Category Archives: deferred taxes

depreciation

January 24, 2011 By in Accounting, cash flow, deferred taxes, depreciation Tags: , , , , , 5 Comments

I want to talk about subscription services and about cloud computing in particular.  This and the next couple of posts will lay some groundwork.

depreciation

As as investor, I’m interested in depreciation in the accounting sense–the expense on the income statement that represents the allocation of part of the cost of a capital asset (that is, an asset that lasts a long time, like a factory or a piece of machinery) against revenues in a given period of time.  (In an economic sense, which I’m not going to write about here, depreciation is the wearing out or obsolescence of a capital asset.  The two senses of depreciation aren’t the same thing.  In the accounting sense, for example, the laws in a given country or accounting convention determine what can be written off, and by how much.  A factory building, for instance, amy be allowed to be written off over 40 years.  At the end of that time, the carrying value on the balance sheet will be zero, or very close.  But the structure itself may be economically usable for another 20 years.  A further aside–this difference can be very pronounced when dealing with the depletion of mineral reserves.)

a non-cash charge

Depreciation doesn’t represent an outlay of cash during the period it is charged against income.  The factory is already built and the machinery is already installed before anything is made for sale.  It actually represents an inflow of cash which the company is not considering to be profit, but rather recovery of a portion of the capital investment it has made in plant and equipment.

figuring what the quarterly depreciation expense is

To determine the depreciation expense in a given accounting period, a company needs several pieces of information.  They are:

–the cost of the capital item

–its estimated useful life

–estimated salvage value, and

–the method to be used in allocating the depreciable cost (cost – salvage value) over the useful life.

Two allied concepts to depreciation are amortization and depletion. Depletion is the cost allocation procedure for the value of mineral reserves;  amortization is the procedure for intangible assets.

depreciation methods

straight line

The most commonly used method of depreciation in financial reporting is straight line. This means that the depreciable cost is spread in equal amounts over the estimated useful life.  Let’s assume, for example, that an asset has a cost of 1,000, a useful life of 10 years and a salvage value of zero.  The the depreciable value is 1000 – 0 = 1000.  1000/10 years = 100/year.  This means depreciation expense of 25 per quarter or 100 per year.

accelerated

Sometimes companies feel that assets, like computer systems, lose value faster than the straight-line method allows for.  So they will voluntarily use a depreciation method that writes off a larger amount of the asset’s cost in the earlier years of its life.  More often, governments will give companies a tax break by allowing them to use an accelerated depreciation method for writing off a given type of investment on the company’s tax return.

two accelerated techniques

There are two main methods of accelerating depreciation.  They may not make a lot of intuitive sense, but since they’re mostly intended as tax breaks, that shouldn’t matter too much.

1)  declining balance

Declining balance is the name for a family of depreciation schemes that key off the straight line depreciation method.  Specific declining balance schemes are designated as, say, 2x declining balance, 1.75x declining balance, etc.  The number in front refers to the multiple of straight line depreciation that’s applied each year to the depreciable balance for the asset.  “Declining balance” refers to the fact that the the gross depreciable amount declines.  It is reduced each year by the value of the prior year’s depreciation, before the new depreciation is calculated.

For example, let’s say we’re going to use double (2x) declining balance to depreciate the above ten-year life asset with original cost of 1000 and no salvage value.  For a ten-year life asset, straight line depreciation is 10% of the value each year.  Using 2x declining balance means using two times the straight line percentage, or 20%, as the percent of the asset value that we’ll depreciate in each year.

In year one, this means our depreciation is 20% of 1000, or 200.  For year two, we first subtract last year’s depreciation from asset value; that is, 1000 – 200 = 800.  Second year depreciation is 20% of 800, or 160.  In year three, the depreciable balance is 800 – 160 = 640.  Depreciation is 20% of 640, or 128.  And so on.

