Accounting for Income Taxes

Introduction

In tax accounting, taxable income is the term used to indicate the amount which income tax payable in calculated. Taxable income is determined according to the internal revenue code. Distinctiveness of tax accounting is modified cash basis and cash availability concept which are placed in the Code. Arnett points out the reasoning for cash basis tax accounting, “Pay the tax when you have the paying power (cash), in spite of the fact that income, by any reasonable definition of the term, has been realized in some instances and not in others,” (Weygandt, 2005).

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Main body

The purpose of depreciation accounting is distributing the cost or other basic value of tangible capital assets, less salvage, over estimated useful life of the unit. The goal in deciding the best method is allocating the costing a manner which reasonably approximates the speed at which the service utility of the asset is being consumed (Weygandt, 2005). In contrast the objective of the taxation policy is providing economic growth through investment stimulation. “Allowing accelerated depreciation deductions for tax purposes is to stimulate investment in new capital equipment, not because that procedure results in a better matching of expenses and revenues,” states Weygandt (Weygandt, 2005).

Income serves as a measurement device of an organization’s well-offness. As an indicator of wealth maintenance, equity holder and investors often use income as the current market value of the organization (Epstein B.J. et. al., 1999). The information needs of equity investors are similar to management. They require the income information to evaluate the performance of the directors, the company’s solvency, the earning power, the financial position of the organization at the end of the period, the director’s stewardship, and whether the company’s funds have been used ethically.

Shareholders must make a decision whether to hold, buy or sell their shares. Their decision is based on their assessment of the risk associated with the organization. As a form of compensation, company’s offer rewards (dividends and an appreciation in the share price) to equity investors. Regardless of these rewards, shareholders often associate risk to the reported financial profit and income level. A strong earnings level and reported profit is often seen as an indicator of a strong upward growth in the share price.

Organizations reporting strong earnings and income figures within a period tend to achieve higher than average share prices in the stock market (Whittred G. et. al., 2000). Income is used as a forecasting tool for investors to allocate their scarce resources since they believe the future value of shares is affected by reported income. Various accounting techniques can manipulate income determination. Preferences between different income determination techniques depend on the purposes of income users and income uses. Therefore income numbers aids users who have a vested interest in the organization.

The primary purpose of manipulating accounting income is to reduce the organization’s tax liability. Accounting income manipulation will produce either a positive or negative income level. (Farrell, 2001) Management, shareholders and creditors seek strong accounting profit to reach organizational objectives. A negative response to income primarily focuses on tax liability.

All inclusive income concept limits management discretion in highlighting future maintainable earnings. The classification of abnormal and extraordinary items serves to accommodate this issue. Abnormal items (items of revenue and expense which are considered abnormal by reason of their size and effect on operating profit or loss after income tax) and extraordinary items (items of revenue and expense which are attributable to transactions outside the ordinary operations of company and are not recurring in nature) should be disclosed as a separate amount under the standard. The separate identification of extraordinary item and abnormal item will help users to make a better decision regarding future maintainable earning capacity of the company.

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The cash basis method of accounting is very simple to use, because it’s usually obvious when you receive money from a customer or other payer, or when you pay an expense with cash, credit card or a check. When money comes in or goes out, it’s recorded and recognized for tax purposes. The cash basis method of accounting is very simple to use, because it’s usually obvious when you receive money from a customer or other payer, or when you pay an expense with cash, credit card or a check.

When money comes in or goes out, it’s recorded and recognized for tax purposes. Under the cash method, income is recognized when it is actually or constructively received. Constructive receipt occurs when money is made available to you without restriction, is posted to your account, or is received by your agent. Some of the more common items that fall under this rule are amounts paid to obtain a loan, such as prepaid interest, points, and loan origination fees, which must ordinarily be deducted over the course of the loan.

