The Impact of Deferred Tax on Business Performance and Valuation

Deferred tax is a concept that often confuses students and professionals alike.

It is the difference between the taxes that a business pays now and the taxes that it will pay in the future, due to the different rules and methods used to measure and report its income and expenses.

In this article, I will explain what deferred tax is, how it is calculated, and why it is important for financial reporting and tax planning.

I will also provide some real-life examples of deferred tax assets and liability from some well-known companies.

What is Deferred Tax?

So just let's get started, DTA and DTL are nothing, but temporary differences arising from accounting profit and taxable income.

• Deferred tax assets represent taxes that have been paid but have not yet been recognized on the income statement,
• and Deferred tax liabilities occur when financial accounting income tax expense is greater than regulatory income tax expense.

The changes in deferred tax assets and liabilities are added to income tax payable to determine the company’s income tax expense as it is reported on the income statement.

There are, 3 types of tax rates that are relevant to analysts:

1. the statutory tax rate,
2. the effective tax rate,
3. and the cash tax rate.

The notes in the financial statements disclose a reconciliation of the statutory tax rate to the effective rate and identify the items that significantly contribute to a temporarily high or low effective tax rate.

ACCOUNTING PROFIT Vs. TAXABLE INCOME

But first, let’s understand what is Accounting profit and Taxable Income

• Accounting profit (income before taxes or pretax income) is reported on its income statement by prevailing accounting standards and does not include a provision for income tax expense.
• Taxable income is its income subject to income taxes under the tax laws of the relevant jurisdiction.

A company’s taxable income is the basis for its income tax payable (a liability) or recoverable (an asset), which appears on its balance sheet.

Income tax paid in a period is the cash amount paid for income and reduces the income tax payable.

• The tax base/Tax basis of an asset or liability is the amount at which the asset or liability is valued for tax purposes, whereas the carrying amount/book value is the amount at which the asset or liability is recorded in the financial statements.
• The tax bases and carrying amounts of assets and liabilities can differ based on differences in accounting standards and the relevant tax laws. Common differences are as follows:

?? Revenues and expenses may be recognized in one period for accounting purposes and a different period for tax purposes.

?? Specific revenues and expenses may be either recognized for accounting purposes and not at all for tax purposes or vice versa.

?? The deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes.

?? Subject to tax rules, tax losses in prior years might be used to reduce taxable income in later years, resulting in differences in accounting and taxable income (tax loss carryforward).

?? Adjustments of reported financial data from prior years might not be recognized equally for accounting and tax purposes or might be recognized in different periods.

A common example is accelerated depreciation of an asset for tax reporting (to increase expense and lower tax payments in the early years) while using the straight-line depreciation method on the financial statements.

But What are Temporary differences ?

• Taxable temporary differences - Taxable temporary differences result from the carrying amount of an asset exceeding its tax base or when the tax base of a liability exceeds its carrying amount.
• Deductible temporary differences - Deductible temporary differences result in a deferred tax asset when the tax base of an asset exceeds its carrying amount and, in the case of a liability, when the carrying amount of the liability exceeds its tax base., that results in the reduction of taxable income in Balance Sheet.

The recognition of deferred tax assets is allowed to the extent, that there is a reasonable expectation of future profits against which asset or liability (that give rise to deferred tax asset), can be recovered or settled.

• To determine the probability of sufficient future profits for utilization, one must consider the following:

(1) sufficient taxable temporary differences must exist that are related to the same tax authority and the same taxable entity; and

(2) the taxable temporary differences that are expected to reverse in the same periods as expected for the reversal of the deductible temporary differences.

Taxable and Deductible Temporary Differences

Treatment of Temporary Differences

and permanent differences?

Permanent differences are differences between tax laws and accounting standards that will not be reversed at some future date. Because they will not be reversed at a future date, these differences do not give rise to deferred tax. These items typically include the following:

?? Income or expense items not allowed by tax legislation, such as penalties and fines that are considered expenses for financial reporting purposes, but are not deductible for tax purposes; and

?? Tax credits for some expenditures that directly reduce taxes. An example is tax credits provided by tax authorities to encourage the purchase of solar power or an electric vehicle.

Because no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s tax rate and its statutory corporate income tax rate.

Impact on Business Performance & Valuation

Some real-life cases of businesses where deferred tax asset and liability impacted their performance and valuation. Here are some examples:

