In almost all countries publicly traded companies maintain three sets of accounting records. They are:
–tax books, in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.
Keeping the tax records may also involve a tax planning element. A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction. Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.
Tax considerations can also have operational consequences. For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.
–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).
If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.
The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue. Financial accounting rules allow such costs to be spread out evenly over long periods of time. Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.
The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.
—management control books, kept according to cost accounting rules. These are the records that a company’s top executives use to organize and direct the firm’s operations. They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals. Not all parts of a firm are supposed to make profits. Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company. A mature division may not have the job of growing itself anymore, but of generating the largest possible amount of cash.
Investors normally don’t get to see either a company’s tax books or its management control books.
Financial reporting books can sometimes give a picture that’s too rosy. The two main culprits are deferred taxes and capitalized interest. “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished. Even though money is going out the door, under GAAP it’s not shown as a current expense. I’ll explain deferred taxes next week.
In a very practical sense, you don’t need to understand either one too much (although it might be nice to). Turn to the company’s cash flow statement in its latest SEC earnings filing. Are there deferred tax or capitalized interest entries? Do they add to cash flow or subtract from it? …by how much? If the answer is no, or that they add to cash flow, there’s nothing to worry about. If they subtract–and a lot, on the other hand, there’s a potential problem.