Accounting

Want to learn more about payroll accounting? In this post, we will look at what is payroll accounting, how it works, types, and more.

Payroll accounting

Payroll accounting is the recording of the compensation of a company’s employees. This typically includes salary, bonuses, wages, commissions, and so on that have been earned by the employees over their tenure in the company. The calculation of payroll is highly influenced by the legal system of the home country.

What is payroll?

Payroll is compensation given by a business to its employees for a set period or on a given date. It also refers to the list of employees who get paid by the company. Payroll is usually maintained by the human resources department or the accounting department. It starts with preparing a list of employees who are supposed to be paid and ends with recording these expenses.

Payroll accounting is one of the most crucial yet complicated business processes. Every business tries their best to carry out this process to the best of its abilities because any mistakes might lead to severe consequences.

Also read: Mark to market accounting | A beginner’s guide

Payroll journal entry

A payroll journal entry is the record of compensation paid to the employees. These entries are later incorporated into an entity’s financial statements through the general ledger. The key types of payroll journal entries are:

• Initial recordation: The entry records the gross wages earned by employees, pay withholdings, and taxes.

• Accrued wages: This is intended to record the amount owed to the employees but not yet paid. This entry may be avoided if the amount is immaterial.

• Manual payments: A business may occasionally issue manual paychecks to its employees because of pay adjustments or employee terminations.

Payroll ledger

Payroll ledger gives a quick view of how the employees are getting paid by a company, how much money is getting deducted from their salaries as taxes and deductions, and how often are the employees getting paid. The financial records are used to make entries in the payroll ledger. A payroll ledger is a standard practice for recordkeeping used all over the world by businesses of different sizes.

A payroll ledger may include payroll accounting details such as:

• Payment frequency
• Tax withholdings
• Business-to-business expenses (e.g. insurance premiums, payroll service charges)
• Contribution towards benefits
• Deductions
• Employee pay totals

Also read: What is materiality accounting & 5 practical examples

Salaries payable

Salaries payable is a type of entry in payroll accounting journals that describes how much a company owes its employees. Salaries payable is recorded when a company owes salary pay to their employees but haven’t made the payments yet.

As employees accrue pay by working, salaries payable keeps getting increased depending on how much money has been earned by the employees. When paychecks are distributed, salaries payable gets decreased by that amount.

Salaries payable are typically recorded by the accounting professionals at the end of a business’s accounting period to provide an accurate reflection of a company’s finances.

Payroll organisation

Here are the 10 tips you should know in order to have a successful payroll organisation:

1. Determine whether your employees should be salaried or paid on an hourly basis.
2. Determine how often do you want to pay your employees – monthly, weekly, bimonthly
3. Classify your workers under full-time employees, interns, independent contractors
4. Pick the best software that suits your business needs
5. Simplify your payroll accounting process to save time and money
6. Keep track of everything
7. Automate state and federal taxes to avoid mistakes
8. Factor is raises and benefits, if any
9. Find out if you need employer ID numbers
10. Create a budget to avoid any last minute surprises

Also read: What is public accounting & what are the important services offered?

Payroll expense

Payroll expense can be described as the amount of wages and salaries given to employees by a business in exchange for their services. The term also assumes to include the cost of all related payroll taxes such as Medicare, Social security, etc. Additionally it includes the amount businesses pay in taxes to federal, state, and local agencies.

However, the tax withholdings from employee paychecks are not part of payroll expenses since they have already been included in the gross wages. Payroll expense is generally the largest expense incurred by a company, so it is important to manage payroll expenditures effectively and efficiently.

Accrued payroll

Accrued payroll is a sum of wages, salaries, bonuses, and other payroll related expenses that have been earned by a company’s employees. This amount has not been paid yet or recorded in the company’s general ledger accounts. It represents a liability for the employer. The concept of accrued payroll is only used on an accrual basis of payroll accounting.

The accrued payroll is an expense that is yet to be paid out to the employees in the future. It is one of the ways in which a business can track its upcoming expenses in advance without any unexpected surprises.

Also read: 10 Best accounting calculators and how to use of them

How does payroll work?

Let us look at some of the general steps that each business follows in order to manage payroll efficiently,

• Step 1: Ensure the paperwork of all the employees is complete and up to date.
• Step 2: Set up a payroll schedule based on how often you wish to pay your employees.
• Step 3: Calculate gross pay of your employees. Take into consideration if the employees are salaried, hourly workers, or have done overtime.
• Step 4: Make necessary deductions including health care plan, social security, taxes, etc.
• Step 5: Pay your employees
• Step 6: Keep record of the payments made.

Payroll types

There are three basic types of payroll accounting:

• Initial Recordings

Under initial recordings, the record of the gross wages earned by the employee is maintained. It also includes the withholdings from the employee salary. The initial recordings also include and account for employment taxes.

• Accrued Wages

The accrued wages are the wages that a business owes to the employees in lieu of their services but is yet to make the payments.

• Manual Payments

The manual payments are the payments made when employees terminate their services to the business. Accounting officials use this line item to clear out the dues of the employees who have resigned.

Also read: What is fund accounting? Key principles, & responsibilities

Payroll bookkeeper

Payroll bookkeepers are the ones collecting and managing the data. Bookkeeping involves recording, storing, and retrieving financial transactions on a consistent basis. For the most part, bookkeeping is straightforward and transactional. While the role of a payroll bookkeeper may seem slightly different, they play equally important roles when it comes to handling business transactions.

Accountants need bookkeepers to meticulously keep all the data ready for interpretation and analysis. Both accountants and bookkeepers work in tandem to help businesses make smart financial decisions. Payroll bookkeepers are the ones who provide a snapshot of all business finances of a company.

