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What a Company’s Tax Disclosures Reveal About Its Quality of Earnings

USA
7 Dec 2010

A company's tax disclosures reveal critical clues to its underlying health. Buyers and lenders use this information to evaluate the "quality" of a target's earnings and uncover hidden liabilities, while financial authorities use it to identify overly-aggressive tax planning and questionable transactions. Taxand US highlights the conditions revealed by tax disclosures and the abnormal indicators that call for further testing such as Effective Tax Rate, Cash Effective Rate Tax, Current and Deferred Tax and Valuation Allowance. From an investor's standpoint, Taxand US highlights the conditions revealed by tax disclosures and the abnormal indicators that call for further testing.

In the investing context, companies that exhibit a strong "quality of earnings" tend to command a higher stock price and better financing terms than those that don't. Quality of earnings describes a company's earning power and financial condition. For example, are its earnings stable and predictable, or erratic? Are they backed up by cash, or through accruals, discretionary items and liberal accounting? How do they compare to other companies in the same industry? Do they reflect growth and investment, or deterioration and poorly maintained assets?

What do the tax disclosures reveal about a company's earnings quality? It's like looking at the results of a blood test. Outwardly, the patient appears healthy and thriving, but the tests reveal symptoms of a possible underlying disease requiring further investigation. Enron, for instance, is a classic example of a company whose tax disclosures highlighted significant, subjective and discretionary accounting practices - like mark to market accounting, recognition of earnings from unconsolidated entities and recognition of income for the issuance of subsidiary stock - which should have, and ultimately did, cast doubt on its earnings quality. Such practices, while perhaps not readily evident elsewhere, were glaring in the footnote.

Effective Tax Rate
For starters, there's the effective tax rate - the tax provision divided by pre-tax income. Essentially, it represents the share of reported income that is owed in tax, either currently or in the future. Critical pieces of information include how it stacks up against its competitors, the factors driving it and how it moves over time. Companies in the same industry should have a similar financial profile in terms of financial ratios, and that includes the effective tax rate. A company whose rate significantly deviates from its competitors raises the question, why?

Clues may be revealed in the disclosure reconciling the components of a company's effective rate with the federal statutory rate. Unusually high or low state or foreign taxes might shed some light. High tax rates often tend to be associated with jurisdictions that have a high cost of living and that are expensive to conduct business in, like certain parts of Europe or states within the United States. A company with a high tax rate relative to its peers may be a sign revealing the company is at a competitive disadvantage because it is operating in high cost areas, or perhaps sourcing too much of its income to high tax jurisdictions as a result of poor tax planning.

A high effective rate doesn't necessarily mean a company is inefficient, however. In fact, some companies may over-accrue as a subtle means of managing the rate prospectively. As a practical matter, this is extremely difficult to uncover without thorough diligence of the company's underlying tax records.

On the other hand, a low tax rate can imply either an operationally efficient company or one that's done aggressive tax planning. Diligence frequently uncovers companies lowering their effective rates by taking aggressive or outdated positions to source less than all of their federal income to the states in which they file returns, or by heroically assuming that foreign earnings will never be repatriated. This latter point can erroneously lead investors to overpay or misstate the target's cash flow projections, if they assume foreign earnings will be repatriated at the same effective rate.

The trend in the effective rate over time also is important. Swings in the rate may indicate big events like changes in operations, significant transactions or tax planning. Erratic jumps and vague descriptions in the effective rate reconciliation may also be a symptom of a poor or complex internal control environment. These conditions tend to give rise to more variances between the tax return and tax provision processes and unexplained adjustments in the underlying tax work papers. Ultimately, they are flushed out in the rate reconciliation disclosure and obfuscated under euphemistic descriptions like "other adjustments" or "rate differences" but can also be hidden in the state or foreign tax line items. Other factors, without explanation - such as switching advisors, financial statement restatements and amended returns - add to the suspicion.

Cash Effective Tax Rate
While the effective rate is useful, it can be misleading because it does not reveal how much tax is actually being paid currently in cash, which may be quite different. This is because the effective rate is not influenced by timing differences in the way items are reported for book and tax return purposes. For effective rate purposes, a tax liability is a liability regardless of whether it is to be paid currently or in the future. Indeed that may be an important distinction, as some companies seem to be able to perpetually defer income tax, while others can't. In fact, many companies pay significantly different amounts than their effective rates would suggest. The timing of when tax is paid is an important consideration for an investor with a limited time horizon, like a private equity investor.

For these reasons, many find it is useful to analyse a company's "cash" effective tax rate, which is the ratio of cash taxes paid to pre-tax book income. The serious drawback to this approach, however, is that it is biased by estimated payments, settlements and refunds, and may be highly erratic as book-tax timing differences unfold. Consequently, it becomes vital to understand the composition of the tax provision in terms of its current and deferred components.

Current and Deferred Tax
Typically, growing companies are expected to have an increasing deferred tax liability, while flat or declining companies are expected to have a declining deferred tax liability or an increasing deferred tax asset. For instance, the deferred tax liability for property, plant and equipment, typically the most common and significant item causing a deferred tax liability, will rise as the level of capital expenditures ("capex") increases. Conversely, companies experiencing operational difficulties are more likely to suffer declining capex and incur losses generating deferred tax assets. Because the deferred tax asset or liability balance captures the relationship between book and tax accounting, analysing the change reveals trends in the business that may not be obvious elsewhere in the financial statements.

It is misleading to conclude, however, that an increasing deferred tax liability is the hallmark of a growing company while the reverse trend reveals a deteriorating one. In fact, it may be the product of earnings management. As a result, not all changes in a company's deferred tax asset or liability should be weighted equally.

If companies are going to manipulate earnings, they will likely try to do so in a way that won't increase taxable earnings, thus leading to greater book tax differences. Typically, such techniques - like more aggressive revenue recognition or expense capitalisation for book than tax accounting, or releasing reserves - will also cause a company's deferred tax liability to increase. Therefore, significant changes or counterintuitive trends in the components of a company's deferred tax asset or liability relating to subjective and discretionary non-cash items, like reserves, should be viewed with suspicion and investigated.

Valuation Allowance
Likewise, changes in a company's valuation allowance should be viewed critically. The release of a valuation allowance results in direct non-cash, non-recurring increase to its earnings and should probably be given little weight by an investor. Notably, many earnings management techniques, like releasing or insufficiently adding to reserves, also increase the deferred tax liability, thereby facilitating the release of the valuation allowance and enabling further earnings management.

Conversely, we often encounter targets being sold that have recently established full valuation allowances against their losses, suggesting they will never be used, yet wanting buyers to pay for this tax benefit. It is always interesting to hear sellers explain why they don't ascribe any value to their losses but a buyer should, or compare their dour projections used to establish the valuation allowance against the rosy ones given to potential buyers. Inevitably, the auditors are to blame.


Taxand's Take


Tax disclosures are a frequently neglected yet fertile area of financial analysis. They reveal hidden characteristics that differentiate well-run companies from those that are not. Like a seemingly outwardly healthy patient, whose blood tests either confirm health or reveal otherwise, a company's health can be evaluated through its tax disclosures. Investors are encouraged to analyse and understand what drives a company's tax rate because it highlights quality of earnings characteristics that may not be apparent on the surface.

Your Taxand contact for queries is:
Martin Williams
T. +1 212 328 8503
E. mawilliams@alvarezandmarsal.com

Taxand's Take Author