Introduction to Deferred Taxes

February 20th, 2010

Recently I did some pro-bono work regarding deferred taxes.  It was a good exercise for me because what they teach in school is not sufficient, nor claims to be, to solve all of the problems that exist in the real world (no surprise there).  Because this is a mostly professional blog, albeit one that has been underutilized lately, deferred tax is exactly the type of topic that I should be blogging about.  This is going to be a multi-part post, starting with the Mickey Mouse stuff that everyone can find by Googling “Deferred Tax,” and moving on to some of the more difficult situations that I have encountered, as well as what I feel are the appropriate solutions.

For starters, what are deferred taxes?  Before I can define what deferred taxes are, I need to lay some groundwork.  To the lay person, it often comes as a shock that companies keep multiple sets of books, and not the kinds where the bosses are “cooking the books” either, but for legitimate and sometimes statutorily required reasons.  The two most common sets of books in the US are the GAAP books and the tax books.  These two sets of books represent the underlying economic substance of a company’s business according to different rules – Generally Accepted Accounting Principles for the GAAP books and the United States Tax Code for the tax books.  The difference between these sets of books can be dramatic, but the differences should be able to be reconciled to specific differences between the rules by which the books were made.

The various deferred tax accounts that we will be discussing are used to effectively reconcile differences in income taxes between a company’s GAAP books and its tax books.  Before we get into what the different accounts are called and how to properly account for them, let’s look at a few of the differences between US GAAP and the US Tax Code.

Issue US GAAP Tax Code
Accounting Basis Accrual Modified cash basis or accrual
Depreciation Companies can choose between straight-line, any variation of declining balance (200%, 150%, etc…), units-of-production, or sum-of-the-year’s-digits. Companies can use straight-line, or MACRS (Modified Accelerated Cost Recovery System).  However, congress periodically offers “bonus” depreciation where companies can depreciate assets at a much higher rate (known as section 179 deductions).
Bad Debts An expense is accrued in the period that the bad debt can be reasonably estimated. A deduction is taken only when a bad debt is actually written off.
Warranty Costs An expense is accrued in the period that the item under warranty is sold. A deduction is taken only when warranty costs are actually paid.
Unearned Income Revenue is not recognized until the earning process is complete.  For example, if a 2-year rental contract were paid in full in advance, the company would only recognize half of the payment as revenue in the first year.  The remainder would be carried as an asset. Amounts received in advance are included in income at the time payment is received.  Using the 2-year rental example, the tax books would include the entire payment as income in the first year, and zero as income in the second year.

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Moral Hazard

August 19th, 2009

With fatherhood impending, my thoughts have recently been filled with how best to raise my child.  A significant part of parenting is discipline; determining what constitutes “bad behavior” or “good behavior” and how to respond appropriately.  We know the classic techniques; positive reinforcement rewards good behavior, negative reinforcement does not reward bad behavior, punishment provides consequences for bad behavior, etc.  As the responsible party, it can be difficult to be sure that the consequences being levelled are affecting the desired outcomes.  This brings up the problem of Moral Hazards, an often encountered situation that, it seems, the general population is ignorant of as a definitional occurrence.

An example to illustrate:  We all want our roads to be safe, and so car companies (and government regulatory bodies such as the NTSB) have gone to great lengths to make cars safer by reinforcing the frames, providing high-tech braking mechanisms, installing airbags, passenger airbags, side-curtain airbags, ad nauseum.  However, it stands to reason that drivers’ actions (DUI, DWI, reckless driving, texting-while-driving, etc.) are a larger determinant for roadway safety than the safety of the car.  So does making a safer car encourage good driving?  Hardly.  Emboldened with the knowledge that you can drive your car off a cliff and survive with naught a scratch actually encourages the opposite.  If what we really want are attentive, courteous, well-behaved drivers, it would be better to install an iron spike in the middle of every steering wheel in America.

While this is certainly an outlandish and severe example that would never happen in real life, it serves the purpose of any philosophic example, which is to have you remember it!  The larger question that needs to be addressed is this; we need to do the best we can to make sure that the consequences imposed on our charges affect the appropriate outcomes.  If Congress wants the financial sector to stop putting everyone’s 401(k) at risk, they should not bail out the firms that did so.  If a company underperforms during a given period, upper management should not receive bonuses.  If some college kid maxes out a dozen credit cards, their parents should not pay them off.  The real-world examples of applied moral hazards are ubiquitous, so it is easy for me to find examples of bad behavior being rewarded.

