US companies are required to pay taxes on their profits to the Internal Revenue Service (IRS) each year and follow Generally Accepted Accounting Principles (GAAP).
Reporting profits and income in financial statements and tax returns is not always the same. This is due to each body having its own rules governing how to calculate income. Furthermore, businesses may use different accounting methods for tax returns and income statements.
In this article, we explore pretax income, how it is calculated, its difference from taxable income, and why it is essential to know how to calculate it.
What is Pretax Income?
Pretax income is the portion of revenue that is subject to taxation. Also known as Earnings Before Taxes (EBT), it gives businesses a better understanding of their profits. The formula for pre-tax income is: Total Revenue-Operating Expenses. Operating Expenses include items such as salaries, sales and marketing fees, utilities and depreciation.
How Do I Calculate Pretax Income From Net Income?
Calculating Pretax Income is a straightforward calculation. You subtract the money you used to run a business from the revenue you collected, then add any income you earned from non-operational factors. The deductions include aspects such as depreciation and legal fees.
Before we get to the formula, here are a few terms you need to understand before calculating pretax income.
- Revenue- This is the total sum businesses collect from providing goods or services. It is usually an addition to all the money they receive, including interest earned.
- Operational Cost/expenses- This is the amount a business uses to run its operations. It includes payroll, shipping, manufacturing, marketing, and utilities. Operating income, on the other hand refers to the financial measure that represents the profitability of a company's core operations. It is calculated by subtracting operating expenses from gross income.
- Depreciation- This is the deduction of the cost of an asset over a period. It is usually calculated differently depending on where the company is based.
- Interest Expenses- This is the amount paid by a business to a lender for extending them a loan or credit.
- Non-operational income- This is the amount you receive from things not associated with your core business. They include interest income earned from savings and wins from lawsuits.
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PRETAX INCOME FORMULA
To calculate a pretax business income, use the following formula:
Pretax income = Total Revenue - (operating expenses + Depreciation + cost of goods sold + Income expenses) + non-operational income
Sample Pretax Income Calculations
We'll take a look at the following calculations to understand how to calculate pretax income.
Example One
In 2021, Fast Foods Limited, which sells burgers, fries, pizzas, and soft drinks, made $400,000 after selling food worth $70,000. However, the business paid wages of $65,000, used 15,000 in a lawsuit they lost, used 10,000 to deliver, and paid rent of $30,000. Additionally, their machines depreciated by $3,500 and used $8,000 in repair and maintenance charges. What was the pretax income of Fast Food Limited in the year 2021?
Pretax income formula= Total Revenue - (cost of goods sold + operating expenses + Depreciation + Income expenses) + non-operational income
Therefore: Pretax Income = $400, 000 - ( $70,000 + $65,000 + $15,000 + $10,000 + $30,000 +$8,000 + $3, 500) + 0
Pretax Income= $98,500
In this example, the company's operational expenses include rent, legal fees, wages, repairs, and delivery costs. Furthermore, they didn't receive any non-operational earnings.
Example Two
Clean Laundry Services made $120,000 from the services they provided in 2021. The cost of delivering and picking up laundry was $10,000, cleaning products cost $5,000, wages added up to $35,000, rent was $20,000, and electricity and water were $6,000. Additionally, the depreciation was $2,000, repairs cost $1,300, and they received $2,500 as interest from their savings. What was the pretax income for Clean Laundry Services in 2021?
Using the formula Pretax income = Revenue - (Cost of goods sold + operational expenses + depreciation + interest expenses) + non-operational income
Pretax Income = $120,000 - (0 + $10,000 + $5,000 + $35,000 + $20,000 + $6,000 + $1,300 + $2,000) + $2,500
Pretax income = $53,000
In the instance of Clean Laundry Limited, they provide services, meaning they have no cost for goods sold. However, the operational expenses include delivery and pickup costs, water and electricity, rent, repairs, wages, and cleaning products. They also receive a non-operational income as interest from savings.
