Tax accounting is a subsection of accounting that focuses on preparing tax returns and tax payments. Individuals, businesses, corporations, and other entities use it. Tax accounting is more complex for companies with more focus on how funds are spent and what is or is not taxable. Even individuals exempt from paying taxes have to participate in tax accounting. Tax accounting is crucial for tracking funds (coming in and going out) associated with individuals and entities.
Keep in mind that tax accounting does not replace financial or managerial accounting performed on a routine basis. The end goal of tax accounting is to assess tax liability to the government. General accounting is used to gauge the profitability of a business and report to stakeholders. Tax accounting also ensures that companies follow regulations so they will avoid penalties. Proper tax accounting can help corporations benefit from tax programs that can save them money on their taxes.
What is Tax Accounting?
Tax accounting is a group of methods for accounting centered on preparing public financial statements showing tax assets and liabilities. The Internal Revenue Service Code outlines the regulations for tax accounting. The code details the rules companies and individuals must follow when developing tax documents. Direct taxes and indirect taxes are the two types of taxes for businesses. Direct taxes indicates a company pays direct taxes directly to a government. Corporate tax is one example of direct tax. Indirect taxes can be passed to others, and one example of this is sales tax.
What are the Objectives of Tax Accounting?
The main objective of tax accounting is to track funds (coming in and going out) associated with individuals and entities. While accounting covers all financial transactions to a certain degree, tax accounting primarily focuses on transactions that affect an entity’s tax burden. It also addresses how those items relate to proper tax calculation and tax document preparation.
Companies have multiple goals concerning accounting for taxes and enhancing their valuation.
The three main objectives of tax accounting are:
- Optimizing After-Tax Profits
- Funding Considerations
- The Timing of Payments
How does Tax Accounting Work?
The government charges corporate taxes that companies can pay by a deadline to avoid penalties (fines). A company’s taxable income is its annual income after it deducts expenses. The tax rate is a percentage that changes based on economic conditions and other factors. Tax accounting works by including a corporate tax expert in a company’s finances to make sure companies pay the correct amount in corporate taxes. They also have to follow specific regulations for reporting their finances.
There are a few tax accounting methods available to companies. Factors such as the size of a corporation, the types of transactions the company makes, and potential tax deductions play a role in choosing a method.
The Internal Revenue Service requires U.S. companies to use one of the following methods for tax accounting:
Certain companies use the cash basis of accounting to determine the company’s taxable income and deductions. Companies record income and expenses after the company exchanges money with a consumer or pays off an expense.
Accrual basis is another popular method since companies can record revenues and expenses when they occur, instead of when the money exchange occurs.
A less common choice, a hybrid basis is available for tax accounting. It combines principles of the cash basis and accrual basis methods. Businesses that use the hybrid basis use a cash basis for most of their transactions. An accrual basis applies for specific line items (inventory). The IRS requires companies that meet specific revenue thresholds to use the accrual basis for tax accounting.
What are the Elements of Tax Accounting?
Tax accounting requires recognizing two items:
Current Year Liability
Current year liability is the recognition of a tax liability or tax asset. This is based on the estimated amount of income taxes payable or refundable for the current year.
Future Year Liability
Future year liability involves recognition of a deferred tax liability or tax asset. However, it is based on the estimated effects in future years of carryforwards and temporary differences.
What are the Tax Accounting Methods?
Companies have multiple options for tax accounting methods. Before choosing one, they have to consider the size of the company, the types of transactions the company makes, and potential tax deductions.
The Internal Revenue Service requires U.S. companies to use one of the following tax methods:
- Cash Basis
- Accrual Basis
- Hybrid Basis
How Does the Cash Method Work for Tax Accounting?
The cash method helps companies determine their taxable income and deductions. Those that use the cash method will not have accounts receivable ledgers and need processes to keep track of outstanding customer accounts. Generally, businesses use the cash method because they primarily deal with cash transactions. Therefore, they need safeguards over receipts and disbursements of cash so that it is not lost or stolen. Cash accounting records revenue and expenses when actual payments are received or disbursed.
How Does Accrual Method Work for Tax Accounting?
The accrual method allows companies to record revenues and expenses when they occur, rather than when the money exchange happens. Companies that use the accrual accounting method enforce procedures to reconcile bank accounts and keep tabs on short-term cash flow. Also, the accrual method provides more accurate results of a company’s financial state than the cash method due to an accounts receivable system.
What are the Advantages?
Tax accounting is the only field of accounting that rewards incurred losses. Tax accounting permits an assessee to carry forward previous years’ losses, which underestimates the current year’s profits. Therefore, the tax liability is reduced. It is the opposite of financial accounting since it has no such concessions available. The entity is under constant pressure to report profits year after year. Additionally, tax accounting allows for the deduction of numerous investments and other qualifying expenditures. And most importantly, it aids in tax planning.
What are the Drawbacks?
Tax accounting requires constant reconciliation between the financial and tax accounts, and laws are updated frequently. This means tax accountants need to adapt quickly and apply amendments to the accounts already drawn up. So, tax accounting is a costly affair requiring the services of professional tax experts. In the US, Certified Public Accountants (CPAs) are eligible to provide taxation advice.
What are the Examples of Tax Accounting?
Suppose Blooming, a small floral business, earned $150,000 in revenue in the 2019-2020 fiscal year. The shop’s COGS was $60,000. The business determines its inventory, priced at $50,000 over the course of the fiscal year, at cost. Applying the revenue formula, Blooming’s revenue ($150,000) minus its cost of goods sold ($60,000) is $90,000.
The tax rate for Blooming type of business and size is 13%. That means Blooming’s owners owe approximately $11,700 in taxes for the 2019-2020 fiscal year.
For individual taxpayers, tax accounting solely centers on income, qualifying deductions, investment gains or losses, and other transactions that affect an individual’s tax burden. As a result, this limits the amount of information needed for someone to manage an annual tax return. Even though an individual can use a tax accountant, it is not a legal requirement.
What is the History of Tax Accounting?
Tax accounting has historical roots in the early years of record-keeping. Clay tablets found in Sumeria in southern Mesopotamia are proof of the development. The tax records discovered date from around 3000 BC. Archaeology confirms that Egypt invented one of the first tax systems between 3000 and 2800 BC. Egyptian pharaohs employed collectors or scribes to impose levies on various goods and produce, such as cooking oil. The tax was collected twice a year and offered revenue primarily to fund government activity, support the head of state, and finance the conduct of wars.
In the modern era, taxes are collected in money, not goods. Tax farming (the collection of taxes by outside contractors) has been abolished, and taxes are assessed and gathered by civil servants. Moreover, the level of most taxes has increased significantly along with the ratio of tax revenues to the national income.