Important Keyword: Accounting for Taxes, AS 22, Income from Business & Profession, Income Tax.
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AS 22 – Accounting for Taxes on Income
The primary objective of Accounting Standard 22 (AS 22) is to provide guidelines for the accounting treatment of taxes on income. This standard addresses situation where taxable income may diverge from accounting income, leading to challenges in aligning taxes with revenue for a specific period. By establishing consistent principles for recognizing and accounting for income taxes, AS 22 aims to enhance transparency and accuracy in financial reporting. This standard ensures that companies appropriately reflect their tax obligations and liabilities in their financial statements, facilitating a clearer understanding of their financial performance and position.
Types of Income
Accounting income refers to the net profit or loss reported in the statement of profit and loss for a specific period, before considering income tax expenses or savings.
Taxable income represents the income (or loss) for a period as determined by tax laws, upon which income tax payable is calculated.
Differences between Taxable and Accounting Income
Taxable income may deviate from accounting income due to various factors:
Disallowed Expenses: Some items debited in the profit and loss account are not permitted as expenses under tax laws.
Partially Allowed Expenses: Certain expenses fully debited in the profit and loss account are only partially allowed or amortized over time under tax laws.
Timing and Permanent Differences
These differences are classified into two categories:
Timing Differences: These differences arise in one period but are adjusted or reversed in subsequent periods. Examples include provisions for bad debts and expenses allowed on a payment basis.
Permanent Differences: These differences between taxable and accounting income do not reverse subsequently. Examples include non-deductible expenses like goodwill amortization and disallowed personal expenditures.
Application of AS 22
Accounting Standard 22 (AS 22) mandates the recognition of deferred tax for all timing differences. It ensures that financial statements reflect the impact of transactions during the year, whether current or deferred.
What is Deferred Tax Asset?
DTA arises when taxable income exceeds accounting income, resulting in higher tax payable based on tax laws. This creates an asset since taxes are paid in advance, with benefits expected in the future.
What is Deferred Tax Liability?
DTL occurs when accounting income exceeds taxable income, leading to lower tax payable under tax laws. It represents a provision for taxes payable in future years, as the amount paid is less than the actual amount per books.
Important Keyword: Deferred Tax Assets, Income from Business & Profession, Income Tax.
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Deferred Tax Assets: Definition, Types, and Treatment
Each fiscal year, organizations compile two distinct financial reports: an income statement and a tax statement. The motivation for crafting these separate reports stems from disparities in the guidelines governing their preparation. This contrast lays the groundwork for deferred tax, a significant accounting concept.
Deferred Tax Assets arises due to differences between the figures reported in a company’s income statement and those presented in its tax statement. These variations emerge from divergent accounting standards and taxation regulations. As a result, certain income or expenses may be recognized at different times or in varying amounts across the two reports.
Deferred Tax Assets serves as a mechanism to reconcile these disparities over time, ensuring consistency and accuracy in financial reporting. It represents the future tax consequences of transactions or events that have occurred but have not yet been recognized for tax purposes.
What is Deferred Tax?
It serves to align a company’s current tax obligations with its future tax liabilities, ensuring a comprehensive portrayal of its financial position. It plays a pivotal role in financial reporting, with its presence noted in an organization’s balance sheet.
One of the primary drivers of deferred tax is timing differences, which stem from variances in the recognition of income or expenses between financial accounting standards and tax regulations. These differences can be categorized into temporary differences and permanent differences.
Temporary differences represent disparities between taxable income and accounting income that are capable of reversal in subsequent periods. On the other hand, permanent differences arise from variances that do not reverse over time.
Deferred Tax Liability (DTL) emerges when tax relief is granted in advance of recognizing an accounting expense or liability, or when income is accrued but remains untaxed until a later period. In essence, DTL reflects the tax consequences of timing differences, indicating when a tax liability accrues compared to when it is payable.
Conversely, deferred tax assets (DTA) arise when a company’s income statement differs from its corresponding tax statement, allowing for either prepayment of tax liabilities for future periods or reduction of tax liabilities in subsequent fiscal years. These variations result in Deferred Tax Assets, signifying potential tax benefits available to the organization.
