Want a great example of why investors should always read the 10-K, a company's official annual report as filed with the SEC? Buried in Ford's (NYSE: F ) most recent annual missive is this obscure-but-fascinating note:
[O]ur current low effective tax rate is primarily the result of our valuation allowance against deferred tax assets. Sustained levels of profitability are expected to lead to reversal of the majority of this valuation allowance, which could occur as early as the second half of 2011.
[source: 10-k (attached), p 75]
Of course, that doesn't mean a whole lot without some understanding of accounting nuances. But here's the essence of it in a nutshell: According to experts cited by Bloomberg, Ford could add more than $10 billion to its net income this year with nothing more than an accounting change.
What's more, not only is it a completely above-board accounting change, but it's also one the company is kind of obliged to make. And contrary to what you might think, it won't increase Ford's tax payments, at least not anytime soon.
What's the story? I'm glad you asked.
Welcome to the world of "valuation allowances"
In a nutshell, a valuation allowance is a reserve held on a company's books when the company doesn't think it will be able to use a tax loss in the near future -- typically because it expects to keep losing money for a while. In essence, this bookkeeping move allows the company to hang on to a credit it could have applied to its taxes until it has returned to sustained profitability -- in other words, until it has profits to actually pay taxes on.
Back in 2006, when then-new CEO Alan Mulally was first laying the groundwork for the company's dramatic turnaround, Ford's green-eyeshade folks created one of these allowances in anticipation of several years of rough seas. As of the end of 2010, according to the 10-K, that valuation allowance was worth $15.7 billion.
That's a hefty sum to have tied up in accounting limbo, and now that Ford's looking solidly profitable, it'll want to find a better use for that money. According to a corporate-tax expert interviewed by Bloomberg, the upshot of getting rid of the allowance is likely to be a $10 billion to $13 billion addition to Ford's net income for the year.
Ford said in the 10-K that it would record the move as a special item for the quarter in which it happens, a move that offers tax advantages. But to go back to the 10-K quote I included above, the valuation allowance is part of what has kept Ford's taxes low. Wouldn't getting rid of it mean that oh-so-profitable Ford will now have to start sending hefty chunks of cash to the IRS?
Short answer: no.
Putting that asset to work
In theory, Ford's profits will be subject to U.S. corporate-tax rates, which max out at 35%. In reality, though, Ford will be able to use its losses from 2005 through 2009 -- $31.4 billion worth -- to offset its tax obligations for the next several years, even if the company continues to be strongly profitable.
That's a good thing, but it's not exactly the huge competitive advantage you might think. The Japanese giants such as Toyota (NYSE: TM ) and Honda (NYSE: HMC ) receive all sorts of help from their home government, of course. And local archrival General Motors (NYSE: GM ) got a whopper of a gift from the IRS when it was allowed to "keep" its pre-bankruptcy losses to offset future profits -- $45.4 billion worth of future profits, as Fool Rich Smith noted last November.
A Barclays analyst recently opined that concerns about taxes have probably held Ford's share price back in recent months. But when the reality of this move sinks in -- first, that Ford won't actually be shipping cash out the door to pay taxes for several years, and second, that the removal of the valuation allowance means that management is very confident that continued profits are likely -- shareholders could see a pleasant upturn in their fortunes.
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