So the news is out: GM is going to take a $39 BILLION, non-cash hit this quarter due to a writedown of its deferred tax assets. What in the heck is a deferred tax asset anyways? If you read the business reporters and journalists on this issue, you still have no idea whatsoever about the real meaning of a deferred tax asset.
Without getting too complicated, think about it this way: a corporation has a set of accounting books, or rather, its “general ledger.” That corporation also has its tax returns, and accordingly, books and tax are not running on the same set of rules. Books are governed by GAAP (Generally Accepted Accounting Principles) and taxes are lorded over by the Internal Revenue Code. The criteria for recognizing income and expense items for book purposes are not the same criteria that apply to tax law. Thus taxable income – for tax purposes – is not the same as financial accounting income for book purposes. So when taxable income and book income don’t match, a future tax consequence is created. This can be a tax asset or a tax liability.Some transactions give rise to permanent differences between the books and tax (for example, something that is deductible for book purposes but not for tax purposes). A permanent difference will impact either the books *or* tax, but not both, so it does not create a “temporary” difference. Thus it does not give rise to a tax asset or liability.
In the case of a deferred tax asset, a “deductible temporary difference” is created. A deferred asset means a transaction took place which will result in a decrease in taxable income in future years. Thus taxes will be “saved” in future years, giving rise to this “asset.” A company may have instances wherein it wrote down assets on its books, however, expenses are not recognized for tax purposes because it is not a “cash event.” The company could expect tax savings in the future. If that company wrote down $1 billion of assets and its tax rate is 38.9%, then it has created a future tax effect of $389,000,000 – a tax asset. The corporation, then, can estimate the value of its future savings, or deferred tax asset, and this is carried on the balance sheet. I don’t yet know enough about GM’s specifics and would rather not speculate.
The problem here is that GM is so unprofitable that its bean counters realized that they had to come clean and write down the value of its future tax assets because it has become completely unpredictable as to when the company can actually return to making a profit, and thus use that tax asset against any future tax liability it incurs. Essentially, GM is admitting defeat and is not confident about making profits anytime soon. Hence the write-off. This is a huge indicator of management’s pessimism about the coming years.
GM’s last balance sheet (June 30, 2007) shows a negative equity position of $3.5 billion. Considering the write-off, the September 30, 2007, 3rd-quarter balance sheet will tell a disastrous story. Likely, the next buzzword that journalists will swoon over will be “going concern.” In financial accounting, “going concern” means that the company’s value, as reflected by its balance sheet, must reflect the value of the company in the long-term (beyond one year). A company facing certain bankruptcy, as reflected in its balance sheet, is not a going concern. Accountants and auditors must act on the principles of going concern when preparing or auditing financial statements. GM, in writing down its tax assets as it did, made a negative judgment about the uncertainty of future events and their outcome. In 2001, when 257 publicly-traded companies went bankrupt, only 48% of these companies had audit reports that included the auditor’s explanatory paragraph expressing doubts about the company being a “going concern.” A huge, huge failure for the audit-accounting industry as a whole.
Lastly, I have long been writing about General Motors and the fact that it operates on the verge of insolvency. I have been vilified for doing so. However, the trend for GM has been the build-up of negative equity, negative working capital, insurmountable losses, and previously, its only profits were coming from its finance arm until it sold majority stake in GMAC. More on its balance sheet woes to come soon.
Past articles on GM (by Eric Englund and myself) here and here.
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Nice article. FAS 109 has never been so fascinating. Now what can you do with FIN 48?
Karen,
Thanks for that explanation; that answers a question that has been on mind since reading the GM story.
But I would like one clarification. You say tax accounting is on a “cash basis”? That is not literally so, is it? The IRS specifies a good many rules about minimum asset depreciation periods, for example. Do they not?
As you point out, book and tax accounting are defined by different rules — but in what sense are the tax laws forcing “cash accounting”?
Thanks.
Tom
Important safety tips:
1. Do not invest your money in GM stock and check your mutual funds to make sure they are not invested in GM stock.
2. More Important: Make sure your OverLords, Congress, does not attempt to steal your money and give it to the stock holders of GM or Ford or anyone else for that matter.
The story in a button:
About two years ago, when talk of a GM bankruptcy was first floated, they cooked the books to make the business appear profitable and goose the stock price.
Now that the stock market appears to be in turmoil pending economic disaster (keep in mind the stock market situation overall is never as good or bad as it appears), GM is comfortable showing some more reality in the books, and may even try and push as much garbage into this and next quarter as possible, in order to make it easier to “book profits” in future quarters.
Business as usual!
This has always been baffling to me. GM has a negative net book value. The DPV of their pension and health obligations wipes out the value of all they have. Competitors are free to make a better product, not having these obligations. Yet the stock still has a positive value, and even *pays a dividend*! Worse, it’s still in the blue-chip Dow 30.