DIFFERENCE BETWEEN PRETAX INCOME AND TAXABLE INCOME
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Pretax income is the amount reflected on income statements as earnings before taxes. The amount is calculated using Generally Accepted Accounting Principles (GAAP) guidelines. On the other hand, taxable income is the actual amount on which a company must pay corporate taxes. The internal revenue service tax codes determine the sum.
During calculation, you may use an accounting method for tax purposes and choose another for financial statements. You'll choose a method that favors your financial position and reduces tax obligations.
PERMANENT DIFFERENCES
Your company is exempt from paying taxes on some types of income. This means that you will not consider those earnings in your tax returns, but will include them in your financial statement. This is permanent and will not change unless regulations change.
Another example of a permanent difference is interest received from state and local bonds. While companies reflect them in their accounting as income, it is not included in taxable income.
Timing/Temporary Differences
Temporary or timing differences occur when some financial aspects affect the pretax income and taxable income at different times. However, the amount of income or financial statements and tax returns are similar in the long run.
An example of a temporary difference is the formula you choose to calculate depreciation. You could decide to use straight-line depreciation or accelerated (ACRS) depreciation.
Companies usually use the former for their accounting purposes to write off an asset evenly over a period. If the acquisition price was $5,000 and the machine has five useful years, it will attract $1,000 yearly in depreciation. However, if you use accelerated depreciation, the depreciation may be $2,000 for the first year and $1,500 for the second year.
As a result, the income statement and tax return might reflect different depreciation rates at different times, causing a difference in net income figures. At the end of five years, the asset would have depreciated fully, and the financial statement and tax returns will reflect the same depreciation.
Importance Of Knowing How To Calculate Your PreTax Income
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It provides a fair way to compare companies.
Investors will want to know how a company performed financially before investing. However, a big hurdle is that tax expenses vary due to tax rates and regulations changing each year and varying between industries and countries. Additionally, companies can carry over losses or apply for tax cuts and credits, making income after tax an unfair way to compare companies.
Fortunately, pretax income makes the job easier by eliminating the differences brought about by tax obligations. Investors can then compare the financial state of a company and how it fairs in the industry, country, region, or worldwide.
HELPS IN TRACKING THE PROGRESS OF A COMPANY
As a company owner, shareholder, or management you want to measure how the company performed in a year compared to previous years. Pretax earnings give you a consistent and reliable way of comparing a company's fiscal health and performance over time. It eliminates the tax obligation differences brought about by a change in tax considerations.
SERVES AS A PROFITABILITY RATIO
Investors and analysts also use pretax earnings to calculate the earnings margin that shows a company's profitability. It is calculated by finding the ratio of a business's tax earnings to its total sales. The higher the rate, the more profitable the company.
For example, we can compare the pretax earnings margin for Fast Food limited with Clean Laundry Service from examples one and two.
For Fast Food Limited:
- Pretax earnings- $98,500
- Total sales/revenue- $400,000
Pretax earnings margin = (98500/400,000) x 100
Pretax earnings margin = 24.63%
For Clean Laundry Services:
- Pretax earnings- $53,000
- Total sales/revenue- $120,000
Pretax earnings margin = (53000/120000) x 100
Pretax earnings margin = 44.17%
Clean Laundry Services has a higher pretax earnings margin meaning it is the more profitable organization.
Take Advantage Of Calculating Your Income Tax
Comparing companies from different jurisdictions can be a hurdle if you use their net income or revenue. This is because your net income is affected by the differences in tax rules from state to state. Additionally, your revenue includes your cost of operations and the cost of production.
Fortunately, you can use pretax income as a fair basis for comparing companies. It is the money you make after deductions but before you pay taxes. The formula is simple if you understand terms such as interest income, interest expense, cost of production, and operation expenses, among others.
Get your calculators out today and calculate your income for the best view of your financial health. If you are looking for more information on accounting ethics follow the link to our other blog that addresses this very topic.
However, you can only develop a strong tax planning strategy when you start early, not when the year ends. Keep in mind creating a tax plan early will help you save more on your annual income taxes.
Monthly tax planning services are a fantastic tool to do this. At Hall Accounting, we have had tremendous success with our monthly clients.