03 Apr Net Income – Accounting vs. Tax
Net income is a key financial metric that is used to assess the financial health of an organization. You may assume that there is only one way of determining a business’ net income, but this is not the case. Net income for accounting purposes (GAAP) and net income for tax purposes are not the same in Canada, and it is essential for business owners and managers to understand the difference between the two.
Net Income for Accounting Purposes (GAAP)
Audited and reviewed financial statements are prepared in accordance with GAAP. GAAP stands for Generally Accepted Accounting Principles, which are a set of guidelines issued by the CPA profession and used by Canadian businesses to prepare financial statements for external users such as lenders, regulators and/or investors. In Canada, GAAP generally refers to International Financial Reporting Standards (IFRS), Canadian Accounting Standards for Private Enterprises (ASPE) or Canadian Accounting Standards for Not-for-Profit Organizations (ASNPO).
The net income for accounting purposes is the amount of revenue earned by a business, minus all the expenses incurred during a specific period. This includes all the expenses related to running the business, such as salaries, rent, supplies and taxes.
The GAAP net income is calculated based on the accrual accounting method, which records revenue and expenses when they are earned or incurred, regardless of when they are paid. This means that GAAP net income includes accounts receivable and accounts payable, which are not yet received or paid, respectively.
Net Income for Tax Purposes
Net income for tax purposes is the income that is reported to the Canada Revenue Agency (CRA) for tax purposes. The CRA uses a different set of rules and regulations to calculate net income than GAAP. The main difference is that the net income for tax purposes is calculated based on the Canadian Income Tax Act (ITA), which allows for different deductions and tax credits.
When a CPA firm such as Clearline prepares a corporate income tax return, also known as a T2, we take a company’s net income for accounting purposes and adjust it to net income for tax purposes. Depending on the type of business and the activities that occurred during the year, this can be a complex and time-consuming process.
Differences between GAAP and Tax Net Income
The main difference between GAAP net income and tax net income in Canada is the accounting method used. GAAP net income is calculated based on the accrual accounting method, which includes accounts receivable and accounts payable. On the other hand, tax net income is calculated based on the Canadian ITA, which may allow for different deductions and tax credits.
In some instances, the ITA permits accrual accounting and in other situations it requires items be accounted on a cash accounting basis. There are also rules within the ITA that dictate how and when an expense deduction can be claimed, which can differ from GAAP. And in some cases, certain expenses can never be deducted for tax purposes, which means the business can’t write them off. (On a lighter note, there is an old bit from Seinfeld which touches on tax write offs and the characters’ confusion on what this term means.
One key difference that should be highlighted is the treatment of depreciation. Depreciation, also referred to as amortization, is the decrease in value of an asset over time. For tax purposes, the CRA allows businesses to deduct a certain amount of depreciation each year based on the Capital Cost Allowance (CCA) rules within the ITA, while GAAP requires businesses to use different depreciation methods, which may result in different depreciation amounts from the CCA rules.
If you would like some assistance with your GAAP financial statements or corporate tax filing requirements, or if you would just like to better understand the concepts discussed above, please contact us to set up a free consultation.