LA Times: Verizon's Deferred Tax Liabilities Too High?

[David Farber <dave () farber net>]

------ Forwarded Message
From: Daniel Berninger <dan () tier1research com>
Date: Thu, 20 Jan 2005 06:56:07 -0500
To: <dave () farber net>
Subject: LA Times: Verizon's Deferred Tax Liabilities Too High?

Dave,

For IP, if of interest.

The article addresses Verizon's $22bn and growing deferred tax liability.
Verizon has the highest level of deferred taxes among the Dow 30
industrials.  A review reveals Verizon noted less in provision for income
tax over the last three years than BellSouth (a company with 1/3 VZ's
revenues.)

Our investigation into the issue is on going.  Readers are welcome to
contact me about the full report.

Dan

...............................................
Daniel Berninger
VP, Senior Analyst
Tier1 Research
v: 202.250.3838
e: dan () tier1research com
w: www.tier1research.com

> > > > > > > > > > > > > > > > > > > > > > >

http://www.latimes.com/business/la-fi-verizon20jan20,1,2593871.story

January 20, 2005  E-mail story    Print

Verizon's Deferred Tax Liabilities Too High?
Some wonder whether reported earnings have been too rosy and whether future
profit might be damped.

By James S. Granelli, Times Staff Writer

As the nation's biggest telephone company, Verizon Communications Inc. has
wrestled with growing competition from cable operators, a slowdown in its
conventional land-line business, costly network upgrades and a weakened
stock price.

Now, some Wall Street analysts are questioning the rapidly rising amount of
money Verizon could owe Uncle Sam.

For years, Verizon has deferred certain taxes, helping the company's
financial statements look rock solid. Those deferred taxes have grown
fivefold in five years to $22.1 billion, the highest in the Dow Jones index
of 30 industrial companies.

So when Chairman Ivan G. Seidenberg insists that Verizon enjoys the
"strongest balance sheet in company history," analysts like Daniel Berninger
of Tier 1 Research aren't necessarily persuaded.

"This is going to be a big story this year for a number of companies because
they can't get around paying it off," said Berninger, who wrote a recent
report on Verizon's tax situation. "The problem is that it's a manipulation
of the balance sheet and a lack of transparency. This is a terrific rock to
hide things under."

He and others wonder whether Verizon's publicly reported earnings have been
too rosy and whether the potential tax bill might drag down future earnings.
The deferred liabilities amount to an interest-free government loan, they
say, and the company will have to pay it back at some point.

Perhaps so, but probably not in cash and probably not soon, if ever,
according to Verizon executives. And the potential tax obligations were
amassed at the federal government's urging, they say, noting that Washington
wants companies to invest in equipment and spur the economy.

"Deferred taxes arise out of the normal course of business," said company
spokesman Robert A. Varettoni. Anyway, he added, the liability will remain
more or less steady for years.

That's because a company that is growing and spending money on property,
equipment, leases and other assets can depreciate the value of those assets
much faster on income tax forms than on public financial statements. The
resulting timing difference generates deferred tax liabilities.

Confused?

Welcome to the world of deferred tax liabilities, "one of the most
complicated parts of the entire financial statement," said Jill Lehman, a
senior analyst at the Center for Financial Research & Analysis.

Typically, public companies want to show investors that they are making huge
profits - but want to show the Internal Revenue Service that they are barely
breaking even so they can reduce their tax bills.

Verizon, for instance, used accelerated depreciation, along with losses from
the sale of properties and other tax benefits, to get a refund of $713
million from the IRS in 2003 - while it reported in public Securities and
Exchange Commission statements that it earned $3.1 billion and deferred $2.2
billion in taxes.

That was an unusual year, according to the company. In the previous two
years, it paid a total of $1.5 billion in taxes.

Still confused? Here's one way deferred taxes work.

A company buys a service truck for $20,000. The government, wanting to
encourage more capital equipment purchases, create more jobs and invigorate
the economy, lets the company deduct a portion of the purchase price from
taxable income each year for four years.

