“Don’t mention debits and credits in polite company,” my mother reminds me. But what if debits and credits provide surprising insights? Ignore mother’s advice.
After more than a decade of unsuccessfully trying to convince financial journalists to write a story about the “contentious debit,” here it comes, straight from the horse’s mouth. Until recently, most U.S. corporations reported much lower effective tax rates than the 35 percent statutory rate. This was, in no small part, attributable to the fact that the IRS allowed a share-based compensation, or SBC, deduction, often much larger than the expense recognized in the financial statements. A less obvious fact was that some highly profitable companies paid no tax at all on their income. A bogus journal entry, which we will refer to as the contentious debit, kept that hidden from the public.
Recall that up until 2004 the Financial Accounting Standards Board held that share-based compensation was not an expense that ought to be recognized as such. Once FASB came to its senses, it provided corporations with enormous leeway as to the actual amount that they had to expense. Suffice to say that almost without fail, management’s dubious estimates of the economic consequences of using stock instead of cash to reward employees fell far short of the amounts found under share-based compensation in their tax returns. Even though corporations claimed then, and still do today, that SBC was not an expense for accounting purposes, they happily took a tax deduction equal to the discount at which they issued stock to employees under their SBC programs. Example: A company grants an employee 1,000 options with a strike price of $15 (the stock price at the date of the grant). The employee exercises the option when the stock price is $60. The employee gains $45,000 (1,000 shares times $45, i.e., $60 minus the $15 strike price that the employee is obligated to pay upon exercise).
Here’s the magic: The IRS allows the company a tax deduction of $45,000, even though there are no cash outflows associated with that deduction. Multiply that by, say, a thousand employees, and the tax deduction could have a material impact on the amount of tax that the company has to pay. For decades, SBC was not considered an expense under GAAP. As noted, eventually, FASB succumbed to economic realities and mandated that companies expense SBC.
Under the “old regime,” companies had this huge SBC deduction in their tax return while recognizing no corresponding charge in the income statement. This caused a significant discrepancy between taxable income in the tax return and pre-tax income in the income statement.
For some companies, it meant that the effective tax rate was practically insignificant. For example, in 2004, eBay reported pretax income of $1.128 billion. eBay’s tax expense was $81.902 million, for an effective rate of 7.3 percent. At that time, eBay had no obligation under GAAP to recognize an SBC expense in the income statement. However, in eBay’s tax return, it booked a tax deduction for SBC of approximately $748.5 million. The tax saving (benefit) of this largesse from the IRS amounted to $261,983, which lowered the effective tax rate from 30.5 to 7.3 percent. Similarly, in 2004, Yahoo reported pre-tax income of $1.185 billion, a tax expense of only $28.990 million and an effective tax rate of 2.4 percent. These ultra-low tax rates go back more than decades, ever since share-based compensation became the fashion. One can easily envisage the embarrassment in the boardrooms as directors find no SBC expense in the income statement, while a gigantic payroll deduction shows up in the tax return. Setting aside this contradiction, it was also not politically expedient for corporations to report these low tax rates when they originated from an expense that management vehemently disavowed. Also, there was the risk that legislators might consider jacking up the tax rate, as constituents might not like the fact that billions of dollars in pre-tax income attracted hardly any tax.
The ever-compliant FASB came to the rescue of corporate America and mandated that a bogus journal entry find its way into the tax expense line. We call it bogus for a good reason. Corporations multiplied the difference between the expense recognized in the income statement (which was zero until 2004), and the amount deducted in the tax return by the statutory tax rate, similar to what corporations would do to account for timing differences that would arise from temporary disparities between the way items of income and expense are treated in the ledger and in the tax return. These temporary disparities gave rise to deferred tax entries in the form of, for example, a debit to the tax line and a credit to deferred tax liabilities.
In the case of the bogus journal entry that gave rise to a debit in the tax line, the credit was posted to shareholders’ equity. The credit could not have gone to a deferred tax liability account because the difference in book and tax treatments gave rise to a permanent difference. FASB’s rules pertaining to deferred taxation specifically exclude any adjustments for permanent differences; for example, exempt income, like interest income on municipal bonds, is recognized as such in the income statement but never treated as income in the tax return. In effect, what the bogus entry did was to reduce pre-tax income with the debit to the tax line but to neutralize the impact by a corresponding credit to shareholders’ equity.
There is nothing in FASB’s voluminous writings to justify such a bogus or contentious journal entry, other than the need to accommodate management and to keep legislatures and their constituents in the dark. The downside of the bogus entry was that it had a negative impact on earnings, but the benefit of disguising the tax dodge on account of a generous SBC deduction from the IRS made the pain all worthwhile. After all, cash flow is all that matters. In the case of eBay above, the bogus journal entry raised eBay’s effective tax rate to 30.05 percent. In the case of Yahoo, its 2004 effective tax rate was 37.0 percent. The bogus journal entry succeeded in keeping the actual effective tax rates of 7.3 and 2.4 percent completely hidden, except from curmudgeons like us who have unsuccessfully tried to find journalists willing to shine some light on the subject.
