Tax Accounting : Work, Principles, Purpose, Types, Methods & Calculation

What is Tax Accounting?

Tax accounting is a method of accounting that is applied to all the assessees whether it is individuals, businesses, partnerships, or other entities. It is the part of accounting that is concerned with the payment of taxes and filing of tax returns. This method of accounting focuses on taxes instead of financial statements. The Internal Revenue Code governs tax accounting and sets out the rules and regulations related to taxation. It is mainly interested in tracking funds linked with individuals and businesses.

Geeky Takeaways:

• Tax accounting is a field of accounting that concentrates on the preparation of information related to tax.
• The standards of tax accounting apply to the computation of income and not the maintenance of the books of accounts.
• Companies use this method to help them make the proper tax calculations and prepare tax documents on time.
• In addition to ensuring compliance with tax regulations, this method of accounting reduces tax liability for individuals and businesses.

How does Tax Accounting Work?

Following is an overview of how tax accounting works effectively,

1. Record Keeping: Individuals and entities must maintain data about all the financial transactions, incomes, expenses, and any other financial information accurately to determine the true position of the entity. It also helps the company to track its investments and their present value.

2. Tax Planning: The method of tax accounting involves strategic planning to make informed decisions for the benefit of the corporation. With proper tax planning, companies minimise their tax liability.

3. Compliance: Tax accountants determine the taxable income and tax liability of the assessee and file the returns timely. This timely filing of the returns of income ensures compliance with tax laws and protects the assessee from paying any late fees or penalties.

4. Risk Management: There is always a risk connected with taxation in large companies due to non-filing of returns or delays in payment. Tax accounting reduces these tax-related risks and protects the entity from reputational damage.

Principles of Tax Accounting

Tax accounting is regulated by the Internal Revenue Service and is guided by several principles that ensure regular and accurate reporting. All the assessors must follow tax accounting principles while preparing and filing their tax returns. These principles are,

1. Transparency: Transparency about the company’s finances is important for the public and stakeholders of the company. This helps the shareholders, creditors and other public to make proper decisions. Hence, the company is required to make accurate disclosures of its financial information.

2. Consistency: Once the assessee has chosen an accounting method, it should be consistently applied yearly. Consistency of the methods makes accounting and calculation of tax easier for professionals. Changing accounting methods frequently may be a cumbersome process and may affect the flexibility of the company.

3. Matching Principles: The matching principle means that the expenses and investments of the company should be matched with the income they are related to. It is based on the cause-and-effect relationship between earning and spending money.

4. Financial Statements: These principles may involve consolidation of financial statements for a comprehensive view, where a business has multiple entities. It is practised by companies that have wholly owned subsidiaries.

Purpose of Tax Accounting

• Tax accounting serves an important purpose because individuals and body corporations need to determine their taxable income and the amount of tax that must be paid by them.
• The primary purpose of tax accounting is to ensure compliance with tax laws and regulations implemented by the government with accurate and timely preparation of tax returns.
• It is an important part of financial planning. Individuals and businesses make financial decisions by considering the tax regulations of various transactions, investments, and activities. In summary, tax accounting helps in tax planning.
• Tax accounting helps in availing benefits offered by the government in the form of deductions, exemptions and credits. It involves identifying and claiming the incentives that an assessee is eligible for. These deductions help in reducing the tax liability of the assessee.

Types of Tax Accounting

1. Individual Tax Accounting: This type of tax accounting focuses on the financial activities of individual taxpayers and determining their tax liability. Slab rates are applied to calculate the total tax liability of an individual. It involves reporting income from various sources, total expenses, claiming various deductions, rebates and credits, and complying with tax laws applicable to individuals.

2. Corporate Tax Accounting: Corporate tax accounting is concerned with the tax obligations of business entities. It is complex as compared to individual accounting due to additional considerations such as depreciation, inventory valuation, and other transactions. It involves calculating and reporting the taxable income of the company according to the Income Tax Act, of 1961, availing deductions allowed to businesses and complying with corporate tax laws.