The hard part will be avoiding doing so myself.

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Property Rights

March 30th, 2009

A key component of my political philosophy, which is mostly libertarian (although, my stances do not always align with those of the Libertarian Party), is the preservation of personal rights, especially personal property rights.  For simple situations involving dispositions of easily identifiable, tangible personal property (viz. theft or trespass), it is easy to support one’s right to their property, but recently I have had trouble extending into more and more complex issues (which may or may not be the result of my reliance upon reason, and its inherent limitations as described by Godel).  As should be no surprise to anyone who reads this blog, Ayn Rand has written at length about the preservation of personal property rights, and as such, when I am having trouble thinking through a certain situation, I wonder how she would approach a contemporary issue like Digital Rights Management (DRM).

It is my feeling that the government’s role in settling property disputes should be to support the liberty of the property owner.  However, in the case of music, for instance, it is hard to tell how much liberty the property owner retains when they broadcast freely their property (over the radio, for example).  This of course is ignoring the question of who is the actual property owner of music, because most lay people innocently reason that it is obviously the artist who owns their music, but this could not be further from the truth.  Many times it is the record label that holds the property rights, and pays the artist a royalty fee for the use, or sometimes it is the songwriter, not the performer, who has either property rights and/or royalty rights in a piece of music.  My question is this: once a property owner freely disburses to the public their property, can they sue the public for theft, conversion, or trespass (or other diverse legal terms for unauthorized use of property)?  On the face of this question, my answer is plainly “Of course not!”, to which a simple example can illustrate:  Were I a famous baseball player who, in the height of stardom, signed and distributed innumerable items of memorabilia for which I never received a penny, but after my playing career ended, fell into financial straits, could I reasonably sue all the holders of those items of memorabilia for theft or unauthorized use?

Thusly, I am confounded.  On the one side, I feel that preservation of property rights is but one of the government’s key responsibilities, while on the other, I see the current state of the system and how certain sectors (read: the RIAA) are abusing these protections.

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Goodwill

March 2nd, 2009

This semester I am lucky enough to be taking Advanced Accounting, in which I spend 3 to 6 hours a week working out consolidated financial statements.  Contained in this process is the creation of an asset that is found on many company balance sheets – Goodwill.  Goodwill is something that shows up only on consolidated balance sheets, and is the result of a parent company “overpaying” for the purchase of a subsidiary.  That is to say, if P buys S for $500 million, and the fair value of S’s net assets is $400 million, then on the consolidated financials there would be $100 million of Goodwill.

Traditional definitions of goodwill state that it represents unidentifiable value of a company, such as a great location of a storefront, extensive customer lists, strong brand loyalty or recognition, and so on.  One technical procedure that gets lost in this definition, is how much leeway there is for value judgment in the calculation of goodwill.  For one thing, goodwill is a derived value, that is, no appraiser assigns a value to customer loyalty or brand recognition, and then adds that to the purchase price of the company.  Rather, the appraisers value everything that is “on the books”, all the assets and liabilities, and the difference between this book value and the eventual purchase price is put into goodwill (or recorded as a gain, if appropriate).

Another inconsistency (in my eyes) concerning goodwill, is that when a company “overpays” for the subsidiary, goodwill is put on their balance sheet, but when a company “underpays” for the sub, they must record a gain.  Why not force companies that “overpaid” to record a loss?  The answer that I have heard most often is that the “overpayment” is reflecting those unidentifiable assets of the acquired company, and therefore are correctly accounted for as assets.  I am personally a little skeptical of this view, because, in essence, the consolidated company has put on their books an asset that previously did not exist on either the parent or sub’s books.  All the expenditures that the sub spent in order to build the brand loyalty are not allowed to be capitalized, yet when that sub is purchased, it is magically right and proper to capitalize this value.

