Yesterday I wrote about what deferred taxes are.  Today,

why it matters

1.  The two most important sources of money coming in the door (i.e., cash flow) for companies are net income and depreciation.  Deferred taxes–that is, tax expense that’s shown on the income statement but not actually paid to the tax authorities, are number three.

Most companies succeed in pushing back the tax bill for an extremely long time.  So although deferred taxes aren’t as rock-solid as net or depreciation as a source of cash flow, they can be pretty dependable.  This means that companies in a heavy investment mode (building new buildings, installing new machinery/computers…) have more money in their hands than the income statement shows.   Look at the cash flow statement–the statement of sources and uses of funds–to see what the effect of deferred taxes on cash flow may be.

Mature companies are gradually forced to pay the tax-break piper.  After all, we’re talking about taxes deferred, not forgiven.  So they have less money coming in than the income statement suggests.  Again, check the cash flow statement.

2.  Deferred taxes have a second, even less intuitively obvious, accounting use.  It’s crucial to understand, though, when dealing with “deep value” (read: really junky) companies.

Suppose the company has a pre-tax loss of $1,000,000 on its tax books.  It can typically “carry back” at least part of the loss, meaning it can retroactively apply it to prior years’ income and get a tax refund.  If it can’t, the after-tax loss is $1,000,000.  And the firm can “carry forward” the loss to use as an offset against taxable income in the future.  These loss carryforwards expire if they’re not used within a certain number of years, however. (Relevant information will be found in the tax footnote to the financials.)

Financial reporting treatment is different.  Normally the firm’s accountants will assume that the tax loss carryforwards will be used to offset future taxable income before they expire.  If so, and the firm has a pre-tax $1,000,000 loss on its shareholder books, the accountants will apply in the current statements a deferred tax credit of, say, $350,000.  So the financial reporting loss will not be $1,000,000 but $650,000.

In this case, the financial reporting books understate the loss.

the crucial issue

That’s not the crucial issue, though.  The accounting firm that prepares the company’s books will only allow the deferred tax deduction as long as it believes the firm will be a “going concern”  (read: will avoid bankruptcy) and will generate enough future taxable income to use the loss carryforwards.  If it decides otherwise, it must require that the company reverse some or all of the previously recorded deferred taxes.

The worst about this is, of course, not the change in accounting treatment, but it signals the words dead and duck have begun to dance across the auditors’ minds.

Check out my post on Mike Mayo and Citigroup for a real-life example.