By recognizing deferred tax liabilities and assets, companies can provide stakeholders with a more accurate depiction of their tax obligations and potential future tax benefits. This enhances transparency and facilitates informed decision-making regarding the company’s financial health and prospects.
The effects of deferred taxes i.e. Deferred Tax Assets and DTL in the financial statements are as under:
Sl. No
Profit Status
CurrentTreatment
FutureTreatment
Effect
1
Book profit higher than the Taxable profit
Pay less tax now
Pay more tax in future
Creates Deferred Tax Liability (DTL)
2
Book profit is less than the Taxable profit
Pay more tax now
Pay less tax in future
Creates Deferred Tax Asset (DTA)
Scenarios where Deferred Tax is Recorded
Unrealized Revenues and Expenses:
According to the Income Tax Act, revenues not yet realized by companies are not subject to taxation. Consequently, when there are unrealized receivables from debtors, although recognized in the income statement, they are not considered for taxation. This mismatch in revenue treatment results in a deferred tax liability since taxes will be paid at a later date upon realization of these receivables. Similarly, expenses recorded in books but not yet incurred are not factored into tax calculations. This discrepancy leads to a situation where the gross profit in a company’s books is lower than what appears in its tax statement, resulting in the creation of a deferred tax asset.
Difference in Depreciation Calculation Method:
Divergence in the method of depreciation calculation between a company and the Income Tax Department creates deferred tax. For instance, if a company calculates depreciation using the straight-line method while the tax department follows the Written Down Value method, a temporary difference arises. This discrepancy affects the tax liability, leading to a deferred tax liability. Although adjustments are made over time to reconcile these differences, they create future financial obligations, thus necessitating the recognition of deferred tax.
Difference in Depreciation Percentage:
A disparity in the percentage of depreciation calculation between a company and the tax department can also result in deferred tax creation. For example, if a company calculates depreciation at 10% while the tax department prescribes 15%, a temporary difference emerges. This difference affects the tax liability, resulting in the creation of a deferred tax asset or liability depending on the direction of the variance.
Gross Loss:
When a company realizes a gross loss in a particular year, it creates an opportunity to carry forward the loss to subsequent years to offset future profits and reduce tax liability. This realization of a gross loss leads to the recognition of a deferred tax asset in the year when the loss is incurred.
Concept of Deferred Tax:
Represents the variance between gross profit in a Profit & Loss Account and a tax statement.
Reflects temporary differences in accounting treatment for financial reporting and tax purposes.
Example Illustration:
Company ABC reports a gross profit of INR 500,000 in its Profit & Loss Account.
However, its tax statement shows a taxable income of INR 450,000 due to variations in accounting standards.
Calculation Process:
Gross Profit (Profit & Loss Account): INR 500,000
Taxable Income (Tax Statement): INR 450,000
Difference: INR 50,000 (Deferred Tax)
Treatment:
The INR 50,000 represents the deferred tax liability or asset, depending on the direction of the difference.
If the taxable income is lower than the reported profit, it creates a deferred tax asset; conversely, if it’s higher, it results in a deferred tax liability.
Understanding deferred tax calculation is essential for accurate financial reporting and tax compliance. It helps businesses manage their tax obligations effectively while ensuring transparency and consistency in accounting practices.
Particulars
As per Books (INR)
As per Tax (INR)
Total income
1000000
1000000
Expenses
400000
400000
Gross profit before depreciation and tax
600000
600000
Depreciation
100000
80000
Gross Profit after depreciation
5000000
520000
In this scenario, since the computed depreciation differs by INR 20,000, the taxable incomes also differ by the same amount. Consequently, the tax liability for both cases varies accordingly. For instance, at a tax rate of 25%, the tax liability on INR 5,20,000 amounts to INR 1,30,000. However, based on its books, the tax liability should have been INR 1,25,000. This results in an additional tax payment of INR 5,000 for the current year, leading to the creation of a Deferred Tax Asset (DTA).
