Taxes, accounting, and management are all phrases that are commonly employed in any financial environment. These are not just catchphrases, as there is more to taxes and accounting than meets the eye when it comes down to businesses. Tax accounting is an important component of financial management that you should be aware of as a financial manager, business owner, or individual.
Accounting and taxation may appear to be alien languages to many people. This should not be the case because grasping the ideas behind these concepts is important to proper money management and the overall success of a business in the long run. Taxation is also a legal requirement; hence, it is an important finance component.
However, tax accounting can be complicated sometimes, especially for firms with multiple revenue streams, assets, and vendors. In fact, understanding taxes and accounting can still be tricky, even if you’re an independent contractor, small business owner, or freelancer. The baseline is that you need to know how much you have spent on your business and keep tabs on every transaction to assess your taxes properly.
Many top-rated firms often use the service of tax accountants, who face the difficult task of making sure they find the most advantageous tax rate possible for firms. Essentially, tax accounting remains a challenging practice, even for these professionals. It is extremely nuanced and requires advanced knowledge of both tax law and accounting principles. However, regardless of whether you handle your taxes yourself or use the services of a professional, a basic understanding of these concepts is critical to the financial well-being and general success of your business.
This article will give you the basics of taxes and accounting and explore the role and significance of tax accounting in financial management.
What is Tax Accounting?
Tax accounting is essentially the accounting branch that deals with taxes. While accounting is a broader concept that encompasses all operations involving processing financial information and economic activity, tax accounting specializes in taxes. Tax accounting is a set of accounting processes associated with tax calculation and reporting, preparing tax returns, paying tax obligations, and determining taxable income.
Tax accounting applies to almost everyone because taxes are a general legal necessity; businesses, private individuals, corporate bodies, and other entities must pay taxes. Evasion of taxes or failure to pay promptly is usually met with legal penalties, including payment of heavy fines, seizure of property, or even jail.
Every country typically has a tax system that governs the structure of taxation. Although taxes apply to everyone, the tax system differs depending on whether you are an individual, a business, or a corporate body. In many nations, an individual’s income usually decides their taxes, and the same goes for a corporate organization sometimes.
The next part of this guide will discuss the most common taxing systems, including progressive, proportional, and regressive taxation.
A progressive taxing system is a type where the tax rate rises from low to high levels. This indicates that the tax rate rises as the taxable amount increases. One advantage of progressive taxation is that it helps to reduce the tax burden on individuals with lower income or the ability to pay. This system tries to move the tax burden to those who earn more and have greater ability to pay, thereby addressing the issue of income inequality. This indicates that persons with higher incomes have a greater paying potential and thus must pay more in taxes. Progressive tax examples include income taxes, estate tax, and tax credits. Although taxes on interest earned and rental revenues are generally considered progressive taxes, they fall under the income tax category.
- Income Tax
An income tax is a sort of tax that is levied based on the amount of money earned. In this situation, the tax payable by individuals, businesses, or corporate bodies is determined by their earnings or net profits. The amount to be paid in tax is normally calculated by multiplying the total taxable income by the tax rate. However, tax rates typically vary between countries and, in certain cases, between states within the same country. It is simply the percentage of a sum of money that must be paid as tax, which is normally set by the government.
Income derived through gifts, inheritance, child support payments, or welfare benefits is not taxable. On the other hand, taxable income is money that can be taxed. Salary, wages, unemployment compensation, interest earned from banks, stock options, dividends, rents from personal property, and so on are all instances of taxable income.
There may also be instances of negative income taxes. This is a situation in which individuals who earn less than a specified income limit receive benefits from the government rather than paying taxes to the government.
- Estate Tax
Although inherited properties are non-taxable items, such an asset will be taxed in certain cases if it’s worth above a certain amount in value. This is what is referred to as estate tax. It is also known as death tax or inheritance tax. The government usually determines the valuation limit that justifies taxation in this case.
- Tax Credits
A tax credit is simply a means of reducing the amount of tax owed to the state. It is a type of benefit that certain taxpayers receive in which they can deduct an amount of money, typically the tax credit they have accumulated over time, from the total amount they are required to pay. These incentives are typically given to less privileged individuals by the government to save them money. It can include child tax credits, elderly or disabled tax credits, retirement savings contribution credits, etc.
This is the direct opposite of a progressive taxation system. In this example, the tax rate falls as taxable income rises. The relationship between tax paid and ability to pay is inverse. As a result, a regressive taxation system burdens the poor more than the rich, who have a greater ability to pay. This tax system usually covers activities more likely to be carried out by the masses. Examples include taxes on consumer goods, sales, gas, and Social Security payroll. These types of taxes often function on a flat rate, which means that the tax rate is the same for everyone, regardless of income. They are regressive in the sense that they are largely paid for by the less privileged.
