Accounting Vs Tax Profits – What’s the difference?
Here at Change we are often asked why the profits that I am taxed on are different from what is says in my accounts?
This difference in accounting and taxable income is mainly due to certain items of “Disallowable” expenditure which HMRC says cannot be used to reduce the amount of tax payable, and so are “added back” (when calculating the tax) and “capital allowances” which reduce the amount of tax payable. Capital allowances are subject to changing rates and bands, but generally speaking, most small businesses can receive an allowance for the full cost of capital assets bought in the tax year.
For example, if you buy a computer for £900 in the accounting year this is a capital addition. It is written off over 3 years in the accounts, using depreciation of £300 each year. However, confusingly, from a tax point of view the full £900 is allowable in the year of purchase. Therefore we “add back” the £300 depreciation and allow the £900 Capital Allowance. You’re probably wishing you never asked. (This is a basic example, it doesn’t take into account the different limits, rates, allowances that may or may not apply to your business).
Generally, anything bought for the purposes of day to day trading can be used to reduce your profits in the accounts, including items such as client gifts, entertaining and depreciation, but only items that are “wholly and exclusively for the purposes of trade” are allowable for tax purposes. This means that those gifts, entertaining of your clients, depreciation and other items such as fines, and even crime related payments get added back for tax.
“So what is the point of putting items that are disallowable through the business?” Good question. Accounting profits essentially detail every expense the business has incurred during the year, and thus gives a full overview of the performance of the business - how it spends its money and where – whereas taxable profits only serve the purpose of calculating your tax payable. Also, if you are a director/shareholder of a limited company, it can have a beneficial impact on your directors’ loan account.
If the above isn’t a good reason to pay a professional to prepare your accounts and tax, I don’t know what is. At Change we look at this area as a matter of course and ensure that we are not only preparing the accounts correctly, but ensuring that the tax position is optimised.
This article was written by Will, who is part of our accounts team