One quirk–the declining balance method can never get the asset fully depreciated, because you’re always taking only a fraction of the depreciable balance each year.   So accountants made up a fudge to get the system to work.  At some point, declining balance gets you a smaller depreciation expense than using straight line would.    In our case it’s at year six (where 2x declining balance = 20% of the depreciable balance; straight line = 25%).  At that point, you switch to using straight line for the remaining years.

3) sum of the years digits

This method, which doesn’t have any rationale that I can see, is nevertheless pretty straightforward.  Take the estimated useful life in years.  Add together all the digits from one through that number.  That gets you the denominator of a fraction.  Assign the highest digit of the series to the first year of depreciation, the next highest to year two, etc.  That get’s you the numerator.  For each year, multiplying  (the gross depreciable amount) x (the digit assigned) /(sum of the digits) = that year’s depreciation.

For example, in our ten-year lived asset, the sum of the digits 1-10 is 55.  Therefore, first year depreciation is 1000 x 10 /55 =   181.82.  Second year depreciation is 1000 x 9 /55 =  163.64.  And so on.

Two points:

–depreciation is a key element in the calculation of cash low, which is the topic of the next post in this series, and

–the difference in between the taxes on profits as shown in a given financial report to shareholders and the (often much lower) amount actually paid to the tax authority gives rise to deferred taxes, which can be a key element of cash flow as well.

More about these topics in the post on cash flow.

Mike Mayo vs. Citigroup on deferred taxes: round III

September 8, 2010 By in Accounting, Banks, Current Market Thoughts, deferred taxes, Industry Analysis Tags: , , , , , , , , , Leave a comment

Mike Mayo’s writing about C’s deferred tax assets again.  They now amount to over $50 billion and Mr. Mayo thinks at least part should be written off and removed from C’s balance sheet.

Mr. Mayo, a respected Wall Street bank analyst now working at CLSA, has always spoken his mind, even when he knows it will arouse the ire of the major commercial banks he covers.  Banks–like any large-cap publicly listed companies–know how to play hardball.  They can, and have, cut off his access to top management, and they can deny his employer their securities underwriting, and other investment banking, business.  But that has never stopped Mr. Mayo–who (perhaps out of necessity) has worked for a variety of Wall Street firms over his career.

Last year, Mr. Mayo predicted that C would write off $10 billion in deferred tax assets from its balance sheet at yearend.  The company didn’t, explaining in its 10-K that if all else failed it would repatriate massive foreign accumulated profits to enable it to use the tax losses has accumulated on its balance sheet.

So, Mr. Mayo’s writing again.  Why?  –because C’s deferred tax account has continued to grow, reaching $50 billion at the end of the June quarter–or a third of the bank’s tangible equity.  The number is also very big relative to C’s market capitalization of $110 billion.  If they could all be used today, they would probably represent C’s single most important asset.

That’s the question, though.  They can’t all be used today.  In fact, C is generating more of them.  But can they all ever be used before they expire?  Mr. Mayo thinks not.  C says they will be.

My guess is that Mr. Mayo is technically correct, but that we won’t see a writedown for several years, if we ever do.  Two reasons:

–I don’t think the authorities see any percentage in portraying a major commercial bank as being in worse financial shape than its audited financials show it to be now.  At least a portion of the deferred tax assets are counted in the regulatory capital supporting C’s loan portfolio.  No one wants to mess with that at the moment.

Furthermore, C is not alone in having substantial deferred tax assets.  A C writedown might snowball into an investor demand for similar writedowns by other European and US banks.  That would be playing with fire, also.

–There’s a technical reason, as well.  It’s important to distinguish between a company’s financial reporting books, which it presents to investors, and its tax books, which it shows to the IRS.  A company may take a writedown of, say, $10 billion in US assets on its financial reporting books.

Let’s assume, to keep matters simple, that it has no other taxable US income.  If so, on its income statement, the company will show a pretax loss of $10 billion, a deferred tax benefit of $3.5 billion and an after-tax loss of $6.5 billion.  In the footnotes to its financials, it will show a tax carryforward of $3.5 billion.

