What does pre tax income mean? And what are differences between book incomes vs. tax incomes? Is taxable income similar to pre tax or book income? If you run a business, you need to understand the differences between these various types of company income.
Why Companies Define Income Differently
Company management, analysts and investors often have different needs and uses for financial information than does the Internal Revenue Service, causing companies to manage two different sets of financial statements.
One set needs to present financial data in a way that complies with generally accepted accounting practices (GAAP). The second set needs to show the company's data in a manner that complies with the Internal Revenue Code (IRC). Because of various temporary and permanent differences, these two sets of financial statements often show different, yet still valid, results.
Typically, pretax financial income represents GAAP accounting, while taxable income is used in tax-basis accounting. Further, book income is usually used as another form of pre tax definition. The statements provide different but valid results.
Read More: How to Account for Fixed Assets With GAAP
Pretax Financial Income and Taxable Income
Companies calculate their pretax financial income, according to GAAP rules in part to create uniform, or standardized, statements that give an accurate picture of the company's financial health, history and future prospects, for use by internal management, outside investors and other stakeholders.
The pretax financial income figure represents revenue minus expenses but is calculated in a way that includes and excludes specific items. You would see this number on a company's income statement before the tax rate is applied.
Companies compile GAAP financial statements to make it easy to compare financial statements between different years for the same company, or to compare different companies to each other because all of the information is classified in the same, uniform manner. All publicly held companies must present their financials according to GAAP, and the vast majority of private companies choose to do so as well.
Taxable income represents the amount of income after expenses that a company shows on its actual tax return.
These financial results are calculated differently than the GAAP format, with certain inclusions and exclusions, due to the application of IRC rules instead of GAAP rules. This represents the tax accounting method, rather than the financial, also known as book or GAAP, accounting method.
Booking Temporary Differences
Temporary differences in the presentation of a company's financial statements are driven mainly by the timing in which they record income and expenses for financial presentation versus tax presentation.
The differences are temporary because the company records offsetting entries in future periods to compensate for these timing differences. For example, for regular financial statement presentations, companies show depreciation expense using a straight line method, meaning they record the depreciation in even amounts across an asset's years of life.
For the tax view, accountants use certain methods to accelerate the depreciation expense. This causes larger expenses in the first few years of an asset's life, so the company reduces the amount of income it must pay taxes on in those first few years.
The offsetting entries in future years are called deferred tax liabilities or deferred tax assets, depending upon the circumstances. This strategy is known as inter-period tax allocation, and the company discloses these differences in the footnotes to their financial statements.
Recording Permanent Differences
Driven by tax code rules, the company removes certain types of revenue, such as the interest income earned from tax-free municipal bonds, from its revenue number. Expenses are also affected.
If the company paid fines for any law violations, it cannot include this in its expenses, to reduce its taxable income. These differences are deemed permanent because they will never be included in the company's tax-basis financial statements.
However, they do show on the company's income statement for the purposes of calculating income from the financial reporting perspective. This process does not generate any accounting issues because these differences will never be adjusted or eliminated and they do not trigger any requirement to record deferred tax assets or liabilities.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer for online finance publications since 2011, including eHow Money, The Motley Fool, and Sapling.com. She has also edited for several online finance publications, including The Balance, Opposing Views:Money, Synonym:Money, and Zacks.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.