- The fourth basic flavor of accounting
is income tax accounting.
Let's start with this provocative question.
How many sets of books does a large corporation keep?
Now, we're not talking about doing anything shady, here.
Legitimately, how many sets of books
does a large company keep?
The answer is that any large company in the world
keeps three sets of books.
Of course, there is one underlying bookkeeping system
that captures all that data,
but then, those raw data are used in different systems
to prepare reports and analysis
satisfying the different purposes.
So, first, there are financial accounting records.
Those are the reports that are provided to outsiders,
banks, or potential investors.
Next, there are the managerial accounting data
that we use inside the company every single day.
Those detailed data are used to make internal decisions.
Third, we use the same broad bookkeeping data
to fill out the tax reports
to be in compliance with the law of our local governments.
These income tax records
can be said to be a third set of books.
Now, let me illustrate the difference
between taxable income and financial accounting income.
Financial accounting income
is an attempt to get as close to economic income as we can.
We call the set of procedures to accomplish this
accrual accounting.
Let me give you an example
of this idea of accrual accounting.
Let's say I earn $20,000 this year,
but I'm not going to collect that 20,000 in cash
until next year.
I earned it in this year,
I did the work this year,
but I'm not going to collect the cash until next year.
Well, do I report the income this year or next year?
This year when I did the work,
or next year when I collect the cash?
The idea of financial accounting income, accrual income,
is that you don't follow the cash, the money.
Instead, you follow the effort.
For your financial accounting records,
you would report the income this year
when you actually did the work.
Taxable income, on the other hand,
is closer to cash flow.
Typically, taxable income is reported
when you collect the cash.
You've probably experienced this
as you filled out your own tax return.
Income is taxed when you collect it in cash.
Why would taxable income be closer
to the objective cash flow
rather than subjective economic income?
Well, because taxable income, it's a legal report,
and a person wants to be able to tell
whether she or he has obeyed the law.
Good laws are objective, clear, and easily understood.
If we're measuring subjective economic values,
it's hard to tell who's right or wrong.
In contrast, cash flow is very straightforward,
so that people can tell
whether they're obeying the law or not.
Also, there's the idea of the ability to pay.
I should pay tax when I have the cash to pay the tax.
Yes, I earned the income this year,
but I can't pay the tax this year
because I haven't collected the cash yet.
Wait until next year when I collect the cash,
then I pay the tax.
Income tax reporting rules
generally are built around the idea
of taxing a person when she or he
has received the cash to be able to pay the tax.