Accounting for income taxes, especially deferred taxes, is a complex and challengingissue. Little surprise then, that it is one of the leading causes of restatements for companies outside India. More often than not, it isin the areas of blocking and tackling that companies get it wrong.

‘Deferred tax’ refers to the future tax consequence of a current transaction. For example, if a company makes a provision for an expense that will only be allowed as a deduction for tax when cash is paid out, the company should recognise a benefit for the future deduction at the time of making the provision. Current tax expense (or benefit) and deferred tax expense (or benefit) always equal total tax expense (or benefit).

The nitty-gritty details

For example: Let us say Company A makes a provision for gratuity in its financial statements of Rs 100. When it prepares its tax calculation, it adds this provision back, since the deduction for gratuity can only be claimed when the company actually makes cash payment for the gratuity.

Company A needs to accrue for the future tax benefit it will get when it makes the cash payment. This is calculated as Rs 100 multiplied by the tax rate, say 30per cent (or Rs 30) which should be recorded as a deferred tax asset with a corresponding tax benefit in the profit and loss account.

So, what makes it so complex?

For one, tax laws are complex and written in different shades of grey – each jurisdiction has its own laws and myriad interpretations. Imagine life for the person handling the tax affairs of a multinational company operating around the world, having to deal with multiple tax authorities!

Income-tax accounting is often done outside the system using Excel or similar solutions, and is thus not subject to the necessary rigour or control that the financial statements themselves may be. This often results in avoidable errors.

There are a number of software tools available that can automate the tax calculation process.

The tax calculation is a year-end exercise. Although the payment of taxes entails a cash payout, companies often do not pay enough attention to the calculation of taxes. The finalisation of the accounting profit is one of the initial steps in the calculation of tax, and as a consequence, the tax calculation is leftto the last-minute exercise.

There is usually a disconnect between tax and accounting with both being separate functions operating as silos, and only interacting when it is close to the year-end.

Some of the common accounting issues include:

Uncertain tax positions: Since tax laws are subject to interpretation, companies need to use judgment, and calculate taxes based on their best estimates. This becomes challenging when the tax laws themselves are not clear,such as whether a certain expense can be claimed as a deduction or not.

Tax assets related to losses carried forward: Companies that areincurring losses need to have strong evidence of profitability to be able to recognize tax assets related to the tax losses carried forward. This is a very subjective area, and one that companies can often get wrong as it involves estimating future profitability.

Tax holidays and incentives: An often misinterpreted and abused aspect. The impact of tax holidays and incentives must be considered in calculating provisions for current and deferred taxes. Judgement is required to determine when companies can start claiming such benefits and how much of them to be recognised.

This often requires detailed future projections order to estimate the future taxable income,

It is important for companies to address these issues upfront and in a timely manner to avoid last minute surprises. In doing so, companies should also consider legitimate tax-planning opportunities.

Karan Marwah is Associate Director at Price Waterhouse.

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