Those advocating a cut in the corporate tax rate today generally ignore the tax on dividends, as well as many other provisions of United States and foreign tax law that may reduce the effective tax rate well below the statutory rate.
A recent study found that only 25 percent of the largest American corporations pay anywhere close to the statutory corporate tax rate of 35 percent on their earnings, while 40 percent pay less than half that rate.
Indeed, General Electric, the nation’s largest corporation, paid no federal corporate taxes in the United States in 2010, according to a report in The New York Times.
The sheer diversity of effective tax rates binding corporations—even though there is only supposed to one rate—suggests that the corporate tax rate is being used as a political tool. This perception is certainly encouraged by GE facing an effective rate of zero. If, as the current evidence suggests, the corporate tax rate is used as a political tool for punishing and rewarding certain corporations, then perhaps abolishing the corporate tax rate would be a good step.
While abolishing the corporate tax would not lead to massive economic growth, it would certainly be a step in the right direction. In the first place, corporations could actually focus on producing things instead of playing pointless political games. Furthermore, government costs could be slightly reduced—the natural result of reduced compliance requirements and the corresponding enforcement costs.
While corporate taxes do not apply to the vast majority of businesses, nor do they account for anything but a minor amount of tax revenue.
However, this is no reason to accept an incredibly stupid, highly politicized tax system.
Join the forum discussion on this post - (1) Posts
You know this whole debate over whether to get the pension fund to 50% funding may not matter as much as it may seem. Or at least the problem may be so much worse than we think and that the numbers we assume are good turn out to be wildly optimistic.
The government accounting folks, GASB, are considering a change in pension accounting rules that would bring public pension accounting more in line with private sector accounting. The result, if it happens, is that the calculations of almost all public pension liability will be much much higher than they are now. So Pittsburgh’s billion dollar liability would be something a lot more. What if the number was $2 billion? Any % increase on a billion dollars is real money. If you want to see more on the accounting issue, see this from the WSJ: Board at Center of Pension Dispute Note the Pittsburgh connection in the story that has nothing to do with the city btw.
I was reminded of that because I was reading a paper that just came out. Remember when I compared Pittsburgh’s debt and pension obligations per capita to that in Vallejo, California (which is still plodding through a bankruptcy proceeding) to Pittsburgh. Someone has taken the time to parse those numbers more systematically across a number of cities.
The Crisis in Local Government Pensions in the United States (link)
or if you want crib notes, read the Economist’s coverage of their research.
It does not look like they included Pittsburgh in their research, most likely because the city is so small. No time to parse all that, but in scanning it I think they calculated some liability valuations that use some more normal assumptions on things like the future discount rate. Public pension plans tend to use a very high discount rate of 8%. Actuarial valuations of private sector pension plans almost always use a much smaller value for their discount rate. I suspect that if they did do such a calculation for Pittsburgh would be quite a shock and show a lot higher than the billion dollar liability we are talking about these days. Just imagine where we would be in that case?
Join the forum discussion on this post - (1) Posts
From Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, G Von Haberler, rev ed., 1939, published by League of Nations:
Prosperity comes to an end when credit expansion is discontinued. Since the process of expansion, after it has been allowed to gain a certain speed, can be stopped only by a jolt, theere is always the danger that expansion will be not merely stopped but reversed, and will be followed by a process of contraction which is itself cumulative.
If the restriction of credit did not occur, the active phase of the trade cycle could be indefinitely prolonged, at the cost, no doubt, of an indefinite rise of prices and an abandonment of the gold standard.
Well, we abandoned the gold standard, had unrestricted credit, so now we wait for an indefinite rise of prices?
Bookkeeping is more or less based on the assumption of a constant value of money. Periods of major inflations have shown that this tradition is very deeply rooted and that long and disagreeable experiences are necessary to change the habit. One of the consequences is that durable means of production – such as machines and factory buildings – figure in cost accounts at the actual cost of acquisition, and are written off on that basis. If prices rise, this procedure is illegitimate. The enhanced replacement cost should be substituted for the original cost of acquisition. This, however, is not done, or is done only to an insufficient extent and only after prices have risen considerably. The consequence is that too little is written off, paper profits appear, and the entrepreneur is temptted to increase his consumption. Capital in such case is treated as income.
The paper profits are also likely to add to the cumulative force of the upswing, because they stimulate borrowers and lenders to borrow and lend more. The foster the optimistic spirit prevailing during the upswing, and so the credit expansion is likely to be accelerated. This phenomenon has its exact counterpart during the downswing of the cycle.
