General Motors: More Than You Ever Wanted to Know About Deferred Tax Assets

So the news is out: GM is going to take a $39 BILLION, non-cash hit this quarter due to a writedown of its deferred tax assets. What in the heck is a deferred tax asset anyways? If you read the business reporters and journalists on this issue, you still have no idea whatsoever about the real meaning of a deferred tax asset. Without getting too complicated, think about it this way: a corporation has a set of accounting books, or rather, its “general ledger.” That corporation also has its tax returns, and accordingly, books and tax are not running on the same set of rules. Books are governed by GAAP (Generally Accepted Accounting Principles) and taxes are lorded over by the Internal Revenue Code. The criteria for recognizing income and expense items for book purposes are not the same criteria that apply to tax law. Thus taxable income - for tax purposes - is not the same as financial accounting income for book purposes. So when taxable income and book income don’t match, a future tax consequence is created. This can be a tax asset or a tax liability.Some transactions give rise to permanent differences between the books and tax (for example, something that is deductible for book purposes but not for tax purposes). A permanent difference will impact either the books *or* tax, but not both, so it does not create a “temporary” difference. Thus it does not give rise to a tax asset or liability. In the case of a deferred tax asset, a “deductible temporary difference” is created. A deferred asset means a transaction took place which will result in a decrease in taxable income in future years. Thus taxes will be “saved” in future years, giving rise to this “asset.” A company may have instances wherein it wrote down assets on its books, however, expenses are not recognized for tax purposes because it is not a “cash event.” The company could expect tax savings in the future. If that company wrote down $1 billion of assets and its tax rate is 38.9%, then it has created a future tax effect of $389,000,000 - a tax asset. The corporation, then, can estimate the value of its future savings, or deferred tax asset, and this is carried on the balance sheet. I don’t yet know enough about GM’s specifics and would rather not speculate. The problem here is that GM is so unprofitable that its bean counters realized that they had to come clean and write down the value of its future tax assets because it has become completely unpredictable as to when the company can actually return to making a profit, and thus use that tax asset against any future tax liability it incurs. Essentially, GM is admitting defeat and is not confident about making profits anytime soon. Hence the write-off. This is a huge indicator of management’s pessimism about the coming years. GM’s last balance sheet (June 30, 2007) shows a negative equity position of $3.5 billion. Considering the write-off, the September 30, 2007, 3rd-quarter balance sheet will tell a disastrous story. Likely, the next buzzword that journalists will swoon over will be “going concern.” In financial accounting, “going concern” means that the company’s value, as reflected by its balance sheet, must reflect the value of the company in the long-term (beyond one year). A company facing certain bankruptcy, as reflected in its balance sheet, is not a going concern. Accountants and auditors must act on the principles of going concern when preparing or auditing financial statements. GM, in writing down its tax assets as it did, made a negative judgment about the uncertainty of future events and their outcome. In 2001, when 257 publicly-traded companies went bankrupt, only 48% of these companies had audit reports that included the auditor’s explanatory paragraph expressing doubts about the company being a “going concern.” A huge, huge failure for the audit-accounting industry as a whole. Lastly, I have long been writing about General Motors and the fact that it operates on the verge of insolvency. I have been vilified for doing so. However, the trend for GM has been the build-up of negative equity, negative working capital, insurmountable losses, and previously, its only profits were coming from its finance arm until it sold majority stake in GMAC. More on its balance sheet woes to come soon. Past articles on GM (by Eric Englund and myself) here and here.