Deferred Tax Assets, Tax Payout (P&L vs. CFO): Queries Answered

The current article in this series provides responses related to the following queries:

• What is Deferred Tax Asset and how do we calculate it?
• Which tax payout should we analyse: profit & loss statement or cash flow statement?
• Resources to understand Deferred Tax Assets & Deferred Tax Liabilities?

What is Deferred Tax Assets and how do we calculate it?

Hi Dr. Vijay,

I attended your “Peaceful Investing” Workshop in Bangalore in July 2017 and was impressed by your clarity of thought and attention to detail. Thanks for teaching investors like me, the tricks of this trade.

I was doing the fund flow analysis for JHS Svendgaard and had a doubt with the deferred tax asset part of this company’s balance sheet. I have attached my fund flow analysis for this company, but I am not entirely clear as to why deferred tax assets are being added instead of being subtracted. If you shed some light on this aspect, it would be helpful.

Regards,

Author’s Response:

Hi,

Thanks for writing to us! It was great to have you at the workshop!

You would notice that the deferred tax assets have increased by ₹17 cr. In the case of fund flow analysis, we treat all asset increases as outflow.

Deferred tax assets (DTA) are equivalent to excess tax paid to tax authorities, which would be adjusted against profits of the future. Such assets are usually created under two circumstances:

1) Due to losses: E.g. in case of JHS, you would read on page 99 that the company sold a few fixed assets that were not in active use and Waves Hygiene Products in FY2016. It had sold them at a loss (about Rs. 17 cr.) and it would adjust this loss against profits of future years.

Further Advised Reading: Understanding the Annual Report of a Company

2) Due to different treatment of expenses by companies act and income tax act: E.g. when income tax act does not allow something to be deducted as an expense which is otherwise allowed by companies act as an expense. In these cases, the company will pay higher tax as per income tax act than as per companies act.

In the case of JHS, the DTA is primarily due to the loss on the sale of assets as per the disclosures in the annual report. However, we find uncertainty in a few things about the manner in which JHS has shown it in the annual report:

1) Usually, the deferred tax asset is created equal to the impact the loss/excess paid tax will have on the future tax payments. E.g. if the tax rate is 30% and the company books a loss of Rs. 100 cr., then in future it can adjust this loss of Rs. 100 cr. against a profit before tax up to Rs. 100 cr and in turn avoid paying an income tax of Rs. 30 cr. Therefore, the DTA should be Rs. 30 cr. and not the entire loss amount of Rs. 100 cr. Therefore, we are not able to understand the amount of DTA shown by JHS from the limited review of the annual report

2) Regarding the addition of an almost full amount of loss as DTA in the tax section in the P&L, it is again difficult to understand on the similar lines of argument in the point 1 above. It seems that this entry in the tax section of P&L, which increases PAT, is needed to show higher reserves/equity on the liability side of the balance sheet. Showing higher equity/liabilities is essential because on the asset side the company seems to have shown higher assets (entire loss e.g. Rs. 100 instead of only the amount of benefit/adjustment in future tax e.g. Rs. 30).

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

We believe that a CA can be a better person to comment on whether JHS is right in handling the treatment of business losses in the manner that it did or it is an attempt to inflate profits. It might be that there is more information required from the company about any other key items, which have affected the treatment of business losses to make it treat the entire loss as DTA instead of only the amount of future tax benefits.

To get a brief overview of DTA, you may read the following article on Investopedia: https://www.investopedia.com/terms/d/deferredtaxasset.asp

All the best for your investing journey!

Regards,

Dr. Vijay Malik

Which tax payout should we analyse: profit & loss statement or cash flow statement?

Hi Dr Vijay,

While doing the tax analysis don’t you think it’s more accurate if we compare the actual tax paid (the figure in cash flow statement) as a percentage of PBT over the years rather than taking the tax paid figure from P&L.

Regards,

Author’s Response:

Hi,

Thanks for writing to me!

P&L and cash flow statement differ many times from each other on account of the timing of the receipt or payment of cash being different from the time when the revenue or expense become certain for recognition. This marks the basis of accrual-based accounting.