Those interested in the above may also find Professor Fekete’s paper Is Our Accounting System Flawed? of interest.
Join the forum discussion on this post - (1) Posts
I am bringing back an old thought that first occurred to me in 2001 after the collapse of Enron. Businesses exist to create real value for real people. Any business should be able to explain how the are adding value and for whom. Ideally, this should be a simple process; a sentence or at most a paragraph. If a company can’t explain this that should raise a red flag.
Of course, some companies provide genuinely obscure products or services. These companies profits should reflect the esoteric nature of their business. The largest most successful businesses from McDonalds to Microsoft should be those companies that are serving vast swathes of the population. If a business claims that its operations are so complex that mere mortals couldn’t possibly comprehend them, that should raise about 10 million red flags.
Accurate, transparent, comparable and thorough financial statements are essential tools for performing mental calculations of value. Being able to assess and weigh the performance of a going concern is vital for a holder of capital considering allocation to more productive uses which benefit humanity. Trust in the accuracy, transparency, comparability and thoroughness of financial statements is indispensable. When that trust is lost then holders of capital rapidly retreat from risk and seek safer and less risky assets.
The Financial Accounting Standards Board asserts, “The capital markets and government are comprised of many participants with competing demands, requirements, and proprietary interests. As independent entities without a political or commercial stake in a particular outcome, the FAF’s standard-setting Boards, the FASB and the GASB, provide objectivity and integrity to our country’s financial reporting system.”
THE SPINELESS GELATINOUS FASB
Financial companies have used their agents, U.S. lawmakers, to pressure the FASB to relax fair-value accounting rules. Yahoo! Finance reports, “The changes will allow the assets to be valued at what they would go for in an “orderly” sale, as opposed to a forced or distressed sale. The new guidelines will apply to the second quarter that began this month.” Bloomberg reports, “Wells Fargo and other banks argue the rule doesn’t make sense when trading has dried up because it forces companies to write down assets to fire-sale prices.”
WOULD BE A FUNNY STORY IF IT WERE NOT SO SAD
Months ago at a conference I was talking with a senior partner at DLA Piper. We discussed mark-to-market accounting and I made the assertion that if there is no bid then the asset may be worthless. He retorted with, ‘It is hard to say that a 60 story office building in New York is worthless.’ As the conversation progressed he told me a story.
One of his clients bought $1B of assets from Lehman Brothers which were to be sold back within a month. Two weeks after the sale Lehman Brothers evaporated and the client received a tough lesson regarding counter-party risk. His client left a quagmire of documents they assumed would never be read because of ‘orderly’ sales and instead asked what him what they owned.
After several weeks of reading and analyzing the documents while being paid hundreds of dollars per hour to do so he came back with some grim conclusions. They owned about 65 various real estate assets; including one large condominium complex in Texas. Many of the various assets had clauses which required further capital injections so the European bank has opened an office in New York and relocated employees to service the assets. But those assets all pale in comparison to this condominium complex.
Only about 15% of the units had been sold, it was built on shifting sand, the local government had condemned it and decreed it would have to be demolished. With a sly smirk I responded, “It seems the skyscraper with no bid is worth less than worthless.”
FAIR VALUE LYING
The recent FASB changes to relax fair-value accounting have a secondary purpose: To perpetuate fair value lying to protect the worthless, or in some cases worse than worthless, financial statements of zombie banks. The vernerable banking behemoths, Bank of America and Citigroup, have become Single Digit Midgets. What type of objectivity and integrity do these rules have?
How long will it take other banks like Wells Fargo, US Bancorp or Credit Suisse Group with their approximately $15.50, $15.50 and $34.50 share price respectively and below $65B, $27B and $40B market cap respectively to join the ranks of the single digit midgets?
Sure, they were profitable for a quarter but it was all an illusion based on bailout money funneled through the apparation AIG. These stolen funds also found their way, of course, to Goldman Sachs, JP Morgan, and $35B ended up in European banks like Deutsche Bank. Is it any surprise that there is a new dress code for bankers at parties like those outside the G-20?
But the primary purpose of these changes that have their catalyst in Washington and Wall Street appear to be to intentionally exacerbate the greater depression and postpone the credit contraction.
