Thursday, January 18, 2007

Deferred Tax Assets

Accounting is one of the most amazing, interesting and ungodly smartest invention of the modern world especially towards the contribution of how it advanced capitalism. Having said that, it is also extremely important to know its limitations, particularly on how things are accounted for. As you may be aware, accounting is just an estimated, not a precise system. For example, the most basic difference is in depreciation, SIA may have a 10 years depreciation policy while Qantas may have a 15 years policy, the way this difference will work out will be all-important to the bottomline with all other things being equal. Thus, there are some areas in the financial statements an investor should train himself or herself to look out for, which will ultimately reduce many unhappy incidents (and of course increases your chances of getting the right pick) which he or she would have otherwise encountered if they had not taken note of.
One area of the balance sheet which can be both frustrating and obscure is known as the deferred tax items. Everyone would have an idea what role "accounts receivable" and "property plant and equipment" play in the balance sheet. But Deferred Tax items? As the name suggests, it is some sort of an asset which a business will receive in the future. But what role does it plays? Let's take a closer look.
Deferred taxes exist because the accounting for the shareholder's income (what the company tells you) and taxable income (what the company tells the tax man) are different. You may ask why. Let's say you're on a date with an attractive person of the opposite sex, and this person politely asks you your disposable income. You employ a brilliant accountant who was able to make your income look like it was $0, thus exempting you from paying any taxes. Would you thus triumphantly declare to your date that you made all of zero dollars in taxable income last year? So, if you put that picture on to the business world, it is similar. Companies paint as dreary a picture as they can to the tax man in order to reduce or tax payments, but to someone they're trying to impress (shareholders), they'll probably show a rosier picture. Here, the large part has nothing much to do with how good you are towards understanding finance, it is more on how you understand human behaviour - of which Charlie Munger advocates as all-important if you want to succeed in anything.
In deferred taxes, there're two parts - Deferred tax assets and Deferred tax liabilities. We shall start with the fairly easier to understand part: Deferred Tax Assets. Think of deferred as delayed, or somewhat in the future. We know what taxes are, and we know that assets are a positive thing. In other words, deferred tax asset (DTA) is a future tax benefit. A DTA is created when shareholder income (what the company tells you) falls short of the taxable income (what IRAS sees). A DTA is somewhat the same as a Prepayment or prepaid tax.
Deferred tax assets can result from Warranties, restructuring charges, net operating losses, and unrealized security losses. For example in Restructuring charges, USG is a prime recent example, they're poised to receive a tax credit of USD1.8 billion some time this year due to their emergence and settlement from Chapter 11. Another example will be in Warrenties, Courts and Best Connection sell ton of electronics that come with multi-year in-house warranties. Every year, these companies have to estimate on their future warranty expenses based on how many returns they think they'll get. The company tells you - the shareholder - these estimates, and expenses them on that year financial statements, thus decreasing shareholder income which in turn decreases shareholder taxes. However, IRAS says that warranty expenses cannot be recognized until the actual event takes place, and as a result, shareholder income is lower than taxable income. Thus, until such warranty expenses take place when the item is return, would Courts or Best has to report higher income (and thus pay higher taxes) to IRAS. This results in a deferred tax asset account simply because Courts or Best has prepaid these warranty taxes and will receive a future benefit (lower taxes) when the warranty event actually occurs.
As highlighted at the outset, accounting is just an estimate and many times, A does not equals to B and thus you need to insert C into the formula to make it A+C = B. Here B is to be Deferred Tax Asset intially estimated or expected. A is the actual Deferred Tax asset that will be received and if A falls short of B, how do you account for that? You need to create an account called "Allowance" which in this case is C. So A+C = B.
In other words, if a company does not think it will receive the full benefit of a DTA (B), it can offset this with a valuation allowance in order to be more conservative. For example, a company losing tons of money will have lots of NOLs (net operating losses) in the form of DTAs. These NOLs can be used to offset future income, which lowers taxes. But, if a company can't reasonably expect to make a future profit, then it'll never reap the benefit of those NOLs, and a valuation allowance must be set up to reflect this.
Here, a word of caution, in today world of creative accounting, you should keep a watchful eye on valuation allowance. The fact is since Valuation Allowance is an estimation by the management standard where they can be either conservation (reserve too much) or aggressive (reserve too litttle), this is a very subjective matter that can lead to manipulation of the company's earnings. For example, if a company has a $100 million valuation allowance to offset $100 million in DTAs, and in a particular year, the management realizes that they're going to miss earnings by $10 million, it can make a slightly more aggressive assumptions to release $10 million in its valuation allowance to make up for the expected shortfall, this release from Valuation allowance will flow to net income and thus, allows the company to meet earnings forecast by whoever.

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