Economic Concept of Income
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A relatively new group of |
How
accounting gets more radical in measuring what really matters to investors
Ten-year
average return on U.S. Treasury bonds: 4.5%
Average ROE for all companies with physical
assets and inventories: 7.0%
Average
expected return on equity for
A new income statement and
balance sheet
minus costs to serve customers
minus costs to produce products/services
minus costs to develop products/services
minus admin costs
minus taxes
plus/minus non-cash adjustments
Cash Earnings
Get
more radical: Calculate Knowledge-Capital Earnings (KCE)
Summary
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(1) |
Solicitors have a duty to tell |
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(2) |
The court can order a party to |
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(3) |
An outline of these provisions is |
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(4) |
Interim orders for costs: Where the court |
|
(5) |
Interest on costs: The court has power |
Summary Assessment
Conditional fee agreements
Comprehensive income
Economic
Income Taxes
Temporary income tax
differences
Income tax disclosures
Analyzing
income taxes
Accounting concepts of
income
This
paper examines how conservative accounting affects the relation between
accounting data and firm value. The analysis shows that conservative accounting
can be characterized equivalently in terms of book value, earnings, or book
rate of return. Furthermore, capitalized earnings generally provide a less
biased estimate of equity value than book value does. In addition, firm growth
affects the way earnings and book values are combined in valuation. A weighted
average of book value and capitalized earnings, with the weight on earnings
being an increasing and convex function of growth, yields an asymptotically
unbiased estimate of equity value. When growth is positive, the weight on book
value is negative.
JEL classification
codes:
A corporate balance
sheet, prepared according to generally accepted accounting principles, does a
reasonable job informing about the physical assets and financial capital
employed by a company. But when it comes to the increasingly important
intangible assets of corporate enterprises, it provides next to no insight.
Usual financial reporting reveal very little that’s meaningful to assess if a
corporation is successful or not when it owns a considerable portion of
intangible assets. And intangible assets such as the value of the relationship
to the people or organizations a company sells to (customer value), the value
of the relationship to organizations or individuals through which a company
sells or is doing business with in general (business partner network value),
the R&D pipeline of new leading edge products that will increase a
company’s market share and will generate new revenue and free cash flow in the
future (R&D pipeline or innovation capital), a highly skilled and talented
work force which is committed to the company (human capital), leading edge
business processes, organization structures and a corporate culture that help
to convert individual knowledge and skills of employees into relationship value
and innovation capital which the company owns when employees go home
(structural capital), represent the major value drivers of today’s new economy
and the basis for innovation, economic growth and wealth – both for companies
and nations.
Under GAAP, expenditures
made to increase brand awareness, to foster innovation, or to improve the
productivity of employees cannot be capitalized. Instead, the logic goes, they
must be expensed through the income statement, because the future benefits of
such investments are so uncertain. The problem is, that corporate investments
in tangible assets have stagnated while corporate value creation has surged at
the same time. The S&P 500 index, reflecting the market value of the major
U.S. corporations, surged between 135.76 at the end of 1980 to 1342.62 on
November 20, 2000 – a ten fold increase. In the same period investments into
tangible assets in the U.S. (as a percentage of corporate GDP) decreased from
14.1% in the 1980s to 12.6% in the 1990s (see “Intangibles: What put the New in the New
Economy”, page 4). This suggest, that a large portion of the growth
in corporate value over the past two decades has been created through
investments into intangibles, for which financial reporting and accounting does
not account for. It is the investments in R&D, in organizational innovation
and organizational capital, in marketing and customer acquisition, that drive
the performance of companies today.
If you look at the
average return for financial, physical and intellectual assets, this becomes
very clear:
Financial
Physical
Intangible
biotech and software industries: 10.5%
This was the result of studies
conducted by Baruch Lev, Professor of Accounting and Finance with the Stern
School of Business at New York University. In a study for the chemical
industry he found, that R&D investments of 83 companies over a
span of 25 years returned 17% after tax,
whereas capital spending earned just the cost of capital of 8%. So investments
into intangible assets remain not only invisible through the traditional accounting approach, they are also the
investments that yield the highest return ! So accountants and CFOs obviously
need to do something about it to make this hidden value drivers more manageable
and provide investors with more useful information.