Since 2004, in terms of new rules promulgated by FASB, corporations began expensing share-based compensation. The expense was ostensibly based on verifiable mathematical constructs that virtually guaranteed an understatement of the true economic consequences of diluting shareholders when employees cash in their stock options. The true economic cost is the compensation deduction claimed on the tax return, i.e., the employees’ gains (market prices vs. exercise prices), or the amount by which a company discounts its stock to employees. Companies routinely buy back stock to combat the dilution caused by SBC. It is our practice to adjust free cash flow and net income by the cost of such repurchases. Management’s guestimates make little economic sense to us.
In the light of the rule change to expense SBC, the bogus journal entry became less of an issue. After all, even if the expense in the income statement comes in lower than the amount claimed on the tax return, the disparities are now less severe. In other words, the impact on the effective tax rate was less pronounced, to the point that FASB decided in 2016 that the time had come to remove this spurious journal entry for good. The effect of this was that from the latter part of 2016 onwards, part of the improvement in corporate earnings had more to do with the normalization of accounting rules than actual economic fundamentals. Again, nobody noticed, but we factored it into our earnings models as we projected future earnings.
Come the first quarter of 2018, and companies were now reporting the tax expense per the new 21 percent corporate tax rate. Perhaps FASB had not foreseen what the change in their rules might look like once a 40 percent cut in the corporate tax rate comes into effect. Additionally, the stock market has ramped up since November 2016. This meant that employees who were cashing in their stock options enjoyed enormous gains, which, similarly, meant hefty tax deductions. Without the bogus journal entry, we began to notice, relatively speaking, infinitesimally small effective tax rates.
One of the stocks we own, Intuitive Surgery, was among the earliest to announce Q1 2018 earnings. Intuitive Surgery’s effective tax rate was only 0.9 percent in Q1 2018. A footnote disclosure in the earnings release points out that the company received a $54.7 million “excess tax benefit related to share-based compensation.” Last year, the tax benefit was $32.6 million, translating into an effective tax rate of 10.5 percent. As we now know, the tax benefit is the additional amount that the IRS allows as a compensation expense that will never find its way into the income statement. Management’s guesstimate, as noted, errs on the side of expediency. When management calculates an allowance for doubtful debts, and the estimate turns out to be too severe or too lenient, an adjustment is made to income to account for the under- or overprovision. Similarly, when management recognizes a loss on the disposal of a fixed asset, it in effect acknowledges that the original provision for depreciation was insufficient; vice versa when a gain on disposal is recognized.
But when it comes to provisions for share-based compensation, there are no such “truing-up” adjustments. It is not possible to under provide for doubtful debt or depreciation on fixed assets. Sooner or later reality catches up and calls for an adjustment to bring a provision in line with reality. Strangely, no such accounting discipline exists when it comes to providing for share-based compensation, but that is a topic for another day. Under the bogus journal entry regime, the Intuitive Surgery would have recognized an additional tax expense of $54.7 million and $32.6 million in Q1 2018 and 2017, respectively, for effective tax rates of 19.8 and 26.7 percent, respectively, instead of the reported 0.9 and 10.5 percent, respectively. By no longer requiring the bogus entry, Intuitive Surgery’s substantial SBC tax deduction becomes apparent. Divide the tax benefit by the statutory rate of 21 percent, and we get $260 million.
In other words, in the first quarter of 2018, employee gains realized on the cashing out of stock options exceeded the mathematically-generated expense recognized in the income statement by $260.5 million. A closer examination reveals that in Q1 2018, the company claimed a tax deduction of $318.0 million on account of stock option exercises (employee gains, the discount at which they bought the stock), while only showing an SBC expense in the income statement of $57.5 million. These outside gains are attributable to the fact the company’s stock was up more than 70 percent year-over-year.
In Q1 2017, the company claimed a tax deduction of $140.5 million on account of stock option exercises, while only showing an SBC expense in the income statement of $47.4 million. There are tables in the appendix with the relevant disclosures and calculations referenced above. As investors, we take a dim view of SBC programs that dilute shareholders. We wrote an editorial for Barron’s (Feb. 23, 2004) under the title, “The Stock-Option Nightmare.” On the other hand, we love these low tax rates as taxing corporations is a most unsuitable way of raising revenue for the Treasury. The destruction of capital from a tax on corporations can be quantified by multiplying the amount of cash a company sends to Washington by the company’s earnings multiple. Hence, the lower the cash transfer, the more advantageous for investors.
Bottom line: Low taxes are terrific, even if they come by way of a substantial tax deduction generated by compensation programs we dislike. The accounting practices associated with SBC have evolved from the ridiculous to the barely sensible. We carefully and meticulously follow the debits and credits. It has never failed to give us an edge in assessing the true economic earnings of a business.