Do You keep two sets of books? Is there anything wrong with that?

Deferred Income Tax Liability vs. Tax Payable 

Article written by EricBank

Small companies benefit from professional tax preparation in many ways. For example, companies usually keep two sets of accounting books, but there is nothing sinister about that. Rather, the practice stems from the different requirements for financial and tax reporting. A company must maintain periodic and annual financial information according to generally accepted accounting principles (GAAP), but also must file an annual tax return that follows IRS rules and doesn't necessarily adhere to GAAP. The role of an enrolled agent is to know the different accounting and reporting requirements for financials and taxes. We can see an example of these different requirements in the reporting of taxable income, tax payments and deferred income tax liability.

GAAP Tax Payable

Under GAAP, a company's pretax income determines its income tax payable. Bear in mind that companies also might have to pay other taxes, such as payroll, local and state tax. The recognition procedure for the income tax a company must pay is to debit the tax expense account and credit the income tax payable account, a liability. Eventually, the company will remit cash to the IRS. At that time, it reduces by the check amount the balances in the cash and tax payable accounts.

How Differences Come About

The difference between the GAAP book values and IRS tax values of a company's liabilities and assets results in a deferred tax liability, which is a GAAP-based future obligation to pay taxes. As an example, suppose ZYX Corp makes a one-year installment sale of merchandise for $30,000. Under GAAP, ZYX must immediately record an income entry of the full amount. However, under IRS rules, only the revenue received in the current year from an installment sale, which in this case is, say, $10,000, is subject to current taxation. This creates a temporary difference of $20,000 income between the financial and tax books.

Deferred Tax Liability

Suppose further that ZYX is in a tax bracket of 25 percent, which means it must pay a quarter of its net income to the IRS. The current tax resulting from the installment sale is 25 percent of $10,000, or $2,500 (for the sake of simplicity, we'll disregard any costs associated with the sale). ZYX credits income tax payable in Year 1 for $2,500, but the GAAP-based income statement shows a total tax expense equal to 25 percent of $30,000, or $7,500. The deferred tax liability is the tax that will eventually become due when the installment sale is completed in Year 2, equal to $7,500 minus $2,500, or $5,000.

Reconciling the Books

ZYX collects in Year 2 the remainder of the income, $20,000, from the installment sale, which creates the expected $5,000 tax liability. Therefore, it records in its financial books a debit to the deferred tax liability account and a credit to the tax payable account for $5,000, thereby zeroing out the deferred liability. When ZYX sends a check to the IRS, it decreases income tax payable and cash by $5,000. ZYX also updates its Year 2 tax books by the payment of $5,000 arising from the $20,000 installment sales in the second year. Now, both the financial and tax books match with regard to this sale. 

If you are not comfortable with the distinctions between financial and tax reporting, consider using profession accountants, bookkeepers and enrolled agents to ensure you don't overpay your taxes.