24 March 2009
Under the old system of accounting only for current taxes, the company's profits would be artificially high in the first year (due to the tax savings).
The profits would, however, be lower in the subsequent years, as the tax laws in the subsequent years would not recognise the depreciation charge or the amortised expense, as the case may be.
But the new accounting standard requires that a company carve out a part of its current year's profits (equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's higher tax liability in those years.
The tax laws may not recognise some of the expenses that a company has charged off in its accounts. For instance, provisions made at the discretion of the management, such as those for bad debts, which are not fully recognised by tax authorities. And expenses which are accounted for on an accrual basis (that is, when they become due and not when they are actually paid). Companies may charge off duty, cess and tax dues against profits when they become due, but they would be recognised for tax computation only when actually paid.
In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the profits that the taxman calculates would be higher than those computed in the company's books of accounts.
So, while the company shells out a disproportionately high tax in the current year, it would save on tax in the years when the expenses or provisions actually materialise.
Another situation where a company may actually owe lower taxes on its future profits when a company has accumulated losses in its balance-sheet. It can carry forward and set off these losses in future years, against its profits, if it does return to the red. If it does so, this will significantly reduce its tax liability.
A company may recognise the excess tax paid over and above the tax liability calculated on the accounting profits as a "deferred tax asset".
However, in the interests of conservative accounting, companies should recognise such deferred tax assets only if they actually anticipate that their income in future will be enough to allow the company to set off the losses or the excess tax paid.
Why account for deferred taxes?
By recognising deferred tax liabilities in its books, a company makes sure that the tax liability for any particular year is reflected in that year's financials and does not carry over to future profits.
It brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations (rather than from fiscal savings).
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