US corporate income tax reform (ii)

To summarize yesterday’s post:

firms with taxable income

Lowering the corporate tax rate in the US, while eliminating special interest tax preferences/exemptions, will benefit companies that have a high current tax rate.  It will boost such a firm’s earnings by as much as 30%.

On the other hand, companies that have a low income tax rate will receive little or no benefit.  Continuing to spend resources on what are in effect tax shelters for themselves will make no sense.  To the extent that they are able to unwind these arrangements, they will benefit by doing so.  If, however, they are recipients of special interest tax reduction deals, they may be absolute losers, as well as relative ones, if/when these special preferences are eliminated.

The greatest uncertainty here is whether industries that are recipients of large tax breaks, like real estate and oil and gas, will have their special interest preferences eliminated.  This will be a key indicator of whether the “Drain the Swamp” rhetoric is more than an empty slogan.

firms with losses

This case is not as straightforward, thanks to wrinkles in the Generally Accepted Accounting Principles used by publicly traded companies in their reports to shareholders.

for the IRS

Let’s assume a firm makes a pre-tax loss in the current year.

 

The company has a limited ability to use this loss to offset taxes paid in past years ( it carries the loss back).  It restates its past returns and gets a refund.

If it still has a portion of the loss that can’t be used in this way, it carries the loss forward to potentially use to shield income in future years from tax.

If the corporate income tax rate drops from 35% to 15%, the amount of pre-tax income that can be sheltered from tax by loss carryforwards remains the same.  But the value of the carryforward is reduced by 60%.

for financial reporting

That’s tomorrow’s topic.

 

oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.

 

 

 

deferred taxes (II): how they’re important

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 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.

deferred taxes (I): what they are

Last week I wrote about how publicly traded companies typically maintain three sets of books:  tax books, management control books and financial reporting books.

The two sets we’ll be concerned about today are the financial reporting books and the tax books, the ones that outsiders get to see.

Hang onto your hat and let’s get started!

why deferred taxes?

It’s reasonable to ask whether these two accounting pictures of a company’s financial health exist in parallel universes–one to poor mouth the company in order to minimize taxes, the other to flatter results so that shareholders will be happier than maybe they should be     …or is there something that ties the two sets together?

they connect tax and shareholder records

There are, in fact, two ways in which these sets of books are connected.

First, the IRS doesn’t let a company pick radically different accounting methods for tax books from the ones it uses for shareholder reports.  Inventories–meaning all that FIFO or LIFO stuff–are an example.

In addition, there are deferred taxes.

what they are

The income tax line is the one place that financial accounting standards compel a company to reveal something about the books it keeps for tax authorities.

When the financial accountants work down the income statement, they start with the sales line.  They subtract various costs, like materials, marketing, interest payments…   from revenues as they work their way to net profit.  When they’ve figured out  pre-tax income, they apply the appropriate income tax rate and subtract to get to net income.  They do this country by country, local and national.  

Then they reconcile with the tax books

They do this by dividing the tax figure they’ve arrived at into two components:

–the tax actually paid to the IRS or its equivalent, called cash taxes; and

–the rest, called deferred taxes.  

The deferred tax figure can be positive, meaning the company is sending smaller check(s) to the tax authorities than the total amount of tax shown on the financial reporting books; or it can be negative, meaning the company is paying out more than the total tax charge shown on the shareholder records.

Sounds weird, doesn’t it?  That’s because it is.

But try to get used to the idea.  It can be important.

how deferred taxes come to be

Lots of ways.  But it’s all about timing differences.

for example

The simplest is this:  a company builds a factory that costs $1,000,000, has a useful life of 40 years and has no value after that.  On the shareholder books, the company allocates the factory expense evenly over the 40 years, at the rate of $25,000 a year.  Accountants call this the straight line depreciation method.

On the other hand, the national government may want to encourage companies to build factories of this type.  So it gives them tax breaks by, say, allowing firms to front-load the tax writeoffs.  Maybe it allows a firm to write off $250,000 of the total cost in the first year (lowering otherwise taxable income by that much), $100,000 in the second, and the rest in progressively smaller amounts over the following seven years.  This is an accelerated depreciation method.

Let’s assume this is the only difference between the company’s tax books and its shareholder books.  If so, in year one the tax books will show $225,000 less in pre-tax income than the shareholder books ($250,000 – $25,000), due to the faster timing of the factory writeoff on the former.  Depending on the rate of corporate income tax, the company will pay something like $80,000 less in cash taxes than the financial books show as due.  This amount will be recorded as deferred tax.

where you can see this stuff

Usually not on the income statement.

Two places:  in the tax footnote to the income statement, and in the cash flow statement   …not usually, however, on the income statement itself.

Tomorrow:  why this geeky stuff can be important