Like many other revenue and expense items, in the case of taxes as well, the timing of the tax being shown as payable in P&L and the tax being actually paid are different. Such instances give rise to deferred tax assets (DTA) & liabilities (DTL).

If an investor wants to use cash flow statement based tax outflow instead of P&L tax expense, then she should use it for the entire 10-year history of the financial data, which is usually used in fundamental analysis. This is because there might be years in the past where P&L tax expense was high and cash flow tax outflow was low. This would have led to the formation of DTL. In subsequent years, when the company paid the tax liability to income tax dept., it might be the case that in this year P&L tax expense might be lower than cash flow tax outflow.

If the investor uses P&L tax expense for previous years and uses the cash flow based tax outflow for the recent year, then she would be over-estimating the tax liability by double counting a single tax liability.

Read: How to do Financial Analysis of Companies

However, as an additional financial analysis parameter, it is advised that an investor should compare the total P&L tax expense for 10 years with the total tax outflow as per cash flow statement. Ideally, they should be similar to each other. In case, these two items are not similar, then the investor should analyse it in detail.

Hope it clarifies your queries!

All the best for your investing journey!

Regards,

Dr Vijay Malik,

Related Query:

Dear Sir,

I have a query regarding a textile company Vardhman Textiles Ltd.

In 2016 Annual report, page no. 71, Standalone Tax expenses was Rs. 211.58 Cr. and 2016 Standalone Interest expenses was Rs. 86.85 Cr. But, in the Cash Flow Statement Tax expenses was Rs. 232.34 Cr. and Interest expenses was Rs. 133.31 Cr.

Could you please explain why this kind of huge difference in tax and interest expenses between profit & loss statement and cash flow statement?

Are these worrying signs? And how important is it from investors’ perspective?

Author’s Response:

Hi,

Thanks for writing to me!

Companies show the tax expense in the P&L, which is calculated as per the rules of the Companies Act. However, in the CF statement, the tax outflow shown is the amount paid to income tax as per the rules of the Income Tax Act. As many times, the two acts treat many expenses differently, therefore, the profit of the company in P&L statement and the income tax return filing is different. Therefore, the companies end up paying different amount in tax to Income Tax Dept. than what they have shown in the P&L. These differences in the tax figures in P&L (as per Companies Act) and CFO (as per Income Tax Act) form one of the basis of deferred tax assets & deferred tax liabilities.

Similarly, the interest figure in the CF statement includes the interest outflow which is expensed in the P&L as well as the interest outflow, which is capitalized as part of the project cost and shown as part of fixed assets/CWIP. Therefore, the interest expense figures in the P&L and CF may differ.

This is normal accounting practice.

Read: Understanding The Annual Report Of A Company

An investor should always assess the interest servicing capability of a company by considering both the P&L interest figure as well as the capitalized interest figure.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

Resources to understand Deferred Tax Assets & Deferred Tax Liabilities?

Dear Vijay,

Hope you are doing well.

I request your inputs on deferred tax implications.

Can you please guide me to understand the implications if a company posted quarterly results with an increase in deferred tax when comparing Q-o-Q results? This question came to me while going through recently declared results by Pennar Industries. There is a significant change in deferred taxes and current tax liability from Sep’ 2017 to Dec’ 2017.

In addition, if a company deferred taxes to a later period, where does it show in their balance sheet?

I appreciate your time and valuable inputs.

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

We would request you to go through the following articles to understand more about deferred tax assets (DTA) and liabilities (DTL):

DTA: https://www.investopedia.com/terms/d/deferredtaxasset.asp

DTL; https://www.investopedia.com/terms/d/deferredtaxliability.asp

The above articles would give you a lot of understanding about deferred tax.

The deferred tax assets, as well as liability, are shown on the balance sheet. DTA under non-current assets and DTL under non-current liabilities. Many times, when companies have both DTA and DTL due to different factors, then they may adjust one with other and then the net DTA or net DTL on assets side or the liabilities side, as the case may be.

All the best for your investing journey!

Regards,

Dr. Vijay Malik

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.