Perspectives on the Relationship between Tax and Financial Accounting

This book chapter analyzes similarities and differences between financial and tax accounting with a view toward understanding how financial accounting might inform and improve tax accounting and vice versa. It begins with a brief overview of the historical relationship between the two and discusses how lawmakers and scholars have traditionally thought about that relationship — one in which financial accounting tends to understate income out of a reflexive conservatism, while tax accounting, ever protective of the fisc, tends to overstate income. The chapter then turns to what I call the “modern era,” in which the traditional values and policies promoted by each system have reversed, with financial accounting overstating income and tax accounting understating it. It considers whether the two systems can benefit by requiring greater conformity or disclosure of the differences between them. The next part of the chapter explores how the financial and tax accounting systems treat intellectual capital, a vital and growing driver of global economic productivity. It finds that the two systems are relatively aligned at this time but are trending in opposite directions. Financial accounting is poised to make significant changes that will more accurately measure income from intellectual capital while tax accounting has regressed to a less accurate treatment of intellectual capital. The chapter argues that tax accounting for intellectual capital can and should be informed by the research and reforms taking place in financial accounting. The final part of the chapter discusses how my endorsement of a close relationship between financial and tax accounting differs from Adam Chodorow's perspective, set forth in a separate chapter. Chodorow advocates that we adopt the cash method of accounting for tax purposes. Alternatively, he argues that the courts and the IRS can effectively police abuses under the current law accrual method. I argue that the accrual method should be retained for tax purposes because it more accurately measures economic income than the cash method. Furthermore, I argue that legislative reform is far superior to judicial and regulatory oversight to defend against abuses of the accrual method