Payroll tax accountant

A payroll tax accountant is responsible for processing salary payments to employees. Their major responsibilities include calculating salaries, updating payroll accounting systems with employee related information, preparing internal and external tax reports, conducting internal tax audits, etc. A payroll accountant usually possesses a degree in accounting along with in-depth knowledge of applicable laws.

Their day-to-day role may include addressing payroll enquiries from employees, issuing timely paychecks, maintaining payroll files, updating payroll systems, and many more. A payroll accountant is someone who is detail-oriented and well proficient in processing salaries in a timely manner on a regular basis.

Also read: Expanded accounting equation | Key principles

Payroll calculations

The payroll calculations involve the determination of gross pay, followed by tax deductions to arrive at net pay. The calculation of payroll is a highly regimented process. The payroll calculation must be done meticulously to ensure there are no mistakes in the amount of net pay calculation.

1. How to do payroll accounting?

There are seven step to follow to do payroll accounting with ease:

• Set up payroll accounts in your chart of accounts. It includes a mixture of expenses and liabilities.
• Calculate taxes and other deductions to find out how much should be withheld from the employee wages.
• Gather payroll reports to get a breakdown of payroll transactions.
• Record payroll expenses in your books.
• Record payables are the record of entry for the amount that you owe but haven’t paid to the employees yet
• Double-check your records for accuracy
• Transition accounting periods so that paid liabilities are no longer payables.

Also Read: Stock Consultant | An ultimate read for best results

2. How to record payroll taxes in QuickBooks?

Recording a payroll tax in QuickBooks for a prior tax period:

• From the left Menu, select Taxes
• Select Payroll tax
• Select Enter Prior Tax History
• Select Add Payment
• Enter the required payment information
• Select OK

Recording a payroll tax that is currently due:

• From the left Menu, select Taxes
• Select Payroll tax
• Select Pay Taxes
• On the Pay Taxes page, select Record payment for the tax you want to pay.
• For the Payment Date, select Other and enter the actual date the payment was made.
• Enter the cheque number.
• Select Approve and print

Also read: Economic profit – How to calculate economic profit

3. How to record payroll journal entries?

A journal entry is best described as the record of credits and debits. If you are using automatic payroll software, then there is no need to make entries as it automatically creates entries when an invoice is generated. However, in the case of a manual accounting software, the entries have to be made often.

While recording payroll, Gross Wage Expense will be debited and liability accounts and cash accounts will be credited. Gross wages will appear on the profit and loss or income statement whereas the liability and cash account will appear in the balance sheet.

Payroll journal entry example

Payroll transactions are recorded in a general ledger and can be either used in a manual accounting system or in accounting software. Let’s take an example to understand this in detail.

XYZ Corp has one employee Jane Smith who is paid on a weekly basis. The below payroll journal entry example shows her gross wages, payment withholdings, and XYZ company’s cost.

Date	Account Names	Debit	Credit
11/10	Wage expense	720.00
	FICA taxes Payable		55.08
	Federal Income Tax Payable		58.00
	State Income Tax Payable		21.00
	Health Insurance Payable		50.00
	Wages Payable		535.92

Also read: Fair value accounting – Basics on fair value accounting

Payroll journal entry template

Journal entry #1

The first entry must show your employee’s gross wages, payroll taxes withheld, deductions, and net pay.

Date	Account Names	Debit	Credit
	Wage expense	XXX
	FICA taxes Payable
	Federal Income Tax Payable
	State Income Tax Payable
	Health Insurance Payable
	Wages Payable

Journal entry #2

Make a second entry when you give a paycheck to your employee.

Date	Account Names	Debit	Credit
	Payroll payable
	Cash

Journal entry #3

Third entry is made when you need to pay employer taxes and remit withheld taxes.

Date	Account Names	Debit	Credit
	Wage expense	XXX
	FICA taxes Payable
	Federal Income Tax Payable
	State Income Tax Payable
	Health Insurance Payable
	Wages Payable

Also read: Tax accounting – Basics on tax accounting & 5 key principles

Payroll chart

A payroll chart or a chart of accounts provides a complete listing of each type of account. It provides a logical structure used to easily record all sorts of information and to add or remove accounts. It is like a map of all your financial transactions that help you guide through your past and future spends. A payroll chart makes it easier to understand what transactions are being recorded in each of your accounts.

A properly created payroll chart is also helpful in following proper accounting standards which aid in making better business decisions in the future.

Also read: Total cost formula – How to calculate total cost?

Payroll for dummies

Payroll can be complicated for beginners, and there’s little room for error. To make payroll accounting easy to understand one should look at the following payroll systems. The below payroll system ranked higher in terms of ease-of-use and user reviews. These are the three most easy to use payroll for dummies.

• Rippling is a cloud-based platform designed to help users take care of their company’s payroll, benefits, and onboarding.
• Zenefits is a core HR suite that helps streamline onboarding, benefits, payroll, etc.
• Netchex is a cloud-based platform used by companies of all sizes to manage the entire employee lifecycle.

Want to learn more about economic profit? In this post, we will deep dive into what is economic profit, how to calculate it, economic profit example & more.

Economic profit 

Economic profit is referred to as the difference between the revenue received by a commercial entity from its outputs and the opportunity costs of its inputs. Opportunity cost can be explained as the opportunity foregone, i.e., an opportunity that is given up in the pursuit of another one.

What is economic profit?

Economic profit is a theoretical measurement of opportunity costs in conjunction with actual revenue cost. In simpler words, it is the excess revenue a company generated from one course of action over another had they picked the other option.

