Income tax 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.
What is Income Tax Expense on Income Statement?
Income tax is a type of liability on the business or an individual and is a tax levied by the government on the earnings of a business and the 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 the 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. This tax money is used by the government 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 expenses.
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 of time, 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 are to be determined. This 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 tax, 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. This 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 period 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.
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Hence, the calculation of Income Tax Expense is as follows,
Income Tax expense formula of Company ABC = $ 2,000,000 x 25% = $ 5,00,000
Hence, Company ABC has to undergo an income tax expense of $ 500,000 in the current accounting period based on the tax rate of 25%.
Further, the income tax expense 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 liability 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
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. This 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. This means there is no tax expense recorded in the income statement. Further, the company can carry forward its losses to the following years and sometimes even end up canceling out future tax liability.
#3 – The Difference in Financial Accounting and Tax Code
Depending on the accounting standards given by GAAP 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 one hand, as per accounting standards companies employ the straight-line depreciation method to determine depreciation for that financial year. On the other hand, as per the tax code, they are allowed to employ the accelerated depreciation method to determine the taxable profit. This 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. This poses a great disadvantage to the stockholders of the company. 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 different accounting methods, income reported for tax purposes sometimes varies from income reported for financial purposes.
This leads to complexities in calculating income tax expense for the company. Hence, analysts or other stakeholders should be very careful while assessing the performance of a company so as to get around these complexities in determining the income tax expense.
This 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 –