Reports skewed by deferred tax “liabilities”

Media release

Issued on behalf of a group of professional directors

23 August 2010

Corporate reporting skewed by deferred tax “liabilities”

Financial results of New Zealand corporates will be distorted by more than $1 billion through the application of international financial reporting standards (NZ-IFRS) to taxation changes announced in this year’s Budget on 20 May 2010.

The bizarre impact on certain companies is so material that their financial statements will arguably not present a “true and fair view” as the market perceives that term

The difficulties arise from the elimination of tax deductions for depreciation on buildings with an expected life of 50 years or more. The NZ equivalent of International Accounting Standard 12 “Income Taxes” requires a deferred tax liability to be set up representing the difference between the carrying values of buildings for accounting purposes and the value for tax purposes – now being zero. Thus an existing building in the books at, eg, $10 million will require a deferred tax charge to current profit (at the new corporate tax rate of 28%) of $2.8 million and the setup of an equivalent liability in the balance sheet.

Many professional directors do not regard this accounting entry as a real liability in an economic sense. Any potential impact on additional future tax payments, due to non deductibility, is required to be expressed in nominal values but is unlikely to occur for decades and/or the impact of loss of future deductions is likely to have been factored into the carrying values of buildings expressed at fair value. In support of this view, critics note that it is illogical that buildings purchased after budget date do not require the establishment of such a deferred liability.

Companies with large property portfolios such as retailers, listed property trusts, industrial entities and utility operators are required to make significant “non-cash” adjustments to balance sheets and earnings statements when reporting results for accounting periods ending after budget date. In the last week a number of listed companies have emphasised “normalised” results excluding the adjustment. These include the “backing out” of liabilities by SkyCity ($40m), Port of Tauranga ($10m), M&C Hotels ($26m) and Freightways ($6m). Notwithstanding this, some journalists have headlined the audited accounts’ Net Profit after Tax(NPAT).

Listed property entities which report later in the year are required to provide for much larger liabilities.

An attempt to address the problem through changes to the international and New Zealand reporting regimes was initiated by a group of 19 senior company directors, many of whom chair audit committees on a range of New Zealand listed and state owned company boards. They acknowledge, however, that such changes take time and need a period of consultation.

“The danger is that many people will not understand that the deferred tax liabilities are merely accounting entries to comply with the rigid application of the international accounting standards that New Zealand companies are obliged to use,” say professional directors Rob Challinor and Tony Frankham, who have the support of fellow directors facing the same issue.

“The deferred tax liabilities required say nothing about the company that is useful to shareholders, potential investors, directors or managers. They are pointless in the sense that they are measuring something that has no practical application or purpose. They are non-cash, have no relevance to underlying or future performance and will not affect the ability to pay dividends.

“Worse than that, their effect is misleading. They create charges at the level of NPAT which will seriously distort the earnings of many companies.

“The combined effect on NZ companies will be in excess of $1 billion in terms of reported bottom-line earnings. Estimates of the effect on the reported earnings by companies that have so far advised the market, total over $900 million (see appendix) - and this is an incomplete list as it excludes state owned enterprises and private companies.

“This is a serious understatement of the performance of corporate New Zealand, which is likely to be misunderstood and misreported, and thus mislead investors and others. We think it impacts the credibility of the accounting profession.

“We are asking media commentators to take particular note of this issue and ensure they adjust the manner in which they report on corporate earnings affected by the deferred tax adjustment. We are requesting that they highlight operating earnings at the level of EBIT (Earnings before Interest and Taxation) or equivalents which will provide a better reflection of performance than NPAT. Alternatively the deferred tax adjustment should be directly added back to NPAT (together with any other appropriate adjustments) to establish an ‘Underlying Profit’ and thus a meaningful measure of tax paid performance.”

A formal response to representations from the 19 senior directors to the International Accounting Standards Board is still awaited. The IASB is about to publish an exposure draft outlining proposed changes to IAS 12 that could eventually bring relief for companies that regularly revalue their buildings, but not for other “in use” buildings recorded at cost. The New Zealand Financial Reporting Standards Board and Accounting Standards Review Board both acknowledge “the serious concerns.” The Boards have just published an updated statement explaining the standard setting process (see www.asrb.co.nz) They advise however that “the suggestion to make changes to, or provide exemptions from, the standard (NZ IRS 12) is not a viable solution, both because of time constraints and the wider implications for the New Zealand financial reporting framework”.

Challinor and Frankham acknowledge these difficulties but encourage debate as this is not the first standard requirement that is inapplicable to the New Zealand situation. “We recommend that until some relief is provided by the Standards, directors of materially affected NZ companies should include in their financial statements, by way of an additional note, the effect on profit and financial position of excluding the ‘liability’.”

While the Financial Reporting Act 1993 requires compliance with NZ IFRS, Section 11(2) of the Act states that “If in complying with generally accepted accounting practice the financial statements do not give a true and fair view of the matters to which they relate, the directors of the reporting entity must add such information and explanations as will give a true and fair view of those matters” (emphasis added).

Attached
• Schedule of estimated impacts announced by NZ companies
• A “simple” example of deferred tax accounting
• Profiles of Rob Challinor and Tony Frankham
(comments made are in a personal capacity and do not necessarily reflect the view of the companies of which they are directors)
Deferred_Tax_Liabilities_NEW_ZEALAND_CORPORATES.doc
Deferred_Taxation_Accounting_Example.doc
Director_profiles_RLC_and_ANF.doc

ENDS

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