Economists and business owners use these implicit costs to analyse the decisions made in the past and figure out if they could have taken a better course of action. The economic profit formula is the way for economists and business owners to check if they made the right choice between the chosen project and the one they had to let go of.

Also read: Fair value accounting | A complete guide [with examples]

Economic profit formula

The formula for economic profit can be calculated by deducting the sum of implicit and explicit costs from the total revenue earned by the business.

Mathematical representation of economic profit formula,

Economic Profit = Total revenue – (explicit cost + implicit cost)

When economic profit is positive, it means a company is making above average profits and attracts new companies to enter the market. The company can recoup lost opportunity costs.

However, if the economic profit is zero, the company has no reason to exit or enter the market.

Also read: Mark to market accounting | A beginner’s guide

What is accounting profit?

Accounting profit is the net income for a company and is calculated by deducting all explicit costs and expenses from the revenues. Common revenue sources can include the sale of goods and services, receipt of dividend or interest, rental income, etc. While common expense type generally includes the cost of goods sold, travel, rent, entertainment, interest, taxes, and more.

Accounting profit is generally found at the button of a company’s income statement. Typically accounting profit or net income is used to measure the financial performance of a company. It is reported on a quarterly and annual basis.

Accounting profit vs economic profit

Accounting profit is the net income after deducting total expenses from the total revenue. Whereas, economic profit is the surplus after deducting the opportunity cost and implicit cost as well. Accounting profit gives a true picture of the financial health of a company, while economic profit may not give an accurate picture as certain parameters are estimated.

Accounting profit is generally used for short term phenomena. Economic profit is taken into consideration for long term decisions/ purposes. Accounting profit is known to be a more practical approach when compared to economic profit as it is based on actual happenings.

Also read: Accounting rate of return | Everything you need to know

Economic profit formula calculations

Now that we have established an understanding of economic profit and accounting profit, let us take a look at the different economic profit formulas. These formulas are helpful in calculating different business costs and optimizing profits based on the results. Here are 5 formulas that you should know,

1. How to calculate explicit cost?

Explicit costs are out-of-pocket costs, the payments that are actually made by the firm towards wage, rent, materials, etc. To understand how explicit cost is calculated, let’s take an example.

Mark currently works for a company as a digital marketer. He is considering opening his own company where he expects to earn $300,000 per year. To run his own company he would need office space ($50,000 per annum) and an employee ($35,000 per annum). Keeping these figures in consideration, let’s see if Mark’s company will be profitable.

Explicit cost = Office rental + law clerk’s salary

Explicit cost = $50,000 + $35,000

Explicit cost = $85,000

Also read: Tax Accounting | A complete guide

2. How to calculate total revenue?

A simple way of calculating your company’s total revenue is by determining the number of units sold by your company and the average price per unit sold. Now to calculate total revenue, multiply the number of total units sold by the average price per good. Any interest or dividend should also be added to determine total revenue.

Here’s a formula for calculating total revenue:

Total revenue = (average price per unit sold) * (total number of units sold)

In the case of a service-based company, the total number of units sold will be replaced by the total number of services sold.

Also read: What is materiality accounting & 5 practical examples

3. How to calculate accounting profit?

Accounting profit is the total money left after deducting the explicit costs from the total revenue. Here is an example to calculate accounting profit:

A firm earns $300,000 per year. They spend $50,000 per annum for rent and $50,000 per annum on their employee’s salary. Let us see firm profitability:

Step 1: Calculate explicit cost by adding wages and rent amount

Explicit cost = Rent + Wages

= $50,000 + $50,000

= $100,000

Step 2: Calculate accounting profit by deducting explicit cost from the total revenue generated

Accounting profit = Revenues – Explicit cost

= $300,000 – $100,000

= $200,000

4. How to calculate implicit cost?

The problem with calculating implicit costs of a company is that such costs are generally hard to quantify. Here is an example to learn implicit cost calculation better,

Fred invested $50,000 on a business prospect intending to earn a profitable income of $10,000. Now to earn this profit he had to forego the interest that could have been otherwise earned on this sum. Let us assume that the interest rate he had to forego was 10%, which would be $5,000 in a year. This $5,000 represents the implicit cost of investing the sum elsewhere.

Also read: What is public accounting? | Everything you need to know

5. How to calculate economic profit?

Here is an example to calculate the implicit cost:

A firm earns $500,000 per year. They spend $50,000 per annum for rent and $150,000 per annum on their employee’s salary. Let us see firm profitability:

Step 1: Calculate explicit cost 

Explicit cost = Rent + Wages

= $50,000 + $150,000

= $200,000

Step 2: Calculate accounting profit

Accounting profit = Revenues – Explicit cost

= $500,000 – $200,000

= $300,000

Step 3: Let’s consider implicit cost as $100,000. Calculate economic profit

Economic profit = Total revenues – explicit cost – implicit cost

= $500,000 – $200,000 – $100,000

= $200,000

Implicit cost vs explicit cost

Explicit cost is the cost that is actually incurred by the organization during production. On the other hand, implicit costs are just opposite to explicit costs. These are the costs that are not directly incurred by the organization but are implied in nature and do not involve a cash payment.

Explicit cost is an out of pocket cost while implicit cost is an opportunity cost.It is helpful in calculating accounting profit and economic profit whereas implicit cost is useful for only economic profit calculations. Explicit costs may include salaries, rent, wages, etc. Implicit cost includes salary to the owner, rent of owner’s building, etc.

