The Fine Print: How to Spot Tax Tinkering

See if products are really boosting profits

Over the past few years, revenue growth has been mighty sluggish at IBM (IBM ). So Big Blue's financial folks turned to a variety of techniques to boost earnings per share, including buying back stock and lowering the tax bill. In fact, Steven Milunovich, a technology strategist at Merrill Lynch, estimates that from 1995 through 2001, tax maneuvering accounted for 25% of the company's earnings-per-share growth.

Like IBM, many companies squeeze a little extra out of the bottom line by reducing their taxes--often by shifting operations to countries with lower rates than the U.S.'s 35%. Companies including Ingersoll-Rand and Stanley Works (SWK ) are seeking to slash taxes--and raise net income--even more by reincorporating in tax havens, such as Bermuda.

There's nothing wrong with most tax-cutting maneuvers. Indeed, money saved by reducing tax rates flows to the bottom line, enriching shareholders just the same as earnings from cost-cutting campaigns or new products.

Still, it's important to note when tax strategies boost profits. Gains driven by tax-rate reductions can mask a slowdown in core business operations. Moreover, investors should be wary of paying a premium for such gains because--as IBM shareholders are discovering--a corporation can't whittle its tax rate forever. Even companies that move to Bermuda could find their tax savings short-lived. That's because Congress is threatening to curtail such tax breaks, partly in response to accusations that Enron used shelters, including offshore subsidiaries, to dodge taxes. Lowering the tax rate "is a positive," says Dennis Beresford, an accounting professor at the University of Georgia. "But it's not quite the same as selling more products."

This installment of The Fine Print, a series examining financial statements, footnotes, and other corporate documents, helps investors analyze the impact of taxes on the bottom line.

The tax footnote gives you what you need to calculate tax rates paid in each of the past three years--making it easy to spot when a company has profited from a rate reduction. It also can alert you to changes in accounting practices designed to engineer short-term earnings gains without improving the company's long-term prospects. "The tax footnote is a good place to hunt for companies that are playing accounting games," says Victor Cunningham, research director at Olstein Financial Alert Fund.

When examining the footnote, start with Table 1. Here you'll find out how much tax the company owes. Example: Student Loan Corp.'s "total income tax provision" was $92.6 million in 2001. This figure, which also appears on the income statement, reflects the tax man's claim on the company's $228 million in pretax earnings.

Things get tricky from here, though, because, in effect, there are two parallel tax systems. This results in companies reporting two different tax expenses (and two different versions of the bottom line)--one to the Internal Revenue Service and the other to shareholders.

Why two systems? Because the IRS's rules for recognizing income and tax liabilities frequently differ from the generally accepted accounting principles (GAAP) that dictate shareholder accounting. Let's say a brokerage buys $1 million worth of stock that appreciates to $1.5 million while in its portfolio. On its official books, the firm must record the $500,000 gain as income--and deduct an expense from net income to cover the capital-gains taxes.

On its tax return, however, it reports no income and, therefore, owes no tax. Why? Under tax law, no tax is due unless the stock is sold and a gain realized--and that hasn't happened. So the firm makes a record of what taxes would be due if the stock were sold. Then, it puts that amount on its balance sheet as a "deferred tax liability." In Student Loan's case, Table 2 shows that the "net deferred tax liability" was $93.9 million in 2001, up from $47.6 million in 2000.

In theory, a company will eventually pay its deferred taxes. For example, when a brokerage sells stock, it must report any profit to the IRS--and send a check to cover the taxes. Sometimes, the IRS requires a company to pay tax before GAAP rules trigger a tax expense on the official books. In such a case, a company would essentially prepay the tax and place a "deferred tax asset" on the balance sheet that can be used to offset future tax expense.

Thanks to this two-tiered system, Student Loan paid the IRS far less tax than the $92.6 million it listed as a tax expense for 2001. In fact, if you look up the "current" portion of its tax bill in Table 1, you can see that the company sent the IRS a check for $46.3 million, deferring the remaining $46.2 million.

Is it good for shareholders when corporations have deferred tax liabilities? You bet. That tax deferral frees up cash for other purposes, such as launching new products or paying down debt, says Beresford.

Still, when deferred tax liabilities jump, shareholders need to ask why. It could be that a company has adopted more aggressive accounting policies. In Student Loan's case, it used to write off the entire cost of making, or "originating," a loan at the time the loan was issued. But now, the company spreads that cost over each year of the loan's life. While perfectly legal, the change allows Student Loan to report higher earnings to shareholders than it would have under the old method. This is especially true now that the company's deferred-loan origination costs have spiked, thanks to a new policy of purchasing loans to supplement its homegrown portfolio.

Yet the change caused Student Loan's deferred tax liability to rise. Here's why: While the company spreads the cost of making new loans over several years on its financial statements, it continues to deduct that cost immediately on its tax return. By taking a bigger deduction on its tax return than on its financial statements, the company reports a lower net income to the IRS than to shareholders. As a result, Student Loan pays the IRS less than what its official books say it owes--and defers the rest.

Table 2 can tell you whether a deferred tax asset or liability has increased or decreased. To find evidence of an accounting change, look in the first footnote to the financial statements, where companies disclose accounting practices. Sometimes, changes are not flagged, so you'll have to compare the current footnote to ones from years past. You can also call and ask the company's investor relations department for an explanation.

Finally, look at Table 3, which traces a company's "effective" tax rate over the past three years. The table calculates the company's tax burden as if it had paid the 35% federal rate levied on most big U.S. companies. Then, it shows why the actual tax bill differs. Effective rates often dip due to tax breaks and lower rates on foreign earnings.

Companies don't always show effective tax rates. To do the math, take the tax expense--the "income tax provision," in Student Loan's case--and divide by pretax income. Thus, Student Loan's effective tax rate is 40.6%, down from 41.7% in 1999. The trend is good--but there's still room for improvement. Now you know where to look to see how well the tax accountants are doing their jobs.

By Anne Tergesen

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