Tax Authority vs Financial Accounting

Knowing the key difference between different accounting methodologies can save time when analyzing certain financial situations. One of those areas is tax calculations: the numbers that tax authorities might use in their tax calculation and the numbers that we might use in our set of accounts can sometimes be different. This is because the numbers are treated differently in different circumstances. Let’s start by looking at the definition of both:

What is a Tax Authority?

A tax authority is a government agency responsible for the administration of tax laws, collection of taxes, enforcement of tax compliance, and provision of guidance on tax matters. Numbers used by tax authorities might differ from those used in a company’s financial statements due to different treatment in various circumstances. For example, if a region was trying to encourage reinvestment in businesses it may create attractive tax incentives such as tax relief or deferred tax costs to encourage companies to do this.

What is Financial Accounting?

Financial accounting is the process of recording, summarizing, and reporting the financial transactions of a business. This information is presented in the form of financial statements including the income statement, balance sheet, and cash flow statement. Financial accounting is guided by Generally Accepted Accounting Principles (GAAP), or International Financial Reporting Standards (IFRS), depending on the jurisdiction. The primary objective of financial accounting is to provide accurate financial information to stakeholders, such as investors, creditors, and regulatory agencies, to help them make informed decisions.

Tax accounting differences can be broadly split into those that are temporary and permanent. Temporary differences are typically timing issues where one system will use a different timeframe. Permanent reflects an alternative standpoint on how the calculations are worked through.

Temporary Tax Accounting Differences

Example 1: Depreciation of IT Equipment

Here is an example of a temporary difference between the two tax accounting methodologies. In this example we have a company that has completed a purchase of IT equipment.

In this example, the equipment costs 90 and the company is going to depreciate it over three years to reflect its useful lifespan. Thus, the accounting expense is going to be 30 in each of those three years using straight line depreciation (shown in line 1) totaling 90 over the period.

However, the tax authority in this example has taken a different stance. It is going to allow a tax allowable deduction, (essentially a tax authority-approved depreciation figure). The tax authority will allow a figure of 60 in the first year, then 20 in the second year, and 10 in the last year. This is effectively front-loading the expense (shown in line 2), but it still totals 90 over the three years.

Why might a tax authority do this? Well, lots of governments like to incentivize companies to invest in their businesses. Thus, if they allow a very large expense in the first year, a large expense will reduce a company’s taxable profit. That’s attractive for the company as it will reduce the tax paid in the first year. It will have to pay a little more in years two and three, but the company gets to delay the payment. Many companies find this a very strong incentive to invest in projects now rather than later.

The allocation of the expense creates a timing difference, and we call this a temporary difference between the numbers. It’s only temporary because over the long term, the total of the three years, it still gets to the same number. Both sets of depreciation figures total 90.

Example 2: Amortization of Software

Let’s look at another example of a temporary difference. In this example, the company has purchased software. It is looking to amortize the software over three years, reflecting its useful life. The accounting expense will be straight-line depreciation and 1,200 has been spread over the three years accordingly (shown in line 1).

But again, the tax authority has taken a different stance: it is going to allow the company to make a tax-allowable deduction. This means the tax authority will approve amortization of the full 1200 in the first year (shown in line 2).

In year one, there’s a very large difference between the two expenses that are allowed. However, over the total of the three years, the same amount is being amortized. 1,200 in the company accounts, i.e. in the income statement, balance sheet, and cash flow statement, and 1,200 in the tax calculation. Again, that’s just a temporary difference where tax calculations will differ from the company’s financial accounting.

Permanent Tax Accounting Differences

Let’s now look at an example of a permanent difference between tax authority and financial accounting.

Example: Staff Entertainment Costs

A good example of a permanent difference is staff entertainment. Many companies like to reward employees with an annual office party or other types of socials. These are legitimate expenses, and the companies will spend money providing the entertainment. It will then put the expenses on its income statement. However, the tax authorities might decide it is not allowed as a deductible expense in its tax calculation.

Why is this the case? One of the reasons is that it deters companies from scaling up staff entertainment to act as a salary substitute or a bonus which does not require taxes such as income tax to be paid on it. The tax authorities do not want to incentivize that kind of behavior. So large-scale staff entertainment is generally not allowed as a tax-deductible expense.

Looking at the accounting figures, the company has incurred staff entertainment expenses of 25 annually, totaling 75 over three years (shown in line 1). However, the tax allowable deduction from the tax authorities is zero (shown in line 2). Over the three years, the figures do not reconcile and thus it creates a permanent difference in the accounts.

