For recognizing income tax payable in books of account and determining tax expenses for the current period, income tax accounting is required. It must be paid before or after the end of the fiscal year, and must be recorded in the books of account.
There is a difference between value recognized in the financial statements for financial reporting and value recognized for tax purposes.
Before we go into the topic in detail, I will first define some key terms in income tax accounting. Keep reading!
Key Terms of income tax in Accounting
To understand income tax accounting, we must first comprehend the meaning of the following components:-
- Accounting Profit - Accounting profit refers to the profit shown in the profit and loss statement after all income and expenses have been taken into account, but before taxes.
- Taxable Profit - A taxable profit is one that is calculated according to tax legislation and on which tax is due.
- Current Tax - The current tax is the tax that is due or paid on taxable profit in the current year, based on the appropriate tax rate.
- Deferred Tax - A deferred tax is one that emerges as a result of changes in timing. The variations between the carrying amounts of assets and liabilities in the financial statement and the amount of assets and liabilities ascribed to the tax base are known as temporary or timing differences.
To understand the various terms explained above, let me explain with an example:
If we buy a $1000 asset at the start of the year, and the depreciation rate is 10% for financial reporting purposes and 20% for tax purposes, the profit before depreciation and tax is $500.
- Accounting profit will be $400 ($500 – Depreciation as per accounting ($1000*10% = $100)).
- Taxable Profit will be $300 ($500 – Depreciation as per tax ($1000*20% = $200))
- Current tax will be payable at a $300 *tax rate.
- Deferred Tax will arise on temporary difference, i.e., the difference between depreciation as per accounting and depreciation as per tax. From the above example, the deferred tax will arise at $100. ($200 - $100)
Journal Entry of Income Tax Accounting
1. Provision of Income tax – Provision of income tax recorded in books of account by debiting Profit and Loss account, and it appears on the Balance Sheet as a liability.
2. Advance Income tax payment – Advance income tax will appear as Assets on the Balance Sheet.
Types Of Deferred Tax
There are two types of Deferred tax – Deferred tax Assets and Deferred tax liabilities. The two will be explained below:
1. Deferred Tax Assets (DTA)
DTA occurs when the book profit is less than the tax profit. With the example below, we can see what we mean.
For example, X Ltd. has a profit of $5000 on its profit and loss statement before depreciation, and the depreciation rate is 20% for financial reporting purposes and 10% for income tax purposes.
- Profit according to the financial statement – $5000 - ($5000 * 20%) = $ 4,000
- Profit for taxation purposes – $5000 - ($5000 * 10%) = $4,500
Since the tax profit exceeds the book profit, we must pay more tax now and less tax later. As a result, DTA will arise, and DTA will be ($4,500 – $4,000). *Tax Rate
2. Deferred Tax Liabilities (DTL)
DTL occurs when a company's book profit exceeds its tax profit. With the example below, we can see what we mean.
For example, X Ltd. has a profit of $5,000 after deducting $500 in interest receivable, but in accordance with income tax, interest is taxable when it is collected.
- Profit – $5000 (according to the financial statement)
- Profit after taxes – $5000 - $500 = 4,500
Since the tax profit is lower than the book profit, we must pay less tax now and more tax later. As a result, DTL will arise, and DTL will be ($5000 – $4000). * Rate of Taxation
Recognition of Deferred Tax
Deferred tax assets will be credited to the profit and loss account, while deferred tax liabilities will be debited to the profit and loss account.
Journal Entries are as follows:
Advantages Of Income Tax Accounting
- When a company does tax accounting, it makes it easier to prepare a tax return.
- It saves a business entity's time when it comes to making the calculations when filing a tax return.
- Tax preparation is something that a company entity can do.
- You can save money on both labor and accounting software by using only one accounting system.
Disadvantages Of Income Tax Accounting
- Only tax accounting can be maintained by a small business organization.
- It will not accurately show operating costs and benefits.
- Companies that must have their accounts audited cannot use the income tax accounting method alone.
We realized there is a difference between accounting profit and taxable profit after reading this article about income tax in accounting. Before calculating income tax profit, we must first understand income tax provisions and compute taxable profit.
If an entity uses a tax accounting system, they are not needed to calculate taxable profit at the end of the year. However, this is only applicable to businesses that are not subject to the Companies Act and are not required to keep books of accounts in accordance with accounting standards.