The financial statements of a company tell about different aspects of the business. Financial health, future growth prospects, underlying problems, expenses, revenues, liabilities, and assets are shown in income statements and balance sheets.
Income taxes and sales taxes are critical elements of a company’s financial calculations, valuation, and operations. Income taxes are payments made by a business entity on its profits from its regular operations or other sources. Income taxes are always paid in the following year of the financial reporting period of reporting. For instance, the tax period and fiscal year are different.
But what about the matching principle?
If income tax of one year is paid in the next year, it will understate profits of the coming financial period. To comply with the matching principle under GAAP, companies record tax expense in the same year it belongs. Taxes are estimated by using tax rates allowed by the government or the taxation period. Since taxes are not paid in the same year, they are recognized, so current tax liability or income tax payable account is made in financial statements.
This blog article will take you through an understanding of current tax payable, current tax liability, and its treatment balance sheet.
Current Tax Liability
IAS 12 of International Accounting Standards regulates the tax expense treatment in a company’s financial statements. Current tax liability, tax accruals, or current tax payable can be defined as,
It is the estimated amount of tax or accrued tax liability calculated on profits that have to be paid under its tax obligations. The amount is recorded under current liabilities because it is expected to be paid within 12 months of its recognition.
As stated under IAS 12.46,
Current tax liabilities are measured at the amount expected to be paid to taxation authorities, using the rates/laws that have been enacted or substantively enacted by the balance sheet date.
The part of the tax payable that is not expected to be paid in the next 12 months is treated as long-term tax liability. Therefore, most of the time, it is recorded as deferred tax liability in the balance sheet.
We can also define tax accruals as a current liability that is an aggregate amount of the tax payable. It also includes adjustments to any deferred tax liabilities or assets. The accrued tax liability is recorded on the closing date of financial statements.
Tax Payable Vs. Deferred Tax Liabilities
Income taxes payable and deferred tax liabilities are both recorded on the liability side of the balance sheet. However, there is a difference between the definition and treatment of both liabilities. Tax payables are the estimated or calculated amount of outstanding tax for a financial year. It represents the taxes a company will have to pay to tax authorities.
Deferred tax liability arises due to the difference in tax accounting methods vs. generally accepted accounting rules—for instance, the accounting methods for financial reporting than those required by IRS in America. The most common difference is in the depreciation methods giving rise to deferred tax liability. It explains how much tax a business entity should have paid to tax authorities; however, a different amount is realized due to tax accounting and accounting rules. The deferred tax liability has to be paid in the future period.
In other cases, a company records deferred tax liabilities if the actual tax paid is less than calculated after the recovery of the carrying amount of another asset or liability.
For instance, a company estimated its tax liability at the end of the financial year to be $2000. However, when the actual tax return was filed, the amount due was only $1700. The company will only pay what tax authorities have billed it. What about the difference?
An amount of $1700 will be debited to current tax liability and credited to the cash account. The difference of $300 will go to deferred tax liability in the company’s balance sheet. A deferred liability can be recorded as a current liability or non-current liability depending on the
Tax Accruals Vs. Tax Expense
In most of the cases, tax accruals and tax expense is the same amount. However, if there is a deferred tax liability or deferred tax asset, the difference between tax expense and tax payable exist. As discussed earlier, there might be a difference between tax accounting and internal accounting. Due to the difference, tax calculated by the business might vary from tax actually payable to tax authorities.
In accrual-based accounting, an income or expense should be recorded when it was incurred and not when it was actually paid. In tax payments, tax is paid in the next year to the common financial year. Therefore, the company calculates the estimated tax amount and charges it to the expense account by crediting current tax liability.
However, tax accrual might differ from the actual tax expense reported in the balance sheet due to deferred tax liabilities or assets.
Classification Of Tax Liability In Balance Sheet
As the name suggests, the current tax liability is reported under the head of current liabilities in the balance sheet. Current liabilities are the financial obligations of a business entity expected to be paid within the next accounting period or fiscal year. Generally, the liabilities that have to be paid within 12 months are recorded under the head of current liabilities.
Tax accruals are also recorded under this head as the tax liability has to be paid in the following year of the financial reporting period.
Categorization Of Current Tax Liability
Tax liability shown in the company’s balance sheet is the sum of different types of direct and indirect taxes a company has to pay. Most commonly following taxes are added to current tax liability:
- Income Taxes On Normal Business Operations
- Taxes On Profits From Capital Gains
- Sales Tax(Collected From Customers)
- Social Security Taxes
- Unemployment Benefit Taxes
- Other local and state taxes
Recognizing Tax Accruals In Balance Sheet
The recognition of income taxes in the balance sheet is done after the calculation of tax expense. For calculation of a tax in a current period following formula is used:
Recognized Tax For An Accounting Period =
Current Tax For Accounting Period + Movement In Deferred Tax Balances For The Accounting Period
According to IAS 12, the income tax payable should be recognized in a period for the tax consequences of different transactions and business events. The recognition for the tax is made the same way as the treatment of transactions and events on which tax is calculated.
A business entity will record current tax for recording in current liabilities as a payable for every transaction except:
- When the business has any events or transactions that are not related to normal business operations of the company. The tax recognition for such transactions is made other than the company’s profit and loss statement.
- When a tax relates to the initial recognition of an asset or liabilities resulting from a merger, acquisition, or another business combination.
Following additional guidelines are also helpful for the business entities when realizing the tax to be paid:
- If the tax rate or taxable income is affected by dividend payments, tax outcomes are linked to the periods for which dividend has been paid.
- When there is difficulty in calculating deferred taxes related to transactions out of normal business operations, a business entity can use a reasonable pro-rata allocation or any appropriate method for calculating tax.
- Any deferred tax profits resulting from business combinations must be treated under IFRS 3(Business Combinations). If they don’t qualify for the adjustments, the tax must be recognized in profit and loss.
- When a company’s goodwill is to be calculated before any business combination, the pre-combination deferred tax benefits are not included in the calculation. They have to be recorded as separate assets.
Presentation Of Income Tax Liabilities
According to IAS 12.71, any business entity’s tax payable is to be recorded under the current liabilities of the balance sheet. However, current tax assets or current tax liabilities can only be balanced off in the balance sheet if the company has the legal right to offset it and intend to settle tax payable on a net basis.
The current tax liability is the part of the total tax payable that has to be paid in the following financial period. The measurement of the current income tax payable is done by using the tax base and tax rates applicable for reporting. The applicable tax regulations are evaluated, and provisions are established. The provision signifies the appropriate amounts expected to be paid to the tax authorities. Any uncertainty in income taxes is also reflected in the provisions. The most likely or most expected value amount of the tax is calculated by the management.
Income taxes of a financial period consist of a deferred tax part and a current income tax. The consolidated income statement accounts for all the taxes related to normal business operations and profits from other sources. The calculation of provisions is made under the matching principle. We’ve tried to comprehensively cover the current part of the total tax payable for any business entity and its treatment.