What’s crucial is that it uses this accounting treatment whether it actually disposes of the assets or retains them at a nominal value on the balance sheet.  And it may not want to sell the assets right away.

Why not?  –because disposal of the assets is what starts the clock ticking on the limited time a company has to make use of the tax losses.  If you’re not making money now, it’s often better to hold off on disposal.  Doing so can extend the time you have to use the lax losses indefinitely.

In C’s case, we don’t know the details of what it has done.  Only C and its auditors know for sure.

Again, why am I writing about this? I think the C tax controversy is interesting, although I don’t own C and have no intention of buying any soon.  I also am intrigued by the idea that yesterday’s loss can be tomorrow’s asset value.  That can be a key issue in evaluating fallen angel bonds or turnaround stocks.  It also has important implications for mutual funds and ETFs, especially in times like these when the securities have big realized losses and are experiencing redemptions.  More on this last topic in a later post.

Mike Mayo vs. Citigroup: score it yourself

March 29, 2010 By in Accounting, Banks, deferred taxes, Industry Analysis Tags: , , , , , Leave a comment

The Mayo prediction

Mike Mayo, the heralded bank analyst of Calyon Securities, predicted late last year that Citigroup would write down its deferred tax asset account, on the books at a net value of $44.6 billion, by $10 billion at yearend.

The 10-k is out

Reporting time has come and gone.  C filed its 10-k, all 272 pages of it, with the SEC about a month ago.  No writedown.  In fact, deferred taxes are up $1.5 billion on a net basis, at $46.1 billion.  This despite three consecutive years of substantial pre-tax losses.  Further, C’s auditor, KPMG, has given C an unqualified audit opinion–meaning KPMG agrees that the accounts give a fair and accurate picture of the company’s finances.

C’s reasoning

in not writing down its deferred tax assets:

1.  Foreign operations aren’t a problem.  The company’s domestic–federal, state and NYC–deferred taxes expire in twenty years.  Over that time the company needs to generate $86 billion in pretax income to use them up fully.  That would be an average of $4.3 billion in pretax a year. (What isn’t said is that if we look back a decade ago, well before the current financial mess, C was earning $10 billion+ annually.)

2.  C has $27.3 billion in profits from foreign operations that are “indefinitely invested” abroad.  Were that money repatriated to the US, $7.4 billion in US income taxes–after allowance for (lower) foreign taxes already paid–would be due.  A reasonable guess (read: my very rough calculation) is that doing so, which would arguably give C greater flexibility in using this capital, would use up about $14 billion of the deferred taxes.

3.  If all else fails, C could sell assets.  Presumably, there are some where C still has a profit.  They might be businesses or physical assets that have been on the books for ages.  Or they could be the money-making side of hedged investment positions.

What to make of this?

Not a lot.

As far as I can tell, Mr. Mayo is keeping a low profile, which is what brokerage analysts do when they make a dramatic, headline-grabbing prediction that doesn’t come true.

C is also leaving well enough alone.  It would be unseemly for a big company to gloat–especially prematurely–over an unfavorable analyst comment.  It will doubtless hope that Mr. Mayo’s future comments about it will be more tempered.  Good luck with that.

KPMG isn’t making a strong statement, either.  Yes, its “unqualified” opinion means it doesn’t see the situation at C as being as dire as Mr. Mayo has been contending.  As far as deferred taxes are concerned, KPMG sees no convincing evidence to say C is crippled enough to be unable to start earning profits at half the rate it did a decade ago.

What makes this news?

Nothing, really.  I just thought I should follow up on the Mayo prediction, since I wrote about it in the first place.  And also, this illustrates a bit about how Wall Street works.

Citigroup’s deferred taxes–what Mike Mayo is saying

November 3, 2009 By in Banks, deferred taxes, Industry Analysis, Vocabulary Tags: , , , , , Leave a comment

The Wall Street Journal reported on Friday that long-time Wall Street bank analyst Mike Mayo told clients in a conference call he expects Citigroup will write off $10 billion in deferred tax assets in December.

