Com 4FK3

Financial Statement Analysis

Week 6, 2012

Income Taxes & Reserve Accounts

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Introduction

• If a firm makes money they have to pay income taxes

• A firm often has to use different methods for income tax and financial reporting

• Some expenses may not be deductible• Some revenues may not be taxable• Tax expense ≠ taxes payable

Tax Reporting

• Financial statements and the decisions on which accounting standards or estimates to use, generally, have no effect on the taxes actually paid.

• This includes; revenue recognition, expense recognition, depreciation expense, etc.

• Inventory cost flow is the major exception USA permits LIFO if used on financial statements

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Income Tax Expense

• Calculated under GAAP as income before taxes, excluding permanent differences multiplied by statutory tax rate

• Objective of this version is the matching principle… the tax expense should be recognized at the same time as the revenue that caused it is recognized, regardless of when it is actually paid

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Deferred Tax Assets

• When an expense is recognized for accounting purposes but not allowed yet for tax purposes, we get a deferred tax asset

• e.g. Warrantee expense is recognized at the time of sale under GAAP, but is not deductible for tax purposes until the money is actually spent

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Deferred Tax Liability

• When an expense is reported at a higher level for tax purposes than for accounting purposes a liability is createde.g. Depreciation for tax purposes uses the

DDB method, meaning that, during the early portion of an asset’s life, a much larger amount of depreciation is reported for tax purposes than for financial reporting purposes

Deferred Taxes; Revenue

• Liabilities and assets can also be created by different revenue recognition methods If revenue is recognized earlier on the financial

statements, a deferred tax liability arises (Time of Sale vs. installment)

If revenue if deferred to a later period, but has to be recognized for tax purposes, a deferred tax asset is created (cost recovery first)

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Contentious Issue

• Should deferred taxes be shown at face value or at all?These taxes are a legal liability, but when will

they be paid?For a growing/stable firm they should continue

to get larger every yearOnly if the asset base shrinks; technological

change, or discontinued operation, will they actually be paid

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Permanent Differences

• Some differences will not reverse over timeSome items will be deductible for financial

reporting but not tax deductible (goodwill)Some tax deductions are not allowed by GAAPSome items that are considered income for

financial reporting are not taxable (dividends from taxable Canadian corporations)

• Reconciliation of Income Tax note

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Required Disclosure

• The notes to the financial statements must include:Components of income tax expenseComponents of income before taxesReconciliation of income taxes at statutory rate

and income tax expenseComponents of deferred tax assets and

liabilities

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Year 3 Year 2 Year 1Current - Federal 191 105 123

- Foreign 128 75 61 - State and Local 18 12 13Total Current 337 192 197

Deferred - Federal 35 40 70 - Foreign 38 30 19Total Deferred 73 70 89

Total Income Tax Expense 410 262 286

Components of Income Tax Expense

Components of Income Tax Expense

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Year 3 Year 2 Year 1United States 700 450 600 Foreign 350 250 200

Total 1,050 700 800

Average or effective tax rate for the 3 yearsYear 3 Year 2 Year 1

39.05% 37.43% 35.75%

Components of Income Before Taxes

Components of Income Before Taxes

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Reconciliation

Year 3 Year 2 Year 1

1Income taxes on income before taxes at statutory rate

35.0% 35.0% 35.0%

2Foreign tax rates greater (less) than federal statutory rate

4.1% 2.5% 1.3%

3 State and local taxes 1.1% 1.1% 1.1%4 Dividend deduction -0.6% -0.5% -0.7%5 Tax exempt income -0.4% -0.4% -0.5%6 Goodwill amortization 0.6% 0.4% 0.2%

7Percentage depletion in excess of cost

-0.8% -0.7% -0.7%

Income tax expense 39.0% 37.4% 35.7%

Reconciliation of income taxes at statutory rate and income tax expense

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Deferred Taxes

Year 3 Year 2 Year 1 Year 0Deferred Tax Asset

8 Uncollectible Accounts Receivable 16 19 17 159 Warrantees 91 105 89 76

10 Pensions 71 83 67 5311 Leases 62 54 42 3212 Net Operating Losses 0 13 0 0

Total Deferred Tax Asset 240 274 215 176

Deferred Tax Liabilities13 Depreciable Assets 476 421 355 27514 Inventories 59 58 49 4115 Installment Receivables 193 205 171 14916 Intangible Drilling and Development Costs 91 96 76 58

Total Deferred Tax Liability 819 780 651 523

December 31Components of Deferred Tax Assets and Liabilities

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Foreign Tax Rates

• If a company operates in more than one country, a single tax rate does not occur

• Tax Expense is calculated as if all taxes were being paid in the home country and then adjustments are made to account for the differences

• For year 3, foreign income was taxed at a rate of: 166/350 = 47.4%

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State and Local Taxes

• In the US, State and Local taxes based on income are deductible from taxable income

