For accounting purposes businesses are required, at the end of the year, to calculate what expenses have or will be incurred in respect of the year, but for which some of the documentation has not yet been received, and to provide for these.
So, for example, if stock has been received, but the invoice has not yet been received, you will still bring the stock and the creditor into the financial statements for the year.
Similarly, if work has been performed for your business, by your attorneys or your accountants for example, but the invoices have not yet been received, you will reflect the estimated expense on your income statement, and reflect a provision in your list of creditors.
Another such provision might be for bonuses. Again, if you intend to pay bonuses to your staff as a consequence of the results for the year, you would generally reflect the expense in the income statement of the year to which it relates, the other side of the entry being a provision in your creditors list.
Similarly a 13th cheque. If your business's year end is February, you will provide for two months of the bonus to be paid the following December.
However, notwithstanding this accounting treatment, the tax treatment may be very different.
In order to be deductible for tax purposes, an expense must be actually and unconditionally incurred. Consequently, if we take the above items, the following may result:
* You have clearly incurred an obligation for the stock you have received, and the tax treatment would therefore be the same as for the accounting treatment;
* Your accountants' fees would probably relate to the audit, which your business may have a statutory obligation to incur if it is operated in a company. Thus, the provided expense may be deductible for tax purposes;
* Your attorneys' fees may be in respect of work already performed and, if so, and assuming they are of the nature that would normally be deductible for tax purposes, they would be deductible. If, however, the provision relates to anticipated attorneys fees in the future, or you have provided for a contingent expense, based on the outcome of litigation, then the expense provided for in your accounts would not be deductible for tax purposes;
* The bonuses perhaps demonstrate the principle of actually and unconditionally incurred expenditure the most clearly. This is because of an Appellate Division case which set out the rules very succinctly.
The case involved a company that paid a bonus to its employees based on the results of the company for the year. The company's year end was June. However, the bonus only became payable to the relevant employees if they were still in the employ of the company in the following October, when the bonuses were to be paid out.
The court held that the condition that the employees were still in the employ of the company at a point in time after the year end meant that there was no unconditional obligation to pay the bonuses at year end, and they were, therefore, not deductible for tax purposes.
The condition may not, however, be that clear. If, for example, the bonus you pay is discretionary, and you have not exercised your discretion by the year end, then the bonus expense provided will not be deductible. By exercising your discretion prior to the year end, and documenting that you have (so that you can prove that you have exercised it prior to year end), you may deduct the bonus in the year in which the discretion was exercised.
Alternatively, if the bonus is unconditionally payable based on the achievement of certain results, then it will be deductible if those results have been achieved regardless of whether the final figures had been quantified on the last day of the year or not.
In relation to a 13th cheque, the two months provided will only be deductible if the employee has an unconditional right (usually set out in the employment contract), to the portion of the 13th cheque that relates to the period up to the date of leaving your employ.
These principles apply for all the provisions. It is important to be aware of them so that you can ensure that you can maximise your deductions (as with the bonus policy) and are aware of what you may not be able to deduct for tax purposes this year.