Net Income for Which Purpose?

I'd like to make a brief post to point out an important difference between income for accounting purposes and income for tax purposes. In 99.99% of cases there is a difference between the income that companies report to their shareholders and the income they report for tax purposes.

Some of these differences are permanent while others are temporary. This means that at some point in the future, temporary difference will reverse while permanent differences will never reverse.

I'll outline a common example for each to clear things up a bit.

Temporary difference:
The amount of depreciation that a company claims in any given year is almost certain to be different under tax and accounting approaches. For tax purposes, a company may use a declining balance method at a prescribed rate depending on the type of asset (e.g. business vehicles are assigned to Class 10 and decline at 30% per year). On the other hand, under the generally accepted accounting principles (GAAP) which are used for accounting purposes, a company is likely to use a straight line amortization schedule (i.e. the depreciation reported on an asset is basically a set amount over its economic useful life).

The result of this is that in early years an asset is going to depreciated faster for tax purposes, which means that it will reverse in later years when the depreciation for accounting purposes will be higher. This leads to future income tax liabilities or assets to be reported on the balance sheet!

Permanent difference:
Meals & entertainment. Under GAAP, these expenses are fully deducted from income. For tax purposes, only 50% of these expenses can be deducted from income. The idea is that you can deduct the cost of entertaining clients (1/2 the bill), but cannot deduct your own meal (the other 1/2 of the bill)!