• The incremental difference caused by paying those taxes and the tax benefit of the deduction is recorded

• In year 3, State and Local taxes were $12 after taxes for an effect of 12/1,050 = 1.1%

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Dividends

• In the USA, only 20-30% (depending on % ownership) of dividends from unconsolidated subsidiaries are included in taxable income if they are subject to US taxation

• In Canada, dividends from qualified taxable Canadian companies are not taxable

• Idea: attempt to limit triple taxation

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Tax Exempt Income

• In the USA, many bonds that are issued by municipal and state bodies are exempt from federal taxation

• Under GAAP, income from these sources is included in calculation of income

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Goodwill Amortization

• Although added to the books under GAAP, goodwill is not recognized for tax reporting

• Since 2002, the handling of goodwill has changed, amortization is no longer required however, periodic revaluations and write-downs can happen and they would also be permanent differences

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Percentage Depletion

• Under US tax laws for mining companies, this deduction is a fraction of gross income from a property

• This often exceeds the acquisition cost• Under GAAP, depletion allowance is not

allowed to exceed acquisition cost

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Deferred Taxes vs. Reconciliation

• Deferred taxes arise because a timing difference in the recognition of expenses or revenues for tax or accounting purposes

• Over the life of the company, these timing differences are expected to reverse

• Reconciliation items arise from differences in what is allowable and are permanent

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Uncollectible A/R

• At point of sale, firms estimate bad debt expense and declare it as an expense

• For tax, only when a specific account is deemed uncollectible can it be deducted

• An increasing balance is quite common as long as the level of sales are increasing, the decrease in year 3 may be due to a decrease in credit sales

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Warrantees

• Due to matching principle, warrantee expense is declared at TOS, but is not tax deductible until the costs are incurred

• A stable growing company will usually have an increasing balance in this account

• The year 3 decline may be caused by a drop in sales (as with bad debt) or by breakdowns

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Pensions

• Expense is recognized for financial statements as work is done and pension obligations incurred

• Tax reporting is deferred until money is actually deposited into the pension fund

• Tax deductions may be limited if the fund is over-funded

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Leases

• Usually occurs if lease is capital for financial statement and operating for tax

• Depreciation expense plus interest expense is likely to be higher than lease payments in the early years of the lease

• Therefore book expenses are likely to be higher than tax expenses in the early life of a leased asset

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Operating Losses

• When a firm reports an operating loss for tax purposes, it can carry it back for 3 years or forward for 7

• If there is a reasonable chance that the deduction is not usable (50%) a valuation allowance must be made

• The appearance in the deferred taxes must relate to a consolidated subsidiary

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Depreciable Assets

• Tax depreciation as DDB means that in the early year’s of an asset’s life, depreciation for tax is greater than financial statement depreciation

• This will create a liability since more tax will be paid during the later stages of the asset’s life

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Inventories

• Rarely a source of deferred tax liabilities• The balance could be created by expensing

some items of overhead for tax purposes while adding them to the cost of finished goods inventory for accounting purposes

• e.g. normal spoilage set at 0% for tax purposes and 5% for cost accounting

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Instalment Receivables

• When allowing 2 or more years to pay, a firm may recognize revenue at time of sale for financial reporting and use the instalment method for tax

• The decrease in this account in year 3 is consistent with the impression of slowing sales given by uncollectible A/R and warrantees

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Intangible Drilling and Development Costs

• Expensed when incurred for tax purposes• Capitalized for financial reporting• Since it has already been fully expensed for

taxes, it won’t generate future tax savings although it will show as a future expense for financial reporting

• The decrease in year 3 suggests a slowdown in spending on such assets

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Book vs. Taxable Income

• Was the book income greater than the taxable income for this company in year 3?Deferred tax assets fell $34Deferred tax liabilities rose $39Overall $73 of taxes were deferred

• Therefore the company recognized higher income on the financial statements than they reported to the tax authorities

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Effective Tax Rate

• The definition of the effective tax rate is:

RateTax Effective

ExpenseTax IncomeTaxes Income Before IncomeBook

Taxes Income Before IncomeBook

ExpenseTax IncomeRateTax Effective

so

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The Firm’s Tax Position

• From the example, the firm is facing an increasing effective tax rate due mainly to higher foreign tax rates

• Can theyShift some operations to lower tax locales?Adjust transfer prices and/or cost allocations?Borrow more in the high tax rate jurisdictions?

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Reserve Accounts

• A result of accrual accountingWhen a firm recognizes an expense but has not

spent any money, a reserve account is credited e.g. warrantee repair liability

If a firm receives cash but does not recognize any revenue, a reserve account is credited

e.g. deposits on purchases

• Can be abused for earnings manipulation

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Other Comprehensive Income

• A line item under owner’s equity• Allows the recognition or unrealized

holding period gains/losses on the balance sheet without having it appear on the income statementTypical uses include value changes in equity

holdings and foreign currency valued assets