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Deferred tax accounting: Debit companies, credit investors

Aarati Krishnan

IT DEALT a body-blow to the profits of quite a few corporates in 2001-02 and sent several companies scurrying to the courts to stop its application. It is now two years since the new accounting standard on recognising deferred taxes became mandatory for companies listed on the Indian bourses.

Companies now include deferred taxes in their profit calculations and in their balance-sheets (see accompanying piece `Why account for deferred taxes?').

But what impact has it had on the financial statements of Corporate India? And what should investors infer from the deferred tax numbers reported by a company?

An analysis of the financial statements of the leading lights of India Inc shows that the new accounting standard is certainly serving the purpose of evening out over the years, the earnings of companies which use aggressive tax planning to perk up their profit numbers.

But for investors who would like to go beyond the immediate impact of deferred taxes on earnings and understand their effect on future earnings, the disclosures leave a lot to be desired.

Pegging up effective tax rates

Predictably, companies engaged in capital-intensive businesses, which routinely use the shelter from concessional depreciation rates to reduce their tax bill, have felt the impact of deferred tax accounting most keenly.

The profit growth for Reliance Industries in 2001-02 (the first fiscal year for which deferred tax accounting became applicable) was snipped by the company's Rs 996-crore provision towards deferred tax liabilities.The provision pegged up Reliance's effective tax rate (including both current and deferred tax provisions) from 4.8 per cent in 2000-01 to 26.7 per cent in 2001-02. The effective tax rate for Grasim and L&T also jumped(see inforgraphic). In contrast, deferred tax accounting did not make much of a dent in the financials of leading companies operating in less capital intensive businesses such as FMCG, pharma or IT such as HLL, Infosys or GlaxoSmithkline Pharma.

Even after the adjustment for deferred taxes, many of these companies still enjoyed a lower effective tax rate than the standard tax rate of 35.7 per cent prevailing that year.

This suggests that the rest of the tax savings for these companies arise from tax exemptions of a permanent nature. That is, these tax exemptions are not likely to reverse in future years.

In the occasional case, recognising the deferred tax liability actually converted a company's pre-tax profits into post-tax losses. For instance, Carrier Aircon reported a profit of Rs 4.5 crore before taxes in 2002. But after a current tax provision of Rs 0.60 crore and a deferred tax provision of Rs 4.81 crore, it made net losses of Rs 0.95 crore for the year.

A dent on reserves

But what if a company had accumulated balances of tax due from the years prior to 2001-02? (Say, assets acquired in earlier years for which the tax depreciation differs from that in the books.)

The accounting standard allowed companies to directly set off these balances against the general reserves, instead of bringing them into the profit statement. This has had the impact of carving out a portion of the general reserves of the major companies into a separate "deferred tax liability".

Quite a few companies now carry significant deferred tax liabilities on their balance-sheets. By March 2002, L&T carried a deferred tax liability of Rs 852 crore, amounting to a fourth of its net worth. Indian Rayon's deferred tax liability of Rs 101.2 crore amounted to 9 per cent of its net worth, while for Reliance Industries, the figure was Rs 2,061 crore, or about 7 per cent of its net worth.

Interpreting deferred tax numbers

Okay, so the recognition of deferred tax makes sure that the company's profit numbers are not boosted merely by the fact that the tax laws allow a company to claim a larger shelter on its profits than would be dictated by prudent accounting.

So when investors read a profit statement now, they may look at profits after current taxes, before the deferred tax provision, to know the total profits that the company has generated for its shareholders in the current year. But for determining growth in profits between years, it may be wise to look at profits after deducting both current and deferred tax provisions.

This is because the deferred tax provision reduces the profit to the extent that it comes from short-term tax savings, which may be reversed in a later year. So profits after the deferred tax provision presents a better picture of how much of a company's profits are actually sustainable over the long term.

But can investors use the deferred tax disclosures to read something more into a company's financial statements? They can, but only to a limited extent.

  • Theoretically, when a loss-making company creates a deferred tax asset, it is a signal that the company's management is optimistic of an early turnaround. This is because conservative accounting requires that a company recognise the tax savings from carry-forward losses only if there is reasonable certainty that the company will actually have book profits in the near future.

    However, investors should make an independent assessment of the company's financials to see if the losses are from one-time factors, which may be rectified in the future.

    For instance, Nagarjuna Fertilisers made a loss of Rs 191 crore before taxes in the March 2003 quarter. But it has created a deferred tax asset of Rs 4.75 crore for the quarter. The company's profits for the quarter have taken a knock from large-scale provisioning to meet the liability arising from a revision in subsidy realised from the government in the earlier years.

    The deferred tax asset suggests that the company believes that the losses are of a one-time nature, resulting from the provisioning.

  • A sharp jump in a company's deferred tax liability may indicate that the company has made a significant change in accounting policies. A higher deferred tax liability may imply that a company has adopted more aggressive accounting policies (such as spreading expenses over a larger number of years), which may have boosted the current year's profits. In such cases, investors may use the signal provided by deferred taxes to discover the impact of the change in accounting policy on future earnings.

  • Since a deferred tax liability or asset is carved out of profits/losses from operations, investors need to factor in this number while arriving at a company's return on net worth and profitability ratios.

    For instance, while computing a return on net worth ratio for a company, it may be reasonable to add back the deferred tax liability carried in its balance-sheet to its shareholder funds, while arriving at the denominator (shareholder funds) for return on net worth. This appears necessary because a company's shareholders have a right to expect returns on the balance held in the deferred tax liability account, as this sum represents company's retained earnings.

    Deferred tax reporting needs toning up

    Deferred tax accounting has undoubtedly helped to re-state the profits of an enterprise based on the sustainable tax savings. But the degree of detail and frequency with which companies now report their deferred tax adjustments, certainly needs toning up.

    Companies have not provided too much detail about the deferred tax adjustment in their quarterly and half yearly financial statements. This is true even where the deferred tax adjustment has had a material impact on earnings for the period.

    For example, Carrier Aircon's March 2002 results. The company's profits for the period jumped to Rs 4.81 crore from Rs 0.50 crore mainly because of a deferred tax credit. Yet, the company offers no explanation in its results announcement, except that it has created the deferred tax asset in keeping with Accounting Standard 22.

    The annual reports of companies shed more light on the how a company has actually arrived at its deferred tax liability or asset. But there is a wide divergence in the way companies have reported the fact.

    The Reliance Industries balance-sheet, for instance, states that Rs 2,289 crore of its deferred tax liability is "related to its fixed assets", while deferred tax assets of Rs 189 crore are due to "disallowances under the Income-Tax Act". But this really leaves investors no wiser about the source of the company's tax liability/asset.

    Conservative accounting requires that recognition of a deferred tax asset is accompanied by more detailed disclosures than the creation of a liability. But companies have usually opted for similar disclosures on both assets and liabilities.

    A good approach to reporting deferred tax liabilities and assets is the one adopted by L&T in its balance-sheet. It provides detailed disclosures on the opening balance of each component of deferred tax liability or asset, takes the reader through the additions and deductions during the year, and arrives at the closing balance as reported in the financial statements.

    A couple of additions to the current reporting norms may help investors form a better understanding of the hows and whys of deferred tax provisions from company financial statements.

    First, companies should be required to explain the source of deferred tax provisions or credits in their interim financial statements just as they do in their balance-sheets.

    Second, in their annual reports, companies may be asked to provide a statement that explains why the taxation provision reported to shareholders differs from the standard tax rate applicable to them. This may leave investors much wiser about the sources of a company's tax savings than is the case with deferred tax accounting, with all its complexities.

    Article E-Mail :: Comment :: Syndication

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