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Author: Plato90s Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 203308  
Subject: Smoothing earnings and Apple's tax rate Date: 8/10/2002 3:49 PM
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As the Worldcom fraud case expands, the main motivation (besides greed) and justification for the CFO's actions were simple - smooth the earnings to hit company projections, at any cost. This was done by improperly expensing operational costs as capital expenditures.

Microsoft has been caught doing the reverse, using "cookie jar" accounting. Rather than recognizing profits as they are taken in, Microsoft stashes the cash away so they can boost earnings in other quarters when real profits aren't up to the expected level.

In both cases, the goal is to artificially smooth out earnings to meet pre-determined projections. Apple did the same in the past quarter, using its income tax rate to artificially boost earnings to the revised estimates handed out in mid-June.

For the first 2 quarters of FY2002, Apple recognized an overall income tax rate of 28%, significantly lower than the official US tax rate. This is the explanation on page 30 of the 10-Q for Q2 '02 (emphasis added).

The Company's effective tax rate for the first six months of 2002 was approximately 28% as compared to 30% for the first six months of 2001. The Company's effective rate in both periods differs from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes will be provided because such earnings will be indefinitely reinvested outside the U.S and the reversal of a portion of the previously established valuation allowance for tax loss and credit carryforwards. The lower tax rate in 2002 versus 2001 is due primarily to a relative increase in foreign earnings on which the Company does not provide U.S. tax. "

So Apple cut its income tax rate by 7% due to profits from overseas operations as well as applying tax credits received during the big loss years of 1996 and 1997.

3 months later, Apple decides to revise its tax rate to 25%, affecting the first 2 quarters retroactively. That's like stepping inside a time machine and re-writing history. The reasoning is explained on page 31 of the most recent 10-Q

" The Company's effective tax rate for the first nine months of 2002 was approximately 25% as compared to 30% for the first nine months of 2001. The Company's effective rate for 2002 differs from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes will be provided because such earnings will be indefinitely reinvested outside the U.S. The lower tax rate in 2002 versus 2001, is due primarily to a relative increase in foreign earnings on which the Company does not provide U.S. tax.

For the first six months of fiscal 2002, the Company recognized an effective tax rate of 28%. Due to lower than expected earnings in the third quarter of 2002, lowered expectations for earnings in the fourth quarter, and the resulting decline in domestic taxable income, the Company expects its effective tax rate for all of fiscal 2002 to be 25%. Accordingly, an effective tax rate of only 18% was recognized for the third quarter of 2002 to adjust the 2002 year-to-date tax rate to 25%. The foregoing statements regarding the Company's expected effective tax rate for 2002 are forward-looking. The Company's future tax rate could differ because of several factors, including those set forth below in the subsection entitled "Factors That May Affect Future Results and Financial Condition." Additionally, the actual future tax rate may be impacted by the amount and jurisdiction of foreign profits"


The explanation does not make any sense given the fact that Apple is not showing an operational loss in Q3, so there is no reason to revise tax rates. This is doubly true because Apple's overseas revenue is down significantly [by 24% in Europe/Japan] but up in the Americas by 11% since Q2. By logical extension, a higher portion of Apple's overall revenue should be taxable by the IRS comparing Q3 to the previous 6 months.

Instead, Fred Anderson is trying to convince the reader the opposite is true, which is why he is reducing Apple's effective tax rate.

I believe Apple is playing a similar game Worldcom did, except legally, by working backwards from the estimate. Fred had an earnings estimate which was given out in mid-June, and working backwards from that number, decide on a necessary tax rate for Apple. Had Apple used the same 28% tax rate it did for the previous 6 months, it would have missed estimates by another cent.

In retrospect, the smoothing was probably unnecessary because AAPL share prices has been pounded as low as it's likely to go. It does go to demonstrate yet another way CFO's can smooth earnings when they feel the need for it. Always check the fine print.
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