The Fair Value Option Leases Deferred Taxes Other Liabilities

Week 8

even if we dont use fair value accounting/dont repurchase the bond, the value at the end of the period will still be 526 (referring to problem from earlier slide)

The fair value option

! ! ! ! Most companies use amortized costs (i.e., the historical market interest rate) to account for liabilities. Both IFRS and US-GAAP allow fair value accounting as an alternative (the fair value option). Under the fair value option the current market interest is used. Companies can choose between amortized cost and fair value accounting on a case-by-case basis. However, the choice to use the fair value option is irrevocable. The fair value option is mainly used by financial institutions.

When you become more risky, you begin to generate a lot of profits (which is confusing because its not because youre better)

JPMorgan Chase & Co.

! ! ! Jamie Dimon, JPMorgan Chase CEO, discussed the financial crisis on March 11, 2009. Part of the discussion is on Fair Value Accounting. Fast forward to 17:45 (stop at 19:03):
http://www.cnbc.com/id/15840232?video=1058977582&play=1

! Notice the three key issues discussed: 1. Mark-to-market (fair value accounting) creates volatility. 2. Too much flexibility in accounting. 3. Increase in credit spreads/credit risk may result in accounting gains.

recognized 3.9 billion in gains because of becoming riskier

JPMorgan Chase & Co Fair value option

Income from continuing operations before income tax was 2,773

Unrealized gains on debt 3,900

69+24+125+3,682 3,900 3,900

Dr. Liabilities (L) Cr. Gain on liabilities (RE)

Ambac, Citigroup and MGM Mirage

! What was the effect of Fair Value Accounting on reported earnings of Ambac and Citigroup?
Citigroup: when citigroup was bailed out by govt they reported 1.6 billion of profits and the market reaction was very positive (many thought was signal of market recovery) but majority of profits were related to the gains on liabilities because they used fair value accounting.

What can explain an increase of 433% in short term liabilities of MGM Mirage?
At the beginning of the crisis there was a lot of business debt. Debts have covenants and the MGM covenant stated that they had to keep a specific level of profitability or declare bankruptcy. Because they had so many losses, they violated the covenant and they had to pay back the moneyso bank gave them 3 months to recover and find more money. The problem: crossdefault prohibition. If you default on one specific loan, then every other lender will declare that you default on everything else? Because MGM was not sure if they could pay off the loan, all of their assets were put on default, hence the dramatic increase in liabilities.

Off-Balance Sheet Financing

! Off-Balance Sheet Financing: Use of assets or services by a firm that obligates them to sacrifice cash payments in the future, but the transaction is structured to avoid recording a liability on the balance sheet ! Why do firms want to keep debt off the balance sheet? !! Reduced perceived riskiness of the firm !! Increased access to new debt !! Maintain slack in existing debt covenants !! => What do we need to assume for this to work? ! Goal of GAAP: Assess whether the company using the assets bears the risks and rewards of ownership. If so, that party will likely have to record the asset and the liability on its balance sheet

Where weve been

! Simple rental agreement
!!

Text

At inception

! Firm issues bonds and uses proceeds to buy asset

!!

At inception

!!

Over the life of the agreement

!!

Over the life of the agreement

Leases
! ! Firms may lease (or rent) assets instead of purchasing them. Lease: Contract where owner of assets (lessor) transfers use of assets to another entity (lessee) for a fixed period of time in exchange for a series of payments. Examples include leased office space or aircraft. Some leases are so inflexible that they are equivalent to a purchase. They may be non-cancelable, long-term and impose on the lessee all costs of operating.
According to GAAP, even if a lease, for accounting purposes we will treat this as the purchase of a lease (if you behaves like a purchase economically speaking)

! !

Leases
! Contrast leasing a car for 5 years with renting a car for a week. Who bears the economic risks? ! Two accounting methods for leases: !! Capital Lease: lessee purchases the asset !! Operating Lease: lessee rents the asset
not a rent even if the legal document says so

! The firm does not choose the accounting method the accounting method is dictated by the structure of the contract. ! However, the firm has the ability to choose the structure of the contract. In effect, they can choose the accounting method.

Leases
! Capital leases recognize the lease as if it were a purchase and thus recognize both the leased asset and lease liability. The lease asset may be depreciated over time and the lease liability may be amortized as payments are made. Similar accounting treatment as if the firm had purchased the asset with the proceeds from a bank loan (which is in effect what it is). ! If the lease is not capitalized, it will be treated as an operating lease. In this case, a lease expense would be recognized as payments were made, but no asset or longterm liability would be recognized.

Capital Lease vs. Operating Lease

! Rules: Firms must use capital lease accounting if lease is noncancelable and any one of the following applies: !! Ownership is transferred at the end of the lease
!!