Benefits of Deferred Tax Assets
While deferred tax does not inherently offer direct benefits, its recognition serves as a crucial aspect of financial planning for organizations. Identifying deferred tax liabilities enables organizations to prepare for forthcoming expenses, thereby ensuring financial stability and foresight. Conversely, the acknowledgment of deferred tax assets presents an opportunity to substantially mitigate future tax liabilities. By leveraging such assets, organizations can effectively reduce their tax burdens in subsequent periods, contributing to enhanced financial efficiency and optimization.
Important Keyword: Fixed Costs, Income from Business & Profession, Income Tax Act.
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Classifying Costs: Fixed vs. Variable
In the realm of financial management, costs can be categorized in various ways, with one of the most common methods being classification according to fixed cost and variable cost. Unlike variable costs, which fluctuate based on the production or output of goods and services, fixed cost remains constant regardless of production levels. Additionally, fixed costs are often associated with specific time periods and typically do not undergo changes over time.
What is a Fixed Costs?
Understanding Fixed Cost in Business
In the realm of business management, fixed costs represent expenses that remain constant regardless of changes in production volume within a certain range. Unlike variable costs, which fluctuate based on operational activity, fixed cost remains stable as long as operations stay within a specific size. These costs are less controllable by an organization since they are not tied to volume or operational changes.
For instance, consider the rent on a building: regardless of the level of activity within that building, the rent amount remains unchanged until the lease term expires or is renegotiated. Similarly, other examples of fixed costs include insurance premiums, depreciation expenses, and property taxes. Fixed costs typically recur on a regular basis, making them period costs.
Furthermore, in marketing endeavors, it becomes crucial to discern between variable and fixed costs to comprehend how costs fluctuate based on their nature. This differentiation also holds significance in forecasting earnings, preparing financial reports, and drafting budgets for organizational operations.
Difference Between Fixed Cost and Variable Cost?
Fixed Costs
Variable Costs
Meaning
Fixed cost are expenses that remain constant for a period of time irrespective of the level of outputs.
Variable cost are expenses that change directly and proportionally to the changes in business activity level or volume.
Incurred when
Even if the output is nil, fixed costs are incurred.
The cost increases/decreases based on the output
Also known as
Fixed costs are also known as overhead costs, period costs or supplementary costs.
Variable costs are also referred to as prime costs or direct costs as it directly affects the output levels.
Nature
Fixed costs are time-related i.e. they remain constant for a period of time.
Variable costs are volume-related and change with the changes in output level.
Examples
Depreciation, interest paid on capital, rent, salary, property taxes, insurance premium, etc.
Commission on sales, credit card fees, wages of part-time staff, etc.
Understanding the Nature of Fixed Cost
Fixed cost, although termed “fixed,” are not entirely immutable; rather, they exhibit variations over time. They are regarded as fixed within a specific contractual or relevant period. Take, for instance, a company’s warehouse costs, which may encounter unforeseen and irregular expenses unrelated to production activities.
Within the realm of fixed cost, there exist two distinct categories: fixed committed costs and discretionary fixed costs. Fixed committed costs pertain to expenses such as investments in infrastructure that cannot be significantly reduced within a limited timeframe. Conversely, discretionary fixed costs are contingent upon management decisions and can be adjusted as needed.
Examples of discretionary fixed cost encompass expenditures on advertising, insurance premiums, machine maintenance, and research and development initiatives. The management’s decisions regarding these discretionary costs can have a substantial impact on the company’s financial health and operational efficiency.
Important Keyword: Income from Business & Profession, Income Tax, Variable Cost, Fixed Costs, Semi-Variable Cost.
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Understanding the Nature of Costs:
For businesses, grasping the essence of costs is pivotal for gauging their production expenditure accurately. Costs are fundamentally classified into two categories: variable costs and fixed costs, each possessing unique attributes.
Variable Costs:
Variable cost exhibits a direct correlation with fluctuations in sales volume or production output. As production escalates, variable expenses surge proportionally, and conversely, they diminish with production downturns. Examples of variable costs encompass raw materials, direct labor, and sales commissions. Given their link to output levels, variable costs are often perceived as controllable expenses that can be managed through operational adjustments.
