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Seven Steps in the Analysis of Income Statements: Income Taxes

May 11, 2011 | About:

Alex Morris

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This is the fifth article of a comprehensive list looking at Ben Graham’s seven steps (from "Security Analysis") for adjusting the accounting numbers in the analysis of the income statement in order to arrive at indicated earnings power. They are as follows:

1. Deal properly with nonrecurring items – see here

2. Eliminate unjustified income recognition

3. Direct entries to surplus – see here

4. Use comparable inventory and depreciation methods – see here

5. Consolidate affiliates – see here

6. Provide for income taxes

7. Record absent assets and liabilities

As I’ve noted previously, I’m going to skip the second step (eliminate unjustified income recognition) for a later date because it is associated in some way with nearly every step above, and will be more useful in the closing discussion. For this article, I will focus on the sixth step, which deals with adjusting the income tax expense in relation to adjusted earnings (as calculated from earlier steps).

INCOME TAXES

The last four posts have dealt with situations where the analyst should change the income statement in order to arrive at a better estimate of “true” economic earnings. One area that has been overlooked is taxation; when the analyst removes a one-time item, they must also adjust for the tax effect from the item as it appears in the income statement. The challenge is that this final adjustment in the income statement will require that the analyst is knowledgeable about the current tax laws, as well as with those of the previous decade. As Graham notes, “Analysts do not have to be tax experts, but should be familiar with the general characteristics of the U.S. tax law and the specialized tax treatment of the industries in which the analyst has an ongoing interest … Some tax situations are very complex because various tax elements interact. In those cases, straightforward analysis and simple rules of thumb become quite workable.”

According to the Instructions from Form 1120, the tax rate schedule for corporations is (numbers based on taxable income):

Over But Not Over Tax Is: Of The Amount Over:
$0 50,000 15% 0
50,000 75,000 7,500 + 25% 50,000
75,000 100,000 13,750 + 34% 75,000
100,000 335,000 22,250 + 39% 100,000
335,000 10,000,000 113,900 + 34% 335,000
10,000,000 15,000,000 3,400,000 + 35% 10,000,000
15,000,000 18,333,333 5,150,000 + 38% 15,000,000
18,333,333 - 35% 0


As can be seen in the bottom row, for companies with any sizable profits, income is essentially taxed at a flat rate of 35% (this figure is rarely realized, with companies like General Electric (GE) and Yahoo (YHOO), which have a total tax rate of 14.3% and 7%, respectively, over the past five years).

In order to remove nonrecurring items from our calculation of net income and the tax rate, we must understand how each figure affects the overall rate. An attempt to cover every possible adjustment is clearly outside of the scope of this article; the investor should consult the IRS’ tax information for corporations (http://www.irs.gov/businesses/corporations/index.html), which can help answer the question of how to adjust for individual adjustments.

I would like to look at an individual situation to give an example of how this adjustment will look, but am going to hold off for the finale of this series, which will look at a ten-year readjustment income statement for a company (still not positive on which one, so shoot me some ideas if you have them!). If there are any specific examples that readers would like to see, post a comment below; I’ll be reading the IRS tax information over the next couple of days, and will try and work them out as they are brought up.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

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