Class 8 - Final

8/12/2019 Class 8 - Final

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Most companies use amortized costs (i.e., the historical marketinterest rate) to account for liabilities.

Both IFRS and US-GAAP allow fair value accounting as an

alternative (the fair value option).

Under the fair value option the current market interest is used.

Companies can choose between amortized cost and fair valueaccounting on a case-by-case basis. However, the choice to use thefair value option is irrevocable.

The fair value option is mainly used by financial institutions.

The fair value option

even if we dont use fair value accounting/dont repurchase the bond, the value at the end of the period will stillbe 526 (referring to problem from earlier slide)


3/43

JPMorgan Chase & Co.

Jamie Dimon, JPMorgan Chase CEO, discussed thefinancial crisis on March 11, 2009.

Part of the discussion is on Fair Value Accounting.

Fast forward to 17:45 (stop at 19:03):http://www.cnbc.com/id/15840232?video=1058977582&play=1

Notice the three key issues discussed:

1. Mark-to-market (fair value accounting) creates volatility.2. Too much flexibility in accounting.3. Increase in credit spreads/credit risk may result in

accounting gains.

When you become more risky, you begin to generate a lot of profits (which is confusing because its not because yourebetter)


4/43

JPMorgan Chase & Co Fair value option

Income from continuingoperations before income taxwas 2,773

Unrealized gains on debt 69+24+125+3,682 =3,900

Dr. Liabilities (L) 3,900Cr. Gain on liabilities (RE) 3,900

ecognized 3.9 billion in gains because of becoming riskier


5/43

Ambac, Citigroup and MGM Mirage

What was the effect of Fair Value Accounting on reportedearnings of Ambac and Citigroup?

What can explain an increase of 433% in short termliabilities of MGM Mirage?

Citigroup: when citigroup was bailed out by govt they reported 1.6 billion of profits and the marketreaction was very positive (many thought was signal of market recovery) but majority of profitswere related to the gains on liabilities because they used fair value accounting.

At the beginning of the crisis there was a lot of business debt. Debts have covenants and theMGM covenant stated that they had to keep a specific level of profitability or declare bankruptcy.Because they had so many losses, they violated the covenant and they had to pay back themoneyso bank gave them 3 months to recover and find more money. The problem: cross-default prohibition. If you default on one specific loan, then every other lender will declare thatyou default on everything else? Because MGM was not sure if they could pay off the loan, all oftheir assets were put on default, hence the dramatic increase in liabilities.


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Off-Balance Sheet Financing : Use of assets or services by a firm thatobligates them to sacrifice cash payments in the future, but thetransaction is structured to avoid recording a liability on the balancesheet

Why do firms want to keep debt off the balance sheet?! Reduced perceived riskiness of the firm! Increased access to new debt! Maintain slack in existing debt covenants! => What do we need to assume for this to work?

Goal of GAAP: Assess whether the company using the assets bearsthe risks and rewards of ownership. If so, that party will likely have torecord the asset and the liability on its balance sheet

Off-Balance Sheet Financing


7/43

Where weve been

Simple rental agreement! At inception

! Over the life of the agreement

Firm issues bonds and uses proceeds to buy asset

! At inception

! Over the life of the agreement

ext


8/43

Firms may lease (or rent) assets instead of purchasingthem.

Lease : Contract where owner of assets ( lessor ) transfersuse of assets to another entity ( lessee ) for a fixed period of time in exchange for a series of payments.

Examples include leased office space or aircraft.

Some leases are so inflexible that they are equivalent to a purchase. They may be non-cancelable, long-term andimpose on the lessee all costs of operating.

Leases

According to GAAP, even if a lease, for accounting purposes we will treat this as the

purchase of a lease (if you behaves like a purchase economically speaking)


9/43

Contrast leasing a car for 5 years with renting a car for aweek.Who bears the economic risks?

