What are the Effects of Prepaid Tax? 

Many businesses estimate tax liability and make payments throughout the year (often quarterly). When a company overestimates its tax liability, this results in the business paying a prepaid tax. Prepaid taxes will be reversed within one year but can result in prepaid assets and liabilities.

Important Terms to Know

Accounting profit is the profit or loss for a period before the deduction of tax expenses.  

Taxable profit is the profit/loss for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable. 

Tax expense is the aggregate amount of tax payable included in the determination of profit or loss for the period with regard to current tax and deferred tax.  

Current tax is the income tax payable in respect of the taxable profit/loss for a period.  

A prepaid expense is an expense for which a company makes advance payments for goods or services to be used at a future date. It appears as a current asset in the balance sheet. As the benefit of the prepaid expense is realized or the expense is incurred, it is recognized in the income statement. Prepaid expenses include expenses like insurance, rent, interest, utility bills, etc. 

Example 1 : Suppose a company pays rent expenses of $240,000 for the next 12 months in advance. Each month, the company will deduct $20,000/- from prepaid expenses on the balance sheet, transferring the amount to rent expenses in the income statement. By the end of the year, $240,000 will be shown in the income statement and zero will be left in prepaid expenses shown as current assets in the balance sheet. 

Prepaid expenses do not reduce net income or shareholder's equity. However, prepaid expenses do reduce cash. An increase in prepaid expenses decreases the cash flow. 

Example 2:  

The following is a journal entry showing prepaid rent expenses:

Why are Prepaid Expenses Not on the Income Statement Initially? 

Prepaid expenses aren’t included in the income statement as per  generally accepted accounting principles (GAAP). The GAAP matching principle requires accrual accounting, according to which revenue and expenses are reported in the same period as they are incurred, no matter when cash or money is exchanged. Thus, prepaid expenses aren’t recognized on the income statement when paid because they are yet to be incurred. 

Due to timing differences, a company will estimate its potential tax liability and make payments over the course of the year. Sometimes a business might overestimate taxes, resulting in prepaid tax. 

What is Prepaid Tax?  

Prepaid taxes refer to payments of tax made in respect of the tax liability before the tax expense is actually incurred (whether by reason of an estimated payment or otherwise) on or prior to the closing balance sheet date. Having enough tax withheld or making quarterly tax estimate payments during the year helps avoid tax issues at a later stage, i.e., taxes are paid as and when the income is received rather than paying together at the end of the year. 

Prepaid taxes are slightly different from deferred tax assets (DTA). Prepaid taxes are reversible within one accounting year, whereas DTA may take over a year to reverse. 

How Do You Account for Prepaid Tax? 

Initially, debit the prepaid tax account for the amount of the payment, and credit the cash account to recognize the reduction in cash account.  

Since both are asset accounts, they do not affect the balance sheet. 

Later, credit the prepaid tax account and debit the tax expense account when the actual liability amount is calculated at the end of the year. 

Effect of Prepaid Tax on Assets:  

Tax expenses affect a company’s net profit given that they are a liability to be paid to the government. Thus, prepaid tax reduces the amount of current assets as shown in the balance sheet and adds to expenses in the income statement, thereby reducing the net profit to be distributed to shareholders in the form of dividends. 

Short Note on Deferred Tax Asset (DTA) & Deferred Tax Liability (DTL) 

A company derives its book profits from financial statements prepared as per the rules of Companies Act and its taxable profit as per Income Tax Act provisions. 

The difference between book profit and taxable profit is called timing difference. It can either be a temporary difference (a difference capable of being reversed in the subsequent period) or a permanent difference (a difference not capable of being reversed in the subsequent period). 

If a company's book profit is higher than the taxable profit, it means less tax is paid in the current period and more in the future, thus creating deferred tax liability (DTL). 

Example: Difference in method and rate of depreciation 

If a company's taxable profit is higher than its book profit, it means more tax is paid in the current period and less in the future, thus creating a deferred tax asset (DTA). 

Example: Business loss, bad debts, penalties  

Example of DTL: An asset which costs $150 has a carrying amount of $100. Cumulative depreciation for tax purposes is $90 and the tax rate is 25%. The tax base of the asset is $60 (cost of $150 less cumulative tax depreciation of $90). In order to recover the carrying amount $100, the entity must earn taxable income of $100, but will only be able to deduct tax depreciation of $60. Consequently, the entity will pay income taxes of $10 ($40 at 25%) when it recovers the carrying amount of the asset. The difference between the carrying amount of $100 and the tax base of $60 is a taxable temporary difference of $40. Therefore, the entity recognizes a deferred tax liability of $10 ($40 at 25%), representing the income taxes that it will pay when it recovers the carrying amount of the asset.  

Common Mistakes 

1. Incorrect journal entries 

2. Transposition errors, i.e., digits reversed by mistake 

3. Errors of omission, i.e., skipping to record a financial transaction 

4. Errors of commission, i.e., entering a wrong value 

5. Errors of principle, i.e., recording in the wrong account or not meeting the generally accepted accounting principles (GAAP) 

Context and Applications  

This topic is important for students pursuing the below-mentioned disciplines.  

• Masters in Business Administration  
• Masters in Commerce 
• Bachelors of Commerce