[Question] Provision for Taxes

[davidbann]

Hi there,

I don't have an accounting background, so forgive me if I seem naive...

As a small business owner, I want to be able, at any point in time, to see exactly how much money we have at our disposal to spend or plan to spend. In order to do this, I need to take the following into account:

• VAT Payable every 2 months
• Income Tax Payable Every 6 Months
• Target Based Commission Payable Every 3 Months
• Open Purchase Orders
• Bills Payable

So I can't just look at the bank balance and say, "Wow we're rich - let's fund a new project!". I need to take all of the above into account and calculate approximately how much cash we have available in the short term.

The way we do it at the moment is as follows - I will give the steps we follow to make provision for Income Tax, but VAT and Quarterly Commission follows a similar process.

1. At the end of each month, we run a report to get the net profit before tax for that month.
2. We then calculate 28% of the amount
3. We DR the calculated amount to an asset account called "Provision for Income Tax"
4. We CR the calculated amount to a liability account called "Income Tax Payable"
5. This means every month both of these account balances are increasing
6. When it comes time to pay provisional tax, our accountants let us know exactly how much to pay
7. We make payment to SARS and DR the "Income Tax Expenses" expense account, and CR the bank account.
8. We CR the total balance of the "Provision for Income Tax" account - leaving it with a zero balance
9. We DR the total balance of the "Income Tax Payable" account - leaving it with a zero balance
10. The process starts again.

This works well because we have reports that can then automatically tell us how much cash we have available to use as opposed to how much cash we have in the bank.

The problem with this method, is that it inflates the balance sheet figures and makes the company look like it is worth a lot more than it really is. I.e the total equity of the company is increased by all of the provisions we have made for tax and vat etc. Is this a bad thing, or do you just have to take that into account when valuating the company?


So my question is - is this the right way of doing it? Is there a better way? Have I completely missed the boat and I need to change the way I think about this?

Thanks

[Mark Atkinson]

Hello davidbann,

While I can completely understand your point of view, my knowledge of the subject tells me that you are approaching it in a slightly misguided way.

From reading your approach to your problem, the thing that becomes most apparent to me is that you should be using budgets to plan your spending, not your financial statements. You cannot technically raise a liability or an asset in respect of your tax expense because you have no present obligation in respect of those taxes. Only once your taxes become payable, can you raise an expense and a corresponding liability (or asset) for that tax expense (or rebate).

My feeling is that you should simply be using a tool that allows you to create a rolling cash budget, which you should use to gauge what your available funds are, as well as how much cash flow you require to cover your upcoming expenditure. You could even do this using a simple spreadsheet in Excel.

The formula is very simple to create a cash forecast/budget.

It's simply your cash balance now
Add: Your income for the forecast month/quarter/etc
Less: Your expenses (including taxes payable and probably a component for unforeseen expenditure)
Equals: What you expect your cash balance to be at the end of the period you're forecasting

You then use and improve on this cash budget by regularly comparing it to your financial statements, which show actual, historic results.

I might even be able to find a cash budget spreadsheet lying around, if you need an example or one to work from.

I hope that helps. Perhaps somebody else will have another solution, but I feel like this is the generally accepted practice.

[Dave A]

When it comes to the way you're doing it:

We DR the calculated amount to an asset account called "Provision for Income Tax"

That looks like why your balance sheet is looking surprisingly good. You'd get a more accurate reflection by debiting an expense account, not an asset account. (A tip: I always use "other expenses" accounts for income tax expenses to get tax figures below the "operating profit" line, but it's still an expense account ).

I agree with Mark though - it's best to look at your cashflow forecast (and making a provision for unexpected expenditure is a must). Another good indicator is the minimum cash you've had available at any point in the past six months, combined with trending whether your cash flow position has been easing or tightening.

[AMB57]

Call me daft, but given the way you are doing it I don't see why your balance sheet needs to be inflated. Takes nothing away from the advice above, which makes helluva sense - but let me try this logic:
When you create the provision asset, you are reducing "cash" by the same amount (into this concept of "available cash" as you mention), therefore total assets should be net unchanged?
When you create the liability payable, you should be reducing retained earnings by the same amount - therefore total liabilities should be net unchanged?

To my mind, in order to avoid the "inflation" effect you should create matching DR/CR entries against cash and retained earnings.

If this is wrong, please don't shoot me - thought I'd throw it out there for consideration

[Mynhardt]

Like Mark said, the accounting records is not the place to "provide" for future expenses and income which hasn't yet occurred. Your accountant will tell you that such provisions for future expenses/income is contrary to formal accounting standards (IFRS, IFRS for SMEs, SA GAAP).
Accounting records are prepared according to the accrual concept, therefore doesn't always match up with the physical cashflows. As Mark said, make use of a cash budget (likely in an excel spreadsheet) which you update on a regular basis, but also compare your previous budgets to your historic figures, so that your can fine tune your budget.

A small correction with your accounting for provisional tax:
The payment of your provisional tax is not an expense (yet). It is a prepayment of tax.
The correct way of accounting for the payment of provisional tax (your journal 7) would be:

Dr Receiver of revenue (balance sheet account)
Cr Bank (balance sheet account)

When year end comes along, and your calculate your income tax payable for the year, and complete your tax return your recognise the tax expense:

Dr Income tax expense (income statement account)
Cr Receiver of revenue (balance sheet account)

By accounting for tax like shown above, your "Receiver of revenue" asset/(liability) on the balance sheet correctly shows how much you how much you owe SARS at year end.

[TravisZA]

Is there no designation income tax expense account in pastel?

Do you always have to create your own under "other expenses"??