Ignacio de la Torre. Professor. IE Business School
13 September 2011
Spain’s new accounting measures, which henceforth will permit companies to use only half the negative tax base to offset future profits, will spell insolvency for many media organizations.
2010 was a landmark year for the press: for the first time in history, the US saw more advertising on the Internet than in newspapers. The same trend is emerging in the rest of the world to the extent that by 2013 Internet will be the world’s second largest advertising platform after television, leaving the press in an ever dwindling third place. This structural shift is actually nothing new here in Spain. What is new is the marked impact that measures approved by the Spanish government last Friday will have on the bottom line results of a large number of press organizations. Allow me to explain.
A “normal” company, which generates pre-tax profits of, say, €100,000, will pay the corresponding corporate tax amounting to some €25,000 if the rate is 25%, its net profit being the difference between these two amounts (€75,000). But what about companies where the tax rate is applied to a negative bottom line result? Strange as it may seem, when companies in Spain lose money (let’s say € 100,000), they can opt to recognize this loss as a net loss of €100,000, which would be the sensible thing to do, or they can recognize a tax shield, which is a more aggressive approach. In this case, the pre-tax loss can be reduced by adding the amount corresponding to the tax shield (€25,000), meaning that the “net loss” would then stand at €75,000.
The tax shield concept enables a company to carry forward any losses it makes in a given tax year and use them to offset tax on future profits, provided that there is a reasonable chance that the firm will be able generate the profit needed to compensate for past losses. Seeing as the judge of whether this is a reasonable assumption or not is not the auditor, and companies use imagined future results of business plans to plead their case, many companies with financial problems end up abusing the system and auditors simply put up with it (the unspeakable digital TV operator, Vía Digital, which posted one of the greatest corporate losses ever made by a company in the history of Spain, is a good example of such abuse).
The system gives the company a dual advantage because a) it enables a prima facie reduction in the “net loss” and b) as a result of this, the company’s book value is only reduced by the reported net loss, rather than the gross loss, which makes it appear more solvent. In contrast to a system that is not based on associated cash flow (the Spanish tax authorities do not “send” any money to the loss making company, even if they appear to do so according to the company’s profit and loss and account), it creates an asset in the form of the deferred tax assets (DTAs). Hence firms whose capital is shored up by dubious DTAs (i.e. their recovery depends on their generating profits in the future) are obviously fraught with danger when it comes to investment.
Press organizations have been using this practice in recent years to alleviate the extremely difficult financial situation they faced. So what changed on Friday 23rd? Spain’s deputy prime minister, Elena Salgado, announced that measures designed to reduce the country’s deficit will henceforth include only permitting companies to use half their negative tax base, and not the full 100%, to offset future profits, while extending the deadline for using these bases from 15 to 18 years. What kind of impact could this have in terms of accounting? The kind that nightmares are made of.
Consider a company which has hitherto used this tax shield system and has activated a total of €10 million in tax credits, thereby reducing net losses by approximately that amount, and whose capital totals, for example, €3 million. In view of the new measures, at the close of the 2011 tax year this company and the auditor could have to reduce the value of the fiscal shield by half (to 5 million) assuming the company has neither profit nor loss that year. This reduction would mean writing down the accounting value of its capital by the same amount of course. The result would therefore be that the company’s own funds would be rendered negative to the tune of €2 million, and it would be insolvent.
I believe that when the Spanish government came up with this measure they did not realize the catastrophic effect it would have due to accounting technicalities. Nor did they realize that it would have a particularly negative effect on the already battered press sector. The axe is poised. Seeing as we are already in the throes of the lead up campaign to the elections and the media are crucial allies, it will be interesting to see which prevails.