Also read: 10 Best accounting calculators

Accounting profit and economic profit example

Accounting Profit: Let’s say a business earns total revenue of $200,000. They make an annual expenditure of $100,000 towards explicit costs such as rent, wages, materials, etc. To calculate accounting profit, the explicit cost is deducted from the total revenue. This means the business has an accounting profit of $100,000.

Economic Profit: Let’s assume, a business or firm has an accounting profit of $50,000. This profit is obtained after making the payments towards materials, labour, rent, wages, etc. However, this profit ignores the implicit cost (foregone income on own financial capital, building, etc). It is achieved by subtracting implicit cost from accounting profit.

What is economic loss?

Economic loss is a term used to describe situations wherein a firm or an individual suffers money loss. The term covers financial losses that are usually covered as part of financial statements or balance sheets. Economic loss can be caused by natural calamity, or by the negligence of another party.

There are two major categories in which economic losses are divided: pure economic loss and consequential economic loss. Pure economic loss is essentially direct loss of money whereas inconsequential loss, loss is caused by another event such as property damage or unsatisfactory goods performance.

Explaining zero economic profit

A business in a normal profit state will have economic profit as zero, which is why normal profit is also known as zero economic profit. A firm making normal profits will continue staying in the industry. A firm will only have a reason to exist if it is making losses in the long run. In the long run, all firms which are part of a competitive firm will earn zero economic profits.

A firm making zero economic profit can still be earning positive accounting profits. The presence of economic profits attracts entry, economic losses will lead to an exit, and in long-term equilibrium, firms in a perfectly competitive environment will earn zero economic profit.

Also read: What is fund accounting – key principles & responsibilities

What is negative economic profit?

Negative economic profit is generated when the cost of equity capital exceeds the accounting profit. This means that it is possible for a firm to have both negative economic profit and positive accounting profit simultaneously. A firm can earn a positive accounting profit but negative profit if there is a possibility of earning greater returns in some other line of business. A firm tries to maximize its profits in a competitive market, making it possible for it to have positive, negative, and zero economic profits. However, in the long-run economic profits will always be zero.

Normal vs economic profit

Economic profit is the remaining surplus left after deducting total costs from total revenue. Normal profit is the least amount of profit required for the survival of the business. While the former shows how well the company is allocating its resources the latter helps in knowing the future prospects of the company.

When profit equals zero as a result of the difference between total revenue and total cost, the normal profit arises. If the amount turns out to be positive, economic profit arises. On the flip side, if the amount turns out to be negative, the economic loss comes into the picture.

If you are keen to learn about the niche of tax accounting, this blog is for you! Here we take a look at what is tax accounting, types and methods.

Tax accounting

Every individual engaged in any sector of society are liable to pay taxes to the respective government. There are certain statutory regulations that need to be followed while filing tax returns and generating tax statements. Tax accounting states down those policies and methods. In this article, we will focus on the roles of tax accountants, important facts on tax accounting, and taxes.

What is tax accounting?

Let us now try to understand what is tax accounting in appropriate legal terms. Tax services accounting or tax accounting specifies the accounting methods that are related to taxes. It states the rules and regulations to be followed by the companies or individual entrepreneurs while preparing their tax returns. The basic purpose of accounting for tax is to track the inflow and outflow of funds associated with individuals and entities. 

It is of two types mainly – Tax accounting for individuals and tax accounting for business. Besides, there are categories segregated into international tax accountants, income tax accountants, and so on.

Also read: Fair value accounting – Basics on fair value accounting & 3 examples

How is tax accounting different from financial accounting?

What is the difference between tax accounting and financial accounting?

Tax accounting is commonly known to be following the cash-based accounting method. Whereas financial accounting is based on accrual-based accounting. 

Tax accounting focuses majorly on actual cash receipts, and payments, and not on the related sale or purchase transactions. A sale or purchase transaction is not recorded until cash is received or paid. Small businesses normally use tax accounting services to easily manage their cash positions.

Companies following the financial accounting, record sales revenues and purchase expenses when they are earned and incurred. The record does not depend on whether the actual cash from sales has been collected or the actual cash for purchases has been paid.

Components of tax accounting

Let us now try to understand what are the different components of tax accounting under bookkeeping and taxes:

1. Deferred tax asset – It is the extra amount you pay as a tax on the incremental profit.  
2. Deferred tax liability – In certain situations, a company or an individual entrepreneur pays fewer taxes in the current year due to timing differences. This leads to deferred tax liability.
3. VAT Accounting – VAT is added to any invoice as part of the taxation policies. 
4. Transfer Pricing – It is paid by a company on the expenses incurred in the operating offshore office while having branches in other parts of the world
5. Income categorization – Income needs to be categorized into various heads like salary, rent, etc. Tax and accounting vary for each of the heads and must be recorded separately.

Also read: Mark to market accounting | A beginner’s guide

Tax accountant types

In this section, we will discuss the different tax accountant types. The focus will be on the individual entrepreneurs and the businesses of companies. There are some differences in the tax accounting elements which you need to remember. The three key types of accountant for taxes are elaborated below:

1. Personal tax accountants

Personal tax accountants are normally attached to a particular individual entrepreneurship firm. They help in calculating the income tax accounting and file the returns on their behalf. A personal tax accountant or income tax accountant is well-versed with the accounting rules, methods, taxation policies, statutory obligations, declarations, and reporting that need to be adhered to. They even help in tax planning and advanced tax services. Their accounting tax services also include managing the taxes related to inheritance tax, income tax, and capital gains and trusts. 

2. Business tax accountants

Business tax accountants are mostly involved in tax planning and filing tax returns for large or medium-sized companies and firms. The tax accounting elements will be more and complex as compared to small businesses or individual entrepreneurs.