Goodwill is not the only asset that is treated differently in consolidations – take an intangible asset such as a patent.  For a company that creates a product and secures a patent for that product, the R & D costs incurred prior to securing the patent must be expensed.  As a result, the patent is listed on the books at only the cost that it took to actually get the patent (legal fees and such).  However, when another company buys the patent-holding company, the patent is listed on the consolidated statements at fair value, which could be exponentially higher than its “book value”.  Thus, it easy to see how blue-chip balance sheets can be best improved not by developing their own technology, but by buying up other companies who developed the technology.

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What is the Fair Value of Fair Value?

February 23rd, 2009

I am an avid fan of Monty Python’s Flying Circus, and their depictions of Accountants are hysterical (for non-accountants) and painfully accurate (for accountants).  One of my favorite episodes involves a Mr. Anchovy visiting the Vocational Guidance Counselor for a change of work (to become a lion tamer), when hilarity ensues.  During the skit, Mr. Anchovy describes being a chartered accountant thusly:

Anchovy: No! No! No!  You don’t understand.  I’ve been a chartered accountant for the last twenty years.  I want a new job.  Something exciting that will let me live.

Counselor: Well chartered accountancy is rather exciting isn’t it?

Anchovy: Exciting?  No it’s not.  It’s dull.  Dull.  Dull.  My God it’s dull, it’s so desperately dull and tedious and stuffy and boring and des-per-ate-ly DULL.

So as you might imagine, it is a rare occurrence when accounting is exciting, and due in no small part to the economic downturn we are currently experiencing, quite a bit of scrutiny has fallen upon some of the more delicate fields of accounting, especially that of fair-value accounting.  Fair value accounting is nothing new, it is in practice today in some respects, and has alot more to do with philosophy than accounting, a that fact seems to be lost on some of the scrutinizers.

It is important to note that in today’s global market system, accounting standards vary from country to country.  The IASB (International Accounting Standards Board - analagous to the FASB (US)) would have you believe that IFRS (International Financial Reporting Standards - analagous to US GAAP) represent global accounting standards that “level the playing field” between countries.  They conveniently omit that each country may, at its option, adopt different versions of IFRS to best suit the local markets and customs.  I bring up IFRS because the version adopted by the EU places more emphasis on Fair Value measurement than does GAAP, specifically in the area of ”writing-up” the carrying value of assets.  Generally, GAAP dictates that assets be carried at the “lower of cost of market” and that write-downs are a one-way street (i.e. once an impairment loss is taken, it cannot be reversed), whereas IFRS requires assets to be carried at fair market value, with adjustments made each year (or otherwise if appropriate).  The technical accounting is not as important though, as the philosophical differences in exactly what is being measured and what it means.

What people need to decide is this: what should a company’s balance sheet represent?  Currently, it represents the historical cost of a company’s assets, less any cost recovery that has been applied over the years.  Should it represent liquidation value?  The present value of future cash flows?  If companies were required to adjust their asset values to fair value every quarter (or year), should increases or decreases impact net income?

My personal belief is that, while the current standards for balance sheet reporting have known disadvantages, all the other systems for fair value reporting also have disadvantages, and the relative merit of either system does not substantially outweigh the other.  Therefore, no matter what system is in place, the burden of accurate interpretation of financial statements falls on the user.  If people don’t know the rules that companies follow during financial statement preparation, they cannot be expected to use the information contained therein in any reasonable fashion.  It doesn’t matter what the rules are concerning balance sheet valuations, if the users are uninformed about those statements, the usefulness of those statements is essentially zero to those users.

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Ants in my pants

February 9th, 2009

Wired.com has this interesting article about entomologists who are trying to model leafcutter ants in order to learn how they navigate around and by each other so as not to get stuck in traffic jams.  Apparently, the ants are very good at what they do; so much so, in fact, that they never encounter ant equivalents of 14 car pile-ups or rush hour traffic.

I like the idea of trying to find a solution to human traffic problems by modeling an organism that is supremely skilled at the task, however I don’t agree completely with all of the researcher’s claims.  For one thing, Marcus Randall is quoted thusly regarding how we might implement ant traffic procedures on human roadways:

“We essentially would have to hand over control of the vehicle to a collectively intelligent system that would move all vehicles from their source to destination,”

To me, this is the incorrect conclusion to derive from the ant studies, because the ants are not being guided by some central system that maneuvers each ant in the most efficient way possible.  Rather, each ant is making its own decisions, and these individual decisions taken together as a whole produce an efficient outcome for the colony.  This is a great example of distrubuted processing in action.  The incredibly tough part of this puzzle is figuring out what inputs, outputs, and logical processes are needed for each individual ant, in order to achieve the emergent goal of efficient traffic.