Proportional taxation is a tax system in which the tax rate is fixed. Regardless of the ability to pay, all taxpayers pay the same tax percentage. It is also known as a flat tax. Proportional taxation may appear regressive in some circumstances because it disproportionately affects low-income individuals. When we consider sales tax, for example, it appears regressive even if the tax rate is uniform across the board since low-income people spend a greater amount of their income on purchasing various things rather than saving or investing.
Overall, taxes can be differentiated based on how they impact the distribution of income and wealth. All of these distinct types of taxation systems are carefully considered in tax accounting. While individual tax accounting is simple and easier to grasp, tax accounting for a business is complicated and requires more examination regarding what is taxable and what is not. It also necessitates more complex returns and reporting requirements. That is why most corporate firms tend to hire tax accountants to do their taxes.
Individual Tax Accounting
Individual tax accounting solely considers actions that impact a taxpayer’s tax burden. It simply involves earned income, permissible deductions, charitable contributions, and any gain or loss on investments. As a result of the limited amount of data that must be taken into account for an annual tax return, processing tax information is much simpler for individuals.
Accounting for Taxes in a Business
Unlike individual tax accounting, processing taxes in businesses often requires much data to be considered. The procedure becomes more complicated as the firm becomes larger. While the process also involves considering a company’s revenue in a way similar to tracking an individual’s income, there are more intricate processes involved that take into account factors such as money spent on shareholders, corporate requirements, or certain commitments. Thus, it is safe to say that the processing of business taxes becomes even more difficult as a result of the diversity of information that must be taken into account. Although most businesses have specialists inside their organizations that handle their taxes, bigger corporations with a lot of complicated data often engage the service of tax accountants.
However, it is challenging to categorize corporate income taxes into progressive, regressive, or proportional taxing systems due to the complexities involved in tax accounting for corporations. This is due to the potential ability of big businesses to maneuver themselves around taxes. It is challenging to ascertain who pays for a business’s tax obligations since many enterprises are deep into shifting their tax burdens constantly. This phenomenon is usually referred to as shifting and incidence.
Shifting and Incidence
The phrase “tax incidence” refers to who eventually pays a tax bill or is subject to a tax burden. The term describes the distribution of tax burdens among stakeholders such as buyers, sellers, producers, consumers, or other parties of interest within an enterprise. It also goes further to distinguish between the entities that end up bearing the tax burden and those initially subject to it. The individual or party whose net income is decreased bears the tax burden, although this isn’t always the party on whom the tax was originally imposed by law. For instance, the tax burden associated with the sale of an item can typically be transferred from businesses to consumers. Thus, taxes can be shifted in any direction. It can be moved forward from the supplier to the consumer or backward, in which case the producer is responsible for paying the taxes.
Tax Accounting for Tax-Exempted Organizations
Tax-exempt organizations, such as charity organizations, religious groups, private foundations, political organizations, and other non-profit organizations, must also file tax returns. Even though they do not pay taxes, tax accounting also applies to them because it allows them to stay in compliance with the legislation that regulates them. These tax-exempt organizations are obliged to make an annual report of their financial operations. They must reveal any incoming resources, such as donations, gifts, or grants, with details about how they went about disbursing funds.
Basic Components of Tax Accounting
The primary purpose of tax accounting is to prepare tax returns by calculating taxable earnings and payable tax via multiple accounting principles. Tax accountants consider several factors in doing this. These factors include deferred tax asset, deferred tax liability, Value Added Tax (VAT) Accounting, transfer pricing and income categorization.
Deferred Tax Asset
When filing taxes, one highly complicated aspect that is always taken into serious consideration is deferred taxes. The word “deferred” means to delay or postponement; therefore, a deferred asset has to do with a delay or postponement. The primary idea behind tax deferrals lies in the fact that the book profit and the taxable profit are not equivalent. As a result, there is a deferred tax asset when the book profit is lower than the tax profit.
Essentially, a deferred tax asset signifies a financial benefit, denoting a tax overpayment. It happens when a corporation pays its taxes weeks or months before the due date, pays too much tax or the tax amount has been carried forward but has not yet been recognized by the appropriate tax authority.
Deferred Tax Liability
In this case, the book profit is higher than the taxable profit. Deferred tax liability is the opposite of deferred tax assets; it occurs due to temporary timing differences regarding when a tax is owed and when its payment is due. It indicates that there are accrued taxes by a business at the present moment, but the payment is not due yet. In essence, the deferred tax liability is the total amount of unpaid taxes a firm must make up for in the future.
