If you’ve never read the income tax note in a company’s annual report, you’re not alone. Many portfolio managers and sell-side analysts don’t bother, either. It’s a mundane and coma-inducing part of the financial statements. So you won’t like this advice: read the tax note.

What’s in there?

The tax note sums up differences between a company’s reported income tax expense versus what might be expected by multiplying income before tax by the statutory tax rate.

There are dozens of reasons differences might occur, such as gains or losses not recognizable for tax, or gaps between accounting depreciation rates and what is allowed for tax purposes, such as capital cost allowance.

After all the exemptions, exceptions, timing differences and other items add up, the result is the company’s income tax expense, which can be used to calculate the effective tax rate. Tax expense reflects what occurred during the year, but can also include adjustments for previous and future years.

So the tax expense and the effective tax rate show what the company will pay in cash taxes, right? Sorry, no. Cash taxes are calculated another way.

An entity’s cash taxes can be affected by other factors. For instance, the company may have tax loss carry-forwards from reported losses in previous years, which can be used to reduce cash taxes owing in the current year.

Analysts often just ask management what cash taxes will be in the coming years, then plug the number into their discounted cash-flow model and dispense with the income tax note. There lies the opportunity. As forensic accountants, we’ve always found interesting items in the tax note. The biggest one by far is valuation allowances.

Valuation allowances

A valuation allowance is an accounting nugget that reaffirms your belief that accrual accounting and financial reporting is just a bunch of nonsense. Accountants go through a significant exercise of calculating the company’s future income tax assets and liabilities, which include amounts deferred to future periods for various reasons and items like loss carry-forwards. The whole exercise looks precise in the notes, but belying that is the process behind applying a valuation allowance.

In a nutshell, companies may possess non-capital tax loss carry-forwards, but it does not mean they can use them in the future before they expire. They will need taxable income from operations to apply the loss carry-forwards. In other words, they’ll need to make money sometime in the future. That throws the potential value of the carry-forwards into question and makes you wonder whether they should be recorded in the financial statements at all.

Then it comes down to figuring out how to adjust their value. For that, you have to turn to the accounting rules. Unfortunately, this is where investors are let down considerably by the accountants. The International Financial Reporting Standards (IFRS) state that management estimates whether the tax assets are “more likely than not” to be realizable. The U.S. rules have the same approach, but give much more guidance in weighing the potential impact of positive and negative factors on whether to apply or revise a valuation allowance.

Ford Motor Co.

A good example is Ford Motor Co.’s recent second-quarter filing with the U.S. Securities and Exchange Commission (SEC). The company currently has a valuation allowance of $15.7 billion recorded on its balance sheet, which results in a net future tax asset of just $868 million. Removing that valuation allowance (which is up to the judgment of management) would result in the tax asset increasing by $15.7 billion in value, and at least $10 billion flowing through net income to the tune of roughly $2.70 extra per share. Analysts are calling for Ford to make $1.95 per share this year without any impact of a change in the valuation allowance.

Back in the first quarter, Ford mentioned it might remove the valuation as early as Q4 of this year. The principal reason was that its record of operating losses was improving, and those losses weighed heavily in determining the need for a valuation allowance.

The company recorded significant losses from 2006 to 2009, but swung back to a profit in 2010. With 2011 on track for more gains, the company’s trailing three-year profit record was turning positive to the point where management felt it might be close to reversing the allowance.

The company actually goes on for several pages discussing the approach taken in determining its valuation allowance. Unfortunately, you could never expect the same in Canada. You might not even see any discussion of the fact that a company has changed its valuation allowance. There might only be a change in the numbers in the tax note, which then flows through the financial statements and has a significant impact on income.

While other factors are also at play, Ford’s previous losses remain the biggest factor. The company explains it as follows:
“In assessing the need for a valuation allowance, we consider both positive and negative evidence related to the likelihood of realization of the deferred tax assets. If, based on the weight of available evidence, it is more likely than not the deferred tax assets will not be realized, we record a valuation allowance.

The weight given to the positive and negative evidence is commensurate with the extent to which the evidence may be objectively verified. As such, it is generally difficult for positive evidence regarding projected future taxable income exclusive of reversing taxable temporary differences to outweigh objective negative evidence of recent financial reporting losses.”

Window into a mindset

The most interesting aspect from the Ford example is the insight into what the company thinks its future will hold. Ford must weigh a number of factors in making its decision. For the company to contemplate removing its $15.7 billion valuation allowance, it must believe it will make significant profits for many years to come.

The change in the record of trailing three-year losses reverses the significant negative factor that held the valuation allowance in place, likely beyond its time. The U.S. accounting rules require that such significant negative factors usually outweigh all other positive factors.

Aside from insight into management expectations for future results, changes in valuation allowances can reveal other significant motives at play. As forensic accountants, we are skeptical since we have repeatedly seen management bending weak accounting rules to its benefit.

This ties back to the previous comment regarding the dearth of required disclosure under IFRS accounting rules compared to U.S. requirements when it comes to management explaining the reasons behind changes in valuation allowances. A valuation allowance is a management estimate that has a direct impact on reported income.

Management might simply remove a valuation allowance for the positive impact on income optics and potentially, profit-sharing bonuses for executives. This possibility is more likely under IFRS because U.S. rules are more stringent in the process that management should follow in removing the allowance.

Adequate disclosure is crucial for advisors to assess management motives behind a change in
valuation allowance. The more robust process and disclosure requirements dictated by U.S. rules help to reassure investors that Ford’s change in valuation allowance is actually a positive sign, indicating its outlook for the future profitability.

By contrast, investors need to watch for examples in Canada under IFRS reporting where management might be taking advantage of the weak accounting process and disclosure requirements to hide something from investors.

So you can see that tax note in the financial statements is worth a second look. Uncovering a few key words might tip you off to something bigger.

Dr. Al Rosen, FCA, FCMA, CIP, CFE, CPA and Mark Rosen, MBA, CFA run Accountability Research Corp., providing independent research to investment advisors across Canada.