Who is Mike Mayo?

He’s an experienced, well-respected sell-side bank analyst.  I don’t think I’ve ever met Mr. Mayo, who now works for French broker Calyon, but I’ve known and used his research for years.  We may even have worked for the same firm for a brief period.

Mr. Mayo periodically draws the ire of bank managements–with not always positive career consequences for himself–for his research findings.  His conclusions, which I think have generally proven to be correct, at times call attention to previously unnoticed company missteps.  Or they may just not be sufficiently bullish to suit company managements that regard analysts as extensions of their public relations efforts, rather than independent researchers.

To understand what he’s saying about Citigroup now,  you have to know some thing about what deferred taxes are.

Deferred taxes

Publicly listed companies keep several sets of books.  Among them are the tax books they use in reporting to the Internal Revenue Service and financial reporting books they use in reporting to shareholders.  Taxable income is typically lower in the reports to the IRS than in those to shareholders.  Deferred taxes are a way of reconciling the two sets of books.

An example:

Let’s say a company has a pre-tax loss of $1 million, and has used up its ability to receive a refund from the government for taxes paid in prior years.  For the IRS, this result is reported as an after-tax loss of $1 million.  The company is able to carry forward this loss, however, and use it to offset future years’ taxable income.  Rules vary from country to country.

In its financial reporting, the company will record a pre-tax loss of $1 million, just like it will for the IRS.  But, in contrast to the IRS filings, it will also record–as a reduction of the current loss–the value of future tax benefits that this loss potentially gives the company.  In this case, let’s say that’s $350,000.  Under financial accounting rules, then, the company will report a net loss of $650,000 to shareholders and record the $350,000 on the balance sheet.

If the company makes $1 million pre-tax next year,

1.  it will record the $1 million in taxable income in its IRS filing, but subtract the $1 million tax loss carryforward and pay $0.

2.  To shareholders, it will report $1 million in pretax income, subtract $350,000 in deferred taxes from that (and remove the balance sheet entry) and report $650,000 in aftertax profit.

Notice that the overall result in both cases is zero. The effect of deferred tax accounting is to make a loss-making company’s results look better in the loss-making years, at the expense of making future profits look worse.

One exception

In order to use deferred tax accounting, a company–and its accountants–have to be convinced that the firm will be able to make enough future profit to actually use the tax loss carryforwards it is taking credit for on the financial reporting books.

In particular, if a company’s fortunes deteriorate after having used deferred taxes to minimize current losses, and it finds it won’t be able to earn enough to actually employ them, it has to write them off.

Finally, to Citigroup

Citigroup had a little over $44 billion in deferred tax liabilities on its books at the end of last year.  According to Mr. Mayo, the company will write off $10 billion of them at yearend.

Typically, a firm’s auditors compel the company to make a writedown like this.  And, unlike Mr. Mayo, accountants are, in my experience, concerned enough about the egos of a client’s top management that they will not do so unless there is overwhelming evidence supporting their conclusion.

So what Mr. Mayo’s statement, if correct, implies to me is that:

1.  the auditors now realize that Citigroup will be significantly less profitable in the future than they had thought less than a year ago,

2.  past earnings have been inadvertently overstated by $10 billion, and

3.  the burden of proof has shifted, away from thinking that the other $34 billion is a conservative number, to worrying about that, too.

Normally, writedown of deferred taxes is an ominous sign for a stock.  And $10 billion is about a tenth of Citigroup’s market cap.  It’s unclear to me in this case, however, whether the writedown Mr. Mayo talked about is an industry phenomenon or something specific to Citigroup.

It also isn’t clear to me even how one could figure out the possibility of such a writedown for a complex multinational business like Citigroup.  My best guess is that this relates to some (unknown to me) legal or regulatory change in the UK, where US firms domiciled much of their activity in toxic assets.

Stay tuned.