Value Added Tax (VAT)
VAT is a common accounting term that means the tax based on the value of an item. It is a tax that applies to virtually every good and service. These taxes are percentage-based; the greater the value of the item, the greater the VAT.
Transfer pricing comes to play when goods and services are exchanged between companies under the same ownership. Although tax authorities frown at this, two businesses under the same ownership often exchange goods and services at manipulated transfer prices to reduce their total tax liability. Big organizations achieve this by charging high transfer prices to their subsidiary company in a high-income country and vice versa. According to the IRS, transfer pricing should be the same for transactions between subsidiaries of the same company as it would have been with external business.
Since each type of income has a different tax rate, it must be classified and recorded individually, making income classification an essential part of tax accounting. This concept also makes it easy to determine taxable and non-taxable income without hassle.
Why is Tax Accounting Important?
Accounting is and will always be a crucial component of finance since taxes are a legal component of any corporation. Therefore, all businesses need effective tax accounting procedures to streamline tax reporting and assure compliance with the relevant accounting standards and laws. Engaging the services of tax accountants to manage taxes is crucial, especially in cases that involve complex computation and processing of tax information. However, having a fundamental understanding of tax accounting is an extra benefit for any individual or business owner who wants to have an efficient handle on their finances.
Below, we have highlighted a few reasons why tax accounting is vital for your organization and why you should hire a tax accountant:
A solid tax accounting system and methods will ensure that your firm always operates within established tax standards while correctly addressing all aspects of your tax records. In cases when you do not fully grasp tax rules and how they affect your business, a tax accountant can always come to your assistance as they are always savvy and up to date on any development regarding tax laws and policies.
The financial position of an individual, business, or corporate body is always reflected in its financial records. As a result, adequate documentation and understanding of taxes will provide you with an overview of how you or your business is doing financially. Thus, engaging the service of a tax accountant is an added benefit to any business because they will not only assist you in sorting your taxes but also in understanding what is going on financially in your business.
Creating Budgets and Future Projections
A proper financial record will help make informed decisions, effective plans, and accurate business projections, which are all critical to the success of a firm. A balanced record is also required for creating effective budgets within a business. You’d agree that most future business plans and estimates are often based on previous financial data; thus, a well-structured tax accounting is critical.
Filing Financial Statements
Every firm is required to file an annual financial statement to the authorized authorities across most countries. Tax accounting is essential to filing this statement because tax records are among the topmost financial documents in any business or financial institution. Tax preparation may be a complicated procedure; however, professional tax accountants are there to handle any of your tax difficulties. They can also prove very helpful in assisting you with various other related financial difficulties.
Significance of Tax Accounting in Financial Management
Simply put, financial management involves keeping an eye on a business’s financial resources. It is the process of handling a business’s finances in a way that enables it to remain profitable and in compliance with all relevant laws. In today’s dynamic environment, businesses of all sizes must make strategic decisions regarding the use of their accounting resources. As a business owner, you must understand the various ways in which accounting can be used to support and drive business performance. Tax accounting is a major subset of accounting that focuses on managing the tax implications of business transactions. Taxes are an inevitable cost, especially when running a business. As a result, tax accounting is highly significant in helping you manage your finances more effectively.
Keeping track of your financial documentation is essential to running any company. Even if you hire an accountant or bookkeeper, it helps to understand how taxes and accounting work as a business owner so that you don’t pay more than what is required by law or get into legal complications. With proper tax accounting practices, you can leverage the tax system to save more money for reinvestment, maximizing your finances.
Overall, financial management and accounting are two concepts that go hand in hand, and a fundamental grasp of taxes will aid in the appropriate management and administration of funds.
Most world-class corporate firms are highly familiar with tax systems and principles, and they ensure to always have the best specialists handling their taxes. These firms understand the significance of proper tax accounting and use it to their advantage. Another reason why tax accounting is vital can be seen in the power it wields in wealthy people’s hands. You’d agree that wealthy people are highly clever when it comes to taxes. This is visible in the fact that they end up paying the least amount possible even though they are meant to pay the greatest proportion of taxes. However, they understand how taxes operate; hence, they exploit tax regulations to keep their tax liabilities as low as possible.
While the notion of taxes might seem complicated, a fundamental knowledge of the concept is nonetheless crucial. Although tax accountants are helpful and sometimes mandatory in managing your individual or business taxes, we believe this guide is successful in giving you a basic grasp of tax accounting, which will help you make profitable decisions and manage your finances better.