Are Taxes Considered an Expense in Accounting?
Clarify how various taxes are accounted for, their classification as expenses or liabilities, and their influence on financial reporting.
The accounting treatment of taxes is not uniform; it depends on the nature of the tax and its purpose. This article clarifies how different taxes are recognized in a company’s financial statements.
Understanding Expenses in Accounting
An expense represents the costs incurred by a business in generating revenue. These costs involve a decrease in economic benefits during an accounting period, typically as cash outflows, asset depletion, or liability incurrence. Wages, rent, utilities, and the cost of goods sold are common operating expenses.
Expenses differ from assets, which provide future benefits, and from distributions to owners. While an expenditure is a payment or liability incurrence, an expense signifies the consumption of an asset or service. For example, purchasing a building is an expenditure that creates an asset, expensed over time through depreciation. Paying a monthly utility bill is an immediate expense.
Accounting principles dictate that expenses are recognized when incurred, regardless of when cash is paid, under the accrual basis of accounting. This approach ensures costs are matched with the revenues they help generate, providing an accurate picture of profitability.
Direct Taxes: Income Taxes
Income taxes are a financial obligation for businesses, but their accounting treatment differs from typical operating expenses. These taxes, such as federal or state corporate income taxes, are levied on a company’s taxable profit, not on its operational costs. As they are a function of earnings after most other expenses, income taxes are generally not categorized as an operating expense.
Income tax expense is typically presented as a separate line item on the income statement, appearing below operating income. This placement highlights that income taxes are a charge against profitability, not a cost directly associated with core business activities. The Financial Accounting Standards Board (FASB) provides guidance for income tax accounting and reporting in Accounting Standards Codification (ASC) 740. This standard addresses how companies recognize, measure, and disclose income tax items, including current and deferred taxes.
The distinction between accounting income and taxable income can lead to temporary differences, giving rise to deferred tax assets or liabilities. For instance, a company might use accelerated depreciation for tax purposes but straight-line depreciation for financial reporting. These timing differences mean the income tax expense reported on the income statement may not equal the amount currently payable. Income tax expense reflects the total tax burden on pretax income, encompassing current and future tax consequences.
Indirect Taxes: Sales, Property, Payroll, and Excise Taxes
Beyond income taxes, businesses encounter other taxes treated differently due to their nature. These indirect taxes are often tied to specific transactions or assets. Their classification as expenses or liabilities depends on whether the business incurs the tax as a cost or collects it on behalf of a government.
Sales tax is typically not an expense for the selling business. When a business collects sales tax, it acts as an agent for the government, holding funds until remitted. Therefore, collected sales tax is recorded as a liability, such as “Sales Tax Payable,” on the balance sheet, not as revenue or an expense. However, if a business is the end-consumer and pays sales tax on purchases, that sales tax is generally included as part of the cost of the purchased item or expensed directly.
Property taxes, levied on real estate or other business assets, are generally treated as operating expenses. These taxes are a cost of owning and utilizing property. Businesses accrue property tax expense over the period to which the tax relates, recognizing it as an expense on the income statement.
Employer-paid payroll taxes, such as the employer’s portion of Social Security and Medicare taxes (FICA), and federal and state unemployment taxes (FUTA and SUTA), are considered operating expenses. These taxes are a cost of employing individuals and are recognized on the income statement as part of compensation expenses. The employee’s portion of payroll taxes, withheld from wages, is treated as a liability until remitted, similar to sales tax.
Excise taxes, imposed on the manufacture, sale, or use of specific goods or services like fuel or tobacco, are typically included in the cost of the product or treated as an operating expense by the business incurring them. These taxes are often embedded within the cost of goods sold or recorded as a separate operating expense. Unlike sales tax, excise taxes are often levied earlier in the supply chain and may be passed on to the consumer through higher prices, but they are initially a cost to the business.
How Taxes Affect Financial Statements
The distinct accounting treatment of various taxes impacts a company’s financial statements, particularly the income statement and balance sheet. The placement of different tax types directly influences profitability metrics and financial obligations.
On the income statement, the positioning of taxes provides insights into operational efficiency separate from tax burden. Operating expenses, including property taxes and employer-paid payroll taxes, are deducted from gross profit to arrive at operating income. This allows users to assess core business profitability before considering financing costs or income taxes. Income tax expense is presented below operating income, typically as the last expense before net income. This separation ensures operating income is not distorted by income taxes, which are a function of overall profitability.
The balance sheet reflects a company’s financial position, and taxes often appear as liabilities. Taxes collected or accrued but not yet remitted are recognized as current liabilities. This includes sales tax payable, payroll taxes payable (both employer and employee portions), and current income tax payable. Current liabilities are obligations expected to be settled within one year or the operating cycle. Deferred tax liabilities or assets may also appear, representing future tax consequences of temporary differences between financial and tax accounting. These deferred amounts are classified as non-current assets or liabilities, providing a comprehensive view of future tax obligations or benefits.