Two accounting methods for leases:! Capital Lease : lessee purchases the asset! Operating Lease : lessee rents the asset

The firm does not choose the accounting method theaccounting method is dictated by the structure of thecontract.

However, the firm has the ability to choose the structure ofthe contract. In effect, they can choose the accountingmethod.

Leases

not a rent even if the legaldocument says so


10/43

Capital leases recognize the lease as if it were a purchaseand thus recognize both the leased asset and lease liability.The lease asset may be depreciated over time and the leaseliability may be amortized as payments are made.

Similar accounting treatment as if the firm had purchased the asset with the proceeds from a bankloan (which is in effect what it is).

If the lease is not capitalized, it will be treated as anoperating lease . In this case, a lease expense would berecognized as payments were made, but no asset or long-

term liability would be recognized.

Leases


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Rules: Firms must use capital lease accounting if lease is non-cancelable and any one of the following applies:

! Ownership is transferred at the end of the lease

! A bargain purchase option exists (right to buy asset atlease end for less than market value)

! Lease period covers more than 75% of assets life

! Present value of contractual future lease payments exceeds90% of the current market value of the asset

Source: SFAS 13 (1976)

Capital Lease vs. Operating Lease


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If the lease fails all four tests, then the lessee accounts for it as anOperating Lease

! No asset or liability is recorded! Record operating lease (rent) expense at time of usage:

Operating Lease Expense XXCash** XX

**Or accrued expense, if the cash changes hands outside of theusage period.

Future operating lease payments must be disclosed in footnotes.

Operating Lease


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Disclosure Example - Target

Future Minimum Lease Payments(millions)

OperatingLeases

CapitalLeases

2007 $142 $15

2008 136 152009 130 15

2010 122 16

2011 113 16

After 2011 2,682 172

Total future minimum lease payments 3,325 (a) 249

Less: Interest (b) (126 )

Present value of minimum capital lease payments $123

doesnt show up on balancesheet (look @ footnotes!)

on balance sheet


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Disclosure Example United Airlines

Number of Leased Aircraft in Operating Fleet United and UAL 142 269 69(In millions)

Payable during(a)2009 $ 351 $ 441 $ 553 $ 2372010 323 441 518 5092011 323 428 457 2902012 312 383 415 1492013 291 367 386 141After 2013 655 1,090 2,798 520

UAL minimum lease payments $ 2,255 $ 3,150 $ 5,127 1,846

Imputed interest (at rates of 2 .1% to 16.0%) (486 )Present value of minimum lease payments 1,360Current portion (168 )Long-term obligations under capital leases $ 1,192

Mainline United Express Capital

Aircraft Aircraft Non-aircraft Leas es (b)


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If lease contract passes at least one test, it is accounted for as a CapitalLease:

! Record an asset and liability at the present value of lease payments

Dr. Capital Lease Asset XXCr. Capital Lease Liability XX

! Annually record depreciation expense and record cash payments asinterest expense and reduction in liability

Dr. Depreciation Expense XXCr. Accumulated Depreciation XX

Dr. Interest Expense (interest rate * book value of liability)Dr. Capital Lease Liability PLUG

Cr. Cash Contract Payment

Capital Lease


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Lease Example($45,000 computer, 3-yr. lease, fixed pmt. of 17,462 per year, 8% market

rate)

Operating LeaseAt inception

No entry

At end of year 1Rent Expense 17,462

Cash 17,462


Cash 17,462


Cash 17,462

Capital LeaseAt inceptionLeasehold asset 45,000

Lease liability 45,000At end of year 1Interest Expense 3,600Lease liability 13,862

Cash 17,462Depreciation Exp. 15,000

Accumulated Dep. 15,000At end of year 2Interest Expense 2,491Lease liability 14,970

Cash 17,462

Depreciation Exp. 15,000Accumulated Dep. 15,000At end of year 3Interest Expense 1,293Lease liability 16,168

Cash 17,462Depreciation Exp. 15,000

Accumulated Dep. 15,000

if not given, can find by: present value of 17462 -future payment (3 pa yments of 17462)

n=3, i=8%

liabilityside

asset side

45000 x 8%

straight line depreciation:(45000-0)/3

(45000-13662) + 8%book value at beg of yr 2

WO SIDES!


