April 25 (Bloomberg) -- Honda Motor Co., Japan's second- largest automaker, reported the biggest drop in profit in at least 10 years as it put aside money for a possible tax settlement and the dollar weakened against the yen.

Net income plunged 86 percent to 25.4 billion yen ($244 million), or 14.01 yen a share, in the three months ended March from 176.2 billion yen, or 96.70 yen, a year earlier, Honda said in a statement today. Sales fell 1 percent to 3.06 trillion yen.

Honda took an 80 billion yen provision to cover possible taxes as the Japanese government investigates whether the Tokyo- based company failed to declare income from China. The carmaker, which earns about 70 percent of operating profit in North America, forecast earnings will drop this year because of a stronger yen.

``The company booked all of its losses now as it expects a difficult year,'' said Takashi Aoki, who help manage about 130 billion yen at Mizuho Asset Management Co. in Tokyo. ``The stronger yen and higher incentives in the U.S. will hurt them this year.''

The carmaker is being investigated for ``transfer pricing taxation'' for a five-year period ended fiscal 2006, it said in a statement today. The company failed to report about 140 billion yen in income, the Nikkei newspaper reported, without saying where it got the information. Kunio Endo, a general manager at Honda's accounting division, declined to comment on the report.

``We believe we're paying taxes appropriately in both China and Japan,'' Executive Vice President Koichi Kondo said at a press conference in Tokyo.

Lower Forecast

Honda expects net income in the fiscal year started April 1 to drop 18 percent to 490 billion yen, even as sales may rise 1 percent to 12.1 trillion yen. The yen's 12 percent gain against the dollar in the first three months of 2008 is eroding the value of repatriated earnings.

The carmaker forecast operating profit will drop 32 percent to 650 billion yen. The stronger yen will cut 303 billion yen from operating profit this year, the company said. Global auto sales to dealers may rise 5.5 percent to 4.14 million vehicles.

U.S. Market

Industrywide vehicle sales in the U.S., Honda's most profitable market, may fall this year to the lowest since 1995, according to Standard & Poor's. In response, Honda said in February that it planned to offer dealers average incentives of a record $1,000 a vehicle in the U.S. to spur sales of Pilot sport- utility vehicles and other aging models amid surging fuel prices and tighter credit.

``The forecasts represent the worst case scenario,'' said Hitoshi Yamamoto, chief executive officer of Tokyo-based Fortis Asset Management Japan Co., which manages $5.5 billion in Japanese equities. ``They may start to reduce their reliance on the U.S. from this year with aggressive expansion into China and India.''

Japanese automakers are also paying more for steel and other raw materials. Nippon Steel Corp. and JFE Holdings Inc., the world's second- and third-largest steelmakers, will raise wholesale prices for sheet steel by 10 percent as early as June, traders familiar with price talks said on April 22.

The boost follows a 25 percent increase to about 100,000 yen per ton this month and is needed to cover an unexpected tripling in annual coking coal prices.

Raw Materials

Honda expects higher raw material costs to reduce operating profit by as much as 75 billion yen this year. Mitsubishi Motors Corp., Japan's fastest-growing car exporter, also forecast profit will drop on the stronger yen. The company expects net income will decline 42 percent this year to 20 billion yen.

The automaker's American depositary receipts rose 72 cents, or 2.3 percent, to $31.92 at 4:15 p.m. in New York Stock Exchange composite trading. They have declined 3.7 percent this year.

The carmaker boosted global auto sales in the fourth quarter 9.8 percent to 1.05 million vehicles, led by demand in Asia.

A stronger yen against the dollar and other foreign currencies hurt Honda's earnings. The yen averaged 105.44 per dollar in the three months ended March 31, compared with 119.36 a year earlier. Every 1 yen gain against the dollar cuts Honda's operating profit by 20 billion yen, according to the company.

The company based its forecast on 100 yen to the dollar compared with 114 yen last fiscal year. It expects a rate of 155 yen to the euro, compared with 162 yen last fiscal year.

Honda, led by Chief Executive Officer Takeo Fukui, is the first company among Japan's three biggest automakers to report earnings. Toyota Motor Corp. will report results on May 8, and Nissan Motor Co. will release earnings on May 13.

To contact the reporters on this story: Naoko Fujimura in Tokyo at nfujimura@bloomberg.net; Tetsuya Komatsu in Tokyo at tekomatsu@bloomberg.net

Last Updated: April 25, 2008 17:10 EDT