Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Four – Key issues in accounting and their treatment under IFRS
Why in this example do we have a deferred taxation liability? It is because profits
in year 1 have only been reduced by a £20,000 depreciation charge whereas
taxable profits have suffered a £150,000 deduction. This means that taxable
income would £130,000 lower than accounting income (£150,000 - £20,000). We
know from the earlier part of this section that current tax is based on taxable
profits (rather than accounting profits). Therefore if we were just to ‘plug in’ the
current tax charge we would show a high profit in the accounts with a small tax
charge. In addition from a balance sheet perspective we would not be showing a
full liability for the tax cost of the profits being recognised. We can see from the
example that ultimately accounting depreciation does catch up with tax
allowances and so the deferred taxation cancels. However, in the meantime
deferred taxation ensures that the income statement and balance sheet produce
superior and more complete information.
3.2.5 Deferred tax assets
These arise in the opposite situation to that outlined above – when taxable profits
are high compared to accounting profits and liabilities are therefore overstated.
Another source of deferred tax assets is operating losses – these have been
recognised in the income statement but not in the tax computation which merely
reported a ‘nil’ result. Another way of thinking about this is to imagine that if a
company makes a loss of, say £10m, it should be able to recover this against
future tax liabilities. Therefore the actual economic cost of the loss is £10m X
(1-t) - i.e. less than the actual loss recognised. This ‘shield’ is an asset as it will
be available to decrease future tax liabilities.
Of course this analysis assumes that sufficient future profits will be earned to
recover the value of these losses. Under IFRS only those deferred tax assets that
are recoverable from future profits are allowed to be recognised. Therefore, the
asset associated with these losses only has value if future profits are earned.
Hence the risk relating to deferred tax assets is the same as the risk of earning
future profits. This point is essentially the justification, outlined in Chapter 2, for
discounting tax shields at the unlevered cost of equity rather than the much lower
cost of debt. The ability to earn future profits is more risky in terms of recovery
than the returns on debt instruments.
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