Accounting for Income Tax
Income tax accounting is required for recognizing the income tax payable in books of account and determining the tax expenses for the current period. It has to be paid either before or after the end of the financial year and recognized in the books of account accordingly. There is a difference between value recognized in the financial statements for financial reporting and value recognized for tax purposes.
Key Terms in Accounting for Income Tax
Understanding the income tax accounting first we need to understand the meaning of the below components:-
- Accounting Profit – Accounting profit means profit, which is showing in profit & loss statement after considering all the income and expenses but before tax.
- Taxable Profit – Taxable profit means profit, which is arrived as per tax laws and on which tax needs to pay as per tax law.
- Current Tax – The current tax is the tax, which is payable or paid on taxable profit as per the applicable tax rate of the current year.
- Deferred Tax – Deferred tax is a tax that arises due to timing differences. Temporary / Timing differences are the differences between the carrying amounts of assets and liabilities in the financial statement and amount of Assets and liabilities attributed to the tax base.
To understand the above terms, let us take an example –
If we purchase one asset worth $1000 at the beginning of the year and Depreciation rate as per financial reporting purpose is 10% and as per tax law is 20% and profit before depreciation and tax is $ 500.
- Accounting profit will be ($500 – Depreciation as per accounting ($1000*10% = $100) i.e. $400.
- Taxable Profit will be ($500 – Depreciation as per tax ($1000*20% = $200)) i.e. $300
- Current Tax will be payable on $300 *Tax Rate.
- Deferred Tax will arise on temporary difference, i.e., the difference between depreciation as per accounting and depreciation as per tax. In the above example, the deferred tax will arise at $100.
Journal Entry of Income Tax Accounting
1. Provision of Income-tax – Provision of income tax recorded in books of account by debiting Profit & Loss a/c, and it will show under liability in Balance Sheet.
2. Advance Income tax payment – Advance income tax will show under Assets in the Balance Sheet.
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Deferred Tax Assets and Deferred Tax Liabilities
#1 – Deferred Tax Assets (DTA) – DTA arises when book profit is lesser than the profit calculated as per tax. We understand this with the below example. E.g.- X Ltd. Has a profit as per Profit & loss statement is $5000 before giving the effect of depreciation and as per the depreciation rate is 20% as per financial reporting purpose and 10% as per income tax purpose.
- Profit as per Financial Statement – $5000 – ($5000 *20%) =$ 4,000
- Profit as per Tax Purpose – $5000 – ($5000 *10%) = $4,500
Since Tax profit is more than the book profit, therefore, we have to pay more tax now, and less tax in future and due to this DTA will arise, and DTA will be ($4,500 – $4,000) *Tax Rate
#2 – Deferred Tax Liabilities (DTL) – DTL arises when book profit is more than profit calculated as per tax. We understand this with the below example.
E.g., X Ltd. has a profit of $5,000 after considering the interest receivable of $500, but as per income tax interest is taxable when it actually received.
- Profit as per Financial Statement – $5000
- Profit as per Tax Purpose – $5000 – $500 = 4,500
Since the Tax profit is lesser than the book profit, therefore, we have to pay less tax now, and more tax in future and due to this DTL will arise, and DTL will be ($5000 – $4000) * Tax Rate
Recognition of Deferred Tax
Deferred tax assets will recognize in books of account by crediting the profit & loss a/c and differed tax liabilities will recognize by debiting the profit & loss a/c
Journal Entries are as follows:
- If a business entity is doing tax accounting, it helps them to file the tax return.
- It saves the time of a business entity for doing the calculation at the time of filing a tax return.
- A business entity can do tax planning.
- By maintaining only one accounting system, you can save the cost of manpower and cost of accounting software.
- An only a small business entity can maintain only tax accounting.
- It will not give the correct picture of operational cost and benefit.
- Companies that are required to get their accounts audited can’t follow only the income tax accounting method.
After reading the above, we understood that there is a difference between accounting profit and taxable profit. Before arriving profit as per income tax, we have to understand provisions under income tax and calculate taxable profit. If an entity follows tax accounting system then at the end of the year, they need not required to do the calculation for taxable profit, but this is limited only for those organization on which companies Act is not applicable and or need not required to maintain books of Accounts as per accounting standard.
This has been a guide to What is Income Tax Accounting. Here we discuss key terms to accounting for income tax along with examples, journal entries, advantages, and disadvantages. You can learn more about accounting from the following articles –