What is tax-adjusted profit?
If you are a trader or professional person, your accounting profit for tax purposes is computed using the ordinary principles of commercial accounting. These principles are recorded in Statements of Standard Accounting Practice (SSAPs). These statements provide, among other things, that it is standard accounting practice:
(a) Not to anticipate income, but to recognise income when you are reasonably certain that such income will materialise. For example, it is not good accounting practice to treat an “inquiry” as a sale. The sale should only be recorded when a definite order has been received from the customer.
(b) To recognise expenditure once it has been incurred, and to write it off against the income in the profit and loss account.
(c) To value stock at the lower of cost and net realisable value.
(d) To write off the cost of a business asset over the expected useful life of the asset. This is referred to as depreciation. If you change your depreciation policy (for example, by starting to write down assets over five years instead of three years), you will need to adjust the opening values of the assets in your balance sheet. Such an adjustment is referred to as a prior-year adjustment.
(e) To prepare accounts on the accruals basis (also known as the earnings basis), rather than the cash basis. Therefore, the profit and loss account will record sales that have taken place in your accounting period, even though all of the sales may not have been paid for. This is reflected in a figure for trade debtors shown in the balance sheet at the end of the period. Similar adjustments are made in relation to purchases, non-trade amounts due (prepayments) and non-trade amounts owed (accruals). The aim is to match the income with the expenditure incurred in earning that income.
(f) To prepare accounts using the historic cost method of accounting. Accounts can be prepared using current cost accounting and this became fashionable when inflation was high in the 1970s. Accounts prepared under the current cost convention are not recognised for tax purposes.
(g) In relation to finance leases, to recognise the economic reality of the transaction in your balance sheet. For example, a leased van is included as an asset in the balance sheet, even though it may technically belong to a leasing company, and the lease payments are effectively treated as loan repayments. The tax treatment is different. The lease payments are treated as rentals and are tax-deductible.
For tax purposes, trading and professional profits are generally based on the profits arising in an accounts year which ends in the tax year, with special rules for commencement and cessation years and short-lived businesses.
The profit figure shown in the profit and loss account is then adjusted, by adding back (disallowing) expenses which are not deductible for tax purposes, and by giving deductions which would otherwise not be given:
(a) Normal wage and salary costs.
(b) Cost of stock, customer guarantees and warranties.
(c) Legal costs in preserving assets and structure of the business.
(d) Trade membership subscriptions, registration fees.
(e) Interest (but not on tax paid late).
(f) Bad debts written off in the accounts, i.e., specific provision for actual bad debts as opposed to general provision for possible bad debts.
To be added back:
(a) Depreciation. Capital allowances are given instead, for plant, machinery, factory-type premises, and commercial premises in tax renewal incentive areas – These generally cease from 31 July 2014.
(b) Capital expenditure, i.e., any expenditure having an enduring benefit to the trade. Maintenance of assets is not generally treated as capital expenditure. Repairs or improvements to premises are allowed; renewal or reconstruction of the entire premises is not.
(c) Drawings (dividends in the case of a company). This is an application of profits already earned, not a cost in earning the profits.
(d) Expenditure with a private or non-business element, i.e., which is not incurred “wholly and exclusively” for the benefit of the trade. If the business part of such “dual expenditure” can be segregated, it may be allowed.
(e) Entertainment expenditure.
(f) Legal costs in acquiring a capital asset.
(g) Motor expenses are also restricted.
Less other deductions if not already given:
(a) Expenditure on trademarks, know how.
(b) Pre-trading expenditure.
(c) Pre-commencement staff training costs.
(d) Cost of establishing an approved employee savings-related share option scheme, or an employee profit sharing scheme.
(e) Employee pension costs.
(f) Gifts to Revenue-approved charities and other bodies.
(g) Additional allowance for cost of previously unemployed person.
(h) Additional rent allowance for premises if located in a renewal incentive area.
(i) Redundancy. Termination payments might otherwise be disallowed as capital, because they will have an enduring benefit.
The resulting figure is the tax-adjusted profit. From this figure is deducted the amount due for capital allowances.