The slickest trick I have ever seen in union negotiations was GM dumping the health care liability on the UAW this year. The UAW was more than willing to take on the responsibility because it gave them more power over their members.
I am tempted to say that autoworkers will rue the day they did that, but probably autoworkers were going to get the shaft either way. I suppose at least now they can take responsibility for their own sins.
On the other hand, the UAW now has a big impetus to support nationalized health care to escape from the abyss that they have hurled themselves into. Maybe GM, the UAW, and the autoworkers will get the last laugh on us in the end.
Democracy is a creative evil.
Michael: “You say tax accounting is on a “cash basis”? That is not literally so, is it? The IRS specifies a good many rules about minimum asset depreciation periods, for example. Do they not?
As you point out, book and tax accounting are defined by different rules — but in what sense are the tax laws forcing “cash accounting”?”
Asset depreciation is not what I was discussing — the difference between tax and book asset values also gives rise to temporary differences, and thus deferred taxes. The IRS creates its own depreciation rules that are different than financial depreciation rules. The matching principle drives financial/accounting rules, and arbitrary IRS decrees drive the tax rules. But discussing that, too, and its many implications is ‘too much information’ and is beyond the scope of my comments. That is not GM’s situation.
You are mixing things up a bit by using the term “tax accounting” and saying that “tax laws are forcing cash accounting.” I did not state that. To put it more clear, a particular non-cash writedown in 2007 has no cash impact (there is no cash expense), so the IRS deems that there is no expense that can be ‘deducted’ to reduce taxable income for 2007.
My apologies: that reply is for Tom, not Michael.
Thanks for the additional explanation, Karen.
All this accounting stuff makes my head spin.
Does anyone have any speculation on what position the gub’mint might take on this particular issue, and how they may bilk taxpayers out of our property in order to save some jobs and a company that’s “too big to fail”?
Being a CPA and knowledgable about deferred tax accounting, I would say that this article, at the very least, contains certain misinformation. First of all, large corporations do not use the cash basis for their tax preparation. Second, the requirement to record an allowance against the tax assets is based upon a “mechanical” three year test, and really says nothing about management’s confidence level about future profits.
Brian, as a CPA, I can tell you there is no misinformation. I did not say that “corps use a cash basis for tax preparation.” Your words. Funny how I never mentioned tax “preparation” at all. I used the term “cash basis” to refer to try and clarify, in the most simple sense, how the IRS views a non-cash event because, essentially, the layman typically cannot relate to non-cash events well enough to understand the overall picture. But surely you knew that.
Secondly, non-accountants don’t want to know the boring details about valuation allowances, so it’s left out of this rather simplified explanation. Let’s try not to bore people too much with the particulars of establishing a valuation allowance. Also, any CPA worth a nickle knows that GM’s balance sheet is toast. I know how decisions on deferred taxes are made–been there, done that. In spite of all the accounting rules that “gently persuade” GM to make a conservative move, it’s still a judgment call, and it’s clearly a no-brainer that GM recognizes the limitations of future growth and therefore figures it cannot justify to continue carrying tax credits. It is _recent developments_ that drove the necessity to *require* the valuation allowance. If you read the financial news you’ll note that part of GM’s decision was based on market conditions in both the US and Germany, as well as a negative outlook for its ResCap business. I would say that qualifies as being less-than-confident about future profits, wouldn’t you? But you actually believe it when a GM talking head says, “We have not changed our long-term financial outlook.”
You do read balance sheets and read the business news, don’t you?
Thanks for the additional explanation
“GM has a negative net book value. The DPV of their pension and health obligations wipes out the value of all they have. Competitors are free to make a better product, not having these obligations. Yet the stock still has a positive value, and even *pays a dividend*! Worse, it’s still in the blue-chip Dow 30.”
Plunge protection team?
http://www.lewrockwell.com/englund/englund40.html
http://www.lewrockwell.com/decoster/decoster114.html
Karen_De_Coster: Great essays, until I got to: “We have little doubt that GM stock is being accumulated by Caribbean-based hedge funds owned and operated by the Federal Reserve”.
I agree that the Federal Reserve is doing some bad stuff. But when you claim that it runs hedge funds that buy lots of GM stock, that’s just insane. I don’t know how to put it otherwise.
So I guess you know who owns the Fed, Person?
Karen,
As a JD / CPA who has to explain difficult tax topics to tax novices frequently, I think your article was well-written. Perhaps it was not technically perfect in some terminology, but I read it in the context of “trying to explain this to laymen” and it made perfect sense. Kudos on explaining a difficult topic well.
I read this morning that Citi has not taken a valuation allowance on its DTAs. Any thoughts? Perhaps a column describing which auditors stick to the “three-year cumulative net loss” rule mechanically, and what that does to F/S reporting?
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