There will be inflow and outflow of funds and the company’s earnings from various sources. The outgoing funds can be directed towards the shareholders or some different business obligations. A business tax accountant needs to understand the complexities, the statutory and tax obligations of the region, and the audit compliances.

3. Tax Manager for Tax-Exempt Organisations

Tax-exempt organizations are the ones that are exempt from paying Federal Corporate Income Tax on the earnings from the various kinds of activities. The activities are related to the specific purposes that drive the granting of tax-exempt status.

For example, withholding tax, income that isn’t taxable, minimum wage and overtime rules, etc. may be exempt from tax. A tax manager is a person or one of the types of accountants, who guides the company in understanding the elements which can be exempted from tax. This helps in calculating the tax liabilities seamlessly.

Also read: Accounting rate of return | Everything you need to know

Federal tax accounting

Federal taxes are mainly of three types – individual income, payroll, and corporate income. The other taxes that need to be paid are excise taxes, estate tax, and other taxes and fees. It is recorded as a tax liability in the book of records.

Federal tax accounting determines when an item can be reported on a tax return file. It can be an income, credit note, or deduction. It’s a weapon to advise tax accountants and preparers on when to include an item in the tax return. The tax principles for Federal tax accounting determine which tax events must be considered.

International tax accounting

International Tax accounting deals with international accounting standards and laws prevalent across two or more countries by virtue of the tax agreements. The most common type of tax agreement is the double tax agreement or DTA. It occurs when a taxpayer is subjected to taxation on the same income in two countries, thus doubling the tax amount.

There are other international agreements or treaties dealing with special types of income or specific types of tax. International accounting for individuals and businesses is to determine the incomes that are subjected to international taxation.

Also read: What is materiality accounting & 5 practical examples

Tax accounting methods

There are primarily two types of tax accounting methods – accrual and cash basis. This is one of the most interesting tax concepts. One additional method in tax accounting is hybrid. In the accrual method, the income is recorded in the tax year when it is earned.

The most common accounting taxation method is cash basis. In this method, the income is reported in the tax year in which it is received. Hybrid is one of the tax accounting methods where some incomes are accounted for and reported through the accrual method and some through the cash method.

Also read: What is public accounting & what are the important services offered?

Difference between tax and audit

In this section, we will try to understand the difference between tax and audit. Taxes are essentially paid towards government funding and expenses towards carrying out public works. Government levies tax on any taxable income earned by businesses and individuals. Accountant taxation or tax accounting defines to a greater extent the fiscal policy of the government. 

An audit is the evaluation and verification of the book of records, the accounts, and the different payment vouchers of a business or an individual entrepreneur. Besides, checking and validating the financial statements for correct representation is also part of audit activities.

Online tax accounting courses

There are several tax accounting courses for you to select, enroll and pursue:

• Tax preparation and law 2021, 2020, 2019, and 2018 Income tax from Udemy
• US International Tax Certificate Program from AICPA, ideal for a tax return accountant
• Taxes and Decision Making by edx.org, instructor-based online course 
• Reporting use of firm resources and taxation by edx.org  
• Taxation certificate program from UCLA with 4 courses on Tax Planning for Individuals and entities, a good course on accounting for income tax
• Certified income tax advisor program, certified tax consultant program, and certified income tax professional program from ICA for the role as a corporate tax accountant or corporate tax advisor

Also read: 10 Best accounting calculators and how to use of them

Tax accounting classes & universities

Some of the tax accounting classes & universities are mentioned below: 

• US Federal Taxation Specialization from the University of Illinois. There are 5 courses in this specialization. At the end of the course, you need to complete a hands-on project. After submission of the project, you will earn a certificate.
• Introduction to Finance and Accounting Specialization by the University of Pennsylvania. There are 4 courses in this specialization course. This course also includes a hands-on project followed by certification
• Master of Science in Taxation from Suffolk University for 46 credit hours
• Master of Tax Accounting from the University of Alabama with 30 hours of coursework

IRS tax accountant

IRS (Internal Revenue Agents or tax agent) tax accountants are entrusted with the responsibility of reviewing tax returns, forms, and claims made by businesses and individual entrepreneurs. 

Their duties include:

• Reviewing and examining annual and quarterly consumer tax returns
• Determine and assess the tax liability and overpayment of a business
• Conduct an audit and evaluate the financial statements and the book of records 
• Analyze and prepare revenue reports for the Treasury Department of the United States
• Determining whether the right amount of tax has been paid by a business or an individual tax-paying entity
• Reviewing tax-exempt organizations to ensure that they comply and adhere to the tax-exempt regulations

Also read: What is fund accounting – key principles, & responsibilities

What is a tax manager?

Let us now try to understand what is a tax manager. A tax manager is essentially a certified tax accountant, assisting in easy tax and accounting services. The person is an expert, specializing in taxes related to federal, state, and local tax laws. One must possess knowledge of the Microsoft suite of products especially spreadsheets. In qualification, they may be CPA for taxes. Experience and expertise in the industrial domain coupled with knowledge of accounting tax service are important.

In this post we take a deep dive into fair value accounting. You will learn everyting from what is fair value, metohods to calculate it & formulas.

Fair value accounting

An accurate valuation is paramount during any accounting exercise. Fair value accounting helps to measure assets and liabilities at their current market value. Fair value meaning is the amount at which an asset or liability is sold at a price, that is fair for both the buyer and seller. In this blog, you will learn what does FMV of account means? What is fair value in accounting? And the difference between market value vs. fair value.

Also read: Mark to market accounting | A beginner’s guide

What is fair value?

