Investigating the treatment of deferred tax in the debt-to-equity ratio

MCom (Management Accountancy), North-West University, Potchefstroom Campus, 2017The current business environment is filled with challenges and companies face a constant struggle to remain competitive and an attractive investment that can guarantee investors long-term growth. One of the most useful tools to determine financial performance is the financial statements published by a company. These statements are a summary of the business performance of the entity and can be used by shareholders to take a closer look at how the entity performed during a specific financial period. The figures reported in said financial statements contain a wealth of information. However, these financial statements need to be analysed and interpreted using certain techniques in order to obtain this information. The main objective of this study is to gain a better understanding regarding the treatment of deferred tax in the debt-to-equity ratio and to determine how this differs between theory and practice. The study firstly focuses on the literature of financial statement analysis, ratio analysis, and specifically the debt-to-equity ratio. Ratio analysis is a critical analysis tool as this technique is one of the most commonly used financial statement analysis tools. Debt and equity are the forms of financing available to an entity and serves as the platform to embark on future projects that will contribute to growth and sustainability of the firm, and in these two forms of financing we can find the capital structure. This is where debt management comes in along with the role the debt-to-equity ratio plays in ensuring that correct decisions are made. The calculation of ratios and the inputs used to calculate these ratios are often open to high levels of subjectivity. This leads to the question of how certain items should be treated in the calculation of ratios. Deferred tax is one of those inputs that is subject to uncertainty when it comes to the proposed treatment of this item in the calculation of the debt-to-equity ratio. The second part of the study employs a qualitative method approach to collect empirical data, using semi-structured research interviews which consist of a pre-arranged set of questions (which are based on the literature review). It is found that the debt-to-equity ratio is very important and that valuable information can be extracted from this ratio based on the responses from participants in academia and practice. Even though there are a multitude of ways in which deferred tax can be treated in the calculation of the debt-to-equity ratio, participants from academia and practice overwhelmingly respond that they would rather include deferred tax as part of debt. In so doing the item is not merely excluded, and this ensures that no unnecessary loss of information occurs. The practical implications of the study is that the research can be used as starting point by financial statement users to investigate the effect that deferred tax can have on other ratios based on the figures reported in the financial statements. This will facilitate discussion regarding ratios and show that the items included in calculations are not set in stone and have a variety of implications. The limitations of the study are that only stockbrokers and portfolio managers are used as the representatives of professionals in practice. The only input investigated in the calculation of the debt-to-equity ratio is deferred taxes. The participants in academia only consist of lecturers from one of South Africa’s major universities. Areas for further research include using participants from more than one university and also including banks as part of the professionals in practice. Other inputs that have an impact on the debt-to-equity ratio can be examined and more focus can be placed on equity, which is also a very important input in the calculation of this ratio. The study recommends that, when calculating the debt-to-equity ratio, deferred tax should be included in the calculation to ensure that the ratio remains comparable and as simple as possible. By doing so this item is not simply excluded this ensures that no unnecessary loss of information will take place. Furthermore, it is also recommended that the debt-to-equity ratio should be calculated including and excluding deferred tax and that both these ratios should be disclosed. By computing both ratios the user has the freedom to select the ratio that best suits their needs and thus the impact of deferred tax will not be ignoredMaster