3. Tax Accounting for Tax-Exempt Organisation: Tax accounting for tax-exempt organisations has less compliance compared to other body corporates. They need to submit annual returns. The tax-exempt organisations are required to disclose all sources of income, including donations and grants, and how the money is utilized to run the organisation and need to adhere to regulations that apply to tax-exempt entities.

Methods of Tax Accounting

Tax accounting methods may have an impact on the taxable income and tax liability of an assessee. The two primary methods for tax accounting are the cash method and the accrual method. However, a taxpayer can employ different methods for the treatment of any significant item, such as inventory, depreciation methods, etc. The two permissible methods for tax accounting are,

1. Cash Method: This method of accounting is mostly used by sole proprietors and other professionals who want to record their income when there is an actual inflow or outflow of cash. In the cash method, income and expenses are acknowledged when they are received or paid, respectively. The cash method is suitable for small-scale businesses. The tax liability of a person is postponed and deductions can be availed by the assessee in the year in which the income is received and not in the year in which it becomes due.

2. Accrual Method: In the accrual method of accounting, the income is recorded in the books when it becomes due and expenses are entered when they are incurred irrespective of when the actual cash is received or paid. This method follows the matching principle. It is generally used by companies as it helps in providing a more accurate representation of the financial performance but it may result in timing differences between taxable income and actual cash flow. In the accrual method, an assessee can avail of the deduction in the year in which income becomes due and not received.

Tax Accountant and Management Accountant

1. Tax Accountant: Tax accountant specializes in tax accounting and use their knowledge to analyse financial statements, prepare tax payments, file tax returns and complete regular tax reports. These professionals provide advisory services to their clients and help them navigate the complexities of tax laws and ensure compliance with relevant regulations. Tax accountants help individuals and business entities in tax planning. They also identify and claim deductions for which their clients are eligible which will ultimately reduce their tax liability and save money.

2. Management Accountant: A Management Accountant is a professional who is responsible for analysing and tracking the costs associated with producing goods or rendering services and is involved in the development of budgets and financial forecasts. They provide financial information and analysis to support decision-making within an organization. These individuals play a critical role in helping management make better decisions to enhance the company’s financial performance. Management accountants oversee the financial status of a business and manage the finance team to achieve the goal of the business.

Advantages of Tax Accounting

1. Legal Compliance: Tax accounting ensures the compliance of tax laws and regulations applicable to individuals and business entities. Professionals make accurate and timely preparation of tax returns which is essential for compliance with tax laws and saving their clients from late fees.

2. Tax Planning: Tax accounting involves strategic tax planning applying which individuals and body corporates can make logical decisions that have favourable tax implications. It can be beneficial in making investments with high returns for the sake of using deductions. Through strategic planning, they can also reduce their tax liability legitimately.

3. Cash Flow Management: Professionals can improve the cash flow of the business by planning strategically. Businesses can plan for tax payments and allocate resources accordingly, reducing the impact of unexpected tax liabilities.

4. Deductions and Incentives: Tax accountants help their clients by availing tax deductions, exemptions and other incentives offered by the authorities. It helps individuals and businesses to reduce their taxable income and consecutively reduce their tax liability.

5. Audit Representation: Proper tax accounting practices contribute to audit readiness. Maintaining organized and accurate financial records allows individuals and businesses to respond efficiently to audit inquiries and also reduces the time and resources required to address potential issues.

Disadvantages of Tax Accounting

1. Time-Consuming: The process of tax accounting involves bookkeeping, analysis, and strategic planning which can be time-consuming for businesses that have multiple transactions.

2. Allocation of Resources: A business needs proper and dedicated resources. Allocation of these resources can be a challenge for small businesses as it affects the cost of business.

3. Frequent Changes: Changes in tax laws and regulations make it difficult to follow one plan. It becomes necessary to keep up with the changes.

4. Risk of Errors: There is a high degree of complexity in tax laws and regulations, due to which there is always a risk of errors in tax calculation. Moreover, inaccuracy in tax returns and other filings may result in penalties or late fees.