Let us begin by explaining what is fair value? Fair value definition is as follows, is the agreed price of an asset by the buyer and seller. We assume there is no coercion and both parties are knowledgeable. Fair value is the estimated value of assets and liabilities as written in the company books.

Fair value is the potential price of an asset or liability. You may need to research to find the selling price or listed price of similar products. You can use the information to calculate the price of your asset. You can determine the price of securities in the share market.

What is fair value accounting?

Fair value accounting helps to measure the assets and liabilities stated on the company’s financial statement. Financial Accounting Standard Board implemented the fair value accounting principle to standardize the calculation of different financial instruments. The following concepts are part of fair value accounting.

• Current market conditions – You base it on the market conditions on the measurement date, rather than historical transactions.
• Intention of holder – The intention of the holder might change the measured fair value. E.g. if the owner wants to sell the asset immediately, they may get a lower value. 
• Orderly transaction – Fair value accounting should be from an orderly transaction. There is no unnecessary pressure like business liquidation.
• Third-party – We calculate fair value when the sale is to a third party, rather than an insider or someone related to the seller.

Also read: Accounting rate of return | Everything you need to know

Fair value formula

The fair value formula is as follows –

Fair Value = Cash × {1+r(x/360)} − Dividends

Where,

Cash = Current S&P Cash Value

r = Current interest rate paid to a broker to buy all stocks in the S&P 500 index

x = Days to the expiration of the futures contract

Dividends = Amount of dividends until contract expiration expressed in terms of points on the S&P contract.

Also read: What is materiality accounting & 5 practical examples

Fair value vs historical cost

Historical cost is the actual price at which the transaction was done. Fair value is actual value of the asset as on the day. The difference between fair value vs historical cost is as follows. 

Historical costs	Fair Value
Historical costs is the cost at which transaction was done	Fair value is the present market price the commodity will fetch
It is not used to for all assets does not reflect true picture	It is more commonly adopted and tested method
It remains stagnant through the lifetime of the asset	The value fluctuates when compared with other valuation methods
It is permitted under US GAAP and not under IFRS	It is globally accepted and applied making it a more user-friendly method when compare historical cost vs fair value
Used for intangible and fixed assets. Not used for assets like marketable assets.	It refers to the actual worth of the asset and is derived fundamentally and is not determined by the factors of any market forces.
It is not tested for impairment loss	It is tested for impairment annually.

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Fair value vs market value

Fair value is the value at which asset changed hands between two parties. Market value is the value of the company calculated from the current stock market price. The difference between fair value vs market value can be summarized in the table below.

Fair Value	Market Value
Fair value is the actual worth of the asset derived by using methods like discounted cash flow methods. It cannot be determined by market forces.	Market value is determined by market value or by factors like demand and supply.
It is commonly used in stock market for valuation. Fair value will help in accurate valuation of the asset.	It is not commonly used valuation method. Companies use it when they want to use loopholes to hide limitation or shortcomings.
Fair value of an asset remains consistent. It fluctuates less frequently when market value vs fair value methods are compared.	Market value is determined by demand and supply and fluctuates more.
Fair value is globally accepted.	Market value method is not used frequently. It is not a globally accepted method.

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Book value vs fair value

In accounting you need to understand the difference between book value vs fair value. Both are used to describe the valuation of an asset, but have different approaches. The distinction between fair market value vs book value is as follows.

Book Value	Fair value
Book Value is the value of an asset is recognized on the balance sheet.	Fair Value is reasonable and unbiased estimate of the intrinsic value the asset.
It is cost paid for acquiring the asset minus depreciation, amortization, or impairment costs applicable to the asset.	Fair value uses factors like utility, related costs, and supply and demand consideration.
It is based on historical value of the asset.	It is based on the value at the measurable date.

Also read: What is fund accounting, key principles, & responsibilities

Futures vs fair value

Fair and future value has impacts the business but deal with different concepts. Fair value helps to determine the value of assets and liabilities. Future value shows how the value of money changes over time. The difference between future vs fair value can be summarized as-

Future value	Fair value
Future value let us know the value of “today’s dollar” will be in the future.	Fair value defines the price that would be paid for market transaction between buyer and seller.
Future value is used for making business capital decisions. It helps to decide the projects to invest in for growth.	Fair value is used to determine the price of securities.

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Fair value hierarchy levels

Fair value hierarchy categorizes the inputs used in valuation in three levels. The accounting titles hierarchy rules, give the highest priority to level 1 – the quoted price in the active markets for identical assets and liabilities. While we give the lowest priority to level 3 to unobservable inputs. IFRS looks ways to improve the consistency and comparability in fair value measurement and related disclosures through fair value hierarchy levels. here are the fair value hierarchy levels.

• Level 1 inputs – are the quoted price in the active markets for identical assets and liabilities that the entity can access at the measurement date. A quoted market price in the active market provides reliable evidence of fair value and is used without adjustment to measure fair value, with limited exceptions.
• Level 2 inputs – These inputs other than quoted market price include level 1 observable for assets or liability, either directly or indirectly.
• Level 3 inputs – Level 3 inputs are unobservable inputs for other assets or liability. Unobservable inputs are not available.

How to calculate the fair market value of assets?

You may wonder, how to calculate fair market value of assets? We base the fair market value of assets on the assumption that the seller and buyer are knowledgeable and have entered into the transaction willingly. There are three ways for fair value calculations-

• Based on market price – you can determine the value of the asset based on the market price. The prices that are quoted on the stock market are liquid and transparent.
• Use the comparable value of similar assets –To determine the value of the asset, you can use the price of comparable assets. E.g. to determine the price of your house, the price of houses recently sold in your neighborhood will give you a good indication of the valuation of the house.
• Discounted cash flow method – Use discounted cash flow method if you have unique assets that have nothing comparable or similar. You estimate the value of the asset by future cash flow.