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Accounting for Lessors

Operating LeaseAt inception

Equipment 39,000Inventory 39,000

At end of each yearCash 17,462

Rent Revenue 17,462

Depreciation Exp 13,000Acm. Depr. 13,000

Capital LeaseAt inceptionLease Receivable 45,000

Sales Revenue 45,000COGS 39,000

Inventory 39,000

At end of first yearCash 17,462

Interest Revenue 3,600

Lease Receivable 13,862

no depreciation expenseeven tho legal owners ofasset b/c lesses arerecording it


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Capital and Operating Leases Problem


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Problem Cont


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Capital and Operating Leases Problema) How did we move from the beginning balance to the ending balance of capital lease liability?

ease liability

1088 BB new liabilities

927 EB

161

Journal entryinterest explease liability

cash 263 (frm footnote)

102161

reduction invalue

b) 102 (interest exp)/1088 (BB) = 9.375% bc value x bb is usually how we get the interest expense

c) LA

BB 1019

EB 865

154 epreciationxpnew leases

depreciation exp 154 acc. dep 154

e) rent expense 1065cash 1065


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Leases Final Thoughts

For a given lease contract, under either method:

! Income effect is the same over the life of the asset(Capital leases usually generate more expense in earlieryears when interest expense is highest and less expensein later years, relative to an operating leases constantexpense)

! Cash flows are the same each year (ignoring incometaxes)

Capital leases - higher expenses at the beginning and smaller expenses at the endOperating leases - amount of expense will be equal every year of the leaseEXAMPLE OF SUPER COMPUTERS


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Contingencies: Potential Liabilities

Contingent liabilities are potential liabilities The more probable the potential to become a legal obligation, the

greater the rationale for recognizing it as a liability.

Probability of a potential liability is very difficult to measure. In general, an obligation should be recognized as a liability if it is

probable that the firm will have make future sacrifices of resources.

Of course, the word probable is also difficult to measure. FASB requires the recognition of a loss and a contingent liability when

! It is probable that a liability incurred, and! The amount of the loss can be reasonably estimated.


23/43

Merck - Vioxx Litigation

As of December 31, 2008, the Company had been served or was awarethat it had been named as a defendant in approximately 10,800lawsuits, which include approximately 26,800 plaintiff groups,alleging personal injuries resulting from the use of Vioxx

Under the Settlement Agreement, Merck will pay a fixed aggregateamount of $4.85 billion for qualifying claims that enter into theSettlement Program.

As of December 31, 2007, the Company had an aggregate reserve ofapproximately $5.372 billion (the Vioxx Reserve) for the SettlementProgram and the Companys future legal defense costs related to theVioxx Litigation.

Dr. Vioxx Settlement Charge (RE) $5,372,000,000Cr. Vioxx Reserve (L) $5,372,000,000


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Merck & Co 2008 Global Restructuring Program

In October 2008, the Company announced a global restructuring program (the 2008Restructuring Program) to reduce its cost structure, increase efficiency, and enhancecompetitiveness. As part of the 2008 Restructuring Program, the Company expects to eliminateapproximately 7,200 positions 6,800 active employees and 400 vacancies across all areasof the Company worldwide by the end of 2011.

As part of the 2008 Restructuring Program, the Company is streamlining management layers byreducing its total number of senior and mid-level executives globally by approximately 25%.

In connection with the 2008 Restructuring Program, separation costs under the Companysexisting severance programs worldwide were accounted for under FAS 112 and recorded in thethird quarter of 2008 to the extent such costs were probable and estimable.

The Company recorded pretax restructuring costs of $921.3 million related to the 2008Restructuring Program in 2008.

