Income tax expense is a type of liability on the business or an individual. It is a tax imposed by the government on the earnings of a business and income of an individual. Income tax is deemed as an expense, for the business or individual, because there is an outflow of cash due to tax payout. Income tax expense is an element that is stated on the income statement under the heading of ‘other expenses.’ After the taxable income is decided, the business or individual is legally responsible to pay income tax on that income.
The article explores income tax expense in-depth; how to calculate income tax expense, and its treatment in final accounts.
Table of Contents
- 1 What is Income Tax Expense on Income Statement?
- 2 Treatment of Income Tax Paid in Final Accounts
- 3 Income Tax Payable
- 4 Income Tax Expense VS. Income Tax Payable
What is Income Tax Expense on Income Statement?
Income tax expense is a kind of expense which is required to be paid by every person or organization on the income earned by them in each financial year as per the standards set by 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.
Through income tax returns that are filed by businesses and individuals alike, the tax liabilities are calculated. The government uses this tax money for financing the establishment of public goods like roads, bridges, basic healthcare, etc. In most countries, a separate agency or institution is created to collect taxes on income.
For example, individuals are accountable to pay individual income tax on their salaries or wages. After the required deductions, exemptions, and tax credits, the final taxable income is computed for each individual. Likewise, businesses are obliged to pay income tax on their annual earnings after subtracting operating expenses.
Formula for Income Tax Expense
The basic formula for this is as follows:
Income Tax Expense Formula = Taxable Income * Tax Rate
Furthermore, income tax is calculated by displaying only the tax expenses that were incurred during a specific period 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 certain period, typically over the financial year. Firstly, the taxable income of the individual and taxable earnings of the business entity is to be figured out. It is a complicated method since various sources of income are taxed in a different way.
For instance, a company has to pay one kind of tax on the salaries it pays to employees – payroll tax, then another tax on the buying of any assets – sales tax. Additionally, there are taxes imposed at the state or the national level as well. Therefore, the accurate tax rate should be calculated as this will eventually have an effect on the income tax expense to be incurred by the company. It can be achieved with the help of accounting standards like Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standard (IFRS).
Example of How to Calculate Income Tax Expense on Income Statement
To understand this better, let us take an example. For instance, there is a certain Company XYZ whose taxable income for the current accounting period is $ 2,000,000, and the tax rate imposed is 25%. Here the taxable income of the company means net income, which is calculated after deducting non-taxable items and other tax deductions.
Thus, the calculation is as follows,
Income Tax of Company XYZ = $ 2,000,000 x 25% = $ 5,00,000
Hence, Company XYZ has to endure an income tax of $ 500,000 in the current accounting period dependent on the tax rate of 25%.
Moreover, the income tax is calculated by adding up deferred tax liability and income tax payable. Here, deferred tax liability implies the taxes that the company is yet to pay. A deferred tax liability may arise due to a difference in the company’s accounting method and the tax code, which decides taxable income.
Critical Points regarding Income Tax Expense on Income Statement
The following are the key points about this tax expense.
1. Reducing Taxable Income
As stated above, income tax results in an outflow of cash, and therefore, it is seen as a liability for the company. Income tax expense is paid out of the operating profits of the entity. This tells us that if companies are not obliged to pay taxes, that amount of money could instead be utilized to distribute as profits among stockholders. Hence, companies try to minimize their tax expenses because if not, they would cut down profits and make stockholders dissatisfied.
2. Losses and Taxable Income
Income tax is collected on taxable income only. Therefore, if a company facing losses, it has basically zero taxable income. It suggests there is no tax expense documented in the income statement. Additionally, the company can carry forward its losses to the following years and every so often can even end up canceling out the future tax liability.
3. The Difference in Financial Accounting and Tax Code
Based on the accounting standards provided by GAAP and IFRS, often, the reported income by companies on their income statements differs from the taxable income as defined by the tax code. One reason this may happen is that, on the one hand, as per accounting standards, companies use the straight-line depreciation method to calculate depreciation for that financial year. On the other hand, as per the tax code, they are permitted to utilize the accelerated depreciation to calculate the taxable profit. It is where the difference between the income tax expense and the tax bill arises.
