The thorny issue of deferred tax

Roger Trapp on how earnings of utilities and other large groups could b e hit Full provisioning could affect companies' ability to borrow

Earnings per share is one of the key measures of company performance. Consequently, anything that threatens to produce a substantial effect on it is bound to be looked upon with scepticism by both the directors and their watchers in the City. And so it is with deferred tax.

The Accounting Standards Board has been known to be looking at the somewhat complex issue of how this should be treated in company accounts for some time, and is due to publish a discussion paper on the subject in the coming weeks. Part of the difficultyin pinning down a publication date, concedes the board secretary, Allan Cook, is finding a way of showing the various options "without making it seem so fearfully complicated". The firmest answer he will provide is that the document should see the lightof day by the end of this quarter.

Not that he is expecting to be overwhelmed by interest from the general public. Deferred tax is a tricky concept for the uninitiated to understand, and the paper will be of real interest to only a few people, says Mr Cook. Nevertheless, it is not withoutcontroversy. In the words of one commentator, it is "an almost permanent thorn in the standard setters' flesh, exceeded only, perhaps, by the debate on inflation accounting".

Basically, accounting for deferred tax is a matching exercise that aims to get the correct tax charge in the profit and loss account. The driving principle, according to Mary Keegan, a partner at the accountants Price Waterhouse, is that the financial statements for a period should recognise the tax effects of all transactions occurring in that period. However, the actual Inland Revenue charge for that period will not be calculated in the same way.

For example, interest income on a loan trade by a company would be recognised in the financial statements in the accounting period in which the interest was earned. But if the interest was actually paid to the company shortly after the accounting period had ended, the revenue would assess that income for tax purposes in the following accounting period.

Alternatively, a difference may arise because a company is embarked on a capital expenditure programme. Unlike depreciation, which is generally provided at a constant rate, capital allowances decline over time. Consequently, for a particular item of expenditure the difference between the two will gradually rise - and with it the company's tax charge will go up.

The deferred tax debate is all about the different methods of accounting for these differences and their effects on profitability.

The first is the flow-through, or "do nothing", approach. Using the argument that the tax liability applies to taxable profits rather than accounting profits, it leaves the tax charge in the profit and loss account as that calculated by the Inland Revenue. It is not believed to be used anywhere where there are significant differences between profits for tax purposes and those reported in the financial statements.

The second is the "full provision" route adopted in the US. This is based on the idea that the tax charge should reflect all transactions that have occurred in that period, irrespective of the fact that the tax effect may be accounted for by the Inland Revenue in a different period. It requires the company to make a full provision for deferred tax regardless of whether or not future reversals in timing differences will be offset by others.

Then there is the "partial provision" route, favoured by Britain. It is essentially a middle position, under which the company should provide for tax on all transactions in the period to the extent that it is probable that the tax will become payable.

The paper will merely call for comments from interested parties in the accounting profession, the City and industry. But the past approach of ASB's chairman, Sir David Tweedie, to accounting rules and an apparent preference for the commitment-based provisioning practised in the US is leading some analysts to believe that his group will eventually opt for that route.

Hoare Govett, the broker, recently published a client note that set out how different companies would be affected by a change to full provisioning. Headed "Tweedie's tax bombshell", it said that utilities would see their reported earnings hit by as much as 40 per cent because they have large capital expenditure programmes, with a significant proportion in infrastructure assets that are not depreciated. However, since they are likely to maintain this level of spending, there is only a slim possibility ofany deferred tax becoming payable in the foreseeable future.

Rather more vulnerable, because they are reducing capital expenditure, according to Hoare Govett, are the transport company NFC, the leisure group Ladbroke and - to a lesser extent - British Airways. While they may face rising tax charges under the current system, a move to full provision would make their difficulty more obvious.

On the other hand, the reported earnings of such companies as United Biscuits and Vodafone could rise if full provisioning required them to set up a deferred-tax asset.

Companies are likely to lobby hard against any such move on the grounds that it would lead to provisions of a huge amount of deferred tax which only has a remote chance of becoming payable. In addition, they will claim that their capacity to borrow will be reduced because full provisioning would make them appear more highly geared than they really are.

Though nothing is certain in these matters, they are not given much chance of success. Flow-through is unlikely to be adopted because its potential for causing volatility, though advantageous for those who want further distractions from the bottom line, would lead to misinterpretation. Moreover, partial provision is complex, is open to manipulation because of the reliance on management projections, and has been rejected by international standard setters. Britain would be isolated if it continued with it.

This does not leave full provisioning as the only solution, however. As if matters were not complicated enough already, some are holding out the prospect of the ASB eventually plumping for full provisioning with discounting. This approach, which involvescalculating the full provision but reducing it to its present value, is designed to overcome the problem of full provisioning in Britain creating large charges that may not reflect real liabilities.

It might also, suggests Ms Keegan's team at PW, bring about similar numbers to those produced now. This would give it the unquestionable appeal of combining strong conceptual arguments with a less dramatic effect on corporate profitability.