Taxation And Finance

Archive for the ‘Purposes’ Category

Accounting analyses present a snapshot of firm performance at a point in time, or generally over a relatively short period of time, to facilitate “mid-course corrections” and incremental decision-making on the part of management and shareholders. Accounting rates of return are computed as the ratio of operating profits to total assets, fixed assets or some other measure of the book value of resources committed by the firm.

Costs are measured by explicit expenditures only, and one attempts to match revenues and the expenditures necessary to generate them on a year-by-year basis. As such, assets are depreciated over their useful lives, in lieu of deducting investment outlays in full when they are made. Firms generally do not maximize their accounting rates of return (or their ratios of operating profits to revenues or costs, or gross profits to cost of goods or operating expenses), because such courses of action will not result in the highest possible shareholder value.

Therefore, as noted, there are no market mechanisms at work to equalize these profit level indicators across firms, and, by implication, no particular reason to expect similarly situated firms to earn the same accounting rates of return, operating margins or operating markups, as noted. The use of accounting measures of profit to determine multinational firms’ country-specific income tax liabilities under profits-based methods has several important practical implications, enumerated below.

The fields of economics and accounting serve very different purposes. Microeconomic and financial theories seek to explain the allocation of resources in an economy through firm, consumer and investor behavior and market mechanisms.Economic profits drive firm behavior and lead to the maximization of shareholders’ wealth (and, thereby, their lifetime consumption).

The calculation of such profits reflects the actual timing of investments (rather than smoothing out periodic capital expenditures via depreciation) and incorporates all costs, including the cost of equity capital (and, potentially, other opportunity costs). The economic profit rate is defined as that rate which equates (a) the discounted present value of forecasted after-tax free cash flows generated by a given investment project with (b) the initial outlays required.1 It is extremely difficult, if not impossible, to quantify a firm-wide economic profit rate as a practical matter.

Under conditions of free entry and exit, and absent financing constraints, firms will continue to enter a given market until the net present value of market participation (that is, the present value of projected after-tax free cash flows, discounted at the opportunity cost of capital and reduced by the initial investment required) is driven to zero. Until this point is reached, incumbent firms will earn positive economic profits (i.e., profits in excess of a “normal” return), and shareholders’ wealth will be increased thereby. Through the process of market entry, additional resources are dedicated to the manufacture of those products that consumers value more highly than the resources necessary to produce them.

The transfer pricing methodologies written into the U.S. and OECD regulations and guidelines are loosely founded on economic concepts of equilibrium under specific competitive conditions. These concepts are taken to justify comparisons of rates of return (and other “profit level indicators”) across firms. Such comparisons are the cornerstone of our current transfer pricing regimes.

More particularly, individual members of a multinational firm are generally likened to a set of quasi-comparable standalone companies, and their gross or operating profits are determined, for tax purposes, by imputing the independent sample companies’ rates of return, gross margins, operating margins or other measures of profits thereto.

In theory, economic rates of return in product markets are equalized (albeit only in the infamous “long run” under competitive conditions). However, as noted, the U.S. and OECD transfer pricing regulations and guidelines substitute accounting measures of profit, rates of return and asset values for economic profits, rates of return and asset values. As described below, accounting measures do not play the same signaling and resource allocation roles that economic rates of return play in an economy.

Therefore, they would not be equalized even in competitive markets poised in long–run equilibrium, much less in the imperfectly competitive markets in various states of disequilibrium that are the norm. Stated differently, there is no reasonable basis for assuming that one firm will earn the same accounting rate of return as a similarly situated competitor. This observation applies equally to other accounting measures of profit.