Property taxes are annual charges we pay to our local government based on the value of our property. However, their timing does not always align neatly with the accounting periods.
That’s where the term ‘accrued’ comes in. In this article, we will explain how to record these growing taxes in a simple, easy-to-follow journal entry example.
Understanding the Purpose of Accrued Property Taxes
Let’s make sense of accrued property taxes with a common example in the business world. Imagine you own a small restaurant. Your local government charges property tax on your restaurant, but the tax bill isn’t due until after the financial year ends.
In keeping with good accounting practices, it’s important to match your expenses (like property tax) with the income you earned when you actually earned it. In order to maintain accurate financial records, you should ‘accrue’ for these taxes, which means you recognize the property tax expense as it builds up throughout the year, not just when you pay it in the year after.
Another way to explain it is that – it’s like placing a sticky note on your cash register saying, “Remember, part of this month’s earnings is set aside for property taxes.” This method helps you avoid surprises and keeps your financial figures transparent and aligned with your actual business operations.
It’s important to note that accruing for property tax will unlikely reduce your taxable income if the tax bill remains unpaid. This is because most businesses pay taxes based on the cash they actually spend rather than on the expenses they expect to pay.
So, what’s the point of doing accruals for property taxes? Well, it’s more of a requirement of GAAP to follow the matching principle (matching expenses with revenue) and to record the liability correctly. Especially if the company needs to share its financial results with other parties (such as the banks when applying for a loan) or the general public (publicly traded companies). In other words, if you don’t accrue for it, your financial statements are inaccurate, as you are not compliant with GAAP.
Journal Entry Example for Accrued Property Taxes
Let’s apply what we’ve discussed to a real-world scenario with the Pho My Life (PML) Noodle Shop. Imagine it’s Year 1, and the shop’s property tax for the year is estimated at $1,200, payable in Year 2. In three steps, we’ll explain how to record the journal entries to accrue for the property tax.
Step 1: Calculating the Monthly Accrual Amount
First, we need to determine how much property tax to accrue each month. Since the total annual property tax is $1,200, we divide this by 12 (for the 12 months of the year).
$1,200 ÷ 12 = $100 per month
This means that each month, PML Noodle Shop needs to account for $100 in property tax expense in its books, even though the payment isn’t made until the next year.
Step 2: The Monthly Accrual Journal Entry
Each month, PML Noodle Shop will make the following journal entry:
This journal entry debits the Property Taxes Expense account for $100, showing that the shop is incurring this $100 expense monthly. Simultaneously, it credits the Accrued Property Taxes, a Liability account, showing that the shop owes this amount in the future.
Step 3: Journal Entry When the Property Tax is Paid
In Year 2, Month 1, when the property tax bill of $1,200 is paid, PML Noodle Shop will make the following journal entry:
This journal entry debits the Accrued Property Taxes Liability account for $1,200, as the liability is now settled. The credit to Cash account reflects the actual payment of the tax bill.
By following this approach, PML Noodle Shop ensures that its Year 1 financial records accurately reflect the expenses and liabilities associated with its property tax. Without this accrual, the restaurant’s expense and liability in Year 1 would have been understated, and its expense in Year 2 would have been overstated.
- Matching Principle: Property taxes don’t always match your accounting period. Accruing spreads the cost evenly throughout the year, ensuring proper recording of expenses and liability.
- There are likely no tax benefits if your taxable income is calculated on a cash basis.
- However, it is a requirement of GAAP for proper financial reporting, especially when a company’s financial results are shared with outside parties.
- Journal Entries: The first step is to calculate the monthly proration of the estimated property taxes. Then, each month, the expense account is debited/increased for that monthly proration, and the liability is credited/increased for the same amount. When the tax bill is paid, the liability account is debited/settled, and the Cash account is credited.
- Final thoughts: Without the accrual entries, the expense and liability would be understated when the property tax is not paid, and the expense would be overstated when the property tax is paid. This causes a mismatch in the periods where the expense should have been recorded, thus making the financial statements for both periods inaccurate.