Restructuring Liability

Dr. Restructuring charge (loss) $921.3Cr. Restructuring liability $921.3


25/43

BP p.l.c.Gulf of Mexico oil spill

On 20 April 2010 an explosion and fire occurred on the semi-submersible rig Deepwater Horizon in the Gulf of Mexico andon 22 April the vessel sank. The accident resulted in the tragicloss of 11 lives and the significant loss of containment ofhydrocarbons.

From the time of the incident until 15 July, oil and gas wasflowing into the Gulf of Mexico from the well at an estimatedrate of between 35,000 and 60,000 barrels of oil per day.

A total of 836 miles of Gulf Coast shoreline in Louisiana,Mississippi, Alabama and Florida have been oiled. If you create a liability before, then you could be admitting to guilt prematurely.Had to create the liability because there is not doubt there will be many fees they have to pay to the govt. They wouldnt beable to get out without paying a large sum, but how do you determine this expense amount? Estimate the direct costs ofcleaning up and litigation and fines.


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How does the oil spill affect BP?

Direct costs of cleaning up ! Since the incident occurred, BP has been pursuing multiple parallel

tracks to stop the flow of hydrocarbons, to contain and capture, ordisperse, the oil subsea, to collect or disperse oil that has reached thesurface, to protect the shores, and to clean up oil that has reached theshores. These efforts are being carried out in conjunction with governmentauthorities and other industry experts. BP has committed to clean up theoil from the spill.

Litigation and fines ! BP is subject to a number of legal proceedings and investigations related

to the incident, including: a US Department of Justice investigation todetermine whether US civil or criminal laws have been violated; a USPresidential Commission to examine the causes of the incident; a jointinvestigation by the U.S. Coast Guard and the Bureau of Ocean EnergyManagement, Regulation and Enforcement; US state and federal agenciesinvestigations . In addition, BP group companies are among thosenamed as defendants in more than 300 private civil lawsuits.


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How do you estimate these costs reliably in Q2 2010?

BP

s response:! BP has agreed to establish a $20-billion escrow account. The escrow

account will be available to satisfy legitimate claims.. Fines and penalties

will be paid separately and not from the escrow account. The establishmentof this account does not represent a cap or floor on BP s liabilities and BPdoes not admit to a liability of this amount. Any amounts left in the accountonce all legitimate claims have been resolved and paid will revert to BP.

What they did was to create a trustee account (instead of an official liability account) to show that they had enoughmoney to set aside to cover everything they did and the trustees will manage that money.


28/43


BPs accounting response

The group income statement for the second quarter reflects a charge for thecosts incurred up to 30 June 2010 and obligations for future costs which can

be estimated reliably at this time.

The group income statement reflects a pre-tax charge of $32.2 billion.This includes $2.9 billion which has been charged for costs incurred to 30June 2010.

The amount provided for future costs reflects offshore and onshore oil spillresponse, BP's commitment to a 10-year environmental research programme,and the funding of the Louisiana barrier islands project, estimated legal costsexpected to be incurred in relation to litigation, and an amount for estimated

penalties for strict liability under the Clean Water Act.

The charge does not reflect any amounts in relation to fines and penaltiesexcept for those relating to the Clean Water Act, as it is not possible toestimate reliably either the amount or timing of such additional amounts.

Are these the total costs to BPs shareholders?


29/43


Political costs and damage to brand:! A six-month moratorium on deepwater exploration and development

drilling has been imposed by the US Government. ! More widespread moves to change regulatory standards elsewhere in the

world are under consideration but have yet to be taken. These could

materially impact the timing and cost of future exploration, developmentand production activity. ! The incident has damaged BP s reputation and brand, with adverse

public and political sentiment evident. This could persist into the longerterm, which could impede our ability to deliver long-term growth.

BP

s response:! BP has committed that its share of the revenue from the sale of oil

recovered from skimming operations and the well containment systemswill be donated to the National Fish and Wildlife Foundation (NFWF).

