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Program Your Radar

Oct 20

Written by: Jack Ciesielski
10/20/2005 3:56 AM

It's early in earnings season, still, but there's one thing mentioned in Unisys' preliminary earnings release today that played with my mind. Not that it was subtle: let me present the headline, and you can try to pick it out:

"UNISYS ANNOUNCES PRELIMINARY THIRD-QUARTER 2005 FINANCIAL RESULTS; COMPANY ANNOUNCES STRATEGIC ACTIONS TO DRIVE PROFITABLE GROWTH, REQUIRING REVIEW OF DEFERRED TAX ASSET"

The magic words are "requiring review of deferred tax asset." Unisys has now had four straight unprofitable quarters, and it's carrying a $1.6 billion deferred tax asset on its balance sheet - which is a monstrous 30% of its total assets. Unisys' managers took pains to remind investors that the third quarter results are preliminary: they may change by the time the firm files its 10-Q, as they continue to evaluate the realizability (read: likelihood of getting cash tax benefits) of the deferred tax assets.

Not to put them in the same boat as Delphi and Dana, but both of those firms, at one time or another, have given investors early warning about the realizability of deferred tax assets.

That's important for investors because Statement 109, the relevant GAAP standard for income tax accounting, requires managers to make a forward-looking estimate of how they expect taxable earnings to consume its reported deferred tax assets. So when a firm increases its valuation allowance for deferred taxes - in effect, writing them down - it's implicitly saying that the future doesn't look too bright. It means there isn't enough expected taxable income to use up tax deductions or tax credits bundled into the deferred tax assets before they vanish because of a pending expiration date. Over half of Unisys' deferred tax assets at December 31 (see Note 7 in the 10-K) had a statutory life beyond 2009, so the size of any valuation allowance might say something about the timing of Unisys' profit expectations for the next few years.

Having gone through the Section 404 wringer this year, managers ought to be paying serious attention to asset realizability. If they do , they might be sharpening their pencils when it comes to deferred tax asset valuation allowances. Throughout the third quarter reporting season, keep your radar primed to pick up any clues given by managers about revaluing a firm's tax assets. It might provide a good context for 2006 earnings expectations.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

For information about subscribing to The Analyst’s Accounting Observer, click here.