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 reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. 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 taxDeferred TaxDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid. is a tax that arises due to timing differences. Temporary / Timing differences are the differences between the carrying amountsCarrying AmountsThe carrying amount or book value of asset is the cost of tangible, intangible assets or liability recorded in the financial statements, net of accumulated depreciation or any impairments or repayments. Accordingly, the carrying amount may differ from the market value of assets. of assets and liabilities in the financial statement and amount of Assets and liabilities attributed to the tax base.Tax Base.Tax base refers to the total value of the income or assets of an individual or firm which is taxable by the government or the relevant taxing authority. This taxable amount is used to evaluate the tax liability of the individual or company.
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 the Balance Sheet.
2. Advance Income tax payment – Advance income tax will show under Assets in the Balance Sheet.
Deferred Tax Assets and Deferred Tax Liabilities
Deferred tax is of two types – Deferred tax AssetsDeferred Tax AssetsA deferred tax asset is an asset to the Company that usually arises when either the Company has overpaid taxes or paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the Company or deducted from future taxes. 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 StatementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. – $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 StatementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. – $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 planningTax PlanningTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities..
- 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 taxProvisions Under Income TaxProvision for Income Tax is the estimated income tax for current year and is the amount that the entity might have to deposit to settle their tax liabilities. It is adjusted for the expenses allowed to be deducted according the relevant tax laws. and calculate taxable profit. If an entity follows tax accounting systemAccounting SystemAccounting systems are used by organizations to record financial information such as income, expenses, and other accounting activities. They serve as a key tool for monitoring and tracking the company's performance and ensuring the smooth operation of the firm. 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 –