Income Taxes
Companies are required to provide for the payment of income taxes. The provision is charged to income. The tax provision is based on statutory rates or rate schedules applicable to "taxable income" at the federal, state, and, if applicable, local level. Taxable income basically includes the net profits of the business with certain statutory exclusions of revenue, expense, gain, or loss. For example, interest earned on state bonds or proceeds from insurance are commonly excluded from taxation. On the other hand, certain expenses for financial accounting purposes, like most goodwill, are not tax deductible.
In certain types of transactions, differences between financial reporting income and taxable income give rise to differences in the timing of tax payments. Unlike the exclusions mentioned above, these temporary differences result in the deferral or pre-payment of taxes that will be reversed by the end of some period, such as the useful life of an asset or completion of a sale transaction. For example, tax laws allow accelerated depreciation of certain assets in calculating taxable income even as those same assets are depreciated on a straight-line basis for financial reporting. Accelerated depreciation reduces taxable income relative to reported income in the early years, while in later years the reverse becomes true. This has the effect of shielding more income from taxes in the early years of the assets life. Temporary differences between financial reporting income and taxable income are presumed to create deferred tax liabilities or deferred tax assets that must be recorded on the balance sheet. Those accounts would be reduced as the differences get reversed, e.g., when financial reporting depreciation comes to exceed tax reported depreciation on older assets.
While the government asserts a claim on taxable income, it also provides credits for losses. Tax credit for losses can be applied against taxes on future income for a limited period of time. The accumulated credit appears on the balance sheet as a deferred tax asset. That asset gets reduced as the tax credit is applied to later taxable income or expires.
Management may choose to reduce the deferred tax asset by a valuation allowance if they feel that it is more likely than not that some or all of a deferred tax asset will not be realized. This valuation allowance relies on a significant amount of judgment that can affect earnings. A substantial addition to the valuation account would penalize earnings. Any revision that reduces the valuation allowance, basically a judgment that contradicts a prior judgment, would serve to boost earnings.
Economics of Income Taxes
Shareholders measure their returns in terms of after-tax cash flows. Thus, EP should account for taxes as accurately as possible while providing management the best signals about the after-tax implications of certain decisions. As with any expense, management should employ strategies to manage their taxes so as to maximize their cash flow to shareholders.
Management can reduce taxes through several strategies, including shifting income from taxable to non-taxable categories afforded by statute, or to entities or locations subject to relatively lower tax rates. Management can also delay payment of taxes through temporary differences, such as accelerating depreciation for assets. Any changes in accounting methods or rules that reduce or leave unchanged income while reducing after-tax cash flow will create value and should be pursued. For instance, tax laws allow the use of either FIFO or LIFO accounting of inventories in calculating taxable income, but whichever is chosen must be used for financial reporting as well. LIFO has the effect of reducing reported income relative to FIFO, which looks bad for accounting earnings, but is good for cash flow because lower taxable income translates into lower taxes. Thus, management in pursuit of maximum cash flow (and value) would always choose LIFO accounting over FIFO. Studies have shown that companies switching from FIFO to LIFO have benefited with stock price jumps upon their announcement of the change(1).
In most instances, tax expense is closely related to other factors affecting operating profit. For example, taxes may be reduced significantly if management moved production operations to certain offshore havens. But these operations may result in higher distribution costs, legal bills, and other expenses that may more than offset the tax savings. As mentioned earlier, management should not be focused on minimizing taxes, but on maximizing the present value of after-tax cash flows.
Tax considerations are complicated by decision making at the business unit level. In fact, the tax liability incurred by business units in multi-business companies may be impossible to objectively determine. By statute, taxes are calculated at the consolidated entity. Losses of one unit may shield income of another from tax payments. Debt incurred at the corporate level usually cannot be identified with specific business units, but it generates tax shields for everyone. If the whole company loses money, the resulting tax assets represents cash that may be saved in the future. It is plausible that the business units most responsible for the under-performance resulting in tax credits will not be the units that eventually enable the company to realize those credits, making deferred tax assets essentially unallocable. Also, the chance always exists that tax assets generated by any given units poor performance may expire unused. For these reasons, the incremental tax effect of decisions at the business unit level is normally impossible to calculate.
Behavioral Impact
Taxes are so complicated that most managers would just as soon not have to think about them. This fact would suggest at least considering reporting EVA results on a pre-tax basis. But two problems arise. First, if managers are not measured on after-tax profits (against a pre-tax capital charge), they will have no incentive to manage their tax expenses. For example, a decision to locate a store on one side of a city line or the other may yield little difference in the projected pre-tax results, while the after-tax implications may be significant. Second, most businesses report only after-tax returns to the outside world, including your competition and, if you have one, your corporate parent. If your results are reported pre-tax, then you would have to translate either their results or yours to properly compare your contribution to corporate results or to benchmark against peers. It is true: "there is no escaping taxes."
The valuation allowance permits management to reflect reasonable probabilities that a tax asset may go unused. However, it also provides a company that has accumulated such assets ample room to manipulate income. This creates a difficult trade-off. Management judgment in setting the valuation allowance enables it to provide a more accurate reflection of the real assets available to the company. That same discretion, however, enables managers to distort assets in order to show a more "desirable" profit picture. This discretion has potentially significant behavioral implications.
At the corporate level, taxes are clearly an objective determinant of cash flow to shareholders and how taxes are measured will determine how they are managed. At the business unit level, where taxes may not be objectively determinable, there remains the need to engage managers in tax avoidance strategies. If we want managers to manage taxes, then some method of relating their business unit results to taxes actually paid by the corporation must be instituted.
Alternative Treatments:
We identify treatment alternatives based on whether the EP center is a corporate or business unit entity. While the treatments for corporate and business unit may be selected independently, some treatment pairs are more compatible than others.
The first step is to determine whether the entity being measured is consolidated or not. Only consolidated entities have tax liabilities objectively related to their business activities. This gives us treatment alternatives that do not exist at the business unit level. Options 1 to 6 below can apply to corporate or consolidated entities. Business units are limited to Options 4 to 6.
Option 1 - Accrued operating taxes
Option 1a - Accrued Operating Taxes with Pre-tax Capitalization
Option 1b - Accrued Operating Taxes with Implied Tax Assets
Option 1c - Accrued Operating Taxes w/o Valuation Allowance
Option 2 (Corporate) - Cash Operating Taxes
Option 3 (Corporate) - Flat Tax with Cash-Based Accruals
Option 4 (Business Unit) - Flat Tax at Marginal Rate
Option 5 (Business Unit) Flat Tax at Corporate Effective Rate
Option 6 (Business Unit) Flat Tax with Tracked Differences
