How much tax should be paid on business income?

Business income raises several problems for the Income Tax Assessment Act.

The first is that accountants, and not the Commissioner of Taxation, are the ones who think they know best how much income a business has made.

The matching principle is just a way of saying that you can not just count up the money on hand at the end of the year and say that is your income

HENRY FORD v the MATCHING PRINCIPLE

It is said that Henry Ford worked out his net income for the year by getting his staff to count the money in all their cash registers on one particular day.

Can you see a problem with such an approach?

Most businesses have to allow their clients time to pay for what they purchase.

So any accounting system that does not include credit sales (sales for which money has not yet been received) as income will understate income.

In just the same way, the business will use credit to purchase the things it needs to operate, so any accounting system which does not include the items purchased on credit as expenses will overstate the income.

Most business have to have more items on hand than they will sell in a year, to ensure that customers will always be able to rely on them.

Let's say Henry Ford made 100 cars in the year, but only sold 75 of them.

If he said his income was equal to the profit on the sale of the 75 cars, he would not really be telling the full story.

Those 25 cars he is still holding will sell and produce income in the following year, but their cost of production will be deducted from the expenses of the current year.

The accountant has to try to reflect the cost of the 25 cars, which were not sold in the income statement of the current year.

He does this by saying that the cost of the cars is really income of the business which has not yet been collected - it is a sort of 'credit sale' which should be included in the accounts.

So each year, the value of the cars on hand at the end of the year are added to the value of the cars actually sold to get income.

Can you see a problem with this arrangement?

Some of the cars sold during the year will have been produced in the previous year.

They would have been opening stock at the start of the year. So we will have to deduct their value from the income for the year.

Accountants like to summarise these calculations in 2 formulae:

What is income?

Is it just the proceeds of selling the cars?

What if Henry Ford sells the paddock at the back of his factory?

Is the amount he receives income?

A real problem in answering such questions is the fact that no one has really come up with a good definition of income.

There are some rather nice ways of describing the difference between income and capital., CAPITAL INCOME

But when it comes to defining income, the problems really start in earnest - the tax avoidance industry of the 1970's and 80's was built around proving income was capital and capital expenses were revenue expenses.

An economist made the most widely accepted definition of income. He suggested that income was the difference between the amount of capital at the start of the year and the amount of capital at the end of the year.

But you can see the problems with that definition?

If Henry Ford builds a new factory, can you say his income should include the cost of that factory? And what if he borrowed money to build it?

And what about the wear and tear on the factory over the years?

Should not that wear and tear be represented as a sort of expense against income?

(the answer is yes - it is called depreciation - more on that later)

Accountants do not really have a better definition of income to offer, but they are rather proud of the way that they can integrate the transactions involving capital with the transactions involving income in two related statements - the Income Statement and Balance Sheet.

If Henry Ford had been prepared to listen to the accountants, they would have told him his accounting system did not show the income that had accrued to his business but not yet turned up in the cash registers.

They probably would have added that he could have any kind of accounting system he wanted, as long as it used the accrual method and income statement and balance sheet designed by them.

Pretty well all businesses have an owner, or owners.

Obviously it must include the money they contributed to get the business started, and also the profits they have left in the business rather than taking out for their own uses. But the worth of the business includes more than just the money the owner has contributed.

If you think about it, it must be the value of everything the business owns, (machines, premises, trading stocks, etc).

Well, not quite. To acquire the assets, the business will often have to borrow money, or acquire the assets on credit.

We call the amounts of money which do not belong to the business but are used by it, the

These three components of the business are put together in a report known as the BALANCE SHEET.

You will probably be able to work out for yourself that NET ASSETS is the same as ASSETS less LIABILITIES. In other words, the proprietor can not be allowed to fool himself that he is rich in assets, if he owes a lot of money to other people. So we can sum this up in what is know as the Accountant's Equation..

In other words, the EQUITY (the worth of the business) is the amounts contributed by the owner PLUS the difference between the ASSETS and the LIABILITIES.

And that, really sums up the way the accountant understands a business.

(as well as the what a balance sheet is)

Businesses do more that just buy assets.

They spend more of their time selling goods or services to the public to gain revenue. The revenue appears in the INCOME STATEMENT.

If the business can sell whatever it produced for more revenue than the expenses incurred in producing it, it makes a profit - (revenue less expenses) and we say this profit becomes part of the owner's equity in the business. In other words, the difference between the cost of the goods sold and the revenue received from the sale (the profit) is an amount owed by the business to the proprietor.

When a business makes a sale it is actually incurring a 'sort of' liability to its owner. Think about that. We will come back to the idea of a business increasing its liability to it's owner when it makes a profit in a short while.

As we said, the difference between the revenue received and the expenses incurred equals the profit. We can add the profit to whatever the owner of the business can think of as the value of the business or the EQUITY.

This equity figure will also include amounts contributed by the owner to get the business up and running.

In general, the tax law seeks to embody the principles of accounting.

There are occasions in which the standards the accountants set themselves are policed somewhat more rigorously by the Income Tax Assessment Act. But on the whole, the Commissioner allows the accountants to produce the figures, then asks for modifications to be made to reconcile the accounting income to the assessable income, which must be returned.