Traditional
accounting does not help to manage and to report on Intangible Assets
But unfortunately the
value creation process of this type of investments is hard to grasp. We had
long had a good idea of how to value manufacturing inventory or assess what a
factory is worth. Today, the value of R&D invested in a software program,
or the value of a user base of an Internet shopping site like Amazon.com is a
lot harder to quantify. As intangible assets continue to grow in both size and
scope, more and more people are questioning whether the true value – and the
drivers of that value – is being reflected in a timely manner in accounting and
in publicly available disclosure. Accounting’s fundamental purpose is to
provide information that is useful in making rational investment, credit, and
similar decision. In 1978 book value, as presented in the balance sheet of
companies, was on average around 95% of the market value of companies in the
US. Twenty years later, book value was just 28% of market value. So investors
simply don’t value what accountants count.
How
to change the actual and insufficient measurement, accounting and disclosure practice?
In October 1999, former
Chairman of the U.S. Securities and Exchange Commission (SEC), Arthur Levitt,
asked Dean Jeffrey E. Garten of the Yale School of Management to form a task
force of leaders from the business community, academia, the accounting
profession, standard setting bodies, and corporate America to examine how the
current business reporting framework can more effectively capture these
momentous changes in the economy. On June 06, 2001 the task force presented its
final report “Strengthening
Financial Markets: Do Investors Have The Information They Need?”. In
that report the task force made two recommendations
for improvements:
1. Create a new framework for
supplement reporting of intangible assets. It recommends that the SEC pull together
the work that has already been done by academics, the accounting firms and
projects sponsored by organizations such as the U.S. Financial Accounting
Standards Board (FASB) in order to move forward with a framework for voluntary
supplement reporting for intangible assets, operating performance measures and
other information that would help investors to assess a company’s future performance. Such a framework of
voluntary supplement reporting should complement existing GAAP-based financial
statements by creating a common language for companies and investors to
communicate about intangible assets and operating performance measures.
2.
Create an
environment that encourages innovation in disclosures. In addition to working
to create a framework for disclosures about intangible assets and operating
performance measures, the task force believes that the government should take
as many actions as it can to create an environment that encourages innovative
disclosures by reducing the risks associated with doing so. Many members of the
tasks force felt, that the actual legal situation in the U.S. has discouraged
companies from experimenting with supplement disclosures, despite already
existing “safe harbour” provisions. The task force recommends to protect
companies, who are willing to disclose more information, by new laws and/or new
regulations from legal actions from shareholders. Companies should be permitted
to provide more “soft” and speculative information as long as they warn
investors that the information is speculative and provide explicit definitions
about how such information is constructed. This could be done for example
through a special marked section on a company’s investor relations website.
What is supplement accounting or reporting?
Some innovators, like the Swedish financial service company
Skandia, already introduced
a supplement report to its annual report 1998. Under the leadership of Leif Edvinsson, its former
director of Intellectual Capital Management, Skandia has pioneered a new system
for visualizing and developing intellectual, intangible and organizational
business assets, which it used to manage the business internally but also to
report to the public in the form a
supplement report to its annual report
He developed the “Navigator”, a kind of Balanced Scorecard, to do that.
The Navigator consists of five value-creating fields which present measure and
key performance indicators for each area (see figure 1): The financial sector
represents the stored past, the company’s achievements so far. The company’s
people, customers, and processes are its very existence. Its innovation and
development powers form the foundation, its future perspective, the new bottom
line. The Navigator provides, beside financial results, ratios and measures on
the status of Skandia’s intangibles assets, such as number of customer
contracts, which gives an indication of the value created for customers, such
as number of contracts per employee, which gives an indication about
effectiveness of processes and about organizational effectiveness at large. Another
example is share of premiums from new launches (products), which gives an
indication about the success of past product innovation (see the supplementary report of Skandia, the navigator,
for 1998). This navigator at Skandia was the basis both for business
planning and management as well as for outside reporting in form of a
supplement report.
Another
proposal for overhauling accounting and disclosure is, to change the structure
and content of traditional financial statements such as the income statement,
balance sheet, and cash flow statement.
