Publicly-held companies must prepare financial statements according to Generally Accepted Accounting Principles, known as GAAP, to present financial data to investors, analysts and other stakeholders. However, the IRS requires a different presentation according to various tax rules, which may result in different taxable income scenarios. While the tax rate remains the same, the dollar value of a company's provision for income taxes may vary within these two scenarios, although each is valid. Additionally, every company has differing revenue and expense items that also affect its provision for income taxes
TL;DR (Too Long; Didn't Read)
In order to calculate the provision for income taxes, you must first determine whether or not you are adhering to the GAAP or IRS models of presentation. Each paradigm will involve different methods of recording revenue and expenses which, in turn, influences net income levels.
Exploring the Tax Provision Definition
The provision for income taxes represents the amount a company anticipates it will pay for income taxes in a given year. The actual tax provision calculation is a simple exercise. After adjusting a company's net income to account for a variety of permanent and temporary accounting differences, the company multiplies its resulting net income by the applicable corporate income tax rate to generate the provision for income taxes.
The Tax Cut and Jobs Act
Before 2018, corporate tax rates worked on a graduated structure, with a maximum tax rate of 35 percent. The Tax Cuts and Jobs Act, effective as of the 2018 tax year, lowers the corporate income tax rate to a flat 21 percent for all income brackets. This simplifies the actual calculation of a company's tax provision as it no longer matters which net income bracket a company falls within; it will pay 21 percent of net income for taxes, regardless.
Tax vs. GAAP Financial Statements
When assembling financial statements, companies often prepare two different scenarios, one according to GAAP, and the other according to Internal Revenue Code tax rules. Between these two scenarios, some of the differences are temporary, meaning the company records additional entries in future periods to offset the initial, differing entries. For example, the timing of the recording of revenues and expenses is different, depending upon whether for tax or GAAP purposes.
Companies also record permanent differences for these two scenarios, including the removal of interest income from tax-free municipal bonds in the tax view, but not in the GAAP scenario. Other permanent differences include the payment of fines for business violations. The IRS does not allow companies to show these as an expense on tax-basis financials, while they do appear on GAAP-based statements, affecting the amount of net income and consequently, the tax provision.
Other Tax-Reduction Strategies
Many companies engage in a considerable amount of tax planning on top of permanent and temporary accounting differences, strategically using revenue and expenses to position themselves so that they can minimize income tax payments. Between two different companies with the same amount of revenue, the tax provision could vary significantly from one company to the other based on each company's tax planning abilities. Some companies, especially those with international operations, may also drive certain business units based on tax strategies that take advantage of legal loopholes to save the company money.
- The provision for income taxes and the income tax paid refer to two different classifications. The provision for income taxes refers to money which the company has not paid yet and owes to the Internal Revenue Service.
- Keep the temporary difference schedules, and update them each year. This eliminates the need to recreate the schedules every year.