The authors point out, quite accurately, that egoism drives (ha!) human behaviors in traffic, and commuters especially are only concerned about themselves and how fast they can get to work (or home, or Dunkin’ Donuts, or whatever).  The contend that altruism drives ant behaviors in traffic, and thus the colony’s best interests are served.  I am skeptical of this assertion, because, going back to emergent behavior, while the end-result (emergent behavior) of the ant’s collective actions is efficient traffic for the colony, this is not necessarily indicative of the motivating forces at work for the individual ants.  For example, were the individual ant’s motivations entirely altruistic, then a slow moving ant would yield to all other ants.  If this ant were carrying a particularly large piece of food, however, the most efficient traffic flow for the colony would involve all the other ants yielding to it so that it could deliver the food more quickly.

What if our cars could talk to each other, and pass information similar to how ants do?  Southbound traffic would be able to tell the Northbound traffic what lay ahead and vice versa.  Have you ever flashed your lights at oncoming traffic to warn them about a cleverly hidden police officer?  Same idea, but with digital communications, the amount and diversity of information being passed between the cars increases exponentially.  Of course, there is a question of what information is relevant, how much is needed, what are the constraints on how much can be reliably passed between passing cars?  Let me know what you think.

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Adventures in Objectivism

February 5th, 2009

*Author’s Note* For those readers out there who cannot describe the philosophical framework by which you lead your life, it is my sincere hope that at some point, hopefully sooner than later, you spend as much time as is needed to build yourself an ethical scaffolding.

Easily the most important event in my philosophical development was the day I picked up Atlas Shrugged by Ayn Rand.  Four months later I finished the tome, and held an altogether different view on life.  Her philosophical doctrine, Objectivism, has as its cornerstones: Reason, Self-Interest, Objective Reality, and Capitalism.  Taking this coherent and complete set of philosophical tools, one can evaluate any issue to arrive at a judgment (moral or immoral, valid or invalid, true or untrue) without fear of contradiction.  This may seem trivial at once, but upon further reflection, there are superfluous examples in contemporary society of ethos being spouted that contain inherent contradictions.  These range from benign to humorous to insidiously calculated misinformation campaigns.  Yet the very pundits who espouse these doctrines seem wholly unaware or unconcerned that their argument today directly contradicts their stance yesterday.

One instance where inherent contradictions are apparent is in the so-called “Expectation Gap”.  Many people feel that the world is different than what it should be, or more specifically, they have created (in some fashion) in their mind a world that is different from reality.  They look at a news story about one thing or another, and remark that things should be different, basing their expectation (what should happen) on the make-believe world in their head.

After learning of Objectivism, my own expectation gap posed quite a dilemma; as a reasonable person and an observer of reality, I expected reasonable outcomes – yet this was plainly not the case in everyday life (meaning that unreasonable outcomes occurred frequently).  The fault was mine, however, in assuming that the world was dictated by reason.  However much I tried to be as reasonable as possible, did not mean that everyone shared my respect for logic, in fact many people avoided it at all costs (politicians especially)!  Thus, I had to necessarily adjust my own expectations to more accurately reflect the real world, narrowing my expectation gap.  This is the step that I feel many people never make, instead preferring to think that somehow their own expectations are justified, and the world is just off-tilt.

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Information Systems

January 26th, 2009

This semester I am taking a course in Accounting Information Systems.  It is the first IS course I have ever taken, or so I thought.  In the introductory lecture and first chapter, they take a top-down view of AIS, starting with all types of Information Systems and breaking them down into subgroups, and sub-subgroups, and so on until arriving at those systems specific to Accounting.

I say that this is not the first information systems course I have ever taken, because, in fact, taking a rather contemporary view of what exactly constitutes “information”, I actually have a Bachelor’s of Science degree in a particular Information System – Biology.  During my Senior year at UT, as I was preparing to receive said degree, I was overwhelmed with regret.  I had failed on my purpose as an undergrad, namely to get into Med School, and was racking my brain pointing out to myself all the times I should have studied harder, not been happy getting C’s in those crappy Liberal Arts courses, and maybe above all, questioning why I had even been an Biology major in the first place.

