This example illustrates the consequences of recognising undiscounted amounts of deferred tax assets and the benefit of thinking in present value terms.
The example supports our article ‘Deferred tax fails to reflect economic value – Vodafone’
Assume that a company reports a loss in ‘year 1’ due to the impairment of an asset. The impairment results in an overall accounting loss and is also deductible for the purpose of calculating taxable profits. No tax is paid in this period and the loss is carried forward for offset against future taxable profits. The tax loss carry forward is the only difference between the financial statements and tax accounts and hence the only source of deferred tax.
Here are the figures and related deferred tax assuming that the deferred tax asset recovery takes place over 5 years and is assessed to be probable each period. We have assumed that the loss cannot be offset against all of the future profits earned. This is quite common and could be due to various factors.
The consequence of the full recognition on an undiscounted basis of this deferred tax asset is that we recognise the whole benefit of the loss in year 1. The effective tax rate incorporating both cash taxes and the deferred tax asset reversal is equal to 20% of pre-tax profit in each of years 2 to 6. The effective tax rate and post-tax profit is the same in years 2 to 6 as it would have been had the company not made the loss in year 1.
Although the company is in a better position in after year 1 than an equivalent company, without any losses to carry forward, this is not reflected in post-tax performance metrics. Of course, the company made a loss in year 1 which clearly affected investors. But for the purpose of subsequent evaluation that loss is a sunk cost and the cash consequences are already reflected in the year 2 balance sheet including, for example, in net debt balances.
In our view the effect of fully recognising the deferred tax asset in year 1 is to overstate profits (in this case understate the loss) in year 1 and understate profits in years 2 to 6. If the deferred tax asset were measured on a present value basis then deferred tax gain in year 1 would be lower, being the economic present value of the asset not the full amount, and the year 2 to 6 deferred tax charge would also be lower. The year 2 to 6 profit therefore better reflects the economics in those periods and would be a better basis for valuation.
Here is the above profit and loss statement revised to allow for discounting the deferred tax asset.
The impact of both the undiscounted deferred tax, and the additional discounting we have applied, aggregated over the whole 6-year period, is zero. This is because, in total, it is cash taxes that affect profit. Deferred tax simply changes the period in which that tax is recognised for the purpose of reporting periodic profit.
In our view the adjustment in respect of deferred tax assets arising from tax losses is better done allowing for the time value of money (and also the probability of realisation, although we have chosen not to illustrate this aspect in the example).