The legislation, administrative, and judicial branches of government each contribute to tax statutes creation, interpretation and disputes. The objectives of the modern tax statutes include several considerations such as revenue needs, economic, social, equity and political considerations. Finally, tax accounting has its conflicts but the goal for financial accounting associations should be, to aid Congress and the Internal Revenue Service, in an advisory capacity, to reach its objectives in a manner which results in the most fair and equitable taxation of the taxpaying units, whether these be individuals or business units.

Financial accounting, management accounting, and tax accounting are the types of accounting information most widely used in the business community. Financial accounting refers to information that describes the financial resources, obligations, equity, and activities of an economic entity. Management accounting involves information specifically designed to help aid managers in running the business in a successful way. Although management accounting information sometimes has non-financial factors it is still a major type of accounting information. Tax accounting is the preparation of income tax retunes.

Tax returns are based strictly on financial accounting information. The preparation of the tax return is not the tough element but rather the Tax Planning. Tax planning consists of anticipating the tax effects of business transactions and structuring these transactions in a manner that will legitimately minimize the income tax burden.

Accounting in the real world would is a necessity these days just like water and food is a necessity to staying alive. If we did not have accounting in the world almost everyone would have very unorganized financial records and have a lot of trouble keeping track of their Assets and Liabilities. Accounting gives order to our lives. With accounting information, a company can do some business forecasting so that they can have useful, right and punctual information to make further business decisions. (Barton, 2002)

And finally, to do accounting is for making tax settlement. A company has to submit a monthly report on tax to a tax department and prepare for making tax payment. They are liable for paying income tax and certain taxes regulated by the government. They have to get in touch regularly with the local tax department to get mutual agreement on computing tax, making tax settlement and recording business transactions.

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To reduce its tax liability, the best effort is to reducing its profit by spending the money. In fact, this money is the prepayment of the major cost, which has not accrued until the next year. But it is spent on other things and, because there is so much money available, its spending is out of control. When the major bill does arrive in the next year or so, there is little or no money left from the project to pay for it. The only way is to use the money received from new projects to pay the costs of the old ones. It looks the company have made a great profit. But as time goes by and the cash deficits accumulate year after year, major costs get harder and harder to pay.

In such situation, the business may slow down and new jobs stop coming. (Parker, 2000) Therefore, the money stop coming and only thing left is lots of unpaid bills. Under the cash basis method of accounting, the unpaid expenses are not recorded in financial statement. Thus, the financial statement will report that the company has made a profit rather than its bankruptcy.

Conclusion

Tax statements prepared on a cash basis of accounting may not only cause bad effects on operating a business by managers who could be internal users, but also effect on external users, such as investors and creditors. Profitability refers to the ability of the business to earn income.

Net income is the most significant measure of profitability. Many people who include investors, management, and government tax collecting agencies, creditors and labour unions have a basic need for accounting information to make well-informed decisions. The major role of accounting information is to provide information in order to make decisions and sometimes referred as a means to an end. Stakeholders and investors need accounting information on a regular basis to help them monitors the company’s success.

The income statement is a report that presents the revenue, expenses, and ending net for a business for a period. The income statement shows the track record of the company and the profitability of the company.

References

Barton A.D; ‘Objectives and Basic Concepts of Accounting’; Australian Accounting Research Foundation; 2002; Australia.

Epstein B.J, Mirza A.A; ‘Interpretation and Application of International Accounting Standards 1999’; Wiley; USA.

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Farrell B, Lim S; ‘Selected Readings in Accounting Theory’; University of Technology, Sydney; 2001; Sydney.

Parker C.; ‘Accounting Handbook 2000’; Prentice Hall; Australia.

Weygandt, J., Kieso, D., and Kimmel, P. (2005). Financial Accounting (5th ed.). Hoboken. NJ: John Wiley & Sons, Inc. 22-25, 110-14.

Whittred G, Zimmer I, Taylor S; ‘Financial Accounting Incentive Effects and Economic Consequences’; Harcourt; 2000; Australia.

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