Accounting for Taxes
Taxes are amounts levied by governments on businesses and individuals to finance their expenditures, to fight business cycles, to distribute wealth more evenly and for a number of other reasons.
There are different ways in which governments calculate and collect taxes. Direct taxes are taxes that are paid by businesses which also ultimately bear them. They are normally based on net income of the business. On the other hand, indirect taxes are taxes which are initially paid by businesses but ultimately transferred to the end users of the taxed product. They are typically based on revenue.
Examples of direct taxes include:
Examples of indirect taxes include:
- Sales tax
- Value added tax
- Import tax
The main difference between direct tax and indirect tax from the perspective of a business that pays it is that a direct tax results in expense and liability while an indirect tax results in a liability but not an expense.
Direct tax and indirect tax have different accounting implications for a business.
Accounting for direct taxes
Income taxes are determined by applying the applicable tax rate to net income of a business calculated in accordance with the accounting rules given in the tax laws.
In most cases, the tax accounting rules differ from GAAP. Hence, some revenues and/or expenses are recognized in different periods under tax and financial reporting regimes thereby resulting in temporary differences. In such a situation, in order to correctly match revenues with expenses, deferred tax expense and associated deferred tax liability or deferred tax asset are recognized.
Example - Direct taxes
Shark, Inc. is a manufacturer of water sports equipment. It sold 990 speed boats in financial year 2014 for $50 million in total. The company’s total expenses for the period amounted to $28 million. Since tax accounting rules are different than the financial accounting rules, net income for the income tax purpose is different than the financial accounting net income. The company’s tax accountant determines that the company’s revenue for the period under tax accounting rules equals $48 million while its allowable expenses are $23 million. Calculate the income tax the company shall pay if the relevant tax rate is 25% and journalize the transaction.
|Revenue under tax accounting rules||$48,000,000|
|Less: expenses under tax accounting rules||$23,000,000|
|Net income under tax accounting rules i.e. taxable income||$25,000,000|
|Income tax @ 25% ($25 million * 0.25)||$6,250,000|
This $6.25 million is the company’s expense for the period which also results in a company’s obligation to the government. The transaction is recognized in the company’s books as follows:
|Income Tax||$6.25 M|
|Income Tax Payable||$6.25 M|
Accounting for indirect taxes
In case of indirect taxes on revenue, for example a tax on goods and services, a business is required to collect an amount from its customers on each unit it sells to them and deposit it with the government.
Example - Indirect taxes
ABC, Inc. provides cleaning services to XYZ, Inc. Under the relevant tax laws, ABC is required to collect a sales tax on services from XYZ, Inc. at the rate of 15%. During the financial year 2014, ABC, Inc. provided services worth $3 million to XYZ, Inc. Explain how will ABC, Inc. account for the transaction.
Sales tax ABC, Inc. is required to collect from XYZ, Inc. = 15% * $3 million = $0.45 million
ABC, Inc. shall invoice XYZ, Inc. for an amount which shall be the sum of the sale price and the sales tax, i.e. $3.45 million ($3 million + $0.45 million). ABC, Inc. shall deposit the sales tax of $0.45 million collected from XYZ, Inc. with the government.
ABC, Inc. shall pass the following journal entry:
|Accounts receivable/cash||$3.45 M|
|Sales tax payable||$0.45 M|
When ABC, Inc. deposits the $0.45 million with government, its liability related to the sales tax shall be settled:
|Sales Tax Payable||$0.45 M|
From the perspective of XYZ, Inc. the sales tax it has paid to ABC, Inc. becomes its expense and shall form part of the cost of cleaning services. ABC, Inc. shall record the transaction as follows:
|Cleaning Expense||$3.45 M|
|Accounts Payable/Cash||$3.45 M|