Scrutiny Seen for Skimpy Tax Disclosures

While many companies report the existence of tax-planning strategies, only a few describe what they are.
David KatzJanuary 28, 2012

What are they hiding? If companies continue to boost their reported earnings without describing their tax-planning strategies, investors and accounting standards-setters may start asking that question.

Currently, many companies report the existence of tax- planning strategies to justify the absence of a valuation allowance in their financials. Such allowances must be used to write down earnings if there’s a likelihood of more than 50% that a company’s deferred tax assets (DTAs) won’t be absorbed by future taxable income.

DTAs are the tax savings associated with future tax deductions. “If you don’t have to put down a valuation allowance, you have higher assets, higher stockholders’ equity, and higher net income. If do have a valuation allowance you have lower net income, lower assets, lower stockholders’ equity,” says Charles Mulford, a Georgia Tech professor and director of the university’s Financial analysis Lab.

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Yet while many companies use the phrase “tax-planning strategies” in their annual reports, a scant few report what those strategies actually are, according to a recent report by the lab, “Deferred Tax Assets and the Disclosure of Tax Planning Strategies.”

In a search of 10-K filings on the Securities and Exchange Commission Website, the researchers identified 1,700 companies that referred to tax-planning strategies within the period of February 1, 2010 to January 30, 2011. Yet out of that total, they could only find 34 firms “that identified the nature of their tax-planning strategies,” according to the report.

And a frustrating search it appears to have been — even among the companies that revealed what kind of strategies they have. “In many cases these disclosures appear to be leading up to a disclosure of the specific nature of the tax-planning strategies they believe that they could or would employ, but in most cases the reader is left hanging — no detailed disclosure is provided,” the researchers write.

One example they cite comes from Valley National Bancorp’s December 31, 2010 annual report. The company justifies a $6.5 million 2008 decrease in a valuation for deferred tax assets by citing the existence of a “qualifying tax-planning strategy allowing the use of Valley’s capital-loss carryforwards.”

Valley National goes on to assert that its strategy “was 1) prudent and feasible, 2) a strategy that Valley had the intent and ability to implement, and 3) a strategy that would result in the future realization of the capital loss carryforwards.”

Yes, but what was the strategy? The lack of such a clarification, “which could be provided with the addition of a descriptive sentence or two,” leaves the reader hanging “with no ability to make an assessment as to the likely effectiveness of the tax- planning strategy.”

There may be consequences for such omissions, however. “Given the general lack of disclosures observed, the [Financial Accounting Standards Board] may wish to consider such a disclosure requirement,” the researchers opine.

The issue stems from a tax-accounting requirement under U.S. generally accepted accounting principles: companies must make an assessment of the likelihood that DTAs will be realized.

The deferred assets arise mainly when expenses are recognized on a firm’s books before their recognition on the tax return. The associated tax-saving potential is recorded as a DTA on the balance sheet, along with an offsetting reduction in income-tax expense on the income statement.

DTAs are realized in the future against taxable income. The expense deduction reduces taxable income and with it income tax payments. To get the immediate reporting boost of not having to record a valuation allowance, many companies report the existence of tax-planning strategies that will make sure that enough future taxable income will be in place to absorb future tax assets.

Among those companies that claimed to identify such tax-planning strategies, the Georgia Tech Lab found that such investment-related moves as selling appreciated shares or switching tax-exempt securities to taxable ones are the most common strategy in use, consisting of 47% of the sample.

Planned sales of other assets make up 16%, and sale-leasebacks and other income-acceleration moves were cited by 13% of the sample. Five percent each deploy permanent reinvestments of foreign subsidiary earnings and capitalizing research and development costs for tax purposes.

The study also cites a grab-bag of other strategies, “including the purchase of replacement properties, the merging of subsidiaries, or the shifting of entities to lower tax-rate jurisdictions.”