The
“old” income statement highlights the most important cost of the
production orientated era: the costs of goods sold. When raw materials and
direct labours made up most of a product’s cost, that was important information
for managers and investors. But today, intangible based businesses have very
low variable costs or costs of goods sold, but high fixed costs or initial
investments – for example into R&D or brand building. So costs of good sold
is not that important any more. Marketing costs and costs spend for R&D is
much more important. And also profit is not a reliable indicator of performance
any more. Often profit has become a subjective number that depends on when
revenues and expenses are recognized. This is because the relationship between
revenues and costs/expenses is not that tight anymore with intangible assets
based business. You invest today into R&D to get some day in the future
revenues out of that – hopefully.
So
one proposal, which was often made in the last couple of years, was to change
to cash based accounting. If you take the other topics mentioned above into
account and remove interest expense (an financing activity – I come back to
that), the format of the new income or operating statement could look like
that:
Revenues
Earnings before interest and taxes
This change of the income statement should give readers an idea where a
company spends money and it replaces manipulated “profit” with easy to
verifiable cash money (you just have to look at the bank account). It focuses
on the important tasks of companies today: taking care of customers (sales and
marketing, shipping, service), producing things to sell (manufacturing or
providing services, materials, equipment), and producing future offerings
(research and development, knowledge creation). And it makes admin costs, a
proxy for efficiency, visible and does not lump it into an item “sales,
general, and administrative costs”.
The balance sheet is usually a snapshot of what resources
(assets) a company controls and where it got the money to buy or built them
(from shareholders/equity or through borrowings from third parties). In many
industries today outsourcing of operations (and of the corresponding physical
assets) has become usual. And some
companies, like retailers, work with negative working capital. So today’s
companies need less of physical assets or working capital to do their job. So
it is not control of resources versus funding of these resources what has to be
in the focus of today’s companies, but investments, mainly investments into the
future, into intangible assets versus financing of these investments. So the
new balance sheet should not compare assets with liabilities and equity but
investments with financings. On the investment side you will then find, beside
working capital and fixed assets, intangible assets. And intangible assets like
the R&D pipeline, the know-how of a work force, brand equity and a large
customer base, relationships to business partners, are the real assets of
knowledge-intensive companies. Therefore money spend on them should be treated
and booked as investments. A balance sheet like this answers questions managers
and investors need to ask: What are you really doing with the money you raise ?
How are you investing into the future ?
And the task of the new cash flow statement is not any more to
tell about a companies effectiveness in using financial resources (that does
the new operating statement and balance sheet). Managers and investors need to
know how much cash a business produces over and above what’s needed to operate
it: free cash flow. So the new cash flow statement might take cash earnings
(from operating statement), deduct from that investing activities (into working
capital, fixed assets, and intangible assets), and get as a result free cash
flow.
With that approach, companies will be better able to focus on the real
concern of business under today’s condition and under the growing dominance of
intangible assets: producing cash and creating value.
Another approach, more from a macro perspective, is, to start with a
company’s performance – company earnings – and then go inside and identify what
assets produced the earnings. This is an approach proposed by Baruch Lev, who
was mentioned already above:
Start with a company’s earnings, for example $500 million and then look
at its balance sheet to see what it has in financial (for example $1 billion)
and physical assets (another $2 billion). As it was outlined above, the average
after-tax return of financial assets is about 4.5% and of tangible assets it is
7%. So $45 million and $140 million respectively of the total earnings can be
credited to financial and tangible assets. So $315 million must have been
produced by other assets. Baruch Lev calls that residual “knowledge-capital
earnings” (KCE). He then calculates the knowledge capital itself by dividing
the earnings by an expected rate of return on knowledge assets (10.5% – see
above). So, to produce $315 million in earnings, that company would need $3
billion in intangible assets.
With Marc Bothwell, a vice president of Credit Suisse Asset Management,
Baruch Lev has been investigating the implications of his work. They analysed
and ranked for the third time leading American companies in 22 nonfinancial
industries by knowledge capital through a so called Knowledge Capital
Scorecard. The result was
published in CFO Magazine in April, 2001.
