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Monday, March 2, 2009

Security Analysis:Chapter 15

Now we will learn the final step of income statement adjustment: comparing the reported earnings to the income tax deduction.
This is necessary because many reports vary significantly - if the results are significantly different, the analyst can question the dependability of the published income.

There are many different reasons why the income accepted for tax purposes has charged to it less than the standard percentage rate of corporate tax:

- net income below a certain amount
- carry-forward or carry-back of losses
- income received on state or municipal bonds is tax free (rarely of importance)
- dividends from domestic corporation have a lower tax rate
- gains realized on the sale of capital assets
- mining and oil companies can use "percentage depletion", insstead of acounting depletion based on the book cost of the properties
- most investment companies or funds are allowed to save paying taxes if income is distributed to stockholders

The management of the company may do any of the following, which cause the reported income to differ from the taxable income:

- charging depreciation at a different rate in the income statement than the tax return
- by use of voluntary reserves
- by placing certain debits or credits into the surplus account, but including the tax result in the income account

The analyst should decide whether depreciation is correct or not compared to the tax deduction; if not, he should change it to fit accordingly.

On the subject of reserves and taxable income, Graham says,"When inventory is valued at LIFO for tax purposes ther are no resulting inventory reserves and no related difference between reported and taxable income. But when the LIFO result is obtained by setting up reserves, not recognized for tax purposes, a difference will, of course, be created."

One will find discrepancies from reserves in cases of:
- amortization of past-service pension payments
- operating reserves
- contingency reserves

Charges and credits through surplus accounts, where the income tax charges or credits are reflected in the income account, can distort earnings in various ways:
-losses or gains on property sales cleared through surplus
-bond discount charged off and redemption premium paid
-interest during construction

So, an analyst should determine why the reported profits and those indicated by the tax deduction differ. In the case of dividends or tax-free interest, no action is needed. If it is due to capital-gains, the anlyst should separate these from ordinary profits. In oil and mining companies he will expect a smaller tax allowance.

In the case of a carry-forward from a past-loss, the analyst should restate the earnings with a normal tax deduction for the profits.

If the reported earnings differ because of reserve entries, the analyst should exclude them and re-calculate the results.

If he finds a significant discrepancy which he is unable to explain, he should contact the company's treasurer.

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