How to Audit Income Tax Expense?
Income tax expense is the expense that company owes to the government or tax authority during the accounting period. The company has to pay income tax expenses after the year-end. The amount will depend on the taxable profit and income tax rate which differs from one country to another.
Income tax expense is a high-risk account as it is related to the payment to the government and tax authority. If the company does not calculate it properly, it will impact the company’s future. The tax authority will require the company to pay the additional tax plus a penalty.
It will become an unrecorded liability for the company. Without the proper audit, it will be a huge risk for auditors as it impact the company’s going concerned. A serious penalty from the tax authority can even liquidate the company.
The tax rule is similar to account, but there are some differences due to revenue and expense recognition. The tax rule is different and more complicated than the accounting rule. The calculation of income tax expenses will be more complex depending on the nature of the business and company structure.
Besides human error, income tax expenses are also facing a risk of fraud. The company intends to reduce the expense to maximize profit. Some of them decide to commit fraud on income tax to increase profit due to performance bonuses. They will do anything to reduce the tax expense even those changing recordings.
Due to these risk factors, the auditor has to test the income tax expense very carefully. They need to apply both analytical procedures and tests of detail to obtain proper audit evidence.
Audit Assertion for Income Tax Expense
- Occurrence: The income tax expense is the balance that company has to pay to the government or tax authority during the year.
- Cut-off: The income tax expense is paid after the year-end, but it is recorded during the year as it represents the current year’s performance. company is paid only one time per year.
- Completeness: All income tax expense has to be included in the current income statement.
- Accuracy: The company has to calculate the income tax properly based on the taxable profit and tax rate. It represents the amount paid to the government.
- Classification: The income tax expense has to be properly classified in the income statement.
Substantive Audit Procedures for Income Tax Expense
The substantive analytical procedure is the testing that auditor use to test the accounting balance by using the overall data of the financial statement. Without checking all transaction detail, the auditor draws the conclusion base on the relationship between financial and non-financial data and others relationships.
It is also testing the relation between all accounts on the financial statement. In the double-entry, each transaction will impact two accounts or more. So if we can find the relationship between these accounts, we can know if it is reasonable when only one account increase significantly.
Income tax expense is the result of taxable income multiplied by the income tax rate. The taxable income arrives from revenue and expense which comply with tax rules.
The income tax rate is mostly consistent unless the government proposes a new tax rate. So most of the time, the income tax expense will be changed depending on the revenue and expense of the company.
In some situations, the revenue, expense, and profit change in a linear relationship. When revenue changes by a certain percentage, it leads to a change in the same percentage of the taxable profit. It will lead to a change in income tax expense in the same percentage.
However, it is not really happening in the real life. There are many factors that do not really have a linear relationship, the expense include both fixed and variable costs, so they will not change in the same percentage. It can only give us some benchmarks and expectations before applying the test of detail.
If we look at the nature of income tax expense, the substantive analytical procedure will not be able to help much in terms of testing. It is more effective to use the test of detail to validate the transaction. Auditor can recalculate the income tax expense to ensure its accuracy.
Test of Detail for Income Tax Expense
- Occurrence: The income tax expense is recorded only when the company is making a profit and expect to pay to the government.
Auditors have to ensure that the company is not under any tax exemption which prevents the company from paying the income tax expense. Some countries exempt the income tax expense to the company with a certain condition.
Moreover, the company makes payments only if they are making a profit. If they are not making any profit, they will not have the income tax expense as well.
- Cut-off: It is the assertion to ensure the company includes a transaction that happens within the year only.
The income tax expense is only one transaction that records at the end of the year. It depends on the taxable profit and tax rate. However, sometimes people record it in the next period when it is paid. It is not correct, income tax must be recorded in the current period as it depends on the current taxable profit.
- Completeness: All transactions related to income tax expenses must be included.
Auditors have to check if the company has paid monthly prepayment tax that could impact the expense balance. They are also required to take into account the deferred tax assets and deferred tax liability.
Moreover, auditors have to consider the nontaxable income and expenses which are different from accounting treatment. These transactions must add back or deduct from the accounting profit to arrive at the taxable profit.
- Accuracy: The income tax expense must be calculated properly.
Auditors must recalculate the income tax expense to ensure its accuracy. They have to check the taxable profit and tax rate as well. Taxables profit arrives from the revenue less the cost of goods sold, operating expenses, and other expenses which are tested under other sections. If there are audit adjustments in these accounts, for sure it will impact the client calculation which depends on the unaudited balance.
Moreover, the taxable profit must be reflected with the nondeductible expenses which need to add back to the accounting profit. It also reflects with nontaxable income will be deducted to get the taxable profit.
- Classification: The income tax must be classified, disclose, and presented fairly on the financial statement.
If the company has deferred tax assets or liability, it must account for and make proper discloser.