Definition of Tax Accounting
Tax accounting is a system followed by companies or businesses to recognize taxation-related duties based on certain accounting methods governed by the internal revenue code.
Tax accounting is a branch of accounting that deals with preparing and assessing financial statements and subsequent reporting for tax purposes. It can be used by corporates, small businesses, partnerships, individuals, etc. However, knowing that it does not fulfill general purposes is important. Hence, companies also need to practice the use of financial accounting required for internal assessment and management.
Examples of Tax Accounting
Example #1
A company assumes a tax rate of 15% on sales of $5 million. First, calculate the sales tax and sales price. Then, assume that the tax is on top of the sales made.
Solution:
| Sales | $5,000,000 |
| Sales tax rate (as given) | 15% |
| Sales tax payable (Sales times sales tax rate) | $750,000 |
| Total sale price (Sales + sales tax payable) | $5,750,000 |
Remember that the sales tax is not included in the sales price here. However, under certain exceptional cases, sales are shown inclusive of sales tax, and hence total sale price becomes the sales themselves (excluding sales tax payable).
Example #2
Consider a scenario where a company books revenue of $1 million in the fiscal year 2019. Under the tax accounting system, the company records a profit before tax of $105,000 and a tax expense of $12,000, while under financial accounting, the profit before tax is $115,000 and a tax expense of $18,000. How does the company record these transactions and comment on the income and margin?
| Particulars | Tax Accounting | Financial Accounting |
| Revenue (a) | $1,000,000 | $1,000,000 |
| Profit before tax (b) | $105,000 | $115,000 |
| Tax expense (c) | $12,000 | $18,000 |
| Tax rate (d) = (c / b) | 11.40% | 15.70% |
| Net income (e) = (b – c) | $93,000 | $97,000 |
| Net margin (f) = (e/a) | 9.30% | 9.70% |
The company recorded $93,000 in net income based on tax accounting. However, in reporting based on financial accounting, the net income was $97,000. The difference in the tax expenses, i.e., $18,000 – $12,000 = $6,000, will be recorded as deferred tax assets and go down on the company balance sheet for the year.
From an income perspective, the company benefitted from financial reporting posting 9.7% in net margin, i.e., net income-to-sales ratio. Another way of looking at tax accounting is to consider a scenario where a company prepares its inventory accounting in the financial statements using the first-in-first-out (FIFO) approach and the last-in-first-out (LIFO) approach. While the former approach may be used for financial reporting, the latter may be applicable for tax purposes.
Tax Accounting and VAT
VAT is a value-added tax and is categorized under the indirect tax. VAT accounting is applicable only if the company has its business registered for VAT. Some of the common ways to account for Value added tax are:
- Cash accounting system where all VAT is applicable at the time of cash receipt rather than receipt of invoice
- A flat VAT rate considers businesses to pay a simplified fixed rate of tax as VAT for a specific taxable income/turnover
- Standard VAT system recognizes the accrual basis of accounting and registers VAT upon receipt of invoice rather than actual cash payment.
Tax Accounting and Self-Assessment
Self-assessment tax returns are mandatory for self-employed or limited companies based on the taxation year. However, suppose there remains any liability related to taxes payable after consideration of TDS (tax deducted at source) and advance tax. In that case, it should and must be paid through self-assessment tax after the end of the fiscal year.
Importance
The importance of tax accounting lies in companies making advance tax planning to allocate costs and expenses while having a forward view of their revenues and profits. Given tax planning, it helps businesses understand the effects and implications of taxes. Sometimes, there arise differences between financial reporting and tax reporting due to revenue recognition and matching principles. This paves the way for the creation of deferred tax assets and liabilities.
It is an important tool for business planning and vital to compliance with federal and local taxation policies. Tax accounting matches revenues with expenses in the same periods, sorting items for financial reporting. It also streamlines deferred tax assets and deferred tax liabilities to help companies gain better control of their pro forma financial statements.
Advantages
- It makes it convenient for small businesses to file year-ending tax returns while avoiding non-compliance
- While using tax accounting and preparing financial statements and reporting, the accounting team saves time and costs
- It also provides for a good format and ledger of reporting the benefits, which extend into other aids covered under the IRS schedule
Disadvantages
- It may involve specialized professionals in the field of tax when working for large corporates, as tax accounting may pose challenges arising out of complex taxation
- Businesses that undergo audit need to keep in place accounting standards and methods other than tax accounting
- It does not give an accurate picture of the operations of the business
Conclusion
It is an important concept in theory as well as practice. The standards and frameworks of different financial reporting systems take into account aspects of taxation and hence issue tax accounting principles and updates from time to time. Corporations, small businesses, and proprietors pay taxes and adhere to tax accounting standards. In addition, individuals outside the ambit of taxes must participate in the process as it addresses federal record-keeping and assessment needs.
Two important terms in tax accounting are deferred tax assets and deferred tax liabilities. When companies pay taxes in advance or pay in excess based on anticipated income, the overpayment results in deferred tax assets. In case there is an underpayment, the deferred tax liability is recorded. It covers a broader spectrum of analyzing transactions for tax purposes, preparing documents, and filing tax returns.
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