Under tax accounting, the company depreciates, say, 75% or $15,000 of the
purchase price in two years, giving it more cash and a higher income in
those initial years. But in its public filings, it would deduct 25% each
year from taxable income, or $10,000 after two years.

At that point, the company has taken more deductions on its tax forms than
the truck is worth, creating a deferred tax liability.

Should it then sell the truck for $10,000, it would owe taxes on the $5,000
difference. Should it keep the truck for four years, it would take much less
of a tax deduction in the final two years, meaning it would have less of a
deduction and pay more in taxes.

After four years, the value on both tax and public filings would be zero,
and the company could junk the truck and owe nothing in taxes, or it could
sell it and pay taxes on the sale price.

Companies usually don't write checks to the IRS to pay deferred taxes.
Instead, they take fewer deductions on future tax filings and, therefore,
pay more taxes then.

And when the value of their properties drops, they can write off the amount
as an impairment, creating tax benefits that can be used to reduce deferred
taxes.

Although such corporate accounting is normal, what worries some experts is
that the aggressive use of deferred taxes can mask actual income.

"Potentially, you may have been overstating [publicly reported] income to
shareholders," said Jim A. Seida, assistant professor of accountancy at
University of Notre Dame in Indiana. "There could be legitimate reasons for
the differences, but I would want to investigate."

A large amount of deferred taxes also could mean that future earnings will
drop as a company pays more in actual taxes, said Seida, who testified
before Congress about how Enron Corp., the bankrupt energy trading firm,
abused deferred tax liabilities, tax shelters and other accounting
procedures.

Adding to the confusion, the federal government allowed a "bonus"
depreciation to spur investments and the sagging economy after the Sept. 11,
2001, terrorist attacks.

The bonus allowed companies to subtract 44% of an asset's value from income,
more than twice the normal amount allowed, in the initial year. The bonus
expired at the end of last year.

Verizon has said little in its quarterly and annual SEC filings about its
mounting deferred tax liabilities.

By contrast, the company has delved into the paring of its interest-bearing
long-term debt, which stood at $37.3 billion at the end of September. Its
cash from operations is so huge that it can pay down that debt, spend $12
billion to $13 billion a year on capital equipment and still give hefty
dividends to its shareholders.

A big chunk of its deferred tax liabilities - nearly $10 billion - arose
from depreciation of its wireless licenses. That amount won't go away unless
the company sells its 55% stake in Verizon Wireless, which spokesman
Varettoni said was an unlikely event.

The next-biggest block, more than $9 billion, stems from depreciation for
improving its network, gear and other properties.

As it builds a new fiber optic network and improves its wireless network,
the continued spending will keep generating deferred tax liabilities, the
spokesman said.

"In the big picture, this means Verizon has about $22 billion in future tax
obligations that may or may not be offset from one year to the next,"
Varettoni said.

"Most investors would put this in perspective in light of Verizon's strong
annual cash flow," which amounted to $22.5 billion in 2003.

Verizon, which serves Southern California's beach communities, isn't alone
in accumulating large amounts of deferred taxes, but it gets more scrutiny
on Wall Street as one of the component companies of the Dow Jones industrial
average.

Exxon Mobil Corp., a Dow Jones component with four times the revenue of
Verizon, had $19.7 billion in deferred tax liabilities, lower than a year
earlier but the second-highest on the index.

Phone and cable companies spend a lot of money to keep up with technology.
That, in turn, helps drive deferred taxes.

SBC Communications Inc., also a Dow Jones index member, had $15.9 billion of
deferred taxes and $16.5 billion in long-term debt at the end of September.

Cable companies have invested a total of $95 billion in the last eight years
to upgrade their networks and offer phone service. Comcast Corp., the
largest, has accumulated $26.4 billion in deferred taxes and its long-term
debt was $22.1 billion at the end of September.

Looming cable competition led Verizon's stock on a downturn for 13 straight
trading sessions on the New York Stock Exchange before it gained 84 cents
Tuesday. Shares dropped $1.03 on Wednesday to $36.65.

Verizon is scheduled to release last year's financial results next Thursday.




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