Accounting for Income Taxes
The dreaded income tax
The dreaded income tax
Tax accounting is one of the largest subsets or specializations within the field of accounting. In terms of corporate finance, there are several objectives when it comes to accounting for income tax.
Firstly, a company’s income tax accounting should be in line with its operating strategy. That is, to maximize profits, a company must understand how it incurs tax and adjust its strategies accordingly.
Secondly, income tax accounting can allow a company to maintain financial flexibility. There are different effects of funding the company’s operations with debt and/or equity, and a company’s capital structure can influence income taxes. Knowing these effects will allow the company to plan accordingly and transitively maintain their financial flexibility by keeping their options open.
Finally, accounting for tax allows the company to manage cash flow and minimize cash taxes paid. It is beneficial to postpone payment of taxes into the future as opposed to paying taxes today. A company will want to take tax deductions sooner rather than later to maximize the time value of their money.
Tax is an intricate field to navigate and often confuses even the most skilled analysts. This is keeping in mind that there are numerous tax codes and policies in any given jurisdiction, and numerous jurisdictions with different tax policies to exacerbate the effect.
A working knowledge of tax accounting, thus, becomes a great skill to have as a financial analyst. When speaking of just the bare necessities, an analyst should at least have conceptual understanding of the following.
Tax as recorded in a company’s financial statement rarely ever matches the taxes filed in their tax returns. This is because each item (company financials and tax return) have different purposes, users and accounting treatment. The company’s financials are intended for investors and lenders, and – as such – are made with application and dependability in mind. In contrast, the tax return is intended for the government or corresponding tax body, and is made with the purpose of adhering to public tax policy.
The financial statements will report a tax expense, but the true tax payable comes from the tax return. The dichotomy in reporting these two items creates differences that need to be reconciled and accounted for. These differences are either permanent differences, which never reverse, or temporary differences, which are timing differences that will reverse over time.