The Hindu Business Line : In the land of deferred taxes

Wafers had spent the day arguing with her client. The guy was a half nut; at least that was her perception. The issue related to deferred tax assets and deferred tax liabilities. Accounting standards was never her favourite topic. The fact that they were imported added to her woes. And now this guy was driving her crazy with his interpretations. She decided to attend a workshop on AS 22.

"Tax provision has no relation to book profit. Book profit multiplied with tax rate is not equal to tax provision," the IIM professor remarked, kicking off the workshop. "True," she told herself. "After all, computation of profit under the Companies Act was different from the computation under Income-Tax Act."

Echoing her thoughts the professor said, "There are expenses that are incurred in the current year but are allowed in tax calculations in a later year. And there are expenses that are incurred in a later year but are allowed in tax calculations in the current year."

"Example Prof," said a voice from the back of the class. "A company might use SLM under Companies Act and WDV Method under the Income-Tax Act. Hence while the depreciation in each year could be different under the two Acts the total depreciation across the asset's life would be the same. Such differences which reverse in future years, and thus even out, are called timing differences," said the professor.

Even as Wafers was digesting that, a guy in the middle row put his hand up. "Sir, a disallowance under Section 43B would also be an example of timing difference." And before Wafers could recolloect what Section 43B stood for, the professor remarked, "Well said." He then offered an explanation. "Section 43B talks about statutory liabilities being allowed as expense only on payment basis.""While timing differences reverse themselves, permanent differences do not," the professor was saying. "Example Prof," someone asked. The Big Man disliked disturbances but he kept his cool. "Permanent differences are expenses that become available in one book only. Take weighted depreciation on an asset. Suppose on Rs 1 lakh you get depreciation of Rs 1.25 lakh. The extra Rs 25K is in tax books only and not under the Companies Act. Someone volunteered, "Sir, a penalty is deductible under the Companies Act but not under the Income-Tax Act." "Right," said the professor, pleased that the students comprehended.

The professor had just concluded part one to his explanations. Namely, how expenses are allowed in one Act in one year and the other Act in another year. And of how some expenses are allowed in one Act only. He felt the same logic could be extended to income.

Crux of the matter

He hadn't as yet explained what all this had to do with AS 22 when Wafers asked, "Prof, what does all this add up to ?" "Let me explain with numbers," the professor said. Number crunching was what he loved most.

"Suppose the profit before depreciation and taxes (PBDT) is Rs 100K. If depreciation as per Companies Act is Rs 20K and that as per income-tax is Rs 30K, the profit before tax (PBT) would be Rs 80K and Rs 70K respectively. If the tax rate is 30 per cent the actual tax would be Rs 21K, which has no correlation to the higher book profit of Rs 80K. For, if tax is paid as per book profit it would have been Rs 24K. This additional tax of Rs 3K will happen sometime in the future when aggregate book depreciation catches up with aggregate tax depreciation. This is a liability and needs to be provided now by debiting Deferred Tax (P&L account) and crediting Deferred Tax Liability account."

The guy in the middle row offered a supplement. "If an expense is disallowed under income tax in the current year but will become allowable in a subsequent year, as in the case of Section 43 B, the book profit will be lower and the tax profit will be higher. In such a case an asset would arise. A suitable credit to Deferred Tax (P&L account) account and a corresponding debit to Deferred Tax Asset (Balance Sheet) account will have to be made."

Wafers scribbled a summary in her notebook.

Rule 1: If the expense in the financial book is less than the expense in tax books, book profit will be higher. Hence create a deferred tax liability by multiplying the difference with the tax rate.

Rule 2: If the expense in financial book is greater than the expense in the tax book, book profit will be lower. Hence create a deferred tax asset by multiplying the difference with the tax rate. Bravo. A method of doing reconciliation between cost profit and financial profit that she had read in PE 2 had come in as a happy parallel! The logic could be extended to income as well.

But what would happen in the second year? Would she have to keep tab of the past? As though on cue, the professor answered. "You don't have to keep a constant tab. Simply look at the WDV. If the book WDV is greater than the tax WDV, it means that the aggregate expense on account of depreciation is less in the books than in tax computation. Hence you must create a deferred tax liability. If it is the other way round, you must create a deferred tax asset." Wow.

That morning after Titanic (the company that she audited) had closed its accounts she had found that an expense had to be disallowed under tax because the related TDS hadn't been paid on time. Of course, it would be allowed in the next year and hence would be a "timing difference." The company had argued that this would leave the final profit in the P&L account unaffected as a corresponding DTA would be created.

Wafers now realised that while this would have been generally true, in the instant case it would not because there would be a 234B (Section under the Income-Tax Act) penalty for delay in payment of advance tax (this arose because no one had anticipated the delay in payment of the related TDS). This would have to be provided in the books. "Well done, Wafers," she told herself.

But for Titanic would she have ever got a clue to this? Would any textbook have explained it to her the way it struck her? Bravo articleship she told herself.

Racy@TheHindu.co.in

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