The creation of a DTA is a new phenomenon created by IAS-12 and has provided an opportunity to the listed companies to credit handsome amount to their income statement without any tangible receipt. This has turned the loss before tax of many companies into a profit after tax without any tangible addition to the assets of the company.
The accounting profession has always been very conservative in recognising an undetermined and un-realised income in the income statement of an enterprise. The International Accounting Standard No. 12 has however, completely changed this age-old tradition. The standard permits creation of deferred-tax-assets (DTA) and deferred-tax-liabilities. As far as the deferred tax liability (DTL) is concerned, the accounting profession in Pakistan has been following it since ages as part of principal of conservatism. The creation of a DTA is a new phenomena created by IAS-12 and have provided an opportunity to the listed companies to credit handsome amount to their income statement without any tangible receipt. This has turned the loss before tax of many companies into a profit after tax without any tangible addition to the assets of the company.
There are very few countries, which have accepted and adopted IAS-12 for preparation and presentation of accounts of public companies. In spite of low level of education and poor disclosure practices being adopted by our listed companies, Pakistan has accepted the new standard without any reservation and SECP has made it obligatory to follow it from the year ended 2002-03.
The standard provides that: “A DTA should be recognised for the carry forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised.”
It is obvious that the creation of a DTA is based on a probability that future tax profits will be available for adjustment against unused tax losses.
The application of new standard has brought substantial deceptive variation in the declared results of some of the listed companies. We can understand the distortion being created by a tax-asset with reference to just one example. Let us say, that ABC Company has created a tax-asset of Rs379 million in its accounts for the year ended on 30th June 2003. The company had incurred a loss of Rs331 million during the year but the creation of tax-asset has converted its loss of Rs331 million to a profit after tax of Rs47 million as can be seen by the following figures:
Net loss before tax Rs331 million
Tax asset Rs379 million
Net profit after tax Rs047 million
The tax-asset which is a hypothetical asset based on probable tax credit in future has converted a loss of Rs331 million to a profit of Rs47 million. A potential investor in stock market usually looks at earning per share after tax of scrip. We can see from the following calculations the extent of distortion introduced by the creation of tax-asset in the case of above example.
Loss per share before tax (in minus) Rs(11.92) per share
Earning per share after tax (in plus) Rs1.69 per share
Increase (in plus) Rs 13.38 per share
It is obvious that this EPS of Rs13.38 is not based on any tangible receipt of income to company nor does it represent the operating performance of the company. It is based on ‘probable’ expectations in undetermined future years.
I am not aware of the number of companies, which might have created a tax-asset during last year. I have however, seen reports of about/20 companies which have created a tax-asset in their accounts for the years ending on 30th June 2003, or 30th September 2003. The tax-asset created by these companies range from Rs379 million to Rs1 million.
The creation of tax-asset has brought about complete distortion in the accounts by turning the operating losses in artificial profits. The following table gives the amount of tax-asset created by some of the companies and the “loss per share before tax” which has been reduced substantially or converted to “earning per share after tax” due to addition of a handsome amount to the income of the company based on creation of an intelligible asset. (see table)
An ordinary investor normally looks at the figures of after tax profit. He can never think of a positive provision for taxation increasing the profit by millions.
The international accounting standard however has taken a number of precautions to guard the interests of investors by giving some warnings. For example, it warns the corporate bodies that they have to be very careful in creating an asset based on the expectation of future profits because if you have a history of losses, the chances of profits arising in future years are negligible. The para-35 of the IAS-12 says: “The existence of unused tax losses is strong evidence that future taxable profit may not be available”.
The para-36 (b) of IAS-12 again raises a very important question and it is for the management of the company and its auditors to answer it: “Whether it is probable that the enterprise will have taxable profits before the unused tax losses or unused tax credits expire?”
This is very important. The management of the company and the auditors have to find out the reasons for the losses suffered by the company in the past and should have a strong reason to assume that the reasons causing losses in the past will not be repeated in coming years.
The para-36(b) again introduces an element of caution:
Whether the unused tax losses result from identifiable caused which are unlikely to recur?
It warns that: to the extent that it is not probable that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised the deferred tax asset is not recognised.
