In the same way that loan capital is subject to a financing cost, the profits generated by a business are subject to a cost; corporation tax. The charge for corporation tax is based upon the level of profits recorded and the tax rates in place at the time of calculation. Company yearends and tax yearends rarely match. Therefore companies must estimate their tax liability at the end of each accounting period and record an appropriate estimate of the liability likely to be paid. These estimates are unlikely to be entirely accurate and as such companies tend to either over or under estimate the provision for corporation tax, which is adjusted for in the following year’s accounts.
It is unlikely the actual charge will match the estimated liability so the tax liability account will be left with a closing balance carried forward. This needs to be removed as the debt has been settled (i.e. there should not be any carried forward balances because the tax authorities have been paid the correct amount).
If there is an over-provision in the prior year (i.e. estimate was greater than the amount paid) there will be a closing credit balance carried forward.
- As the company overestimated, the charge for the following year is reduced by the appropriate amount so that over the two year period the correct charge has been recorded.
If there is an underestimate in the prior year (i.e. estimate was less than the amount paid) there will be a closing debit balance carried forward.
- As the company underestimated, the charge for the following year is increased by the appropriate amount so that over the two year period the correct charge has been recorded.
Remember and note: The liability in the statement of financial position= the estimated amount payable for the current year. The tax charge in the income statement = the estimated amount payable for the current year – last year’s over-provision.
As for provision, a provision can be defined as a liability of uncertain timing or amount.
For example; a business is facing legal action for breaching health and safety law. The likely repercussion is that they will be fined. The timing and severity of the fine will be decided by criminal court at some point in the future. The key question is should the business attempt to reflect this cost in their financial statements?
These are all questions you should be asking and discussing with your business consultant. We are ready to answer any questions you may have and even offer a free consultation! Contacts us today.