And it indicates clearly the value of incorporating knowledge capital
into investment analysis. For example, the Scorecard shows that the market
valuations of such New Economy stars as Dell Computer, Microsoft, and Intel, as
well as knowledge-intensive companies in the pharmaceutical and biotech
industries, have very little to do with the assets reflected on their balance
sheets. Their stocks trade at huge multiples of book value (examples: Dell,
17.5; Pfizer, 18.2). But when knowledge capital is added to book value (a sum
deemed comprehensive value by Baruch Lev), the ratio of market value to that
comprehensive value becomes far more reasonable: Dell, 1.26; Pfizer, 1.90.
And Companies with a ratio of market
value to comprehensive value significantly above 1 can be viewed as overvalued.
Those with a ratio below 1 are probably undervalued. The negative correlation
between this ratio and the subsequent stock returns of the 105 companies
evaluated in the Scorecard was remarkably strong. Between the August 31, 2000,
cutoff date for the Scorecard analysis and the end of last year, the average
weighted return of 53 companies with a ratio of market value to comprehensive
value below the median of 1.08 was 7 percent. For the 52 companies with a ratio
above the median, the average return was -15.5 percent. Companies with some of
the highest ratios, such as Broadcom (8.5) and Siebel Systems (5.8), have since
experienced some of the most severe slides in the stock market. Broadcom was
down 80 percent since last August, and Siebel is down 60 percent compared with
their stock value in April 2001. In contrast, companies trading at low
multiples of comprehensive value fared far better. The shares of Rockwell
International, for example, with a ratio of 0.62, and Georgia Pacific (0.35)
were both up 15 percent over the same period.
As we have seen, there are serious
reasons to reengineer the traditional accounting approach and how business
information for management and investors is prepared. There are already
different concepts and methodologies available – each with a different focus.
The solution probably lies in a combination of these different approaches and
of some other important aspects into a new comprehensive accounting, management
and reporting system. The design of that new system will need the engagement of
consultants, accounting professionals, academics and practitioners. And it will
take some time. Therefore I will continue here and in my forthcoming “Intangible
Assets oder die Kunst, Mehrwert zu schaffen: Erfolgreiche Unternehmensführung
im Zeitalter des Intellectual
Capital” (“Intangible Assets or the Art to Create Value: Successfull
Enterprise Management in the Era of Intellectual Capitalism”) to present the actual status of discussion and the new evolving
concepts.
More about
New Economy Economics and Management Best Practice in general, and about other
related topics will be continued here in this new New Economy Analyst reports.
Interest cost
This Chapter does not set out to do
more than refer to some salient points on costs
relevant to proceedings
in the Chancery Division. In particular it does not deal with the processes of
detailed assessment or appeals in
relation to such assessments.
costs in
the CPR and in the PDpdp-43,
pdp-48.
Supplementing Parts 43
to 48
(Costs PDpdp-43)
are likely to be relevant to Chancery proceedings:
The court will generally make a
summary assessment of costs
whenever the hearing lasts for less than one day. The judge or Master who heard
the application or other hearing (which will include a trial, or
the hearing of a Part 8
Claim, lasting less than a day) carries out the summary assessment. The court
may decide not to assess costs
summarily either because it orders the costs to be
“costs in the case” or because it considers the case to be otherwise
inappropriate for summary assessment, typically because substantial issues
arise as to the amount of the costs
claimed. Costs
payable to a party funded by the Legal Services Commission
cannot be assessed summarily.
costs
summarily at the end of the hearing each party who intends to claim costs must,
no later than 24 hours before the time fixed for the hearing, serve on the other party,
and file with the court, his or her statement of costs.