Identifying temporary and permanent differences is very important when coming up with the company’s set of accounts. When looking at the temporary differences it often leads to deferred tax.

Tax Authority vs. Accounting Numbers – Permanent Differences

Looking closer at permanent differences, we can see that it will create a difference in the tax charge that the company will face. It is also creating a different tax rate versus the one calculated by the company.

Let’s look again at non-deductible expenses such as staff entertainment. Normal expenses would receive tax relief at the marginal tax rate of maybe 25% or 30%. A non-deductible expense does not allow any relief at all. The impact of this will alter and either increase or decrease the overall company costs.

If a particular expense is non-deductible then it’s going to reduce the company’s allowable costs. This will increase taxable profits and increase the tax the company is going to pay versus its own accounting. This can create a problem in the tax calculation. The tax paid is going to be different from the accounting tax expense.

To work through this, an adjustment is made in the tax expense. The tax expense in the accounting numbers (in the income statement) has to match the figure calculated by the tax authorities in the tax calculation. This has an impact on the ETR or the effective tax rate, and it will end up being different to the marginal tax rate.

Example of Permanent Difference Tax Calculation

In this workout we’re asked to calculate the tax liability, tax expense and ETR. Just as a reminder, the tax liability figure appears on the balance sheet and the tax expense is found on the income statement

Download this free Excel tax calculation template from Financial Edge. This allows analysts to work through the example in their own time and can be used as a template for new calculations.

In the excel model we can see profit before tax from the income statement is 13,773, however there is also a non-deductible expense of 39,047. The statutory tax rate or the marginal tax rate (MTR) is 8.5%. So, we need to adjust the company’s profits before we calculate tax.

The profit before tax (PBT) figure of 13,773 from the income statement is our starting point. Then we can add back the non-deductible expense of 39,047. Profit that is subject to tax is now 52,820. At this point we can now apply the statutory tax rates of 8.5% and this is the MTR, marginal tax rate. This calculation works out that 4,489.7 of tax is due. That is the company’s tax liability.

Now the ongoing issue could be where do companies get the tax expense from? In theory, the company could calculate its tax expense from the wrong profit, from the 13,773. A permanent difference between the tax authority figure and the accounting calculations means the tax expense can just come from the tax liability. It is best to replace any in-house calculation with the figure that the tax authority provide. Once factored in then analysts can calculate the effective tax rate. This is the tax expense divided by the company profit before tax from the income statement. In our example it gives a figure of 32.6%. We can immediately see that this is quite different to the statutory tax rate, the MTR, because we added back the non-deductible expense.

Tax Authority vs. Accounting Methodology – Temporary Differences Lead to Deferred Taxes

Let’s now look in detail at temporary differences between tax authority numbers and accounting numbers. The main reason for temporary difference is usually different timing for the tax and accounting expenses. As the previous example showed, in financial accounting the depreciation expense may be straight line (for example, over three years). However, a tax allowable deduction for depreciation may well be front-loaded or accelerated. This does not impact the overall cost. It’s still the same amount being depreciated over the asset life, but it does impact the payment schedule.

If the tax authority calculates a much higher expense in the first year it will reduce company profits and thus reduce the tax paid in the payment schedule. It does not impact the ETR, the effective tax rates. Reconciling the two tax calculations requires an adjustment to be made on the balance sheet – this is deferred taxes.

Temporary differences lead to deferred taxes – the company create a deferred tax asset when tax is paid earlier. For example, the financial accounting says the company should be paying 100 in tax but the tax payable (calculated by the tax authority) is 120, it feels like the company is overpaying. This creates an asset. On the balance sheet a line will be created for Prepaid tax asset, which is the deferred tax asset.

Conversely, a deferred tax liability is where tax owing is pushed into the future. If the tax payable today (calculated by the tax authority) is less than the tax expense today, this feels like underpaying taxes with more owing in the future. If the company is paying the expense in the future, this is accrued tax and creates deferred tax liability.

Conclusion

Understanding the differences between tax authority calculations and financial accounting is crucial for accurate financial reporting and compliance. Temporary differences, such as depreciation methods, and permanent differences, like non-deductible expenses, can significantly impact a company’s tax liabilities and effective tax rate. By recognizing and adjusting for these differences, businesses can ensure their financial statements accurately reflect their tax obligations.

When analyzing a company’s financial statements, it is important to look at these details. Tax charges may look unusually low or high on the income statement, but the balance sheet details can help clarify why this is the case. Often there will be more detail available in the Notes accompanying the Financial Statements.

Additional Resources

Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)