Definition

Taxation is often assumed to be a cumbersome task by almost all businesses. This is primarily because of the fact that there are numerous different factors that need to be inculcated in order to ensure that tax calculation is executed in a proper manner.

Income Tax is considered to be one of the most important heads when it comes to taxation in an organization. Therefore, it is highly important for organizations to ensure that they are able to understand the functionality, as well as the calculation of this particular tax so that they can comply with all the stated laws and regulations.

From an internal perspective too, organizations need to be fully prepared regarding the provision of Income Tax. Therefore, accountants are supposed to be prepared in this regard, Provision of Income Tax is one such preparatory step.

The provision of income tax is defined as the estimated amount that a business or an individual taxpayer expects to pay in terms of income taxes in the given year. The amount of the said provision of Income Tax is mainly calculated using the firm’s reported net income, in addition to other relevant income tax rates that are applicable.

Therefore, the provision of income tax is best described as an estimate of the amount of tax that the company is likely to pay with respect to the income threshold they have attained in the said year. This also involves making adjustments to the net income by considering temporary and permanent differences. This is considered to be a very integral part of tax planning.

Example of Provision for Income Tax

Provision for Income Tax is simply calculated by multiplying the tax rate with the income before tax. This can be described using the formula below:

Provision for Income Tax = Income Earned before Tax * Applicable Tax Rate.

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Calculation of Provision for Income Tax is further illustrated using the following example:

Sandra Co. deals with manufacturing and selling office furniture. For the year ended 31st December 2019, they had the following estimated list of balances:

  • Sales Revenue: $ 125,000
  • COGS: $50,000
  • Selling and Administration Expenses: $30,000
  • Distribution Expenses: $10,000

The applicable Income Tax rate is 20%. Sandra Co. wants to ensure that they have a clear cut idea regarding the provision for income tax for the current year.

In order to calculate the provision for income tax, the following methodology needs to be applied:

Net Profit before tax = Sales – COGS – Overheads = $125,000 – $50,000 – $30,000 – $10,000 = $35,000

Given the fact that the tax rate is 20%, provision of Income Tax is going to be calculated as follows:

Provision for Income Tax = Income Earned before Tax * Tax Rate = $35,000 * 20% = $700

This implies that Sandra Co. has created a provision of $700 that is the estimated amount to be paid in taxes. For Sandra Co, the following journal entries need to be made in order to record the Provision of Income Taxes.

ParticularDebitCredit
Profit and Loss Account (debit)$700 
Provision for Income Tax (credit) $700

Over and Under Provision of Income Tax

Net Income calculation of the company is often subject to a couple of changes. Therefore, there is no doubt to the fact that the provision of income tax is an estimate, and the actual amount of tax paid might vary from the provision that was formerly created. In this regard, it is important to consider the concept of Over Provision of Income Tax, and Under Provision of Income Tax.

As far as Over Provision of Income Tax is concerned, it can be seen that it is said to occur when the provision of income tax is higher than the actual amount paid as income tax. This might be due to two main reasons. Firstly, it might be because of lower income earned during the period or lower applicable tax rate.

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On the other hand, as far as Under Provision of Income Tax is concerned, it occurs when the provision of income tax is lesser than the amount paid as Income Tax. This might occur because of a higher income earned, or a higher applicable tax rate.

The concept of over and under provision of Income Tax can be explained using the following illustration.

From the example mentioned above, let’s assume Sandra Co. managed to report a net income of $40,000 instead of $35,000. Therefore, the actual Income Tax that was paid by Sandra Co. was $800. Compared to the previously calculated provision of $700, the actual Income Tax paid was $800. Therefore, there was an under-stated provision for Income Tax.

In the same manner, let’s assume Sandra Co. managed to report the same profit, but the applicable tax rate was 10% and not 20%. This implies that in reality, Sandra Co. had to pay $350 in Income Tax as compared to the previously calculated provision of $700. Therefore, the provision is said to be overstated in comparison to the actual amount paid.   

Accounting for Over and Under Provision of Income Tax

Over and Under Provision Account is an expense account that is created under the objective of the prudence concept. The following journal entries are undertaken in order to account for the over and under-provision of Income Tax.

Over Provision of Income Tax

Over Provision of Income Tax implies that the organization had estimated a higher Income Tax Expense for the current year, and the actual Income Tax was lower than that. In the case where this happens, the provision is carried forward to the next year. In the next year, the provision is adjusted in order to accommodate the new provision for Income Tax.

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Let’s assume in year 1, an organization had a Provision of Income Tax of $2500. The provision of Income Tax in this case is going to be recorded in the journal entry in the following manner:

ParticularAmount
Profit and Loss Account (debit)$ 2500
Provision for Income Tax (credit)$ 2500

However, the actual Income Tax during the year amounted to be $500. Therefore, this amount is going to be carried forward to the next year. If the organization has a Provision of Income Tax of $1500 the next year, they are going to charge $1000 to the account, in order to make the total provision to $1500.

Under Provision of Income Tax

Under Provision of Income Tax merely implies that the organization had a lower Income Tax Expense projection for the current year, and they ended up paying more in the amount of Income Tax for the current year. Therefore, the provision account has a contra-balance that needs to be adjusted for in the next year.

From the example mentioned above, let’s assume that the actual Income Tax for the year was $3000. This implies that the Provision of Income Tax was understated by $500. If for the next year, the Provision of Income Tax amounts to $2000, the organization is going to charge $2500 to the Provision of Income Tax Account, so that the total amount of Income Tax amounts to $2000.

Therefore, it can be seen that the Provision of Income Tax is maintained as a recurring account, and the balance is carried forward to the next year, depending on the actual amount of Income Taxes paid. Provision of Income Tax is considered to be an important metric because it helps organizations to have an idea regarding the amount they need to pay as Income Taxes during a subsequent year.