Provision for Income Tax

Entities are liable to pay income tax on their yearly profit. This is usually estimated by applying a fixed percentage. As it is an estimate of tax liability therefore, it is recorded as a provision and not a liability. The actual payment of tax can be lesser more than the estimated amount which gives rise to under and over-provisions.



The provision for tax is based on profits in entity’s income statement and reasons why it is a provision and not a liability

  1. Entity can have accounting policies and estimation process differ from taxation rules; also
  2. Financial year end date can be different from tax year end date, thus entity cannot exactly calculate the tax liability to be recorded in the financial statements

Provision amount is calculated by applying rate as per tax rules on profit before tax figure. Profit before tax is usually a gross profit less operating, financial and other expenses plus other income.

The journal entry to record provision is:

Profit or loss a/c ###
Provision for income tax a/c ###

Example: Provision for taxation

Miar company has reported the following figures for current year end:

000
Turnover 1000
Cost of sales 700
Administrative expenses 150
Distribution expenses 50
Interest expense 80
Rental income 20

If income tax rate is 30% calculate the profit before tax and provision for taxation for this year

Solution:

Following is the calculation for profit before tax:

000
Turnover 1000
Cost of sales (700)
Gross profit 300
Add: Other incomes
Rental income 20
Less: Expenses
Administrative expenses (150)
Distribution expenses (50)
Operating profit 120
Less: Financial expenses
Interest expenses (80)
Profit before tax 40

Based on the profit before tax calculated above the tax provision amount will be 12,000 (40,000 x 0.3)

Journal entry will be following:

Profit or loss a/c 12,000
Provision for income tax a/c 12,000

In the income statement it will be reported as following:

Miar Company
Income statement for the year ended ________

000
Turnover 1000
Cost of sales (700)
Gross profit 300
Add: Other incomes
Rental income 20
Less: Expenses
Administrative expenses (150)
Distribution expenses (50)
Operating profit 120
Less: Financial expenses
Interest expenses (80)
Profit before tax 40
Less: Provision for tax (12)
Profit after tax 28

1 Under and Over provision of tax

As provision for tax is an estimate of probable cash outflow, the actual tax payment can be different. In this case we can have under or over provision of tax.

The under/over provision is determinable only after the actual payment is usually made when the financial statements of the relevant year are already published and the subsequent year is already underway. Therefore, any under or over provision related to previous year are adjusted in current year’s provision in the income statement. The adjustment of over/under provision however, has no effect on current year’s provision in the statement of financial position.

1.1 Accounting treatment for under/over provision

Previous year’s under provision increases current year’s tax charge in the income statement. This is because previous year’s leftover provision will also be flushed to income statement WITH current year’s provision causing the total to increase.

Similarly the over provision will cause the tax charge to decrease it will offset the current year’s value in provision account. It will be better understood with the following example.

Example: Under/Over provision for tax

Kampire Dior is preparing financial statements for the year ended December 2016. The tax year ends by June every year. The accountant has estimated current year’s tax provision to be 250,000 whereas the provision for December 2015 was 300,000.

Give the relevant T-account for the year ended December 2016 if payment towards taxation for 2015 was:

  1. 170,000
  2. 320,000

Solution:

1: If payment is 170,000

Before the payment was made entity must have recorded 300,000 provision and its provision for tax account should be as following by December 2015:

Provision for Tax a/c
C/d balance 300,000 Profit and loss a/c 300,000
300,000 300,000

After the payment of 170,000 is made by June 2016 the account will following:

Provision for Tax a/c
Cash a/c 170,000 Opening balance 300,000
C/d balance 30,000
300,000 300,000

The closing balance of 30,000 is considered over provision as the amount provided exceeded the actual payment.

At the end of December 2016, entity requires a closing balance of 250,000 in the provision for tax account. With 30,000 already in the account, we need to charge only 220,000 in December 2016:

Provision for Tax a/c
Opening balance 30,000
Profit and loss a/c 220,000
C/d bal 250,000
250,000 250,000

We could have reached the same results without any T-account.

Current year tax charge = Current year’s tax provision – Prior year’s over provision
220,000 = 250,000 – 30,000

To emphasize again, only the amount charged to income statement has reduced by 30,000 and the amount reported in balance sheet is still 250,000 which is the closing balance of the account thus, confirming that under/over provision of prior year has no effect on current year’s provision amount in balance sheet.

2: If payment was 320,000

Before the payment was made entity must have recorded 300,000 provision and its provision for tax account should be as following by December 2015:

Provision for Tax a/c
C/d balance 300,000 Profit and loss a/c 300,000
300,000 300,000

After the payment of 170,000 is made by June 2016 the account will following:

Provision for Tax a/c
Cash a/c 320,000 Opening balance 300,000
C/d balance  20,000
320,000 320,000

This time we have under provision as the amount provided was lesser than the actual payment made. This will give rise to a debit balance of 20,000.

At December 2016, entity requires provision for tax account to be 250,000. For this they need to raise the account by 270,000 (250,000 + 20,000) so that debit effect of 20,000 can be nullified and accounts ends up with 250,000 closing balance:

Provision for Tax a/c
Opening balance 20,000
Profit and loss a/c 270,000
C/d bal 250,000
270,000 270,000

We could have reached the same results without T-accounts:

Current year tax charge = Current year provision + Under provision of previous year
270,000 = 250,000 + 20,000