Paragraph 13.5
of the Costs
PDpdp-44
contains requirements about the information to be included in this statement,
and the form of the statement. Failure by a party to file and serve his or her
statement of costs
as required by paragraph 13.5
of the Costs
PDpdp-44
will be taken into account by the court in deciding what order to make about costs and
could result in a reduced assessment, in no order being made as to costs, or
in the party being penalised in respect of the costs of
any further hearing or detailed assessment hearing which may be required as a
result of the party’s failure.
receiving
party (the party to whom the costs are
to be paid) is funded by the Legal Services Commission
the court cannot assess costs
summarily. It is not, however, prevented from assessing costs
summarily by the fact that the paying party
(the party by whom the costs are
to be paid) is so funded. A summary assessment of costs
payable by a person funded by the Legal Services Commission is not by
itself a determination
of the amount of those costs which
the funded party is to pay (as to which see section 11 of the Access to Justice
Act 1999 and regulation 10 of the Community Legal Services (Costs) Regulations
2000). Ordinarily, where costs are
summarily assessed and ordered to be paid by a funded person the order will
provide that the determination of any amount which the person who is or
was in receipt of services funded by the Legal Services Commission
is to pay shall be dealt with in accordance with regulation 10 of the Regulations
costs to be
paid by one person to another can be determined on the standard basis or the
indemnity basis. The basis to be used is determined when the court decides that
a person should pay the costs of
another. The usual basis is the standard basis and this is the basis that will
apply if the order does not specify the basis of assessment. Costs that
are unreasonably incurred or are unreasonable in amount are not allowed on
either basis.
On the standard basis the court only
allows costs
which are proportionate to the matters in issue. If it has any doubt as to
whether the costs
were reasonably incurred or reasonable and proportionate in amount, it resolves
the doubt in favour of the paying party.
The concept of proportionality will always require the court to consider
whether the costs
which have been incurred were warranted having regard to the issues involved. A
successful party who incurs costs which
are disproportionate to the issues involved and upon which he or she has
succeeded will only recover an amount of costs which
the court considers to have been proportionate to those issues.
On the indemnity basis the court
resolves any doubt it may have as to whether the costs were
reasonably incurred or were reasonable in amount in favour of the receiving
party.
The court must take into account all
the circumstances, including the parties’ conduct and the other matters
mentioned in rule 44.5.
Indemnity costs
are not confined to cases of improper or reprehensible conduct. They will not,
however, usually be awarded unless there has been conduct by the paying party
which the court regards as unreasonable or unless the case falls within rule 48.4 .
costs which
are awarded against him or her and summarily assessed within 14 days of the
assessment. But the court can extend that time (rules 44.8,
3.1(a)). The court may therefore direct
payment by instalments, or defer the liability to pay costs until
the end of the proceedings
so that the costs
can then be set against any costs or
judgment to which the paying party
then becomes entitled.
If the parties have agreed the amount
of costs, they
do not need to file a statement of the costs, and
summary assessment is unnecessary. If the parties to an application are able to
agree an order by consent without the parties attending they should also agree
a figure for costs
to be inserted in the order or agree that there should be no order as to costs. If
the costs
position cannot be agreed then the parties will have to attend on the
appointment but unless good reason can be shown for the failure of the parties
to deal with costs
as set out above no costs will
be allowed for that attendance. The court finds it most unsatisfactory if
parties agree the terms of a consent order but not the provision for costs.
Depending on the facts and circumstances, the court may not be able to decide
on the question of costs
without hearing the application fully, but it is not likely to be consistent
with the overriding objective to allow the necessary amount of court time to
the dispute on costs
in such a case. The court may then have to decide the costs issue
on a broad brush approach, making an order against one party or the other only
if it is clear, without spending too much time on it, that such an order would
be appropriate, and otherwise making no order as to the costs.
The court should be informed, on any
application for the payment of costs, if
any party has entered into a conditional
fee agreement. The court can then consider whether, in the light of
that agreement, to stay the payment of any costs which
have been summarily assessed until the end of the action, or to decline to
order the payment of costs on
account under rule 44.3(8).
Over the past decade, companies increasingly have been called on to
create more value for their owners. Led by aggressive institutional shareholders
like the California Public Employees Retirement System and fueled by widely
published reports of overcompensated executives, shareholders are demanding
that managers be given incentives to focus on corporate value creation.
Consulting firms have responded with a host of new performance metrics. Some of
the most popular are known as “economic value added,” “flow
return on investment” and “economic profit.”