Fixed Costs:
In contrast, fixed costs persist at a steady rate irrespective of alterations in production levels or sales volume within a specified range. These expenditures remain unaltered in the short term regardless of output variations. Illustrations of fixed costs encompass rent, salaries of permanent staff, insurance premiums, and equipment depreciation. Fixed costs are incurred regardless of production activity levels and are perceived as indispensable for upholding operations, regardless of sales fluctuations.
Discerning between variable and fixed costs empowers organizations to comprehend their cost framework better and make informed decisions regarding resource allocation, pricing strategies, and overall financial management. By accurately delineating and scrutinizing these costs, businesses can streamline their production processes, enhance profitability, and ensure sustained viability.
What is Variable Cost?
Understanding Different Types of Costs:
In the realm of organizational expenses, costs come in various forms, including variable cost, fixed costs, and semi-variable costs. Unlike fixed costs, which remain constant over time, variable costs fluctuate based on the production or output of goods and services.
Variable Cost:
Variable costs are intricately tied to the production process, rising or falling in tandem with output levels. These expenses include direct materials, wages, and other operational outlays directly linked to the manufacturing or provision of goods and services.
Semi-Variable Costs:
Semi-variable costs exhibit characteristics of both fixed and variable cost. They consist of components that remain fixed up to a certain production level, beyond which they increase with rising output volumes. Common examples of semi-variable costs include electricity charges and sales force wages.
For instance, electricity costs may remain fixed up to a specified consumption threshold but escalate with additional usage beyond that level. Similarly, a portion of a salesperson’s wage may comprise a fixed salary, while the remainder is contingent upon sales commissions.
Variable Cost Examples:
Direct Materials: Raw materials essential for product manufacturing.
Production Supplies: Supplies necessary for machinery maintenance and operation.
Sales Commissions: Portion of employee salaries tied to sales performance.
Credit Card Fees: Fees associated with offering credit card services to customers.
Delivery and Shipping Charges: Expenses incurred for product transportation.
Salaries and Wages: Compensation for labor involved in production processes.
Performance Bonuses: Incentives provided to employees based on performance metrics.
Conclusion:
Variable costs play a pivotal role in business operations and profitability. Their flexible nature allows for easier management and adjustment, offering opportunities to enhance profitability and streamline expenses. By diligently tracking variable costs, businesses can gain valuable insights into cash outflows and optimize resource allocation strategies to maximize profitability while maintaining competitive pricing structures.
Important Keyword: Deferred Tax, Deferred tax liability, Income from Business & Profession, Income Tax Act.
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Deferred Tax Liability
Understanding deferred tax liability in India requires grasping the complexities of the country’s tax system, which is characterized by various elements. To comprehend deferred tax liability better, it’s crucial to recognize that organizations in India prepare two distinct financial reports each fiscal year: an income statement and a tax statement. The divergence in guidelines governing these statements creates the scope for deferred tax.
These two reports serve different purposes and adhere to separate sets of regulations. While the income statement reflects the financial performance of a company, including revenues and expenses, the tax statement focuses on computing the tax liability based on the applicable tax laws and regulations.
The misalignment between the income statement and the tax statement stems from differences in accounting principles and tax laws. For instance, certain expenses or revenues may be recognized differently in financial accounting compared to tax accounting, leading to variations in taxable income. These variations give rise to deferred tax liability, which represents the taxes that will be payable in future periods due to temporary differences between the financial and tax accounting treatment of certain items.
In essence, the existence of deferred tax liability underscores the need for organizations to navigate the intricacies of India’s tax landscape, ensuring compliance with regulatory requirements while effectively managing their tax obligations.
What is Deferred Tax Liability (DTL)?
Deferred tax liability (DTL) arises when a tax obligation accumulates in one financial year but is not due until a subsequent year. It signifies that the organization may have to pay more tax in the future for a transaction that occurred in the current period. The deferral occurs due to the disparity in timing between when the tax is accrued and when it is actually paid.