The truth is, Biology is very interesting, and for any person out there who ponders the meaning of life, studying Biology is the place to start, for it is the study of the very thing which you ponder.  The more I came to accept that Med School wasn’t for me, and working in Clinical Labs for 3 years, I drew more and more upon my education in order to apply it to the real world.  In doing so, I came to see Life as the most ingenious Information System ever devised - one which is self-replicating, adaptable, and resourceful.  For what purpose do cells exist, other than to harbor information, in the form of DNA, RNA, and all the proteins begotten from the former?  Cell division is analagous to so many scribes, dutifully copying manuscripts of old so that the next in line can do the same to preserve the information contained on the pages for years to come.  This analogy can be drawn out further, for certainly a scribe would make errors in their transcription (also a Cell Biology term, but I won’t get into that), and this occurs frequently (more than you think) during cell processes.  Up the evolutionary chain from cellular processes, there are tissue processes, and organ processes, and of course, organism processes.  All organisms would not exist but for a progenitor of some sort (Mothers & Fathers, seeds, spores, or sister cells in the case of bacteria and other asexual reproducing life forms), and the one trait that is omnipresent across Life is the need to procreate.

If the science fiction community is any indicator, people are already looking at the blueprint that biology has provided us in order to design the next generation of computers (another vessel for IS), as illustrated greatly by two of my favorite authors: Michael Crichton’s Prey, and Neal Stephensons’s Diamond Age.  Both novels deal, more or less, with nanoparticles capable of simple logic, of which there are prodigious amounts, and together these clouds demonstrate “emergent behavior”, something that is no secret to microbiologists.

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*Updated* New Blog Created

January 20th, 2009

Author’s Note:  So I have changed the presentation of the Baby Blog a little bit, now it is it’s own blog which can be found at www.michaelboatright.com/baby/, so if you wish to link to that directly, ignoring somewhat bland and boring financial discourses that will populate this main page, please update your links.  You should also see a link to “Baby Blog” under “Links” on the right side.  Thanks to everyone who has commented so far!

Make sure you check out the latest addition to the Boatright Family by checking out the latest addition to MichaelBoatright.com!  In the upper right of the page layout, you will see that a new page has been created, which will be updated with appropriately gratuitious sonogram pictures and other memorabilia that any self-respecting proud father-to-be wants to show off to the world!

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Separate but Equal

January 14th, 2009

It is almost tax season, and soon many US taxpayers will sit down with their W-2’s, a couple 1099’s, a 1040 and a calculator in order to file their taxes.  Last semester I had the pleasure of completing three different tax research projects given by a professor (who had malice of forethought), which required exploration of ticky-tacky details hidden deep within the tax code.  Digging through the tax code offered me an interesting look at a real-life application of the “division of powers” that everyone learns in 4th grade civics.

Tax laws are (obviously) created by Congress (Legislative Branch) and are notoriously convoluted.  Were laypeople required to use only the tax laws in order to file their taxes, it would be a near impossible task.  So the IRS (Executive Branch) creates forms that try to put a method to the madness so that, for instance, when you are filling out your Form 8829 (Deductions for Business Use of Your Home), you don’t have to know the difference between a Tier 1 and Tier 3 expense or that depreciation of your home cannot create a loss; instead just follow the instructions, do simple arithmatic, and you’ll stay within the rule of law.

Sometimes, however, the law is vague or too broad (intentionally or otherwise), so that there really is no way for the IRS to make a clever flow chart for you to follow to determine if that $400 gold watch you received for 10 years of service at your job should be included in income (no).  In these cases, people do what they (or their accountant) thinks is correct, and if one of them gets audited and the IRS disagrees, the Courts (Judicial Branch) get involved.  It is somewhat important to note that when it comes to “Authoritative sources” of tax law, only the Tax Code and Court Decisions are considered authoritative – IRS publications and opinions are not.  So if you get audited, and you point to a paragraph Pub. 589 as the reason you took that deduction, the IRS agent could say, “Yeah, I know, but I’m still not allowing it.”

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