Whatever they’re called, they’re catching on fast. “The number of
firms that have chosen to adopt value-based performance measures in recent
years has shot up dramatically,” says Stefan Reichelstein, professor of
accounting at the Graduate School of Business. “According to some
estimates, around 200 of the Fortune 1000 firms are now using some value-based
metric to measure the performance of their top-level managers.”
Economic value added has become so popular a concept that its acronym
actually has been trademarked by consulting firm Stern Stewart & Co. Still,
it’s not really new. “The concept of economic value added has been known
for quite some time in the accounting literature as ‘residual income,'”
Reichelstein says. “It’s really a very simple formula: accounting income,
properly measured, less a capital charge for the assets used by that particular
business or division.
“In contrast to ordinary accounting income, residual income is
fundamentally compatible with present value considerations. That aspect in turn
is critical in motivating managers to make long-term decisions that enhance the
overall net present value of the firm.”
Which is all well and good. But the problem remains that managers may not
be willing to engage in projects that increase value way down the line, value
that isn’t measured — and therefore rewarded — now. “This is where the accounting
rules come in,” Reichelstein says. “Good accounting rules allocate
current and expected future cash flows so as to reflect value creation in the
performance measure early on and consistently over time. That way, it is of
less importance whether managers have shorter planning horizons than
shareholders.”
Economic value added and similar formulas proposed in the “war of
the metrics” all make adjustments to the accounting rules used for
external financial reporting. But which of these adjustments is most effective
in aligning the objectives of managers and shareholders remains a subject of
lively debate.
In a paper that won the Best Paper Award at the Review of Accounting
Studies conference at Cornell University last year, Reichelstein and Sunil
Dutta, assistant professor of accounting at the Haas School of Business,
University of California-Berkeley, analyze a model that compares the
effectiveness of alternative performance metrics and accounting rules. The
study, “Controlling Investment Decisions: Depreciation and Capital
Charges,” focuses on capital investment decisions and the choice of
depreciation method to account for these investments.
Dutta and Reichelstein establish that residual income, or economic value
added, is indeed an efficient performance metric. When combined with particular
depreciation schedules, residual income can align the objectives of
shareholders and management consistently over time. In general, these
depreciation schedules will differ from the common straight-line method used
for external financial reporting purposes. The model analysis also shows how
the capital charge rate used for performance evaluation purposes should vary
with the riskiness of the investment project.
The authors believe their theoretical framework is useful for sorting out
the many recommendations and prescriptions expressed in the growing field of
value-based management. “Controlling Investment Decisions” analyzes
one particular problem, capital investment decisions. But for other assets,
such as receivables, inventory or multi-year construction contracts, similar
issues arise.
“So once again the question is: To make the performance measure as
effective as possible, how should the accounting be done?” says
Reichelstein. He and Dutta broaden their inquiry in a related paper,
“Stock Price, Earnings and Book Value in Managerial Performance
Measures.”
“The setting in this paper is richer,” says Reichelstein,
“in that you can base performance evaluation on both stock price and the
accounting numbers. Stock price obviously is what shareholders ultimately care
about. From a performance evaluation perspective, however, one drawback of
stock price is that it aggregates all value-relevant information even though
some factors are beyond the manager’s control. Accounting-based performance
measures can mitigate that problem, and therefore you want both.” In this
second paper, the authors identify the need for performance measures that are
calculated as a properly weighted average of market value added and economic value
added.
There is growing evidence that value-based management does deliver for
shareholders. Reichelstein and his colleagues in academia predict that further
analytical and empirical research will explain why and how. They believe that
the interest in these metrics isn’t likely to lessen. After all, Reichelstein
says, “People in the field realize the old adage that ‘whatever gets
measured also gets delivered.'” SR
Comprehensive income is defined by the Financial Accounting Standards Board,
or FASB,[1] as “the change in equity [net assets] of a business
enterprise during a period from transactions and other events and circumstances
from nonowner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.”
Comprehensive income is the sum of net income
and other items that must bypass the income statement
because they have not been realized, including items like an unrealized
holding gain or loss from available for sale securities and foreign currency
translation gains or losses. These items are not part of net income, yet are
important enough to be included in comprehensive income, giving the user a
bigger, more comprehensive picture of the organization as a whole.
