Interpreting Income Statements - Part II



Why Tax?

Basically, the revenue of any company is shared by its stakeholders. First of all who are all stakeholders?


Shareholders get their share in terms of Dividends because they invested in the company

Banks get their share in terms of Interest because they lend to the company

Employees get their share in terms of Salary and Wages because they work for the company

Do we need to include Government as a stakeholder?

The answer is Yes! but why? because they maintain law and order, protect your patents, frame rules and policies, regulate with institutions like SEBI, IRDA, Company's supply chain wouldn't be possible if they didn't construct Railways or Roadways etc.

How do they get their share? Obviously Taxes!



Let us understand some basics Indian taxation system. When you pay taxes on your personal income, it is called Personal Income Tax. Similarly, for a company's income, it is called Corporate Income Tax. There will be cess and surcharge added to it making it an Effective tax rate. It swings between 25% to 35%.


But wait, Government tax on income? No!Government tax on profit.

What is Profit? Revenue - Expenditure

Is it Profit before tax in Income Statement? No! Accounting profit/Book profit(i.e Profit before tax) is for financial purposes whereas Taxable profit is for Tax liability to the government.


Basically Accounting income is calculated based on Accounting rules whereas Taxable income is based on Tax laws. As a rule of thumb, they differ on depreciation, inventory valuation, fines and penalties, accrual vs cash-based etc.


Companies tend to increase Profit after tax so they try all loopholes in tax laws to decrease tax expense but Government wants to increase tax collections in all possible ways. This creates a dichotomy. To solve this problem, the Government introduced Minimum Alternate Tax(MAT).


Concept of MAT

In simple terms, if a company's taxable profit is less than 15% of book profit/accounting profit, then the company needs to pay 15% of book profit/accounting profit as tax. This tax on book profit/accounting profit is called MAT.


This gives Government the upper hand over companies like economic violence on corporate. Also sounds unfair and hence the concept of MAT credit entitlement.


MAT Credits

It can be illustrated through an example.

Assume ABC ltd company has normal tax liability(as per taxable income) has 10 lakhs but as per MAT(as per accounting income) has 10.5 lakhs.

Here,Normal tax liability < MAT.Therefore,it needs to pay 10.5 lakhs.

MAT credit = MAT - Normal tax liability = 10.5 - 10 = Rs.50,000


Claiming MAT credits

These credits are valid for 15 assessment years but not as a whole.

Say you have

MAT liability of 10.25 lakhs

Normal tax liability of 10.5 lakhs

MAT credit of 50,000.

Now the company can claim 25,000 from MAT credit and pay 10.25 lakhs to the government.

Here credit claimed shouldn't exceed the difference (Normal tax - MAT liability).

Whatever credit is left is carried forward to subsequent years.


Recap

  • Accounting income and taxable income is different

  • Tax is paid on taxable income which follows tax laws

  • This creates a difference in taxable income and accounting income

  • The government needs to increase tax revenue whereas company tries to decrease tax expense

  • Therefore MAT and MAT credits are introduced

The difference in accounting income and taxable income gives rise to two problems basically

  1. Government vs Company objective dichotomy - MAT is the solution

  2. Time of recognition of revenue and expense by accounting procedures and tax laws are different

If you notice the income statement, there will be items - Current tax and Deferred tax.

Current tax - What you actually pay to the government

Deferred means postponed or put off to a later time. Deferred tax is the solution to the second problem.

Deferred tax - You don't actually pay now but uses it in future


Deferred Tax

For illustration, let's create a scenario where there is a difference in tax laws and accounting procedures.

Assume you bought a machine worth 1 lakh which lasts for 5 years. According to tax laws, depreciation can be claimed this whole 1 lakh in the current year itself whereas accounting procedures split this 1 lakh for 5 years(Rs.20000 each year)(everything is an assumption). The tax rate is 25%




I admit it's messy! but let me give you important points from the above table

  • At the end of 5 years, whatever tax you pay is the same irrespective of accounting or taxable profit

  • But each year tax differs and this difference is due to the time of recognition of depreciation is not the same for accounting and tax laws and this is called time difference

  • This tax effect due to timing differences is called Deferred taxes

  • Tax expense = sum of current tax and deferred tax

  • Profit after Tax(PAT) in the income statement is calculated by deducting tax expense from Profit before Tax(PBT)

  • PAT = PBT - Tax expense









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Disclaimer: This article is me speaking to me through this blog! Short Intro: If you want to innovate in a particular field, you need to understand how things work in the first place. Innovation is a