Perhaps the inmates infected with the financial insanity virus who are running the asylum have a King Canute complex where he decreed, “And then he spoke to the rising sea saying “You are part of my dominion, and the ground that I am seated upon is mine, nor has anyone disobeyed my orders with impunity. Therefore, I order you not to rise onto my land, nor to wet the clothes or body of your Lord”.
The great credit contraction should not be feared but embraced. The result is that the malinvestment during the credit expansion which has severely damaged the world economy is liquidated and no additional malinvestment results. This is because capital seeks safer and more liquid assets as it moves down the liquidity pyramid. It is important to point out that the ETFs GLD and SLV have problems and do not have the same risk or liquidity profile as physical gold or silver.
The institution of fair-value lying and Geithner’s plan for toxic assets, which is how the banks will siphon more wealth out of the world economy to feed their parasitical vampiric appetite, are but vain attempts to entice capital to move up the liquidity pyramid. Gold loves truth and has no fear of accurate, transparent, comparable and thorough financial statements and those who trust in it build their financial castle on the immortal unchanging element. In contrast, fiat currency loves lies, cannot withstand the sun of scrutiny and those who trust in it are building their financial condominium on sand. The great credit contraction has arrived and only begun.
Disclosure: Long physical gold and silver with no positions in GLD, SLV, BAC, C, WFC, USB, CS, GS, JPM.
Lok Housing & Constructions made the following disclosure during the just concluded Dec’08 quarter:
The global economy in general and the real estate industry in particular is passing through recessionary scenario, which has resulted in to financial melt down of un-precedential scale. From time to time the Company had entered several agreements for sale of plots, properties, development rights and constructed units held by it as stock in trade. In accordance with the consistently followed accounting policy of the Company, sales revenue and profit thereon were recognised at the time of entering in to such agreements to sell. Due to the financial meltdown and Severe economic recession, some of the parties with whom the Company had entered in to agreement to sell have failed to meet their commitments and considering the overall interest of the Company, the agreement for sale entered in to in the past financial years and in respect of which revenues already recognized have been mutually terminated / cancelled. The Company has been legally advised that though the agreements for cancellation of sales have been entered in to during this quarter (being October to December 2008), but since cancellation of sales pertains to sales recognised earlier, the financial statements of the period during which sales and profits were recognised needs re-construction / amendment, on the doctrine of “Relation back”. The Company shall amend the financial statements of earlier years and get the same approved in the next general body meeting. Accordingly no effect in respect of cancellation of sale agreements has been given in the financial statements of this quarter. During the quarter under review the Company has entered in to 53 agreements for cancellation of sales made in the earlier financial years, the sale value of which is Rs 282.14 crores and the resulting loss / reversal of profit recognized earlier being Rs 225.01 crores”
How big is this restatement, compared with the size of the firm?
It is huge. In the last three years (FY06, ‘07, & ‘08), Lok Housing Constructions reported cumulative revenues of Rs.578 crore and cumulative net profit of Rs.226.4 crore. The revenues were taken in the income statement based on the Company signing sales agreement with potential buyers (as mentioned in the explanation provided by the Company).
Now they say those contracts have been mutually terminated/cancelled, which means it will have to restate earlier numbers, ie. sales by Rs.282 crore (50% of total sales of the last three years) and net profit by Rs.225 crore (almost 100% of all profits earned during the last three years). Prior to FY2006, the company did not even make profits.
Using the CMIE standardised definition of PAT net of P&E, the profits ever made by the company are: Rs.14.55 crore (’06), Rs.79.07 crore (’07) and Rs.109.78 crore (’08). Compared with these more modest values, a restatement of Rs.226.4 crore is even more massive.
How did this happen?
In its accounting policies section of the Annual Report for FY07 and FY08, the Company states the following:
- The Company follows completed contract method of accounting in respect of its construction activity. Under this method profit in respect of units sold is recognized only when the work in respect of the relevant units are completed or substantially completed, which is determined on technical estimates.
- The construction and development cost for completion relating to the sold units, which are considered for profit are estimated on the basis of technical evaluation.
- Revenue recognition in respect of property sale transactions is on the basis of agreement to sale and are subject to execution of conveyance and compliance of applicable legal formalities.
The first and second statement is clearly not in sync with what the Company describes in its Note to Accounts for the Dec’08 quarter. Thus, it has to be the third point which states that it recognizes sales in respect of property sale transactions on the basis of “agreement to sale”. However, according to Accounting Standard 9, the Company can book revenues only if the following two are fulfilled:
- The seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
- No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.
