What is Income Tax Expense on Income Statement?
Income tax expense is a type of expense which is to be paid by every person or organization on the income earned by them in each financial year as per the norms prescribed in the income tax laws and it results in the outflow of cash as the liability of income tax is paid out through bank transfers to the income tax department.
It is a type of liability on the business or an individual. It is a tax levied by the government on the earnings of a business and income of an individual. Income tax is considered as an expense, for the business or individual, because there is an outflow of cash due to tax payout. Income tax expense is a component that features on the income statement under the heading of ‘other expenses.’ After the taxable income is determined, the business or individual is liable to pay income tax on that income.
- Through income tax returns that are filed by businesses and individuals alike, the tax liabilities are determined. The government uses this tax money for funding the provision of public goods like roads, bridges, basic healthcare, etc. In most countries, a separate agency or institution is set-up to collect taxes on income.
- For instance, individuals are liable to pay individual income tax on their salaries or wages. After the necessary deductions, exemptions, and tax credits, the final taxable income is calculated for each individual. Similarly, for businesses, they are obligated to pay income tax on their annual earnings after deducting operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit..
The standard formula for this is as follows:
Additionally, income tax is arrived at by showing only the tax expenses that occurred during a particular period when they were incurred and not during the period when they were paid.
How to Calculate Income Tax Expense?
Income tax is calculated for a business entity or individual over a particular period, usually over the financial year. This formula is simply the tax rate multiplied by the taxable income of the business or individual. Firstly, the taxable income of the individual and taxable earnings of the business entity is to be determined. It is a complex process since different sources of income are taxed differently.
For example, a company has to pay one kind of tax on the salaries it pays to employees – payroll taxPayroll TaxPayroll taxes are statutory deductions made by the employer from an employee’s regular salary and wages, and usually, such withholdings mostly have both employer and employee equal contributions. These taxes are collected by tax authorities from respective employers and paid for human welfare schemes, infrastructure development., then another tax on the purchase of any assets – sales tax. Further, there are taxes levied at the state or the national level as well. Hence, the correct tax rate should be determined as this will ultimately affect the income tax expense to be borne by the company. It can be done with the help of accounting standards like Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standard (IFRS).
Example of Income Tax Expense on Income Statement
To understand this further, let us take an example. For instance, there is a certain Company ABC whose taxable income for the current accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. is $ 2,000,000, and the tax rate levied is 25%. Here the taxable income of the company means net income, which is arrived at after subtracting non-taxable items and other tax deductions.
Hence, the calculation is as follows,
Income Tax of Company ABC = $ 2,000,000 x 25% = $ 5,00,000
Hence, Company ABC has to undergo an income tax of $ 500,000 in the current accounting period based on the tax rate of 25%.
Further, the income tax is arrived at by adding deferred tax liability and income tax payable. Here, deferred tax liability refers to the taxes that the company is yet to pay. A deferred tax liabilityDeferred Tax LiabilityDeferred tax liabilities arise to the company due to the timing difference between the accrual of the tax and the date when the company pays the taxes to the tax authorities. This is because taxes get due in one accounting period but are not paid in that period. may occur due to a difference in the company’s accounting technique and the tax code, which determines taxable income.
Important Points about Income Tax Expense Income Statement
The following are the important points about this tax expense.
#1 – Minimizing Taxable Income
As mentioned above, income tax involves an outflow of cash, and hence, it is seen as a liability for the company. Income tax expense is paid out of the operating profits of the entity. It means if companies didn’t have to pay taxes, that amount of money could instead be used to distribute as profits among stockholders. Therefore, companies try to minimize their tax expenses because otherwise, they would eat into the profits and make stockholders unhappy.
#2 – Losses and Taxable Income
Income tax is levied on taxable income only. So if a company is running in losses, it has practically zero taxable income. It means there is no tax expense recorded in the income statementRecorded In The Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.. Further, the company can carry forward its losses to the following years and sometimes even end up canceling out the future tax liability.
#3 – The Difference in Financial Accounting and Tax Code
Depending on the accounting standards given by GAAPAccounting Standards Given By GAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting. and IFRS, often, the reported income by companies on their income statements differs from the taxable income as determined by the tax code. One reason this may occur is that, on the one hand, as per accounting standards, companies employ the straight-line depreciation methodStraight-line Depreciation MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. to determine depreciation for that financial year. On the other hand, as per the tax code, they are allowed to employ the accelerated depreciationAccelerated DepreciationAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset's useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. to determine the taxable profit. It is where the mismatch between the income tax expense and the tax bill.
All companies and individuals who have a taxable income are liable to pay taxes. For companies, this translates into an expense on their income statements and takes away a significant part of their profits. It poses a great disadvantage to the stockholders of the companyStockholders Of The CompanyA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares.. Since income tax is to be paid only if there is taxable income, companies try to further minimize their taxable income by under-reporting profits or showing exaggerated losses. Further, given the accounting methodsAccounting MethodsAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods., income reported for tax purposes sometimes varies from income reported for financial purposes.
It leads to complexities in calculating income tax expenses for the company. Hence, analysts or other stakeholders should be very careful while assessing the performance of a company to get around these complexities in determining the income tax.
This article has been a guide to Income Tax Expense on Income Statement. Here we discuss how to calculate Income Tax Expense and its formula along with practical examples. You can learn more about financing from the following articles –