One common scenario leading to the creation of DTL is depreciation. When the depreciation rate specified by the Income-tax Act exceeds that prescribed by the Companies Act, especially in the initial years, the organization pays lower tax in the current period. As a result, deferred tax liability is recorded in the books to account for the tax that will be payable in future periods when the depreciation expenses catch up.
How is Deferred Tax Liability created?
Variance in Depreciation Methods and Rates:
Deferred tax liability can arise when there is a variance between the depreciation methods and rates used by a company and those prescribed by the tax authorities. This difference creates a temporary incongruity between the depreciation figures reported in the company’s financial statements and those in its tax filings.
For instance, let’s consider a hypothetical scenario involving Company XYZ, which assumes a manufacturing machine worth INR 4,00,000 with a depreciation rate of 15%. However, for financial reporting purposes, the company applies a depreciation rate of 10%. In a given year, Company XYZ generates revenues of INR 10 lakh and incurs expenses of INR 6 lakh, excluding depreciation on assets.
The following table illustrates the comparison between the depreciation figures reported in the company’s financial statements and those in its tax filings:
As depicted, the depreciation expense reported in the financial statements is INR 20,000 lower than that in the tax filings. This results in a higher gross profit reported in the financial statements compared to the tax filings. Over subsequent years, this disparity is expected to diminish as the depreciation catch-up aligns the figures more closely.
Particulars
For books (in INR)
For tax purposes (in INR)
Difference (in INR)
Revenues
10,00,000
10,00,000
Nil
Expenses
(6,00,000)
(6,00,000)
Nil
Depreciation
(40,000)
(60,000)
20,000
Gross Profit
3,60,000
3,40,000
20,000
Tax @ 25%
(90,000)
(85000)
5000
Net Profit
2,70,000
255000
15000
Treatment of Revenues and Expenses:
Discrepancies in the treatment of revenues and expenses between a company’s income statement and tax reports can lead to deferred tax liabilities. This occurs when tax is levied based on revenues that have not yet been realized by the company, creating a temporary difference in tax obligations between reporting periods.
Consider the example of Company X in the fiscal year 2019-20. The company sold goods totaling INR 12 lakh on credit, of which only INR 6 lakh was received during the year, with the remaining amount expected to be received from debtors in the subsequent year. Meanwhile, expenses incurred during the year amounted to INR 4 lakh. The tax calculations for both the income statement and tax report are outlined below:
Particulars
Income Statement (in INR)
Tax report (in INR)
Difference (in INR)
Sales
12,00,000
6,00,000
6,00,000
Expenses
(4,00,000)
(4,00,000)
Nil
Gross Profit
8,00,000
2,00,000
6,00,000
Tax @ 25%
2,00,000
50,000
1,50,000
In this scenario, the company’s income statement reflects a net profit of INR 8,00,000, while the taxable income reported for tax purposes is INR 2,00,000. Consequently, the tax liability differs between the income statement (INR 2,40,000) and the tax report (INR 60,000), resulting in a deferred tax liability of INR 1,80,000 for the company, which it must account for in subsequent years.
Carry Forward of Current Profits:
Companies frequently have the opportunity to carry forward their profits from one fiscal year to the next, allowing them to reduce their tax liabilities effectively. However, since the company will be obligated to pay taxes on the carried-forward profits in the subsequent year, a deferred tax liability is created.
Comparison between Deferred Tax Asset (DTA) and Deferred Tax Liability (DTL):
Deferred tax assets and liabilities stem from differences in accounting standards and tax regulations. To illustrate the variances between DTA and DTL, a detailed comparison is provided in the table below:
Parameters
Deferred Tax Asset
Deferred Tax Liability
Basis of recognition
When tax accrues in a later period, however, it is paid in advance in the current year, it is recorded as a deferred tax asset.
When tax accrues in the current year but is paid in a later period, it is considered a deferred tax liability.
Creation
When profits in a company’s income statement are lower than the one mentioned in the tax reports.
When profits in a company’s income statement are higher than what is mentioned in its tax reports.
Treatment
It appears in the Balance Sheet under Non-current assets.
It appears in the Balance Sheet under Non-current liabilities.
