Effects of GAAP on the Income Statement

Effects of GAAP on the Income Statement

Although most of the information on a company's income tax return comes from the income statement, there often is a difference between pretax income and taxable income. These differences are due to the recording requirements of GAAP for financial accounting (usually following the matching principle and allowing for accruals of revenue and expenses) and the requirements of the IRS's tax regulations for tax accounting (which are more oriented to cash). GAAP's assumptions, principles, and constraints can affect income statements through temporary (timing) and permanent differences.

Income statements GAAP and IRS accounting can differ.

Such timing differences between financial accounting and tax accounting create temporary differences. For example, rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets may create timing differences. Also, there are events, usually one time, which create "permanent differences," such as GAAP, which recognizes as an expense an item that the IRS will not allow to be deducted.

To achieve basic objectives and implement fundamental qualities, GAAP has four basic principles:

1. 1The historical cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.
2. 2The revenue recognition principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received.
3. 3The matching principle governs the matching of expenses and revenues, where expenses are recognized not when the work is performed or when a product is produced but when the work or the product actually makes its contribution to revenue.
4. 4The full disclosure principle suggests that the amount and kinds of information disclosed should be decided based on a trade-off analysis since a larger amount of information costs more to prepare and use. GAAP reporting also suggests that income statements should present financial figures that are objective, material, consistent, and conservative.

Key Points

• Items that create temporary differences due to the recording requirements of GAAP include rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets.
• Also there are events, usually one-time events, which create "permanent differences," such as GAAP recognizing as an expense an item that the IRS will not allow to be deducted.
• The four basic principles of GAAP can affect items on the income statement. These principles include the historical cost principle, revenue recognition principle, matching principle, and full disclosure principle.

Terms

• Fair Market Value – An estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or extrapolation but is subjective. Fair market value differs from other ways of determining value, such as intrinsic and imposed value.
• Deferred – Pertains to a value that is not realized until a future date, e.g. annuities, charges, taxes, income, either as an asset or liability.