This means, revenues can be booked only upon delivery of the said property, which clearly was not the case for Lok Housing, else it would not have to restate sales and profits. So how is Lok Housing able to book revenues and profits and yet not deliver the property to the purchaser with whom it has an agreement to sale in place for more than 2-3 years?
Could it be because of the following Guidance note by the ICAI on Recognition of Revenue by Real Estate Developers?
Revenue in case of real estate sales should be recognized when all the following conditions are satisfied:
- The seller has transferred to the buyer all significant risks and rewards of ownership and the seller retains no effective control of the real estate to a degree usually associated with ownership;
- no significant uncertainty exists regarding the amount of the consideration that will be derived from the real estate sales; and
- it is not unreasonable to expect ultimate collection.
7. The determination of point of time when all significant risks and rewards of ownership are transferred depends on the facts and circumstances of each case considering the terms and conditions of the agreement. In case of real estate sales, all significant risks and rewards of ownership are normally considered to be transferred when legal title passes to the buyer (e.g., at the time of the registration, with the relevant authorities, of the real estate in the name of the buyer) or when the seller enters into an agreement for sale and gives possession of the real estate to the buyer under the agreement. All significant risks and rewards of ownership are also considered to be transferred, if the seller has entered into a legally enforceable agreement for sale with the buyer and all the following conditions are satisfied even though the legal title is not passed or the possession of the real estate is not given to the buyer:
- The significant risks related to real estate have been transferred to the buyer. In case of real estate, price risk is generally considered to be one of the most significant risks.
- The buyer has a legal right to sell or transfer his interest in the property, without any condition or subject to only such conditions which do not materially affect his right to benefits in the property.
8. When the seller has transferred to the buyer all significant risks and rewards of ownership, it would be appropriate to recognize revenue at that stage subject to fulfillment of other conditions specified in paragraph 6 above, provided the seller has no further substantial acts to complete under the contract. However, in case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue should be recognized on proportionate basis as the acts are performed, i.e., by applying the percentage of completion method in the manner explained in Accounting Standard (AS) 7, Construction Contracts. An example is a building or other facility on which construction has not been completed though all significant risks and rewards of ownership have been transferred pursuant to the fulfillment of conditions stated in paragraph 7 above. Another example is of a land which is yet to be developed though the seller has transferred all significant risks and rewards of ownership of the land to the buyer through an agreement for sale as per paragraph 7 above.”
I think this means that having once sold the rights to the buyer, the seller is merely a contractor and can therefore start booking revenues based on the work completed, i.e. even if a building is still under construction, the builder can start booking revenues and profits on it.
I am no expert on the accounting standards that are practiced by real estate companies in India, and after looking at the Notes to Accounting Policies in the Annual Report and in the most recent quarterly result for Lok Housing, my doubts have only increased. However, there have been some insightful articles in the press in recent times, which touch upon this topic:
- An article in the Hindu Business Line by Dolphy D’Souza of E&Y [link].
- An article in the Business Standard [link]
An unsatisfactory situation
This raises two questions:
- How can a Company be allowed to book sales and profits for transactions never completed and allowed to carry it for 2-3 years? Surprisingly, there are no provisions for bad debts in any of the years during 2006-08, the maximum sundry debtors (outstanding for more than six months that the Company reported by Rs.147 crore in FY08, half of what was due to Lok Housing and that they belonged to previous years?
- Even if our Accounting Standards do allow companies to book sales and profits without delivering the underlying consideration because there is an ‘agreement to sale’ in place, why is Lok Housing mutually terminating/cancelling these contracts and not going to the Court of Law and make those involved pay for the agreements entered into? How can a company benignly view cancellation of the agreements that are supposed to have earned it all the profits it reported in the last three years?
Disclosure: I have no shares of any Indian real estate company, and never have. I may never even invest in them in future too, unless there is more transparency in the way they operate, report their financials and the way the entire real estate market in India operates.
What can we do better?
I think the government would do well to:
- Make it compulsory for all the local municipalities (such as the BMC) across India to provide all information pertaining to real estate projects (the clearances/objections, blue prints of plans applied for by developers and thereafter approved by the municipal authorities, and other related and important documents), on the Internet.
- Ask every builder to a) Create a website, b) Make the entire plan as approved by the local authorities, the various clearances (CC, OC, etc.), and the flats/offices (including the ones currently on sale/already sold) available on the site with daily updates.
- Clarify guidelines on financial reporting, or else more episodes like Lok Housing will come about, particularly given the softness in real estate prices.