Income tax expense

This chapter explains how to record income tax expense in financial statements. It covers:

• The current year tax calculation
• Prior year adjustments (under- and over-provisions)

Learning objectives

By the end of this chapter, you should be able to record income tax expense in the statement of profit or loss, including any under-/over-provision of tax from the prior year.

Definitions

Income tax expense

It is the amount of tax a company must pay on its profits. It appears as an expense in the statement of profit or loss.

At this level, it helps to think of income tax expense as having two parts:

1. Current year tax
2. Prior year adjustment

So, total income tax expense is:

• Current year tax
• Plus or minus the prior year adjustment

Current year tax

Definitions

Current year tax

This is the tax the company expects to pay on the current year’s profit to the government authorities. It is calculated by applying the tax rate to the taxable profit.

For example, if a company has a profit before tax of $100,000 and the tax rate is 25%, the current year tax expense is $25,000 (25% × $100,000).

In practice, the final tax payable is confirmed by the tax authorities after the year-end (often a few months later), using the audited financial statements. That means the current year tax shown in the financial statements is an estimate, not the final agreed amount.

Because it relates to the tax that will be paid later, the current year tax creates:

• An expense in the statement of profit or loss
• A liability (income tax payable) shown as a current liability in the statement of financial position

Prior year adjustments

Definitions

Prior year adjustments

When companies prepare their accounts, they ESTIMATE the tax they will pay. Later, when they agree on the actual amount with the tax authorities, it might be different. The difference between the estimated and actual income tax from the previous year is the prior year adjustment. The difference must be adjusted in the CURRENT year’s tax expense.

A prior year adjustment happens because last year’s tax expense was based on an estimate. When the actual amount is agreed later, any difference is corrected by adjusting the current year’s tax expense.

Types of prior year adjustments

Definitions

Under-Provision

Arises when the tax expense is underestimated. That is, the actual income tax from the previous is more than the estimated tax reported. This increases the tax expense. They appear on the debit side of the trial balance. Over-provision

Arises when the tax expense is overestimated. That is, the actual income tax from the previous is less than the estimated tax reported. This decreases the tax expense. They appear on the credit side of the trial balance.

Illustration: Recording tax expense

You have been given the following about a company.

• Current year tax (20X8): $60,000
• Prior year (20X7) estimated tax was: $50,000
• Actual 20X7 tax agreed in 20X8: $52,000

Required: Determine

1. the total tax expense to be reported on the statement of profit or loss
2. the tax liability to be reported on the statement of financial position

Suggested Solution:

3. Total tax expense to be reported on the statement of profit or loss

Do you know the answer?

1. Tax liability to be reported on the statement of financial position

Do you know the answer?

Illustration 2: Recording tax expense

A company has a profit before tax of $200,000 in 2024. Tax rate is 20%. The prior year tax was estimated at $35,000, but the actual amount agreed was $33,000.

1. What is the total tax expense for 2024?
2. What is the tax liability for 2024?

Suggested Solution:

3. What is the total tax expense for 2024?

Do you know the answer?

1. What is the tax liability for 2024?

Do you know the answer?