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Method to determine the fair market value of derivatives

A derivative is a financial instrument that gets its value from another asset. Fair value tries to put an objective price on a financial instrument instead of current market prices. There are different methods used to determine the fair market value of derivatives.

• Future pricing basics – future contracts are standardized financial contracts that allow the holder to buy or sell an underlying asset or commodity at a certain price in the future. The future contract value is based on the commodity’s cash prize.
• Options pricing basics – Options are common derivative contracts. Options give buyers the right, no obligation to buy or sell the derivatives at a pre-determined price called strike price before the contract expires.

How to calculate the fair value of a futures contract?

In this section, we elaborate on how to calculate fair value.

Fair value = cash price + cost of carry

The fair value of commodities

The cost of carrying is the supplier’s associated cost with fulfilling that contract and need to be taken into account to calculate the fair value of commodities.

• Storage cost
• Insurance cost
• Loss of interest on funds that could have been reinvested if the asset was sold immediately.

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Fair value for financial products

There are no storage costs associated with financial storage.

Fair value = cash price + Interest cost – Dividend payment

The interest costs are based on the Libor interest rate at the time to run until expiry.

Fair value = Cash + [cashx days until Expiry/ (Libor/360)] – Dividend payment

Fair value accounting examples

Fair value accounting example 1

Mr. X is planning to buy a Road Roller. The income from the Road Roller year wise is mentioned below –

• Year 1: $80,000
• Year 2: $50,000
• Year 3: $200,000

The Interest rate running in the market is 5%. The life of the Roller is five years. Calculate the fair value of the asset.

The fair Value of the asset should be its capacity to earn throughout the life after adjustment for the interest rate

Years	Cash Flow	Interest Rate
Year 1	$80,000	5%
Year 2	$50,000	5%
Year 3	$200,000	5%
Total earnings from road roller	$330,000

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Step 2: Calculate the present Value of future cash flow 

Years	Cash Flow	Interest Rate	Discounted Rate	Present cash flow = Cash flow/discounted rate
Year 1	$80,000	5%	1.05%	$76,190
Year 2	$50,000	5%	1.102%	$45,351
Year 3	$200,000	5%	1.158%	$172,768
Total Present value(Fair Value)				$294,309

Total Present Value (Fair Value) = $294,309

Fair value accounting example 2

Mr. Y has bought derived contracts at $100,000 in November 2019. The contract is for three months. The accounting year starts in January. At the end of December, the contract value is $90,000. How will Mr. Y show this change if he is following Fair value accounting?

Solution

According to fair value accounting, Mr. Y will need to reduce the value on the contract by $10,000 to show the loss

November 2019

In Balance sheet – Contract $100,000

January 2020

In Balance Sheet – Contract $90,000

In Profit and Loss Statement = Unrealized Loss $10,000

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Fair value measurement disclosure examples

A firm holds an equity instrument for which sale is restricted for a specific period. The restriction is characteristic of the instrument and will be transferred to market participants. In this, the fair value of the instrument measures on the price of the quoted price of unrestricted equity document of the same issuer in the public market, for the instrument in the specified period. The adjustment will depend on:-

• The nature and duration of the restriction
• The extent to which buyers are limited by the restriction
• Qualitative and quantitative factors specific to instrument and issuer.
• Fair value accounting advantages and disadvantages

Fair value accounting advantages and disadvantages are as follows:-

Advantages

• Accurate valuation – Accounting fair value provides an accurate valuation of assets and liabilities, as per the company’s financial records. The price indicates the price that would be received if it sold an asset or would have to pay to square up a liability.
• True income – Fair value accounting limits the tendency of companies to manipulate their net income. It helps to accurately report the losses and gains from the price change of assets or liability for the period in question.

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Disadvantages

• Value reversal – Fair value accounting can be challenging, especially when the value of assets and liabilities fluctuates and becomes volatile. Even if you reevaluate the valuation in volatile market conditions, there are chances of creating large swings.
• Market information –The fair value method may further affect down market value. Companies when assets are revalued downwards because of current prices it can trigger the selling of assets at more depressed prices.

Do you want to learn about the mark to market accounting method? In this post, we deep dive into the basics of mark to market accounting.

Mark to market accounting

Mark to market accounting is an accounting method that involves measuring the fair value of an asset or a liability that can fluctuate over time. The fair value can be assessed on the basis of current market conditions. In this article, we’ll learn more about mark to market accounting.

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What is mark to market accounting? 

Mark to market accounting means can be defined as recording the value of the balance sheet assets and liabilities at current market value. The reason behind mark to market accounting is to provide the real picture and the value is more relevant as compared to its past value. The aim is to provide a fair appraisal of the company’s financials.

The mark to market principle was largely adopted in the 20th century. Mark-to-market is a tool that can affect values on either side of the balance sheet depending on the market conditions. For example, the stocks held in an individual’s demat account are marked to market every day.

Why is mark to market accounting needed? 

The need for a method like mark to market accounting is to prevent market manipulations from happening. It ensures maximum transparency by fairly estimating the real value of an asset, a company’s financial situation, or an account at any given point of time.

Mark to market accounting was an alternative to the popular historical cost accounting methodology, where an asset’s cost was evaluated based on its original price. This method failed to provide the actual value of the asset in the current times as the information used was outdated and irrelevant to the current market scenario.

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How is marked-to-market calculated?

