Taxable profit vs. accounting profit – explaining financial statements

Have you ever wondered how the current tax expense (i.e. the income tax for the period which is usually one year) in a company's income statement relates to the accounting profit before tax and why this is normally different to the applicable tax rates?

Why is this not a straightforward percentage of the profit figure? If tax is say 30% then the tax liability for that year should be 30% of the profit right? Well…no! Tax rules are completely different to Accounting rules.

Let’s try to understand this with an example.

Entities A and B are two unrelated entities which operate in the same industry and in the same tax jurisdiction (i.e. they operate in the same geographical area and are subject to the same tax laws). Here is an extract of their respective income statements: In the year ended 31 December 20X5, the applicable tax rate for both entities is 25%.  Notice the current tax expense as a percentage of profit before tax is 20% for Entity A and 36% for Entity B.   Why is the current tax expense as a percentage of the profit before tax not equal to 25%? The reason is that current tax is calculated based on taxable profits (profits according to the tax laws) as opposed to accounting profits (profits according to the accounting standards such as IFRS). So in the diagram above we see that we compute the tax liability, and only once we know this Tax Expense we can then go to the Financial Statements and show it as a cost for the year. There are normally differences between taxable profits and accounting profits as certain accounting expenses/income may not be deductible/taxable for tax purposes and certain expenses/income that are deductible/taxable for tax purposes may not be reflected in the income statement. Some examples: - Entertainment of clients expenses may be “allowed” as costs under accounting rules but the tax rules may not allow all of these.  - Depreciation charges may not be the same, e.g., because the tax rules may be encouraging the usage of certain equipment and their depreciation may be faster than under accounting rules. In other words, the tax rules are based on political, economic and social objectives which are not considered by accounting rules because the objective there is different: it is to present to investors a fair set of financial statements on the basis of which they can make their decisions. The tax computations below show how the taxable profits are calculated for Entity A and B: - Depreciation is added back to arrive at a profit before depreciation because tax will apply different rates. - Same with penalties and fines: they are added back as tax law does not recognize them.  - Tax allowances are expenses on things like research and development or machinery and equipment. This means that on this spending the tax law does not claim any tax at all. So you deduct these from the profit to arrive at the profit that is taxable. Therefore, the current tax payable by an entity is calculated using the taxable profit (i.e. according to the relevant tax laws) which is not necessarily the same as the accounting profit (which is determined by accounting standards such as IFRS). So first we go to tax rules to find out what the tax liability is and then we show this in the financial statements that we prepare for the shareholders.