Deferred capital employed: Meaning, Criticisms & Real-World Uses

What Is Deferred Capital Employed?

Deferred capital employed refers to the portion of a company's total capital employed that arises from the recognition of deferred tax liabilities or certain other deferred income items. While "capital employed" broadly represents the total funds invested in a business's operations, the "deferred" component specifically accounts for future tax obligations or benefits that influence the overall capital structure. This concept falls under the umbrella of financial accounting and plays a role in analyzing how a company finances its assets and operations, particularly concerning its long-term tax position. The inclusion of deferred capital employed in financial metrics helps provide a more comprehensive view of the resources a company utilizes to generate revenue and profit. When assessing a company's financial statements, understanding deferred capital employed can reveal nuances in its reported capital base that stem from differences between accounting and tax treatments.

History and Origin

The concept of "deferred capital employed," particularly as it relates to deferred tax liabilities, is rooted in the evolution of accounting standards for income taxes. Accounting for income taxes became more formalized with the introduction of standards designed to address the timing differences between when revenue and expenses are recognized for financial reporting purposes versus for tax purposes. These temporary differences lead to the creation of deferred tax assets and deferred tax liabilities.

Internationally, the International Accounting Standards Committee (IASC), the predecessor to the International Accounting Standards Board (IASB), first issued IAS 12, "Accounting for Income Taxes," in July 1979. This was later revised and reissued as IAS 12 Income Taxes in October 1996, becoming operative for financial statements covering periods beginning on or after January 1, 1998.⁸ Similarly, in the United States, the Financial Accounting Standards Board (FASB) developed Accounting Standards Codification (ASC) 740, "Income Taxes," which mandates the asset and liability method for accounting for income taxes.⁷ These standards require companies to recognize the future tax consequences of current transactions and events, which directly gives rise to deferred tax liabilities. When these deferred tax liabilities are considered as part of the financing used by a business, they effectively become a component of its "deferred capital employed."

Key Takeaways

Deferred capital employed primarily represents the portion of a company's capital base influenced by its deferred tax liabilities.
It arises from temporary differences between accounting income and taxable income as reported in financial statements.
While not a standalone metric, its presence impacts the overall calculation and interpretation of a company's capital employed.
Understanding deferred capital employed is crucial for a comprehensive analysis of a company's financial structure and its long-term tax obligations.
It reflects future tax obligations that are considered a source of financing or an investment in the business's operational assets.

Formula and Calculation

Deferred capital employed is not a standalone formula but rather a component that is sometimes explicitly included in the broader calculation of capital employed. Capital employed itself can be calculated in various ways. One common approach is to subtract current liabilities from total assets:

\text{Capital Employed} = \text{Total Assets} - \text{Current Liabilities}

Alternatively, capital employed can be expressed as the sum of fixed assets and working capital:

\text{Capital Employed} = \text{Fixed Assets} + \text{Working Capital}

When "deferred capital employed" is referenced, particularly in relation to tax liabilities, it implies that deferred tax liabilities are treated as part of the long-term capital financing the business. For example, some analytical approaches or specific corporate financial statements might present capital employed including Tangible net worth + Total debt + Deferred capital employed due to tax liabilities and other income.⁶ In such cases, the "Deferred Capital Employed" component is simply the value of the deferred tax liabilities, which are considered a long-term financing source alongside equity and debt for calculating metrics like Return on Capital Employed (ROCE).

Interpreting the Deferred Capital Employed

Interpreting the presence and magnitude of deferred capital employed requires an understanding of its origin in deferred tax liabilities. When a company has significant deferred capital employed, it indicates that a portion of the capital financing its operations is derived from temporary differences between its financial accounting and tax accounting. Essentially, the company has postponed paying a certain amount of taxes, and this deferred tax obligation is contributing to its pool of capital.

A large deferred capital employed suggests that a company has accumulated significant taxable temporary differences, meaning its current accounting income is greater than its taxable income, leading to future tax payments. While this can provide a short-term cash flow advantage by deferring tax payments, it also represents a future obligation. Analysts examine this component to understand the quality of a company's earnings and its future tax burden. Companies with high deferred capital employed may appear to have a larger capital base, but this capital is tied to future tax payments rather than being fully unencumbered.

Hypothetical Example

Consider "Tech Innovations Inc.", a growing software company. For financial reporting purposes, Tech Innovations uses accelerated depreciation on its servers, resulting in higher depreciation expenses in early years. However, for tax purposes, the company uses straight-line depreciation, which results in lower depreciation expenses in the same early years.

In its first year of operation, Tech Innovations Inc. reports a pre-tax accounting profit of $10 million. Due to the differences in depreciation methods, its taxable profit for the same period is $12 million. Assuming a corporate tax rate of 25%, the current tax payable would be $3 million (25% of $12 million). However, the tax expense on its profit or loss statement based on its accounting profit would be $2.5 million (25% of $10 million).

This creates a deferred tax liability of $0.5 million ($3 million current tax payable - $2.5 million accounting tax expense). This $0.5 million is recorded on the company's balance sheet as a non-current liability. When calculating its "capital employed" for certain internal or analytical purposes, Tech Innovations might include this $0.5 million deferred tax liability as part of its "deferred capital employed," acknowledging that this liability effectively serves as a temporary source of financing for its total assets until it reverses in future periods.

