You might think calculating your tax bill is easy: just look at the Net Profit on your Income Statement and multiply it by the tax rate. Unfortunately, the government often disagrees with your accountant. Let's learn about the “Two Books” of business.
Many large companies maintain two sets of records: the first is Financial Accounting for their investors. The second is Tax Accounting for the Government. Why? Governments use the tax code to promote or restrict particular types of business activities.
Accounting profit refers to the profit that you declare to the shareholders. Taxable Income refers to profit to which the government actually applies a tax rate. The two numbers are hardly similar.
To find your Taxable Income, you must adjust your Accounting Profit using rules laid down by the government.
Sometimes, a company spends money on things that the government will not accept as a business expense (for example, expensive client entertainment or corporate fines). To arrive at your Accounting Profit, the accountant deducts this expense, but the government makes you add it back, increasing your tax bill.
The government desires companies to invest in the economy. They may provide “tax breaks” as an inducement to buy new machinery or green energy. This lets you deduct extra money from your Accounting Profit, thereby lowering your taxes.
The formula to calculate your final amount of tax bill is:
\[ \text{Taxable Income} = \text{Accounting Profit} + \text{Disallowed Expenses} - \text{Tax Incentives}. \] \[ \text{Corporate Tax Bill} = \text{Taxable Income} \times \text{Corporate Tax Rate} \]This difference is the reason you might see in the news a huge, profitable company legally paid zero tax in a year. The company had a high Accounting Profit, but it used tax incentives in order to lower its Taxable Income to zero.
Taxation is basically a game of rules. When a manager understands that Accounting Profit and Taxable Income are different, they can work with their finance team to structure a project in a way that optimizes government incentives. Let's check whether you can calculate a tax bill!