Hodak - Measuring EP/EVA

Option 3 (Corporate): Flat Tax with Cash-Based Accruals

The easiest method of accounting for taxes would be to simply assign a single tax rate on net operating profits (i.e., NOP or adjusted Income before taxes) and subtract deferred tax assets from net assets. The obvious drawback to such simplicity is the loss of all tax sensitive information associated with the business's activities and the associated loss of incentive to manage taxes at all. (Reporting results on a pre-tax basis is just a special version of this flat tax treatment, i.e., a flat tax of zero.) However, a great benefit of consolidated financial statements is that cash taxes paid can be easily tracked. The cash taxes thus derived can be compared to a "flat tax" applied to NOP, with the difference tracked as a net deferred tax asset or liability. This deferred tax amount can then be treated in either of the above Options 1 or 2.

This treatment is a cleaner, simpler version of the prior options. Instead of working from the tax provision, management applies a standard tax rate to their income, either at the business or project level, and separately accounts for their potential cash consequences. Any analysis based on these results will account for all relevant tax information, i.e., taxes paid and taxes deferred. It is always true that the tax based on the flat rate plus the difference between that amount and the cash tax will always equal the cash tax, regardless of what "flat" tax rate is chosen.

Tax provision                              Flat tax

+ Change in net deferred taxes    + (Cash taxes - Flat tax)

Cash taxes                                 Cash taxes

Choosing a flat tax rate that approximates the long-run effective rate of the company (either in terms of accrued or cash taxes) improves matching of income and taxes and simplifies tracking and project analysis.

The drawback to this treatment is that the difference between the chosen flat tax and actual cash taxes will need to be tracked. This will require a schedule of the differences to be established and maintained by financial management, with the results communicated to operating management on a regular basis.

Business Unit Alternatives

Business units rarely have a choice with regards to accrued or cash taxes. Even if taxes are reported for the unit, they generally include allocations that are insensitive to any of the business's activities. Even if the business is a tax entity for reporting purposes, its bottom-line results may be heavily affected by transfer prices specifically designed to either minimize the unit's taxable income or minimize the taxable income of a sister unit. Neither of these outcomes is likely to reflect the economic condition of the business unit on its own. Therefore, business units below consolidated require a tax rate that must either be derived from that of the corporate entity or created from the business unit's own identifiable results.