A bargain purchase option exists (right to buy asset at lease end for less than market value) Lease period covers more than 75% of assets life Present value of contractual future lease payments exceeds 90% of the current market value of the asset

!!

!!

Source: SFAS 13 (1976)

Operating Lease
! If the lease fails all four tests, then the lessee accounts for it as an Operating Lease !! No asset or liability is recorded !! Record operating lease (rent) expense at time of usage: Operating Lease Expense Cash** XX XX

**Or accrued expense, if the cash changes hands outside of the usage period. Future operating lease payments must be disclosed in footnotes.

Disclosure Example - Target

Future Minimum Lease Payments (millions) Operating Leases Capital Leases

2007 2008 2009 2010 2011 After 2011 Total future minimum lease payments Less: Interest (b) Present value of minimum capital lease payments

$142 136 130 122 113 2,682 3,325 (a)

$15 15 15 16 16 172
on balance sheet

249 (126 ) $123

doesnt show up on balance sheet (look @ footnotes!)

Disclosure Example United Airlines

Mainline Aircraft United Express Aircraft Non-aircraft Capital Leases(b)

Number of Leased Aircraft in Operating Fleet United and UAL (In millions) Payable during(a) 2009 2010 2011 2012 2013 After 2013 UAL minimum lease payments Imputed interest (at rates of 2.1% to 16.0%) Present value of minimum lease payments Current portion Long-term obligations under capital leases

142

269

69

351 $ 323 323 312 291 655 2,255 $

441 441 428 383 367 1,090 3,150

553 518 457 415 386 2,798 5,127

237 509 290 149 141 520 1,846 (486 ) 1,360 (168 ) 1,192

Capital Lease
! If lease contract passes at least one test, it is accounted for as a Capital Lease: !! Record an asset and liability at the present value of lease payments Dr. Capital Lease Asset Cr. Capital Lease Liability
!!

XX XX

Annually record depreciation expense and record cash payments as interest expense and reduction in liability XX XX

Dr. Depreciation Expense Cr. Accumulated Depreciation Dr. Interest Expense Dr. Capital Lease Liability Cr. Cash

(interest rate * book value of liability) PLUG Contract Payment

Lease Example
($45,000 computer, 3-yr. lease, fixed pmt. of 17,462 per year, 8% market not given, can find by: present value of 17462 rate) if future payment (3 payments of 17462)
Operating Lease At inception No entry At end of year 1 Rent Expense Cash 17,462 17,462 Capital Lease
n=3, i=8%

At end of year 2 Rent Expense Cash

17,462 17,462
(45000-13662) + 8%
book value at beg of yr 2

At end of year 3 Rent Expense Cash

17,462 17,462

At inception Leasehold asset 45,000 Lease liability 45,000 At end of year 1 45000 x 8% TWO SIDES! Interest Expense 3,600 liability Lease liability 13,862 side Cash 17,462 Depreciation Exp. 15,000 asset side Accumulated Dep. 15,000 At end of year 2 straight line depreciation: Interest Expense 2,491 (45000-0)/3 Lease liability 14,970 Cash 17,462 Depreciation Exp. 15,000 Accumulated Dep. 15,000 At end of year 3 Interest Expense 1,293 Lease liability 16,168 Cash 17,462 Depreciation Exp. 15,000 Accumulated Dep. 15,000

Accounting for Lessors

Operating Lease At inception Equipment Inventory 39,000 39,000 Capital Lease At inception Lease Receivable 45,000 Sales Revenue 45,000 COGS 39,000 Inventory 39,000 At end of first year Cash 17,462 Interest Revenue 3,600 Lease Receivable 13,862
no depreciation expense even tho legal owners of asset b/c lesses are recording it

At end of each year Cash 17,462 Rent Revenue 17,462 Depreciation Exp 13,000 Acm. Depr. 13,000

Capital and Operating Leases Problem

Problem Cont

Capital and Operating Leases Problem

a) How did we move from the beginning balance to the ending balance of capital lease liability? Journal entry lease liability 102 interest exp reduction in 1088 BB lease liability 161 161 value new liabilities cash 263 (frm footnote) 927 EB b) 102 (interest exp)/1088 (BB) = 9.375% c) CLA BB 1019 new leases EB 865 e) rent expense cash 1065 1065 154 depreciation exp bc value x bb is usually how we get the interest expense depreciation exp 154 acc. dep 154

Capital leases - higher expenses at the beginning and smaller expenses at the end Operating leases - amount of expense will be equal every year of the lease EXAMPLE OF SUPER COMPUTERS

Leases Final Thoughts

! For a given lease contract, under either method:

!!

