Get a handle on how accounting and tax profitability metrics differ
November 19, 2024
The pretax (accounting) profit that’s reported on your company’s income statement is an important metric. Lenders, investors and other stakeholders rely on pretax profits to evaluate a company’s financial performance. However, business owners also need to keep their eyes on taxable income to optimize tax outcomes and manage cash flow effectively. Here’s an overview of how these profitability metrics differ.
Crunching the numbers
Under U.S. Generally Accepted Accounting Principles (GAAP), pretax profit includes all revenue and expenses (except income taxes) for the accounting period. Accrual-basis accounting rules require revenues earned during the period to be “matched” with the expenses that were incurred to generate them. Reporting higher profits on the financial statements is generally preferable because it’s equated with more robust financial performance.
In contrast, taxable income is reported to tax authorities using applicable tax laws. Higher taxable income leads to higher tax obligations. Accounting professionals can help companies implement legitimate tax planning strategies to reduce taxable income.
The tax rules and accounting standards may differ for certain items (such as depreciation methods, expenses and deductions). This may lead to differences in timing and amounts between the two metrics.
Understanding common differences
To illustrate, consider the following calculations: A hypothetical calendar-year C corporation earns $10 million of revenue and incurs $4 million of general operating expenses for book and tax purposes in 2024. Under GAAP, the company’s income statement also reports the following items for 2024:
- $1 million of depreciation using the straight-line depreciation method,
- $500,000 of bad debt expense based on management’s estimated allowance,
- $600,000 of accrued bonuses, and
- $700,000 of regulatory fines to the Environmental Protection Agency (EPA).
So, the company’s pretax profit is $3.2 million ($10 million − $4 million − $1 million − $500,000 − $600,000 − $700,000).
On the other hand, the company’s Form 1120 reports the following for 2024:
- $1.6 million of depreciation using the accelerated depreciation methods, and
- $300,000 of bad debt expenses based on actual write-offs.
Under federal tax law, accrued bonuses are generally deductible in the year employees earn them, but only if they’re paid within 2.5 months of the year end. This company routinely pays year-end bonuses on April 30 of the following year. So it can’t deduct its 2024 accrued bonuses until 2025. In addition, fines and penalties paid to a governmental agency aren’t deductible under current tax law. As a result, the company’s taxable income is $4.1 million for 2024 ($10 million − $4 million − $1.6 million − $300,000).
Most differences — such as those related to depreciation methods, accrued expenses or bad debt deductions — are temporary and will reverse over time. But permanent differences, including nondeductible EPA fines, don’t reverse. It’s also important to note that state tax rules may differ from federal rules, adding complexity.
Why it matters
Had the business owners in this hypothetical scenario paid estimated taxes using only pretax profit estimates, they likely would have underpaid tax for 2024. This could result in a surprise tax bill, which also might include an underpayment penalty. Coming up with funds on Tax Day could be challenging.
Anticipating differences between pretax profits and taxable income is essential for tax planning and cash flow management. For instance, the company could reduce taxable income for 2024 by paying year-end bonuses by March 15, 2025. The owners also could adjust estimated tax payments or set up a tax reserve to avoid a shortfall when filing the company’s return.
We can help
Our experienced accounting professionals can help you understand how pretax profits and taxable income may differ based on your company’s situation and plan accordingly. Contact us for more information.
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