Bridging the GAAP to Tax: The Importance of the Income Tax Provision

In order to accurately understand the financial state of their business, many CFOs, controllers, and accounting departments utilize Generally Accepted Accounting Principles (GAAP). However, income tax accounting rules differ in important ways from GAAP procedures. Most corporations that issue financial reports utilizing GAAP will need to calculate a tax provision in accordance with Accounting Standards Codification 740 (ASC 740), Accounting for Income Taxes. An income tax provision, which provides an important link between GAAP financial statements and tax liabilities, helps provide an accurate financial picture to management and shareholders. This article will highlight some of the important aspects of an income tax provision and how it clarifies GAAP financial statements. 

A tax provision is comprised of two parts: current income tax expense and deferred income tax expense. A company’s current tax expense is based upon current earnings and the current year’s permanent and temporary differences. The deferred tax calculation, which focuses on the effects of temporary differences and other tax attributes over time, is the more complicated part of the provision. 

Current year tax expense calculation 

The starting position for the current year tax expense calculation is the company’s net income as calculated by GAAP rules before income taxes. Then, you must calculate the permanent differences between GAAP accounting rules and income tax accounting rules. 

Permanent differences 

In general, a permanent difference is an item of income or expense that is not allowed for income tax purposes, but is allowed for GAAP. These differences are permanent in that they are expenses that are disallowed or income that is not recognized for income tax purposes and are not merely a timing difference. Common examples of permanent differences include entertainment expenses, the 50% limitation on the deduction of certain meal expenses, penalties, social club dues, lobbying expenses, and tax-exempt municipal bond interest. 

Temporary differences 

After calculating current year permanent differences, you should calculate current year temporary differences. A temporary difference is an item of income or expense that is allowed for either income tax or GAAP purposes in one year, but not allowed under the other accounting system until a later year. Thus, the income or expense item will eventually be allowed for both GAAP and income tax purposes, with the only difference being the timing of the item of income or expense. Temporary differences are determined by reviewing the current year balance sheet and identifying differences between GAAP accounting and income tax accounting. For example, for GAAP purposes, fixed assets are generally required to be depreciated utilizing a straight-line method over a longer period than the depreciation method under income tax accounting, where the company is generally able to deduct the full cost of the asset in the year it is placed in service. Other common temporary differences include amortization, prepaid accounts, allowance for bad debts, and deferred revenues. 

After taking into account the permanent and temporary differences, you will arrive at current year taxable income. Once the taxable income is calculated, credits and net operating losses (NOL) should be applied, and that amount is multiplied by the current statutory federal tax rate. The resulting amount is the current year tax expense for the income tax provision. 

Deferred tax calculation 

For the more complicated part of the tax provision, the deferred tax calculation, the company will need to delve deeper into the temporary differences. The deferred tax calculation includes a cumulative total of the temporary differences and applies an effective tax rate to that total. This calculation accounts for the deferred effects of income and expenses as well as the deferred effects of net operating losses and tax credits. The deferred tax expense will then be accounted for on the company’s GAAP balance sheet as an asset or liability, depending on whether the company will owe tax or will receive a tax benefit in the future, due to the reversal of these temporary differences. 

Do Employee Retention Tax Credits affect my deferred taxes?  

Since the ERTC is a non-income tax credit, ERTC should not influence your deferred tax calculation.  

When should my organization consider a valuation allowance? 

Due to the COVID-19 global pandemic and current economic uncertainty, some companies may want to consider a valuation allowance of their deferred tax asset on their balance sheet. A valuation allowance should be considered if there is more than a 50% chance that the temporary differences or net operating loss will not be recognized in future years. 

Understanding and calculating an income tax provision 

Although an income tax provision can be complicated to calculate, it is an important tool for any business that utilizes GAAP standards. It offers management and shareholders a better outlook on the company’s future tax obligations. Such a provision can provide useful predictive information when planning for significant corporate transactions, such as mergers, acquisitions, and sales.