• Reliance Industries Limited reported a deferred tax asset of Rs. 3,789 crore and a deferred tax liability of Rs. 16,830 crore as of March 31, 2020, resulting in a net deferred tax liability of Rs. 13,041 crore. The deferred tax asset was mainly due to the carryforward of unabsorbed depreciation and losses, which can be used to reduce future taxable income. The deferred tax liability was mainly due to the difference in depreciation methods for property, plant and equipment, and intangible assets.
• Infosys Limited reported a deferred tax asset of Rs. 2,945 crore and a deferred tax liability of Rs. 1,063 crore as of March 31, 2020, resulting in a net deferred tax asset of Rs. 1,882 crore. The deferred tax asset was mainly due to the accrual of expenses that are not currently deductible for tax purposes, such as employee benefits, provisions, and allowances. The deferred tax liability was mainly due to the difference in the tax basis and the book value of intangible assets, such as software products and licenses.
• HDFC Bank Limited reported a deferred tax asset of Rs. 1,452 crore and a deferred tax liability of Rs. 2,244 crore as of March 31, 2020, resulting in a net deferred tax liability of Rs. 792 crore. The deferred tax asset was mainly due to the provision for bad and doubtful debts, which can be used to reduce future taxable income. The deferred tax liability was mainly due to the difference in the tax basis and the book value of investments, such as bonds and securities.
• Amazon.com , Inc. reported a deferred tax asset of $14.2 billion and a deferred tax liability of $1.4 billion as of December 31, 2019, resulting in a net deferred tax asset of $12.8 billion. The deferred tax asset was mainly due to the carryforward of net operating losses and tax credits, which can be used to reduce future taxable income. The deferred tax liability was mainly due to the difference in depreciation methods for property and equipment.
• Apple Inc. reported a deferred tax asset of $5.8 billion and a deferred tax liability of $43.4 billion as of September 26, 2020, resulting in a net deferred tax liability of $37.6 billion. The deferred tax asset was mainly due to the accrual of expenses that are not currently deductible for tax purposes, such as warranty costs, stock-based compensation, and deferred revenue. The deferred tax liability was mainly due to the difference in the tax basis and the book value of intangible assets, such as goodwill and acquired technology.
• Tesla, Inc. reported a deferred tax asset of $2.4 billion and a deferred tax liability of $0.4 billion as of December 31, 2019, resulting in a net deferred tax asset of $2 billion. The deferred tax asset was mainly due to the carryforward of net operating losses and research and development tax credits, which can be used to reduce future taxable income. The deferred tax liability was mainly due to the difference in the tax basis and the book value of property, plant , and equipment, and deferred revenue.

More Impact as many as can be, some are below:-

1. Accelerated Depreciation:

• Case: Company B adopts accelerated depreciation methods for tax purposes, allowing higher deductions in the early years of an asset's life.
• Impact: This creates a temporary difference between accounting profit (using straight-line depreciation) and taxable income. Company B may recognize a DTL, as the taxable income is temporarily lower than accounting profit. As the asset depreciates, the DTL decreases over time.2. Revenue Recognition Timing:

• Case: Company C recognizes revenue for accounting purposes when goods are shipped, but tax regulations require revenue recognition upon delivery to the customer.
• Impact: This timing difference leads to a temporary excess of accounting profit over taxable income. Company C may have a DTL until the revenue is recognized for tax purposes. This affects the current tax liability and future cash flows.

3. Mergers and Acquisitions:

• Case: Company D acquires Company E, and the fair value of assets acquired differs from their tax bases.
• Impact: The differences in asset values may result in temporary differences and the recognition of DTL or DTA. The acquirer needs to assess the impact of these deferred taxes on future earnings and cash flows, influencing the overall financial health of the combined entity.

4. Changes in Tax Legislation:

• Case: Country F introduces new tax laws that impact the deductibility of certain expenses or change the corporate tax rate.
• Impact: Companies operating in Country F may need to reevaluate their DTL and DTA positions. A reduction in the corporate tax rate, for instance, might lead to a revaluation of DTL, positively affecting future tax expenses.

5. Intangible Assets:

• Case: Company G acquires intangible assets whose fair value exceeds their tax base.
• Impact: This creates a temporary difference and may result in the recognition of a DTL. As the intangible assets are amortized for tax purposes, the DTL gradually reverses over time.

6. Global Operations:

• Case: Multinational Company H operates in multiple countries with different tax rates and regulations.
• Impact: Variances in tax rates and rules between countries can lead to complex deferred tax situations. Changes in exchange rates may also affect the translation of deferred tax balances, impacting financial statements.

It's important to note that the impact of DTA and DTL on businesses can vary based on the specific circumstances of each company and the dynamic nature of tax regulations. Companies must carefully manage and communicate these impacts to stakeholders for transparency in financial reporting.

Crux:

At the end of each reporting period, deferred tax assets and liabilities are recalculated by comparing the tax bases and carrying amounts of the balance sheet items. The changes in deferred tax assets and liabilities are added to income tax payable to determine the company’s income tax expense (or credit) as it is reported on the income statement.

so we can conclude:-

? Tax Expense - A company’s tax expense or its provision for income taxes, appears on its income statement and is an aggregate of its income tax payable (or recoverable in the case of a tax benefit) and any changes in deferred tax assets and liabilities.

?? Taxes payable - The taxes a company must pay in the immediate future are taxes payable

?? Income tax expense - aggregate of its income tax payable (or recoverable in the case of a tax benefit) and any changes in deferred tax assets and liabilities.

?? Deferred tax Asset - represents taxes that have been paid but have not yet been recognized on the income statement,

?? and Deferred tax liabilities - occur when financial accounting income tax expense is greater than regulatory income tax expense.

Source: CFA Institute, ACCA Global, ClearTax, Incometax. India.