! BP has committed to fund up to $500 million for a 10-year research program studying the impact of the Gulf of Mexico oil spill


30/43


Going concern? ! Since the incident the credit rating of BP p.l.c. has been downgraded. In

addition, the adverse news flow and market speculation has led to thegroup s credit default swap spreads widening to levels that implysignificantly weaker ratings. Consequently the group has not accessedsome of the financing options that were available on more acceptableterms in the past.

BP

s response:! The group conducted a liquidity review. Monthly cash flow forecasts

have been prepared for the period to the end of 2011. These forecasts have

been subject to sensitivity testing under various downside scenarios whichhave been designed to model the impact of the reasonably foreseeableuncertainties faced by the group.

! BP believes that, taking into account its undrawn borrowing facilities andits ability to generate cash, including disposal proceeds, the group hassufficient working capital for foreseeable requirements.

!

The group intends to reduce net debt to $10-15 billion within the next 18months.


31/43

Should we invest in BP?

What factors are most important for an investor toconsider?

As an investor how would you value BP in this situation?

Things to consider: total expense from accident, are we expecting them to generate enough cash in the future tocover this, damage to brand name/falling stock prices (and some people might pull out of company > maybeits a good time to invest?), is the estimated $3.2 billion a reasonable estimate?, look at other similar cases andhow they were settled, look at how much revenue this specific rig was bringing.

SEC claims BP misled investors in discussions right after spill regarding the magnitude of the situation andfurther fined them.

Last summer BP had to pay a hefty legal fee to the US govt (single largest sum recorded in history)$4.5 billion dollars (on top of $3.2 billion dollars)

PENALTY TAX DEDUCTIBLE?Fees and legal penalties are not tax deductibleCannot tell IRS sorry we committed fraud and our profits werent as high as expected. Can we have our moneyback?


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What is tax expense?

! Tax is an expense like any other expense (e.g., rent or utilities).! You might think that tax expense for a particular year is simply the

taxes paid for that year. Which would look like this:Dr. Tax expense (RE) XXX

Cr. Cash/tax payable XXX! That is not the case, because tax rules for income recognition are

different from GAAP rules.! For instance, tax rules sometimes allow later recognition of income

than GAAP (e.g., accelerated depreciation methods).

! GAAP requires us to recognize expenses independent fromcash flows!The payment that we make to the IRS may be very different from the tax we actuallyrecord


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Terms

Book income (Pre-Tax Income) is income before income taxes forfinancial reporting purposes.

Income tax expense on the income statement is based on pretax incomecomputed using accrual accounting methods.

Taxable income is the amount of income on which the income tax is based.

Income tax paid is based on IRS taxable income using IRS tax rules.

The two may be different because of:

! The timing of recognition may be different, or! Some revenues or expenses may have special tax treatments


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Deferred Taxes

Matching Principle says tax expense should equal: Taxes Payable to the IRS

! Plus income taxes payable in the future when temporarydifferences reverse

! Less income taxes saved in the future when temporarydifferences reverse

Thus, tax expense this period recognizes all taxes payabledue to revenues/expenses this period, regardless of whenthose taxes are paid.

We dont care when something is paid, we just look at all the revenues/expenses related to their period

Simple examp le: assume for the year we have BDE of $100 (expense that reflects the expectation of future losses because ofuncollectibles) and net income before tax is $200 with a tax rate of 40%Estimate of NI before tax for IRS = $200 + $100 BDE = $300 (BDE not considered an expense for IRS purposes and is not takenout from revenues)Tax expense in financial statement = $200 x .4 = $80Tax payment to IRS = $300 x .4 = $120$80 (tax exp) = $120 (tax payable) - $40 (tax saved in the future) deferred tax assets

IRS tax accounting is still accrual accounting!