Items included in comprehensive
income, but not net income are reported under the accumulated other comprehensive income
section of shareholder’s equity.
Comprehensive income
(or earnings) [2] attempts to measure the
sum total of all operating and financial events that have changed the value of
an owner’s interest in a business. It is measured on a per-share basis to
capture the effects of dilution and options. It cancels out the effects of
Equity transactions for which the owner would be indifferent; issues of
dividends; share buy-backs; share issues at market value.
It is calculated by reconciling the the
book-value-per-share from the start of the period to the end of the period.
This is conceptually the same as measuring a child’s growth by finding the
difference between his height on each birthday. All other line items are
calculated, and the equation solved for Comprehensive Earnings.
Shareholders’ Equity, beg. of
period
– Dividends
+ Premium to book value received from new shares
(and vice versa)
+ Comprehensive Earnings (and vice versa)
——————————————
= Shareholders’ Equity, end of period
Income tax expense is a substantial cost of business.
Understanding accounting for income taxes is important to successful analysis
of financial statements. The discussion here focuses on the accounting and
analysis of periodic income tax expense and not on tax law.
Accounting
for income tax
The accounting and reporting standards for income require
both an assets and a liability approach. Specifically deferred taxes are
determined separately for each tax-paying component in each tax jurisdiction.
Determination includes the following procedures:
Identifying
the types and amounts of temporary difference and the nature and amount of each
type of operating loss and tax credit carryforward including the remaining
length of the carryforward period.
Measuring
total deferred tax liability for taxable temporary difference using the
applicable tax rate.
Computing
the total deferred tax asset for deductible temporary difference and the
operating loss carryforwards using the applicable tax rate
Measuring
deferred tax assets for each type of tax credit carryforward.
Reducing
deferred tax assets by a valuation allowance if based on the weight of
available evidence, it is more likely than not some portion or all deferred tax
assets will not be realized
Permanent
Income tax difference
Items are nontaxable for example,
income on tax-exempt bonds and the life insurance proceeds on an employee.
Special deductions are granted: for
example tax exclusion on dividend form unconsolidated subsidiaries or from
other domestic corporation
The effective tax rate paid by a company on net income can
vary from the statutory rate for many reasons including;
Basis
of property differs for financial and tax accounting due to reorganization or combination.
Non-
qualified and qualified stock option plans.
Special
tax privileges, for example, in savings and loan associations, shipping lines
or insurance companies.
Lower
corporate income tax rate up to a certain level.
Tax
credits, for example; research& development credits or foreign tax credit
Different
tax rate on foreign income.
Tax
expense that includes both state and local income taxes, net of federal tax
benefit.
Unlike permanent differences, temporary differences are expected to
affect taxable income at some future time/ that is, they are expected to
reverse.
Companies disclose the
following components of the net deferred tax liability or net deferred tax
assets as recognized on their balance sheets:
Total
deferred tax liability
Total
deferred tax assets.
Total
valuation allowance recognized for deferred tax assets.
Additional disclosures are also
available on the components of income tax expense for each year reported,
including:
Current
expense or benefit.
Deferred
tax expense or benefit.
Investment
tax credits.
Government
grants
Benefit
of operating loss carryforwards.
Tax
expense resulting from allocating tax benefit to either contributed capital or
goodwill deduction or another noncurrent intangible assets of an acquired
entity.
Adjustment
in the beginning of the year balance of the valuation allowance due to
circumstances yielding a revised estimate of the realizability of the deferred
tax asset in future period.
Our analysis must understand the
relation between pre tax income and income tax expense. We should remember that
procedures applied to loss carryforwards differ from those applied to
carryback.tax loss carrybacks result in a tax refund in the loss year and
recognized as an asset. A loss carryfoward results in deferred asset. This
deferred tax assets is reduced by a valuation allowance to the extent” it is
more likely than not” that all or part of it will not be realized by a
reduction of taxes payable during the carryforward period.
Our analysis of components of
deferred income tax expense can also yield insights. Through evaluation of
components we can learn about capitalization of cost, early recognition of
revenues and other discretionary accrual adjustment. We can also acquire
information about expected future reduction in deferred income taxes.