Treatment of Income Tax Paid in Final Accounts
In order to correctly account for income taxes, it is important to understand that the Internal Revenue Service code that regulates accounting for tax liability isn’t the same as the generally accepted accounting principles (GAAP) for reporting tax liability on the financial statements.
The result is the taxable income a company reports to the IRS may not be the equivalent to the pre-tax profit reported on its financial statements.
Additionally, the actual amount of tax liability due to the IRS may not be equal to the income tax expense reported on the income statement.
The discrepancies in what is reported on the financials and what is reported to the IRS are split into two classifications, temporary difference, and permanent difference.
Temporary difference: The book income (income displayed on the company financials) may be higher one year, but lower in future years. Hence, the cumulative profit will be the same for both.
Permanent difference: Due to generally accepted accounting principles treating items such as income and expenses differently than the IRS, the difference may never reverse.
Accounting for Deferred Taxes
In this method, the deferred income tax amount depends on tax rates in effect when the temporary differences started. The deferred method is an income-statement-oriented method. This method seeks to correctly match expenses with revenues in the period the temporary difference began. Remember that this method is not acceptable under GAAP.
In the asset-liability method, deferred income tax amount depends on the expected tax rates for the periods in which the temporary differences reverse. It is a balance-sheet-oriented method. This method is the only one accepted by GAAP.
Loss Carry Backs and Loss Carry Forwards
Under U.S. Federal income tax law, a net operating loss (NOL) arises when certain tax-deductible expenses surpass taxable revenues for a taxable year.
If a company realizes a net loss for tax purposes, the IRS lets the company balance this loss against the prior year’s taxable income (which could result in a refund of taxes paid in prior periods).
The company could carry those losses back three years. If the company doesn’t have the adequate taxable income in the past three years to absorb the loss, then it may carry the remaining losses forward for 15 years. This permits the company to deduct the loss against future taxable income.
Income Tax Payable
Income tax payable is the business organization’s tax liability to the government where it functions. The amount of liability will depend on its profitability during a given period and the relevant tax rates. Tax payable is not deemed as a long-term liability, but instead a current liability, since it is a debt that requires to be resolved within the next 12 months.
The calculation of the taxes payable is not exclusively based on the reported income of a business. The government typically accepts certain adjustments that can decrease the total tax liability.
How to Calculate Income Tax Payable on The Balance Sheet?
In order to come up with a correct reporting of financial status, it is vital for businesses and organizations to know how to calculate income tax payable on the balance sheet.
- Take the balances of the different taxes to be paid, such as income tax, Medicaid tax, social security tax, and unemployment benefits tax. Add the values of all the taxes together.
- Make sure that the balances are already inclusive of the employer’s contribution, particularly on the balances of the Social Security and Medicaid accounts.
- Add the total to the sales tax payable account, other local taxes, and state income tax.
- Write down the final amount and put the figure under the Tax Payable section of the balance sheet.
Income Tax Expense VS. Income Tax Payable
Income tax expense and income tax payable are two distinct concepts.
Income tax expense can be calculated for recording income tax costs since the rule says that expenses are to be displayed in the period during which they were incurred, instead of in the period when they are paid. A company that pays its taxes monthly or quarterly must make adjustments during the periods that generated an income statement.
Fundamentally, income tax expense is the company’s computation of how much it really pays in taxes during a given accounting period. It usually is displayed on the next to last line of the income statement, right before the net income calculation.
Income tax payable, on the other hand, is what looks on the balance sheet as the amount in taxes that a company owes to the government but that has not yet been paid. Until it is paid, it stays as a liability.
All companies and individuals who have a taxable income are legally responsible to pay taxes. For companies, this turns into an expense on their income statements and takes away a substantial part of their profits. It presents a great detriment to the stockholders of the company. Since income tax is to be paid only if there is taxable income, companies attempt to further reduce their taxable income by under-reporting profits or showing overstated losses. Moreover, given the accounting methods, income reported for tax purposes sometimes changes from income reported for financial purposes.
It results in complications in determining income tax expenses for the company. Therefore,
analysts or other stakeholders should be very cautious while evaluating the performance of a company to get around these complications in ascertaining the income tax.