Practical Applications

Deferred capital employed, primarily driven by deferred tax liabilities, has several practical applications in financial analysis and corporate strategy.

Financial Reporting and Analysis: It provides a more complete picture of a company's capital structure in its financial statements. Analysts consider how deferred taxes impact the overall capital employed to assess profitability ratios like Return on Capital Employed (ROCE). A company with a significant deferred tax liability might appear to have more capital at its disposal, affecting how efficiently its operations generate returns.
Valuation and Mergers & Acquisitions (M&A): During valuation or M&A due diligence, understanding deferred capital employed is crucial. Acquirers must assess the future tax obligations represented by deferred tax liabilities. These liabilities are real future cash flow outflows, even if their timing is uncertain. Tax accounting issues, including those related to deferred tax liabilities, are a significant consideration in business combinations.⁵
Tax Planning and Strategy: Companies strategically manage their accounting methods to optimize their tax position. The creation of deferred tax liabilities can indicate that a company is legally deferring tax payments, thereby retaining more cash in the present for operational or investment purposes. This requires adherence to Tax Accounting Principles to ensure compliance while maximizing benefits.⁴
Credit Analysis: Lenders and creditors analyze deferred capital employed to understand a company's true long-term leverage and ability to meet future obligations. While not immediately due, these deferred liabilities represent a claim on future economic benefits.

Limitations and Criticisms

While providing a nuanced view of a company's capital structure, relying heavily on "deferred capital employed" or the underlying deferred tax liabilities can have limitations. One primary criticism stems from the inherent uncertainty and estimation involved in their calculation.

Estimation and Future Uncertainty: The calculation of deferred tax assets and liabilities depends on future tax rates, future taxable income, and the timing of the reversal of temporary differences.³ These are estimates, and changes in tax laws or a company's financial performance can significantly alter the actual tax burden or benefit. This introduces a degree of subjectivity into the reported deferred capital employed.
Complexity: Accounting for deferred taxes is often complex, requiring a deep understanding of both financial accounting standards (like IAS 12 or ASC 740) and tax regulations. This complexity can make it challenging for external stakeholders to fully grasp the implications of a company's deferred capital employed without detailed knowledge.²
Non-Cash Nature: Deferred tax liabilities do not represent actual cash that has been set aside. Instead, they represent a future obligation that will result in a cash outflow at some point. Investors and analysts must remember that this "deferred capital employed" is not liquid capital available for immediate use or distribution.
Impact on Ratios: The inclusion of deferred tax liabilities in the calculation of capital employed can impact various financial ratios, potentially skewing performance metrics if not interpreted with caution. For instance, a higher capital employed figure due to deferred taxes could lead to a lower calculated return on capital employed (ROCE), even if the operational efficiency remains high.

Deferred Capital Employed vs. Capital Employed

The relationship between deferred capital employed and capital employed is one of a part to a whole.

Feature	Deferred Capital Employed	Capital Employed
Definition	The portion of capital employed that arises specifically from deferred tax liabilities or other deferred income/expense items.	The total financial resources invested in a business to generate profits, typically representing the sum of shareholders' equity and long-term debt, or total assets minus current liabilities.¹
Primary Component	Primarily driven by deferred tax liabilities (and sometimes deferred income).	Encompasses all sources of long-term funding, including equity, long-term debt, and sometimes specific non-current liabilities such as deferred tax liabilities.
Nature	Represents a future tax obligation or benefit that temporarily serves as a source of financing.	Represents the total long-term funds tied up in a business's operations and assets.
Calculation Role	An item that is included in certain definitions or analyses of total capital employed, affecting the denominator in profitability ratios.	A standalone metric used to assess a company's investment in its operations, serving as the denominator in key efficiency ratios like Return on Capital Employed (ROCE).
Focus	Highlights the impact of tax timing differences on a company's capital base.	Provides an overall view of a company's investment in its operating assets, indicating how much capital is actively being used to generate returns.

In essence, deferred capital employed is a specific element that can refine the calculation of a company's total capital employed, acknowledging that deferred tax liabilities can influence the total resources deployed by a business.

FAQs

What creates deferred capital employed?

Deferred capital employed typically arises from deferred tax liabilities. These liabilities are created by "temporary differences" between how a company recognizes income and expenses for financial accounting (based on GAAP or IFRS) and how it recognizes them for tax purposes. For example, using different depreciation methods for accounting versus tax can lead to these differences.

Is deferred capital employed a good or bad thing?

It is neither inherently good nor bad; rather, it's a characteristic of a company's financial structure. A high deferred capital employed, driven by deferred tax liabilities, can mean the company has effectively delayed tax payments, which can improve current cash flow. However, it also represents a future obligation that will eventually need to be settled, impacting future cash flows. Its impact depends on the company's specific situation and management of these future liabilities.

How does deferred capital employed relate to capital employed?

Deferred capital employed refers to the portion of a company's capital employed that specifically comes from items like deferred tax liabilities. While capital employed is the total funds invested in the business, deferred capital employed accounts for the contribution of these future tax obligations to that total. It's a specific component that can be added to or considered within the broader capital employed calculation.

Does deferred capital employed represent actual cash?

No, deferred capital employed, especially when it stems from deferred tax liabilities, does not represent actual cash on hand. It is an accounting entry that reflects a future tax obligation. While the deferral of taxes might free up current cash, the amount itself is not a physical asset but a recognition of a future liability based on current operations.