How are Taxes Calculated for Businesses?

1. Choosing Accounting Method: A business needs to choose one of the two permissible accounting methods: the cash method and the accrual method.

2. Calculation of Income: The gross income of the business is calculated by considering all the transactions. After claiming eligible deductions from the gross income, the net income of the entity is generated. The net income of the entity is also known as taxable income.

3. Tax Rates: According to the Income Tax Act, of 1961, the tax rate for domestic companies having gross receipts of not more than 400 crores in the previous year is 25% whereas domestic companies having gross receipts of more than 400 crores in the previous year is 30%. The tax rate on foreign companies and partnership firms is flat at 40%. and 30% respectively.

4. Surcharge and Health and Education Cess (HEC): Surcharge is calculated on the tax liability obtained whereas Health and Education Cess is calculated at the rate of 4% on the amount obtained after calculating surcharge on tax liability.

Examples of Tax Accounting for a Business

1. Depreciation: Depreciation is the reduction in the value of the asset due to its usage over time. Companies use it to reduce the cost of capital assets. Tax accountants use different methods for the calculation of depreciation such as the straight line method or written down value method. Depreciation is one of the allowed deductions for businesses which is shown in the debit side of the profit and loss account.

2. Inventory Valuation: Businesses with inventory have to calculate the cost of goods sold. Inventory valuation shows the total goods sold by the company with its profit margin. Entities use various methods to calculate the cost of goods sold such as the Last In First Out method (LIFO), First In First Out method (FIFO) etc.

3. Tax Returns: Tax accountants file timely returns of the business after assessing its total tax liability. Entities are allowed to file their returns quarterly, half-yearly and annually according to their ease. Returns include income tax returns, tax deducted at source, tax collected at source, and other required filings.

Difference Between Tax Accounting and Financial Accounting

Basis	Tax Accounting	Financial Accounting
Meaning	It is the sub-division of accounting that deals with the preparation of tax returns and tax payments.	It is the branch of accounting that involves the systematic recording, summarizing, and reporting of an organization’s financial transactions.
Objective	The goal of tax accounting is to ensure compliance with tax laws while minimizing tax liability.	It concentrates on accruing, managing wealth and making informed decisions for the business.
Focus on Income	It focuses on determining the net taxable income to calculate the total tax liability of the business.	It focuses on the net income in the profit and loss account and balance sheet of the company which shows the financial position of the business
Information User	It primarily serves tax authorities and focuses on compliance with laws.	The users of financial accounting information are shareholders, creditors and other stakeholders

How to Start a Career in Tax Accounting?

Starting a career in tax accounting requires knowledge in the field of taxation and a combination of professional certificates and practical experience.

• To become a tax accountant, a person should hold a bachelor’s degree in accounting, finance or related fields. For specialised knowledge, doing a Masters in Taxation is a plus.
• Familiarisation with taxation and related knowledge through online courses will help you gain a better understanding of the field. Pursuing professional courses in Chartered Accountants, Company Secretaries, Chartered Financial Analysts etc. helps enhance credibility and job prospects.
• Acquiring practical knowledge through internships in accounting firms will help you in applying theoretical knowledge in real-world situations.

Frequently Asked Questions(FAQs)

1. What Is the main purpose of Tax Accounting?

Answer:

The fundamental purpose of tax accounting is to ensure compliance with the tax laws and regulations implemented by the government with accurate and timely preparation of tax returns.

2. What qualifications are needed to be a tax accountant?

Answer:

To become a tax accountant, a person should have a bachelor’s degree in accounting, finance and related fields.

3. What is the difference between a Tax Accountant and a Management Accountant?

Answer:

Tax accountants help individuals and business entities in tax planning while management accountant provide financial information and analysis to support decision-making within an organization.

4. What types of taxes do businesses deal with?

Answer:

Businesses commonly deal with income taxes, payroll taxes, sales taxes, property taxes, and potentially other taxes depending on their industry and location.