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GAAP (pre-tax) income vs. IRS (taxable) income

The difference between book and taxable income are of two types:Temporary differences - Items recognized in both tax and GAAP reporting, but the amounts differ

due to timing." For example, book income may use straight line depreciation while taxable income

will use an accelerated depreciation method. Over time, both will depreciate the sameamount but at different times.

" Other examples include: Bad debt expense and warranty expense." Over the life of the firm, the amount of cash paid to the IRS must be equal to the tax

expense recorded for financial reporting purposes.

=> These differences give rise to deferred tax assets or liabilities.

Permanent differences are differences caused by items that either enter book income but never taxable income or vice versa.

" Some GAAP revenues are not taxable and some GAAP expenses are not taxdeductible.

" Examples include: Municipal bonds yield book income but not taxable income; finesare not tax deductible.

=> These differences never reverse and therefore do not give rise to deferred taxassets/liabilities.

IRS tax accounting is still accrual accounting!


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Examples of book-tax timing differences

Item Tax Method GAAP MethodAccountsReceivable

Direct charge-off method foruncollectible accounts

Allowance method

DepreciableAssets

Accelerated Straight-line

WarrantyClaims

Deduct actual expenditures Accrue liability to matchrevenue

Restructuringcharges

Losses are deducted as incurred Losses are expensed whenmanagement adopts plan andlosses are estimable

Capitalizationof interest costs

Interest on some self-constructedassets is deducted when incurred

Interest is capitalized

Long-termcontracts

Percentage of completion method Contractor may use completedcontract method in some cases

Pensions Deducts cash contribution to pension trust fund but limits

deductions when fund isoverfunded

Recognize expense whenemployees render services

only recognize BDE when they happen

high amt of exp at beg,low amt at end


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Simplified Formulas

Income Taxes Payable (the amount the firm must pay tothe IRS) = Taxable Income * Tax Rate

Income Tax Expense (recorded on the firms IncomeStatement) = (Pre-Tax Income Permanent Differences) *Tax Rate

The difference between the two affects either a DeferredTax Asset or a Deferred Tax Liability

Income Tax Expense = Income Taxes Payable+/- Deferred Tax Assets/Liabilities

Over time, the amount of cash paid to the IRS must beequal to the tax expense recorded for financial reporting

purposes. Deferred tax assets and liabilities simply affectthe timing of the expense.

(according to IRS)

differences that are never the same forIRS and books

DTL:


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Deferred Tax Assets and Liabilities

Deferred Tax Liabilities! From temporary differences that will result in future taxable income (i.e. book tax

today > IRS tax today). Example: Book Income = $250; IRS Income = $225Dr. Income tax expense 100

Cr. Deferred tax liability 10Cr. Income taxes payable (or cash) 90

DTL of $10 equals ($250 - $225) * 40% tax rate

Deferred Tax Assets! From temporary differences that will result in future tax deductions (i.e. book tax

today < IRS tax today). Example: Book Income = $500; IRS Income = $600Dr. Income tax expense 200Dr. Deferred tax asset 40

Cr. Income taxes payable (or cash) 240

DTA of $40 equals ($600 - $500) * 40% tax rate

rom income statement

depreciation: $25 forbook purposes, $50for IRS, hence thediscrepancy inbook and IRS income

based on tax for book purposes = 250 x .4we pay MORE taxes in thefuture related to thisdifference because in thefuture accelerateddepreciation will be slower

225 x .4

500 x .4 =were going to SAVE taxessome time in the futurebecause finally IRS willaccount for the deferred taxincome

= 600 x .4

Everything that is an expense for IRStoday but I havent accounted for todaycreates DTL

Depreciation expense for IRS is higher because of accelerated depreciationliability taxes payable < taxes expense


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Deferred Tax Liability Example($120,000 machine w/3-year useful life; 40% tax rate)

Journal Entry Year 1 Year 2 Year 3Income tax expense 24 24 24Deferred tax liab. 9

Deferred tax liab. 4 5Income tax payable 20 19 33

KEY: Note that DTL balance = [AD(tax) AD(book)] * tax rate

DTL balance 4 9 04 = (49-40)*.4 9=(102-80)*.4 0=(120-120)*.4

Straight Line (books) Accel. (tax)

Yr.

