Book income is the amount of income corporations publicly report on their financial statements to shareholders. It provides a picture of a firm’s financial performance and follows Generally Accepted Accounting Practices (GAAP). While it is a useful measure for assessing financial performance, it is not useful for assessing tax liability.
Book Income vs. Taxable Income
Companies use book income to report their income and expenses to shareholders according to rules and guidelines set by the Financial Accounting Standards Board (FASB). Companies calculate taxable income to determine their tax liabilities according to rules set by Congress.
The two measures of income can differ dramatically and understanding that difference is key to understanding why some businesses may report profits on financial statements but pay little or no federal income tax.
For example, firms deduct the cost of investment over different schedules to calculate book income and taxable income; the tax code generally provides faster write-offs to reduce the tax liability on investment, while book income uses slower write-offs to match expenses with expected income. The timing difference for capital investment costs can make some firms look unprofitable on tax returns and profitable on financial statements, but that gap resolves over time.
Similarly, net operating losses (NOLs) may be carried forward to future years if firms post losses in a given tax year. NOLs ensure that the income tax applies to a firm’s average profitability and does not penalize a firm for variable profits. In this case, creating a distinction between taxable income and book income is necessary for the proper tax treatment of firms with varying profitability across tax years.
Using book income, rather than taxable income, as a tax base raises the cost of investment and disproportionately penalizes firms with losses that don’t fit with the calendar year.
How Is Book Income Measured?
Book income is defined using GAAP and is designed to report profits consistently in a way that reflects a business’ financial performance, and it is reported on the income statement. GAAP requires accrual accounting, which has implications for measuring both costs and earnings.
For example, if a construction firm purchases several new vehicles, the full cost of those purchases would not be reflected in a calculation of book income in the year they are purchased. Instead, the cost would be spread out as those vehicles depreciate. Even though the business expense (and the cash out the door) occurred in a single year, the business would account for that expense over multiple years.
Book income treats earnings in a similar way. If a client makes a purchase for a future delivery but only pays the bill after the delivery is completed, the seller will book the earnings as accounts receivable even if the cash is not in the door.
Combining both the accrued costs and earnings into book income allows for a good, though incomplete, overall financial picture of a firm. Analysts consider other financial documents, like the cash flow statement, to gain a more complete understanding of a firm’s condition.
Financial statements include taxes paid by firms. These tax numbers are sometimes used to measure tax as a share of book income. But because book income is calculated differently than taxable income, it is common for book income measures to diverge from taxable income measures. Because of the differences in calculations, an effective tax rate calculated as taxes paid (as reported on financial statements) divided by book income may not match the effective tax rate if measured by dividing taxes paid by taxable income.
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