Book Income

What is Book Income?

Book income is the amount of income corporations publicly report on their financial statements to shareholders. This measure is useful for assessing the financial health of a business but often does not reflect economic reality and can result in a firm appearing profitable while paying little or no income tax.

How Is Book Income Measured?

Income is generally measured as income minus expenses. However, different definitions of income can be used for different purposes.

Book income is defined using Generally Accepted Accounting Principles (GAAP) and is designed to report profits consistently in a way that reflects a business’ financial performance. GAAP requires accrual accounting, which has implications for measuring both costs and earnings.

If a construction firm purchases several new vehicles, the full cost of that purchase would not be reflected in a calculation of book income in the purchase year. Instead, the cost would be accounted for as the value of those vehicles depreciates. 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 company making the sale will need to book the earnings even if the cash is not in the door (as an accounts receivable).

Combining both the accrued costs and earnings into book income allows for an overall financial picture of a firm that may not perfectly match economic reality. This mismatch could be something as simple as cash that has been spent for a purchase but only part of the cost is reflected in financial accounts because of depreciation.

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 those income measures to diverge. Because of this, 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.

Book Income vs. Taxable Income

Book income is used by companies to report their income and expenses to shareholders. Taxable income is used by businesses to report earnings and tax liability to tax authorities.

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 may deduct from their gross income the cost of investment when determining taxable income, which reduces the firms’ tax liability. This is an important structural difference that helps make sure the tax code only targets net profits and not the cost of investment when levying income tax.

Similarly, net operating losses (NOLs) may be carried forward to future years if firms post losses in a given tax year beyond their tax liability. This ensures that the income tax is assessed on a firm’s average profitability and does not penalize firms with 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.

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