At the end of each quarter, the tax footnote accompanying a company’s financial statement lands on the desks of corporate executives, audit committee members, lenders, and others who are tasked with interpreting the results. For many non-tax readers, it is one of the most complex sections of the entire statement, full of dense, highly technical, and unfamiliar terminology that only tax specialists and auditors truly understand. It is certainly not the CFO’s job to be a tax expert; however, they do need to know which areas of the tax footnote and its underlying calculations matter most because it offers a window into the company’s operational risk, cash flow sustainability, and the quality of its earnings.
Probably the most important metric in the tax footnote is the effective tax rate (ETR) reconciliation. The ETR gives the footnote reader an indication of how much pretax book income is being consumed by tax. Quite simply, it is total tax expense divided by pretax book income.
Currently, the U.S. federal corporate income tax rate is a flat 21%, but the ETR almost always is different. There are several reasons why, including state income taxes, foreign operations, permanent book-to-tax differences, tax credits, and valuation allowances, among other variables.
The ETR is not the same as cash taxes paid or due. It is a blended figure that combines both current taxes (cash or near-cash obligations) with deferred taxes (noncash timing differences that reverse in a later period). This is why the rate reconciliation should matter to executives. It provides insight into what is driving the rate up or down from the anticipated statutory 21% tax rate on a line-by-line basis.
There are three key areas that executives should focus on when reviewing the ETR:
Corporate executives should also compare their company’s ETR with that of their competitors or other businesses of similar sizes in the same industry, then ask why their ETR is significantly higher or lower to better understand the drivers and get comfortable with associated risk, if any, that their tax positions may have created.
In addition, executives should be doing an analytical review of the ETR and looking for large swings year over year. Often there is an explanation regarding anticipated shifts in the geographical earnings mix or acquisition related adjustments. But it can also signal deeper concerns, including deteriorating profitability, expiring tax attributes, tax audit exposure, or valuation allowance issues.
It is important to understand what the ETR is saying, as it can provide valuable insight into the overall health of the company and what tax burdens may be lurking in the future.
Deferred tax assets (DTAs) and deferred tax liabilities (DTLs) arise from timing differences between when income or expense is recognized for book purposes and when it is recognized for income tax purposes. The financial statements are generally prepared under generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), while tax returns are filed under a different set of rules – the Internal Revenue Code (IRC) and regulations thereunder. These two systems often recognize the same economic event at different times, giving rise to temporary differences that eventually reverse in a future period.
Most companies have a healthy mix of DTAs and DTLs from common book-to-tax differences, including compensation accruals, interest expense limitation carryovers, accelerated tax depreciation, and net operating losses (NOLs). The most important issue is not necessarily which DTAs and DTLs exist, but rather whether the DTAs are realizable. This is where the valuation allowances come into play.
Under ASC 740, the tax benefit of a DTA is only recorded at full value when it is “more likely than not” (which is greater than 50% probability) that it will be realized in a future period. If realization is uncertain or outright impossible, a valuation allowance is recorded offsetting the DTA, effectively writing it down. Even though ASC 740 rules try to make the assessment of valuation allowances a science as opposed to an art, there is still a lot of subjectivity and professional judgement involved. Management must weigh positive evidence (such as future taxable income projections) against negative evidence (such as history of losses) to determine if a valuation allowance is needed. An increase in the valuation allowance may indicate that management is forecasting ongoing losses or perhaps valuable NOLs and tax credits are at risk of expiring unused, while the decrease of valuation allowances may indicate the opposite.
This is why it is so important for tax footnote readers to understand what is happening, what story is being told, and how it impacts the financial statement. If a company beat earnings estimates and the release of a valuation allowance was the main contributor, did the company really improve its underlying cash flow and operations? Readers of the tax footnote should be looking for trends in the overall DTA/DTL position and movement in any valuation allowance. If an overall DTL is expanding it could mean that the gap between book income and taxable income is widening. Whereas, if the net DTA is expanding it could mean the company is accumulating future tax benefits faster than it is able to use them. All of these can provide valuable insight for those trying to assess the overall quality of earnings and future outlook.
ASC 740-10 (formerly FIN 48) requires companies to evaluate all of their tax positions and record a reserve (or liability) for any positions that do not meet the 50% “more likely than not” threshold. A reserve would be recorded related to a particular tax position if, under a hypothetical audit scenario, the company believes an IRS agent would rule against the company on that particular matter. A reserve can be recorded for rather benign reasons (such as taking a haircut on an R&D credit due to its highly subjective nature and the IRS’s history of finding ways to reduce it under audit) or it can be more alarming (such as with aggressive tax positions or failing to file tax returns in a jurisdiction where nexus was triggered). This can provide valuable insight to readers and lenders as it is a direct measure of risk. It is important for non-tax readers to understand what the largest uncertain tax positions are, whether reserve trends have materially changed, and if there are ongoing or pending audits close to resolution that require cash outlays in the future.
Non-tax readers do not need to master the technical rules of ASC 740 to be able to decipher the tax footnote. They simply need to know where to focus and what to look for. They should be looking for trends, because the most important questions are often very straightforward. Is the ETR sustainable and reasonable? Are the DTAs realizable? How much risk does the company have from its tax positions?
Getting answers to these questions can improve oversight and decision-making because, in many cases, the tax footnote tells an important story about the business long before management says it directly.
Michael J. Tighe, CPA, is managing director, tax, with Global Tax Management Inc. in Wayne, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at mtighe@gtmtax.com.