Peeling away financial reporting issues one layer at a time

More Not to Like about Deferred Taxes: The Foreign Earnings Loophole

A seasoned accountant and regular reader of my blog wrote that, until my last post, he had seen little discussion of the potential to manage the effective tax rate upwards. He has, however, seen numerous instances where companies have done just that using foreign earnings; hence, he derived a measure of satisfaction from reading something related to that problem.

With respect to the foreign earnings issue my reader mentioned, here is the official language of the loophole in U.S. GAAP (ASC 740-30-25-18):

As indicated in paragraph 740-10-25-3, a deferred tax liability shall not be recognized for either of the following types of temporary differences unless it becomes apparent that those temporary differences will reverse in the foreseeable future:

a. An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration 

[italics supplied]

It’s a little bit technical, so here is a simple example of how it works in practice.  Let’s say there are two substantially similar U.S. companies, each with various foreign subsidiaries. The companies agree completely on one thing: to park their foreign taxable earnings overseas until there is worthwhile tax relief at home.  Unless things get desperate, neither company is going to repatriate their foreign earnings if they would have to pay taxes on them at the prevailing statutory rates.

Beyond that fundamental agreement on tax strategy, financial accounting by the two companies diverges. One company determines that all earnings are permanently reinvested and another determines that only x% of its foreign earnings will not be remitted in the “foreseeable future.”

Both companies report the same pre-tax operating earnings.  But as a consequence of the difference in their accounting estimates, the company that takes the stance that all of its earnings are permanently reinvested reports higher net income.  It also draws attention to itself for the resulting lower effective rate.

The accounting by the second company is more “conservative” — i.e., resulting in lower reported net income.  But, its more conservative estimate produces some desirable accounting effects:

First, as mentioned above, it gets to report the same pre-tax operating earnings as the first company.  Many companies consider pre-tax operating margin to be a key performance indicator.

Second, it avoids attention by reporting a higher effective tax rate, making it look like the company is ‘paying’ (ha ha) its ‘fair share’ of taxes.  In the process, it builds up a deferred tax liability that, realistically, will just sit on the balance sheet like cream cheese on a bagel.  Analysts will ignore it, because it will never, ever, turn into a real tax obligation.  This is because the company will not remit earnings unless tax rates are reduced substantially.

Third, and perhaps most insidious, it can manipulate its reported net income and EPS simply by changing its estimate of its foreign earnings that will not be remitted in the “foreseeable future.”   Read ASC 740-30-25-17 and ask yourself whether the permanently reinvested determination is based on overly-broad criteria.  To my eyes, it invites earnings management that auditors are largely powerless to prevent.  It is hard enough for an auditor to prevent its client from overstating EPS, but to reject a “conservative” estimate must be orders of magnitude more difficult.

* * * * * * *

I reckon that I have written somewhere around 500K words in my blog posts over the years, yet only in these last three posts have I tackled the issues surrounding accounting for income taxes.  As this will certainly be my last post on the topic for the foreseeable future (pun intended), I’ll conclude with a brief summing up.

I began by observing that there doesn’t seem (anymore) to be much of a conceptual difference between “income taxes”  and other forms of taxation to justify making a distinction for accounting purposes.  If all taxes were presented in one location on the income statement with appropriate note disclosure of the components, readers would have a clearer idea of pre-tax operating income and the dimensions of the burden imposed on the entity by taxing authorities.

The bulk of these three posts were devoted to explaining why I don’t think that there is any normative or adequate empirical justification for deferred taxes.  It adds items to the balance sheet that don’t qualify as assets or liabilities, and it obscures information about the tax burden that a company will pay in the “foreseeable future.”  Moreover, deferred tax accounting is extremely complex; the manuals published by the Big Four firms on this topic alone typically run to about 700 pages.  Even if it were true that there is some informational benefit to deferred tax accounting, surely there is a less costly and more straightforward way to provide that information to users of financial statements.

Finally, as I conjectured in my previous post, deferred tax accounting may have survived for as long as it has because the effective rate strongly tends to indicate a higher tax rate than companies consistently pay.  If you think I was being too cynical in that post, perhaps this latest post will moderate your views somewhat.

* * * * * * *

Shameless self-promotion —

On January 23rd, I will be making a day-long presentation (8 CPE credits) to the Institute of Internal Auditors Central New Jersey Chapter.  Registration is open to the public.

The title of my program is “Internal Auditing & Management Judgement: Current Topics.”  I am planning for a broad ranging discussion that both provides timely technical information, plus perspectives that are similar to those I write about here.

If you are in the area, I hope you can attend!

 

2 Comments

  1. Reply Kevin Brown December 29, 2016

    I agree to a certain extent. But one thing to keep in mind is that income taxes are the second or third largest item on the income statement to determine EPS. Management is incentivized to manage that area for the “benefit” of shareholders.

  2. Reply Darrin Simon January 3, 2017

    It begs the question, I think – if auditors are that powerless to prevent it happening, why hasn’t more been done to stop it? Can foreign earnings be that hard to track down in today’s era of better business communication? I feel like unless proper sales/income receipts are produced it shouldn’t be hard to call a business out on doing this. Of course, I don’t get too much into business preparation just yet, but I have to wonder if this is really as hard to prevent as it sounds.

Leave a Comment