Mark to market profit and loss calculations help you understand how much profit or loss you incurred during a given period, regardless of whether the positions were open or closed. Marked to market calculations assume that all open positions and transactions are settled at the end of the day and new positions are opened the next day.

For the purpose of simplification, Marked to market calculations are split into:

1. Calculations for transactions during the statement period, referred to as tranaction MTM on the statement
2. Calculations for positions open at the beginning of any day, referred to as prior period MTM on the statement

• Marked to market Profit/Loss= Position MTM + Transaction MTM – Commissions
• Position Marked to market = (Current Closing Price – Prior Closing Price) x Prior Quantity x Multiplier
• Transaction Marked to market = (Current Closing Price – Trade Price) x Current Quantity x Multiplier

Advantages of mark to market accounting 

Mark to market accounting methodology has several advantages as compared to the previous historical cost accounting method,

• Reflects the actual value of an asset

The calculated asset value is genuine and informative as it is calculated based on the current market scenario. It doesn’t rely on historical or outdated data in any form.

• Reduces risk level

Mark to market accounting can alert a company whether its current state is good enough to justify investments or predict future performance.

• Beneficial for both the parties

Mark to market accounting brings benefits on both macro and micro level.

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Disadvantages of mark-to-market accounting

Like any other metric or methodology in the financial world, mark to market has its own flaws. While it successfully overcomes a lot of issues, it also falls short on some.

• Might produce inaccurate results during volatile periods

The higher the market fluctuation, the more distorted and unstable portfolio or asset value estimations are produced.

• Fails to contextualize information

This is not a major disadvantage but mark to market accounting cannot tell how the price at the closing bell was formed.

• Momentum dependency

Momentum dependency can harm valuations during economic distress such as low liquidity, economic downturns, etc.

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Mark to market example

Let us look at some of the mark to market accounting examples to understand it better,

1. Let’s assume there are two parties who are agreeing to enter a contract over 30 bales of cotton at $150 per bale with a 6-month maturity period. It takes the value of security to $4500 ($150 * 30). At the end of the next trading day, the prices per bale increases to $155. The trader in a long position will collect $150 from a trader in a short position [$155 – $150]. If the situation is reversed, the trader in the short position will collect from the trader in the long position.
2. Another example is of a farmer who is anticipating the increase in price of apples. The farmer considers taking a long position in 20 apple contracts on a particular day. Assuming each contract represents 10 bushels, the farmer is heading against a price of 200 bushels of apples. Let’s say the price of one contract is $5 on that day, the account of the farmer will be credited with $10,000. Now the farmer will either make profit or loss depending on the change in price everyday.
3. Available for sale is the most common example of mark to market accounting. Such an asset can either be in the form of debt or equity purchased to sell the securities before it reaches its maturity. In cases of securities which do not have maturity, these securities will be sold before a long period for which these securities are generally held.

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Mark to market accounting Enron collapse

During the 1990s, Enron exploited a loophole in the mark to market accounting method to skyrocket its natural gas business profits. The Enron mark to market method misled investors and allowed Enron to continue operating its business on a non-existent budget. Enron accounting method enabled deception that let Enron book more revenue than they were actually earning. It also helped them keep losses and debt out of their balance sheets.

All this structure became so twisted that no one pieced together the dependencies between Enron’s deals. The mark to market accounting method distortions by Enron hid the true nature of the problems brewing underneath. And once the stock prices fell, Enron began to crumble.

In order to minimize losses, banks asked for return of collateral but Enron didn’t have it. Ultimately Enron had to file for bankruptcy and the Enron mark to market accounting strategy had failed.

Mark to market losses

Mark to market losses are the losses generated due to an accounting entry error rather than the actual sale of a security. Mark to market losses can occur when the assets are valued at the current market value. Several assets are revalued at the new market price after they experience a price decline from their original cost leading to mark to market loss.

A mark to market accounting loss is similar to a paper loss, the holder doesn’t experience any capital loss in both the cases, as the assets have not been actually sold.

A real example of mark to market losses was during the financial crisis of 2008 and 2009. The equity and real estate market went into a free fall. All the banks had to revalue their books to reflect the current prices of their assets at that time, resulting in a significant mark to market loss.

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What is fair value adjustment journal entry?

An accounting adjustment is required in case of any increase or decrease in the fair value of held-for-trading security. An accountant achieves this by debiting an increase or crediting a decrease in the fair-value change to an account called ‘securities fair value adjustment’, which is a sub-account of the asset account for trading securities. Journal entries are made to record the increase in the fair value of a financial asset, or the decrease in the fair value of a financial liability. Another entry is made to recognize the tax implications caused due to the fair value gain or loss.

What is the mark to market futures?

In securities trading, the price or value of security, account, or portfolio is recorded as part of the mark to marketing accounting to reflect the current market value instead of the book value. This record is generally maintained in a futures account to ensure that margin requirements are being met satisfactorily. Daily marketing to market reduces counterparty risk for the investors in Futures contracts.

Mark to market futures indirectly reduce credit risk by ensuring that at the end of any trading day, after the daily settlements are made, there will not be any outstanding obligations.

Also read: What is materiality accounting & 5 practical examples

Differentiate futures vs fair value 

Futures indicate where the market will be heading towards over the next few sessions, whereas fair value is the futures rate before the market opening adjusts for purchasing shares at the opening. Fair value is the cost of buying shares based on the value of the stock market futures that expire at the next expiry date.

Investors expect the market to rise, when futures are higher than the fair value, whereas if the futures value is lower compared to fair value, the market is likely to fall on opening. Futures rate changes as soon as trading commences.