EBITDADepr.Exp.

EBIT

TaxExp.

Acm.Depr.

Depr.Exp.

EBIT

TaxPyble

Acm.Depr.

1 100 40 60 24 40 49 51 20 49

2 100 40 60 24 80 53 47 19 102

3 100 40 60 24 120 18 82 33 120120 72 120 72

differences between tax expense and tax payable

b/c youve fully depreciated an assetfor financial AND tax purposes sothe balance evens out


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Assume we have a $120,000 machine with a 3 year useful life; 40% tax rateBook purposes: straight line depreciation (so $40 depreciation each year), as a result tax expense is constantevery yearTax purposes: accelerated depreciation (so decreased depreciation expense each year), as a result tax payable

decreases every yearShortcut to find DTL balance:(accumulated dep for tax purposes - accumulated dep for book purposes) x Tax Rate


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Deferred Tax Footnotes

Components of Income before Tax! Domestic vs. Foreign

Components of Income Tax Expense! Currently payable vs. Deferred

Reconciliation from Statutory to Effective Income Tax Rates Components of Deferred Tax Assets and Liabilities

Note: Deferred tax assets and liabilities are not discounted to present value, but are based on future expected tax rates

If < 50% chance of recognizing the benefit from a deferred taxasset, then set up valuation allowance for deferred tax assets contra-asset account that reduces value of the deferred tax asset.

I (l ) b f t i t d f


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Merck & Co:

Deferred TaxFootnotes

Income (loss) before taxes consisted of:

Years Ended December 31

Domestic $ 5,086.20 $ (2,647.2 ) $ 2,124.40Foreign 4,721.60 6,017.90 4,097.00

$ 9,807.80 $ 3,370.70 $ 6,221.40

Taxes on income consisted of:

Years Ended December 31

Current provisionFederal $ 1,053.60 $ 988.1 $ 1,618.40

Foreign 292.4 687 458.3State 123.3 202.2 241.1

1,469.30 1,877.30 2,317.80

Deferred provisionFederal 419 (1,671.5 ) (374.1 )Foreign 55.8 157.2 (130.3 )

State 55.3 (267.7 ) (25.8 )530.1 (1,782.0 ) (530.2 )

$ 1,999.40 $ 95.3 $ 1,787.60

2008 2007 2006

2008 2007 2006

! Deferredtax

Dr. Income tax expense (RE) 1,999Cr. Income tax payable (L) /cash 1,469Cr. Deferred tax liability 530

Tax payables


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Merck & Co: Footnote on effective tax rate"

Effective tax rate = Income Tax Expense / Pretax Book Income= 1,999.4 / 9,807.8 = 20.39% (< 35% U.S. statutory rate).

Tax rate Tax rate Tax rate

U.S. statutory rate applied toincome before taxes $ 3,432.70 35 % $ 1,179.80 35 % $ 2,177.50 35 %

Differential arising from:

Foreign earnings (1,155.2 ) (11.7 ) (1,196.0 ) (35.5 ) (1,024.1 ) (16.5 )

Foreign tax credit utilization (192.0 ) (2.0 ) - - - -

State tax settlements (191.6 ) (2.0 ) - - - -Tax exemption for Puerto Ricooperations - - - - (87.6 ) (1.4 )

State taxes 310.9 3.2 11.6 0.3 129.6 2.1

Acquired research - - 113.8 3.4 266.9 4.3

Other (1) (205.4 ) (2.1 ) (13.9 ) (0.4 ) 325.3 5.2

$ 1,999.40 20.4 % $ 95.3 2.8 % $ 1,787.60 28.7 %

2008 2007 2006

Amount Amount Amount

Documents

Class 8 - Final