What is Tax Accounting?
Tax accounting refers to the methods and policies used for the preparation of tax returns and other statements needed for tax compliance and therefore, it provides frameworks and guidelines for arriving at a taxable profit.
Also, tax policies in each country differ with Generally Accepted Accounting Principles on various items. This variation leads to the generation of 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 liabilities. Also, there are separate guidelines for VAT (Value Added Tax) accounting, transfer pricing, and cross border transactions, which all fall under tax accounting.
Basics of Tax accounting
The reason for doing Income Tax accounting is arriving at taxable profit and tax payable by making adjustments in the book profit arrived by accounting principles. All these working and adjustments form part of the Tax return, and these statements are kept for Tax audits. There are various components of accounting for taxation, some of which are discussed below –
#1 – Deferred Tax asset
Is generated when there is a difference in book profitBook ProfitBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. , and taxable profit arises due to a timing issue. There are expenses like provision for doubtful debts, which are considered for deduction in accounting in the current year. However, these are allowed for a deduction for taxation only when the amount is declared as bad debtBad DebtBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation., which can happen in the coming years.
In this case, the taxable profit will be higher compared to accounting profit, and the person or organization will pay more taxes this year, which. The extra amount paid as tax on incremental profit due to rejection of provision amount for deduction is considered as deferred tax, which will be realized in the coming years.
#2 – Deferred Tax liability
Deferred Tax Liability is generated when the person or organization has to pay fewer taxes in the current year due to the timing difference. For example – let’s consider that an asset of $10,000 is being depreciated in accounting books under (SLM) straight-line method(SLM) Straight-line 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. for 8 years – the depreciation each year will be $1,250 ($10,000/8).
However, if the tax rules state that assets have to be depreciated @20% (WDV) written down value methodWritten Down Value MethodThe Written Down Value method is a depreciation technique that applies a constant rate of depreciation to the net book value of assets each year, resulting in more depreciation expenses recognized in the early years of the asset's life and less depreciation recognized in the later years of the asset's life.. The depreciation for taxation purpose in second year will be $1,600 (($10,000 – 2000 i.e. 20% for first-year) = $8,000*20% = $1,600)).
Here the organization will get an extra deduction of $350 ($1,600-$1,250) for taxation purposes. If we consider the tax rate to be 30%, the deferred tax liability here is $105 ($350*30%).
#3 – VAT Accounting
Most of the countries a Good & Service Tax (GST) or VAT (value-added tax)VAT (value-added Tax)Value-added tax (VAT) refers to the charges imposed whenever there is an accretion to a product's usefulness or value throughout its supply chain, i.e., from its manufacturing to its final selling point. It is an indirect tax levied on the product consumption., which forms part of almost all the invoices issued. Now, this should not be considered as expenses directly because the organizations get an Input Tax credit on the amount already paid. To claim those inputs, the tax authorities lay certain conditions regarding the format of invoice, name, and registration of the company, details of the second part, etc. and all these conditions have to be met by tax accounting team before claiming VAT/GST input credit.
#4 – Transfer Pricing
In today’s world of globalization, many companies open their branches in various parts of the world. A policy monitors transfer pricing called an Arm’s Length transactionAn Arm's Length TransactionAn arm's length transaction is one in which two parties operate independently and the price agreed between them (also known as the transfer price) is free of any influence. Pricing, which advocates the fair-trade policy across the globe. In simple words, it says that a related part or person should not avail good or services at a lower cost than the price at which it has been sold to an unrelated third party.
Also, if an organization has set up an only offshore office where people are working, and no other business is being done in that country. As per the Transfer pricing policy, the organization has to pay a certain percentage (8-15%) of tax on the expenses incurred in operating the offshore office. Transfer pricing is one of the fast-paced and challenging components in today’s world.
#5 – Categorisation of Income
Accounting considers all the receipts and payments for calculating the accounting profit. However, not all receipts are related to business, and the rate of tax differs depending on the type of receipt it is.
Let’s consider below example –
In table 1, the extract from accounting books is shown, and in the second table shows how tax accounting has to categorize the type of income as the Income-tax rates differ on types of income.
- Categorization of Income for application of correct tax rate;
- Statutory compliance adherence.
- Losses of current and previous years can be set off in future periods by filing Tax returns.
- Tax audit facilitation.
- Self-assessment and tax payments in a timely manner;
- Needs extra time and resources for the work;
- Tax professionals charge dearly to organizations.
- There are changes in tax policies almost every year.
Important Points to Note
Every time there is a change in policies, tax rates, etc. the organizations/individual must keep themselves updated, and accounting software should be amended accordingly.
Tax accounting is pivotal to any business or individual as it provides a framework to declare the correct income and pay appropriate taxes. In case of ambiguity, a tax professional should be consulted to avoid any miss in tax compliance as there are fines and penalties for tax defaulters. It also works for tax avoidanceTax AvoidanceTax avoidance is the process of reducing the income tax liability of an individual or firm by adopting the lawful methods. The taxpayers can claim exemptions and deductions as allowed under the nation's tax provisions. Such as investments in municipal bonds and deductions for business loss. by selecting which method works best for each type of business or individual.
This has been a guide to Tax Accounting and its meaning. Here we discuss various basic components of accounting for taxation, including deferred tax assets & liabilities, VAT, Transfer pricing, advantages, and disadvantages. You can learn more about accounting from the following articles –