Understanding Business Accounting For Dummies, 2nd Edition (24 page)

You must keep adequate accounting records to determine your business's annual taxable income. If you report the wrong taxable income amount, you can't plead that the bookkeeper was incompetent or that your accounting records were inadequate or poorly organised - in fact, the good old Tax Man may decide that your poor accounting was intentional and is evidence of income tax evasion. If you under-report your taxable income by too much, you may have to pay interest and penalties in addition to the tax that you owe.

When we talk about adequate accounting records, we're not talking about the accounting
methods
that you select to determine annual taxable income - Chapter 13 discusses choosing among alternative accounting methods for certain expenses. After you've selected which accounting methods you'll use for these expenses, your bookkeeping procedures must follow these methods faithfully. Choose the accounting methods that minimise your current year's taxable income - but make sure that your bookkeeping is done accurately and on time and that your accounting records are complete. If your business's income tax return is audited, HM Revenue and Customs agents first look at your accounting records and bookkeeping system.

Furthermore, you must stand ready to present evidence for expense deductions. Be sure to hold on to receipts and other relevant documents. In an HM Revenue and Customs audit, the burden of proof is on
you
.
HM Revenue and Customs don't have to disprove a deduction; you have to prove that you were entitled to the deduction.
No evidence, no deduction
is the rule to keep in mind.

The following sections paint a rough sketch of the main topics of business income taxation. (We
don't
go into the many technical details of determining taxable income, however.)

Different tax rates on different levels of business taxable income

Personal taxes, which apply to sole traders and partnerships, come on a sliding scale up to a maximum of 40 per cent. When trading as a company a business's annual taxable income isn't taxed at a flat rate either. In writing the income tax law, the government gave the little guy a break. As of 2008, corporate income tax rates start at 20 per cent on the first £300,000 of taxable income, then quickly move up to a 32.5 per cent rate on taxable income in the range of £300,001 to £1,500,000, after which they drop back to 30 per cent. Simple it ain't! The income tax on the taxable income for the year is calculated using these tax rates.

In years past, corporate income tax rates were considerably higher, and the rates could go up in the future - although most experts don't predict any increase. The Chancellor of the Exchequer looks at the income tax law every year and makes some changes virtually every year. Many changes have to do with the accounting methods allowed to determine annual taxable income. For instance, the methods for computing annual
writing down expense
, which recognises the wear and tear on a business's long-lived operating assets, have been changed back and forth by chancellors over the years. You can check with HM Revenue and Customs for the latest rules at
www.hmrc.gov.uk
by simply clicking on ‘Corporation Tax'.

Businesses pay tax on income at one or two rates depending on their size. But, any capital gains (made, for example, when part of a business is sold or when owners cash in) used to be taxed at 10 per cent (if the asset concerned had been owned for two years or more) and then on a sliding scale up to 40 per cent for some assets and some time periods. However, some fiendishly complicated ‘taper reliefs' existed that made understanding the true tax position very difficult. So, from 2008, all capital gains are now taxed at a single rate of 18 per cent. The simplification does mean that some taxpayers (in particular, any entrepreneurs selling up) face a tax hike of 80 per cent (from 10 per cent up to 18 per cent).

Profit accounting and taxable income accounting

You're probably thinking that this section of the chapter is about how a business's bottom-line profit - its net income - drives its taxable income amount. Actually, we want to show you the exact opposite: how income tax law drives a business's profit accounting. That's right: Tax law plays a large role in how a business determines its profit figure, or more precisely the accounting methods used to record revenue and expenses.

Before you explore that paradox, you need to understand something about the accounting methods for recording profit. For measuring and recording many expenses (and some types of revenue), no single accounting method emerges as the one and only dominant method. Accountants have a certain amount of legitimate leeway in measuring and reporting the revenue and expenses that drive the profit figure. (See Chapter 13 for further discussion of alternative accounting methods.) Therefore, two different accountants, recording the same profit-making activities for the same period, would most likely come up with two different profit figures - the numbers would be off by at least a little, and perhaps by a lot.

And that inconsistency is fine - as long as the differences are due to legitimate reasons. We'd like to be able to report to you that in measuring profit, accountants always aim right at the bull's-eye, the dead centre of the profit target. One commandment in the accountants' bible is that annual profit should be as close to the truth as can be measured; accounting methods should be objective and fair. But in the real world, profit accounting doesn't quite live up to this ideal.

Be aware that a business may be tempted to deliberately
overstate
or
understate
its profit. When a business overstates its profit in its profit and loss account, some amount of its sales revenue has been recorded too soon and/or some amount of its expenses has not yet been recorded (but will be later). Overstating profit is a dangerous game to play because it deceives investors and other interested parties into thinking that the business is doing better than it really is. Audits of financial reports by chartered accountants (as discussed in Chapter 15) keep such financial reporting fraud to a minimum but don't necessarily catch every case.

More to the point of this chapter is the fact that most businesses are under some pressure to
understate
the profit reported in their annual income statements. Businesses generally record sales revenue correctly (with some notable exceptions), but they may record some expenses sooner than these costs should be deducted from sales revenue. Why? Businesses are preoccupied with minimising income tax, which means minimising
taxable income.
To minimise taxable income, a business chooses accounting methods that record expenses as soon as possible. Keeping two sets of books (accounting records) - one for tax returns and one for internal profit accounting reports to managers - is not very practical, so the business uses the accounting methods kept for tax purposes for other purposes as well. And that's why tax concerns can drive down a business's profit figure.

In short, the income tax law permits fairly conservative expense accounting methods - expense amounts can be
front-loaded,
or deducted sooner rather than later. The reason is to give a business the option to minimise its current taxable income (even though this course has a reverse effect in later years). Many businesses select these conservative expense methods - both for their income tax returns and for their financial statements reported to managers and to outside investors and lenders. Thus financial statements of many businesses tilt to the conservative, or understated, side.

Of course, a business should report an accurate figure as its net profit, with no deliberate fudging. If you can't trust that figure, who knows for sure exactly how the company is doing? Not the owners, the value of whose investment in the business depends mostly on profit performance, and not even the business's managers, whose business decisions depend on recorded profit performance. Every business needs a reliable profit compass to navigate its way through the competitive environment of the business world - that's just common sense and doesn't even begin to address ethical issues.