in Year 1; $20,000 in Year 2; $10,000 in Year 3 and $5,000 in Year 4. Taxable income is $55,000 in Year 1; $70,000 in Year 2; $80,000 in Year 3 and $95,000 in Year 4. Applying a 40% tax rate as before, tax expense comes to $22,000 in Year 1; $28,000 in Year 2; $32,000 in Year 3 and $38,000 in Year 4.
In Year 1, ABC Inc pays actual taxes of $22,000 to the government compared to GAAP taxes of $26,000 on the income statement. Therefore, the company has paid lower taxes to the government in Year 1 and will have to pay higher amounts in the future. This shortfall of $4,000 is recognized as a deferred tax liability or DTL. In year 2, ABC Inc pays actual taxes of $28,000 compared to GAAP taxes of $30,000 on the income statement. Once again, the company has paid lower taxes to the government and will have to pay higher amounts in the future. This difference of $2,000 is recorded as a deferred tax liability. At the end of year 2, DTL balance on the balance sheet will be $6000, which is the existing DTL of $4000 and the additional DTL of $2,000 in Year 2. These temporary differences are reversed in the future and comes into play in years 3 and 4 for ABC Inc.
In year 3, as the company pays higher taxes to government, this results in the creation of deferred tax assets of $2,000. These can be shown separately as DTAs on the assets side of the balance sheet. They can also be offset against the existing DTL . DTL of $6,000 on the balance sheet will reduce to $4,000 at the end of Year 3. In year 4, ABC Inc’s tax liability under tax rules and GAAP is $38,000 and $34,000 respectively. As the company has paid higher taxes to the government in year 4, this results in the creation of DTAs. At the end of Year 4, DTL will reduce to $0 because of the addition of DTAs worth $4,000.
To sum up, differences in depreciation between GAAP and tax accounting created temporary timing differences and gave rise to deferred tax liabilities. In Years 3 and 4, these deferred tax liabilities were offset and reversed by the creation of deferred tax assets.