much of the discretion for the application of rules that are built into financial reporting.
The differences between the amount of income reported to shareholders and the amounts reported to tax authorities, known as book-tax differences, have generated attention both in the press and in policy. However, once a dual measurement system is in place, income differences are a natural occurrence, and the key issue becomes understanding the causes and consequences of the differences. Book-tax differences have been a characteristic of the U.S. reporting system since the inception of the corporate income tax, generating academic interest from the start. For example, Smith and Butters (1949) provide an analysis of book-tax differences for a small sample of corporations active during the 1930s.
Book-tax differences occur because the amount of income reported as earned is based on different concepts and rules under each reporting system. Since the target audience of financial statements is investors and others who need information to make decisions about a company, including whether to invest in the company’s equity or debt, companies that issue publicly traded equity or debt securities are required by the Securities and Exchange Commission to file audited financial statements. Such statements must follow generally accepted accounting principles (GAAP), which include an adherence to pronouncements of the Financial Accounting Standards Board (FASB) and other accounting standards.
Tax accounting is designed to administer the U.S. tax laws, with the Internal Revenue Service (IRS) the primary audience for tax filings. In contrast to GAAP, tax rules can change frequently, depending on legislative initiatives, and are not necessarily designed to present as consistent a definition of income over time as are financial accounting rules.
An important element of financial accounting is the amount of discretion left to the corporation in implementing GAAP in their business. For example, in determining the useful life and depreciation pattern of a capital asset, depreciation schedules of the same asset can vary by company and by usage and usually follow a straight-line pattern. Tax depreciation is determined by the Internal Revenue Code and leaves less discretion to the company. The lack of discretion in the tax code is intended to lead to more uniform application of the tax system.
Differences between tax and financial measures of income can arise from two types of measurement differences in the accounting systems: temporary and permanent. Temporary (timing) differences occur when both tax and financial reporting recognize the same total amount of income or expense, but they do so either over different time periods or in