Income effect is the same over the life of the asset (Capital leases usually generate more expense in earlier years when interest expense is highest and less expense in later years, relative to an operating leases constant expense) Cash flows are the same each year (ignoring income taxes)

!!

Contingencies: Potential Liabilities

! ! ! ! ! ! Contingent liabilities are potential liabilities The more probable the potential to become a legal obligation, the greater the rationale for recognizing it as a liability. Probability of a potential liability is very difficult to measure. In general, an obligation should be recognized as a liability if it is probable that the firm will have make future sacrifices of resources. Of course, the word probable is also difficult to measure. FASB requires the recognition of a loss and a contingent liability when
!! !!

It is probable that a liability incurred, and The amount of the loss can be reasonably estimated.

Merck - Vioxx Litigation

! As of December 31, 2008, the Company had been served or was aware that it had been named as a defendant in approximately 10,800 lawsuits, which include approximately 26,800 plaintiff groups, alleging personal injuries resulting from the use of Vioxx ! Under the Settlement Agreement, Merck will pay a fixed aggregate amount of $4.85 billion for qualifying claims that enter into the Settlement Program. ! As of December 31, 2007, the Company had an aggregate reserve of approximately $5.372 billion (theVioxx Reserve) for the Settlement Program and the Companys future legal defense costs related to the Vioxx Litigation. Dr. Vioxx Settlement Charge (RE) Cr. Vioxx Reserve (L) $5,372,000,000 $5,372,000,000

Restructuring Liability
Merck & Co 2008 Global Restructuring Program
! In October 2008, the Company announced a global restructuring program (the 2008 Restructuring Program) to reduce its cost structure, increase efficiency, and enhance competitiveness. As part of the 2008 Restructuring Program, the Company expects to eliminate approximately 7,200 positions 6,800 active employees and 400 vacancies across all areas of the Company worldwide by the end of 2011. As part of the 2008 Restructuring Program, the Company is streamlining management layers by reducing its total number of senior and mid-level executives globally by approximately 25%. In connection with the 2008 Restructuring Program, separation costs under the Companys existing severance programs worldwide were accounted for under FAS 112 and recorded in the third quarter of 2008 to the extent such costs were probable and estimable. The Company recorded pretax restructuring costs of $921.3 million related to the 2008 Restructuring Program in 2008.

Dr. Restructuring charge (loss) Cr. Restructuring liability

$921.3 $921.3

BP p.l.c. Gulf of Mexico oil spill

! On 20 April 2010 an explosion and fire occurred on the semisubmersible rig Deepwater Horizon in the Gulf of Mexico and on 22 April the vessel sank. The accident resulted in the tragic loss of 11 lives and the significant loss of containment of hydrocarbons. From the time of the incident until 15 July, oil and gas was flowing into the Gulf of Mexico from the well at an estimated rate of between 35,000 and 60,000 barrels of oil per day. A total of 836 miles of Gulf Coast shoreline in Louisiana, Mississippi, Alabama and Florida have been oiled.

If you create a liability before, then you could be admitting to guilt prematurely. Had to create the liability because there is not doubt there will be many fees they have to pay to the govt. They wouldnt be able to get out without paying a large sum, but how do you determine this expense amount? Estimate the direct costs of cleaning up and litigation and fines.

How does the oil spill affect BP?

!
!!

Direct costs of cleaning up

Since the incident occurred, BP has been pursuing multiple parallel tracks to stop the flow of hydrocarbons, to contain and capture, or disperse, the oil subsea, to collect or disperse oil that has reached the surface, to protect the shores, and to clean up oil that has reached the shores. These efforts are being carried out in conjunction with government authorities and other industry experts. BP has committed to clean up the oil from the spill.

Litigation and fines

!!

BP is subject to a number of legal proceedings and investigations related to the incident, including: a US Department of Justice investigation to determine whether US civil or criminal laws have been violated; a US Presidential Commission to examine the causes of the incident; a joint investigation by the U.S. Coast Guard and the Bureau of Ocean Energy Management, Regulation and Enforcement; US state and federal agencies investigations . In addition, BP group companies are among those named as defendants in more than 300 private civil lawsuits.

How does the oil spill affect BP?

! !
!!

How do you estimate these costs reliably in Q2 2010? BP s response:

BP has agreed to establish a $20-billion escrow account. The escrow account will be available to satisfy legitimate claims.. Fines and penalties will be paid separately and not from the escrow account. The establishment of this account does not represent a cap or floor on BP s liabilities and BP does not admit to a liability of this amount. Any amounts left in the account once all legitimate claims have been resolved and paid will revert to BP.