The para-35(b) discusses the issue in detail: (b) Therefore, when an enterprise has a history of recent losses, the enterprise recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent that the enterprise has sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit will be available against which the unused tax losses or unused tax creditors can be utilised by the enterprise. In such circumstances, paragraph 82 requires disclosure of the amount of the deferred tax asset and the nature of the evidence supporting its recognition.
The requirement of this paragraph has to be noted because it requires that the enterprise, which has a history of recent losses, must have convincing evidence supporting the management’s expectation about future profitability. The standard requires disclosure of “nature of the evidence” supporting and recognising the asset but none of the companies has made any disclosure of evidence, which has been relied upon as the basis for creation of the tax-asset.
The disclosure requirements have been specifically dealt with by para-82 of the IAS-12, which says: an enterprise should disclose the amount of a deferred tax asset and the nature of the evidence supporting its recognition, when: (a) The utilisation of the deferred tax asset is dependent on future taxable profits in excess of the profits arising from the reversal of existing taxable temporary differences, and (b) The enterprise has suffered a loss in either the current or preceding period in the tax jurisdiction to which the deferred tax asset relates.
Pakistan has very low level of education and the disclosure practices being adopted by our listed companies are not still adequate. The adoption of IAS-12 in Pakistan at this stage is likely to have negative impact for the investment climate in Pakistan may open the doors for deception of small investors.
The distortion in the published accounts being introduced by IAS-12 will be deceptive for many small investors who use the figure of earning per share published in various newspapers as criteria for their investment decisions. They will be misled to make investment in companies, which are not profitable at least presently. Ultimately, it may result in some sort of scandal in Pakistan’s stock market. None of the companies whose reports have been seen by this writer has made the disclosure required by IAS-12.
No evidence has been presented or even discussed about the possibility of profits in future. The readers can have an idea of the type of disclosure made by the following paragraphs taken from the director’s report.
“During the year under review, due to the effect of deferred taxation of Rs384.911 million, the company has posted net profit after taxation of Rs47.134 million as compared to net loss after taxation of Rs238.397 million in the preceding year.”
Another company’s directors report states: however, the international accounting standard-12 “Income Tax (Revised 2000)” bas become effective in Pakistan from the accounting periods beginning after January 01, 2002 and on adoption of this standard, a deferred tax debit balance of Rs256.947 million, after accounting for the deferred tax liability, has been recognised in these accounts. On recognition of deferred tax asset, the profit after tax of the current year amounts to Rs150.103 million.”
It must be kept in mind that the carry forward of business losses of the purpose of income tax is allowed for a period of six years only. It is possible that some of the carry forward tax losses of the company who have created a Tax Asset might expire in the next years. As a result of expiry of tax losses, these companies shall have to reverse the entry of Tax Asset creating an anomalous situation for the investors who will see that the company’s profit which were increased artificially have been reduced in similar pattern in the subsequent year or years.
That tax-assets being created by listed companies under IAS-12 are directly credited to the income statement and the consequent profit becomes part of general reserves. By tradition, a general reserve is considered as a free reserve available for distribution as dividend. However, any tangible asset did not back the portion of the general reserve, which consists of tax-assets, and the company does not have the means to distribute it among the shareholders. It is difficult for an ordinary investor to realise and appreciate this fact. He is certain to be misled by the figure of the general reserve especially, in the following year in which the Tax Asset was created.
I earnestly request Security & Exchange Commission of Pakistan to kindly suspend the Adoption of IAS-12 with immediate effect and direct all the companies, which have created Tax Assets to reverse the entry.
In case the SECP does not find it appropriate to suspend the operation of IAS-12, it may introduce some variation in the methodology of accounting for the credit for Tax Asset. I suggest that instead of crediting the value of Tax Assets to income statement, the amount should be credited to an account which can be named as ‘Tax Reserve’ or whatever other nomenclature the SECP may like to adopt. I personally feel that it’s a very important matter and need immediate action by SECP and the professional accounting bodies of the country.
Note: The views expressed in the article are the author's and Accountancy may or may not agree with them. This article was previously published in the Daily Dawn.