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Deferred Tax: An important change - Views on News from Equitymaster
 
 
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  • May 11, 2002

    Deferred Tax: An important change

    Keeping pace with the international practices, deferred tax accounting was made mandatory to all listed companies. A flip through the latest corporate results would make one realize a strong impact of this new accounting policy. Tax rate more or less remaining constant, the bottom lines of several corporates came under strain.

    Tax being one of the most important variables affecting the profitability of a company, let us understand the implications of this new deferred taxation policy and how does one interpret the same for analytical purposes.

    To put it in simple terms, hitherto tax provision in the financial statements was equivalent to amount due to the taxman inline with tax regulations. Effective tax rates thus, varied heavily across companies. This was on account of the fact that there are various exemptions/ benefits available under the tax laws. Thus at times there is a wide gap between 'accounting income' and 'taxable income'. The tax provision in the financial statements was hitherto on 'taxable income'.

    However, the deferred tax standard advocates the use of matching principle. In other words, taxes on income should be accrued in the same period as the revenue and expenses to which they relate. Thus, tax provisions should show taxes payable notwithstanding exemptions/ reliefs/ benefits under tax laws.

    Thus, companies enjoying these exemptions were hitherto providing a lower tax provision. Most important and frequent one was on account of differential treatment of depreciation expenses. Tax laws in India and even in several developed countries allow accelerated depreciation as an incentive for corporates going in for expansions. Thus, companies with high capex end up paying lower taxes on their income. A closer look of the latest corporate results would justify this point. The impact of the new accounting policy was most felt on companies enjoying a considerable depreciation shield against taxes.

    Let us take a simple example to understand this concept better. Let's say a firm acquires an asset for Rs 9,000 with a three-year useful life and no salvage value. Assume that the asset will generate Rs 5,000 annual revenue for next three years. The firm is allowed to depreciate the asset over two years for tax purposes. The tax rate is 40% each year.

    As per tax laws Year 1 Year 2 Year 3 Total
    Revenues 5,000 5,000 5,000 15,000
    Depreciation 4,500 4,500 - 9,000
    Taxable income 500 500 5,000 6,000
    Tax @ 40% 200 200 2,000 2,400
    Net income 300 300 3,000 3,600
    As per P&L Year 1 Year 2 Year 3 Total
    Revenues 5,000 5,000 5,000 15,000
    Depreciation 3,000 3,000 3,000 9,000
    Accounting income 2,000 2,000 2,000 6,000
    Tax @ 40% 800 800 800 2,400
    Net income 1,200 1,200 1,200 3,600
    Deferred tax liability (600) (600) 1,200  

    Notice the stark difference in 'Net Income' as per accounting and tax laws. A deferred tax liability is created in Year 1 due to difference in depreciation methods used for accounting and taxation purposes. The accelerated depreciation method allowed for tax purposes results in lower taxes in the early years that are then reversed (or paid off) in later years. But as per profit and loss account, tax outgo would have been higher in early years. The deferred tax provision thus, tries to capture this liability, which becomes due.

    In practice however, this may not be always true. The above example dealt with a 'timing' difference, i.e. one, which reverses over time. There are other differences termed as 'permanent differences' that don't reverse in subsequent periods. An ideal example over here would be benefits to software companies where revenues are export concentrated.

    The export income is exempt (to a certain extent) from income tax. Unlike depreciation benefit, obviously export benefit is not going to reverse over time and thus is a permanent difference. In such cases deferred tax assets or liabilities will not be carried forward in the balance sheet.

    Impact of deferred tax

    Having understood, the basics of deferred taxation, let us understand the implications and how does one analyze the same.

    Practically, for some companies with significant Capex lined up over a number of years, deferred tax liability never becomes due. This is due to the fact that these companies continue to enjoy depreciation benefits on new incremental assets and actual outgo may remain insignificant. In these cases, one can safely add up the deferred liability as reserves, as this amount is unlikely to reverse for a foreseeable period of time.

    We have tried to analyze the impact of deferred taxation on companies across various sectors, which have recently declared results. As indicated earlier, companies in commodities and energy sector seem to be most affected due to higher capex. IT companies are least affected, as most of the differences are permanent differences as explained earlier.

    Typically, FMCG companies are distribution giants with manufacturing done through third parties. Thus, differences in accounting and taxable income are minimal for this set of companies. As is evident from the table below, FMCG companies are a set apart with negligible impact on profitability from deferred tax accounting.

    Comparative table
    Companies Net profits Profits excl.
    deferred tax
    Effect on
    profits
    P/E*
    Hindalco 6,860 7,480 -8.3% 8.0
    ACC 1,664 1,869 -11.0% 16.7
    Grasim 3,868 4,383 -11.7% 7.8
    Indogulf 2,964 3,026 -2.0% 4.1
    GAIL 11,709 13,189 -11.2% 5.6
    Ashok Leyland 923 1,015 -9.1% 13.3
    Ranbaxy 2,401 2,551 -5.9% 41.9
    Infosys 8,080 8,002 1.0% 31.4
    Satyam 4,901 4,922 -0.4% 16.5
    Nestle 1,927 1,848 4.3% 26.9
    Cadbury 597 577 3.6% 28.9
    Reciktt 253 261 -3.2% 31.8
    SBCH 1,301 1,267 2.7% 13.3
    *P/E calculated on earnings excluding deferred tax

    Conclusion

    Deferred tax liability lowers profitability impacting return ratios. Obviously, price earnings multiple increase with lower EPS. However, cash flows remain unchanged. Investors can thus, refer to cash flows when there seems to be significant divergence between tax liability and actual tax outgo. Another most significant figure, which investors should look at is the cumulative deferred tax liability in the balance sheet.

     

     

    Equitymaster requests your view! Post a comment on "Deferred Tax: An important change". Click here!

    1 Responses to "Deferred Tax: An important change"

    SJain

    Feb 9, 2012

    Thanks for this article which clearly explains Deferred Tax Liability.

    Like (1)
      
    Equitymaster requests your view! Post a comment on "Deferred Tax: An important change". Click here!
     

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