Adjustments to trading profit- I don’t undertsand why bother?

Its perhaps easier to see why these adjustments are made if you consider the position that would exist if these adjustments were not made. If these adjustments were not made with regard to,for example, depreciation it would be in an entity’s interest to exaggerate the level of depreciation charged to the assets it owns in order to decrease the profits or income attributable to the entity and therefore the level of taxation the entity has to pay. This is why depreciation is added back and instead capital allowances are given. Similarly, it is thought undesirable to allow individuals to effectively obtain tax relief on the payment of fines incurred by owners or directors of a business so these have to be added back to profit where they have been deducted so that this does not occur.Similar reasoning applies to most of the other adjustments that have to be made to adjusting trading profit.

Continuing from Wannabeacct’s proforma, you can see that you have Trading income. In a typical question, you will have to GO AWAY from this basic proforma to RE-CALCULATE trading income for TAX PURPOSES.

WHY ADJUST?
The profit (Net) as shown on company accounts (Accounting Profit) is profit which includes some items like Depreciation which have been subtracted by the company as an expense. Therefore these “disallowed” expenses reduce the company’s profits — and remember HMRC is looking to tax something from those profits! The smaller they are, the less HMRC gets. So they have to be made “just”. Depreciation for example is subjective. The entity could make it huge so that profits to be taxed would be small, hence their tax liability. So a NOT SUBJECTIVE provision is made in another form which is in this case Capital allowances (see this as Depreciation, even as it has reducing balance etc kind of stuff). But the directors can go around this, and it is same for everybody. OK, other expenses, mostly which are not incurred exclusively for business purposes are usually subtracted from the entity’s income to arrive at this net profit. So for Tax purposes, these need to be added back so as to get taxed.

You have also noticed that some figures are rather being SUBTRACTED in the adjustment. WHY? They are income which the company considers in its accounts, but which are not to be taxed (exempt for tax purposes) or which are taxed elsewhere. So HMRC tries to be fair by removing this income (not taxing it). But you must know the rules …. which is exempt income for tax purposes? eg. ISA interest received. The entity has this in its accounts as income. If left that way, they would be taxed … but they are NOT to be taxed!! So we subtract them from the profit to be fair. Next e.g … Which income is taxed elsewhere? e.g Income from sale of plant and machinery. This income must be removed and taxed under CGT where completely another rate and other rules apply. Finally at this stage, we get the ADJUSTED trading profit (for tax purposes). Notice the difference with ACCOUNTING profit (entity’s). NEXT … we will calculate the CAPITAL ALLOWANCES (“depreciation”) and subtract it from this adjusted profit to get the final figure. Well, sometimes you’d be asked to ignore capital allowances if the focus of the question is on adjusting the profit and so too long to deal with capital allowances. Sometimes the capital allowances will be very short – for a few items only, and so you need to be prepared for either case. You can get the general point.

THE BIG PICTURE:
Now, go back and remember Wannabeacct’s proforma … remember we’d GONE AWAY from it to do all this adding back and subtracting. That figure you see there (well, what should be there) for TRADING PROFIT/INCOME is NOT what the entity holds in its accounts. It is what we have come up with after adjusting their profit and taking off capital allowances.

The basic income tax computation itself is very very simple. But you will never just be given Employment income = x, Trading income=y, property income=z etc as you see on that proforma. You will often need to GO AWAY to work out one or more of those incomes (e.g Trading income) for TAX PURPOSES, and then COME BACK and fit the figure in.

Please let me know if this has helped, and especially if you have understood the reason why profits need to be adjusted..

Thanks alot guys…much clearer now