What they did was to create a trustee account (instead of an official liability account) to show that they had enough money to set aside to cover everything they did and the trustees will manage that money.

How does the oil spill affect BP? BPs accounting response
!
! The group income statement for the second quarter reflects a charge for the costs incurred up to 30 June 2010 and obligations for future costs which can be estimated reliably at this time. The group income statement reflects a pre-tax charge of $32.2 billion. This includes $2.9 billion which has been charged for costs incurred to 30 June 2010. The amount provided for future costs reflects offshore and onshore oil spill response, BP's commitment to a 10-year environmental research programme, and the funding of the Louisiana barrier islands project, estimated legal costs expected to be incurred in relation to litigation, and an amount for estimated penalties for strict liability under the Clean Water Act. The charge does not reflect any amounts in relation to fines and penalties except for those relating to the Clean Water Act, as it is not possible to estimate reliably either the amount or timing of such additional amounts.

Are these the total costs to BPs shareholders?

How does the oil spill affect BP?

! Political costs and damage to brand:
!!

!!

!!

A six-month moratorium on deepwater exploration and development drilling has been imposed by the US Government. More widespread moves to change regulatory standards elsewhere in the world are under consideration but have yet to be taken. These could materially impact the timing and cost of future exploration, development and production activity. The incident has damaged BP s reputation and brand, with adverse public and political sentiment evident. This could persist into the longer term, which could impede our ability to deliver long-term growth.

! BP s response:
!!

!!

BP has committed that its share of the revenue from the sale of oil recovered from skimming operations and the well containment systems will be donated to the National Fish and Wildlife Foundation (NFWF). BP has committed to fund up to $500 million for a 10-year research program studying the impact of the Gulf of Mexico oil spill

How does the oil spill affect BP?

! Going concern?
!!

Since the incident the credit rating of BP p.l.c. has been downgraded. In addition, the adverse news flow and market speculation has led to the group s credit default swap spreads widening to levels that imply significantly weaker ratings. Consequently the group has not accessed some of the financing options that were available on more acceptable terms in the past.

! BP s response:
!!

!!

!!

The group conducted a liquidity review. Monthly cash flow forecasts have been prepared for the period to the end of 2011. These forecasts have been subject to sensitivity testing under various downside scenarios which have been designed to model the impact of the reasonably foreseeable uncertainties faced by the group. BP believes that, taking into account its undrawn borrowing facilities and its ability to generate cash, including disposal proceeds, the group has sufficient working capital for foreseeable requirements. The group intends to reduce net debt to $10-15 billion within the next 18 months.

Should we invest in BP?

! What factors are most important for an investor to consider?
Things to consider: total expense from accident, are we expecting them to generate enough cash in the future to cover this, damage to brand name/falling stock prices (and some people might pull out of company > maybe its a good time to invest?), is the estimated $3.2 billion a reasonable estimate?, look at other similar cases and how they were settled, look at how much revenue this specific rig was bringing.

! As an investor how would you value BP in this situation?

SEC claims BP misled investors in discussions right after spill regarding the magnitude of the situation and further fined them. Last summer BP had to pay a hefty legal fee to the US govt (single largest sum recorded in history) $4.5 billion dollars (on top of $3.2 billion dollars) PENALTY TAX DEDUCTIBLE? Fees and legal penalties are not tax deductible Cannot tell IRS sorry we committed fraud and our profits werent as high as expected. Can we have our money back?

What is tax expense?

!! !!

Tax is an expense like any other expense (e.g., rent or utilities). You might think that tax expense for a particular year is simply the taxes paid for that year. Which would look like this: Dr. Tax expense (RE) XXX Cr. Cash/tax payable XXX That is not the case, because tax rules for income recognition are different from GAAP rules. For instance, tax rules sometimes allow later recognition of income than GAAP (e.g., accelerated depreciation methods). GAAP requires us to recognize expenses independent from cash flows!
The payment that we make to the IRS may be very different from the tax we actually record

!!

!!

!!

Terms
! Book income (Pre-Tax Income) is income before income taxes for financial reporting purposes. Income tax expense on the income statement is based on pretax income computed using accrual accounting methods. ! Taxable income is the amount of income on which the income tax is based. Income tax paid is based on IRS taxable income using IRS tax rules. ! The two may be different because of:
!!

The timing of recognition may be different, or Some revenues or expenses may have special tax treatments

!!

Deferred Taxes
! Matching Principle says tax expense should equal: ! Taxes Payable to the IRS !! Plus income taxes payable in the future when temporary differences reverse !! Less income taxes saved in the future when temporary differences reverse
We dont care when something is paid, we just look at all the revenues/expenses related to their period

! Thus, tax expense this period recognizes all taxes payable due to revenues/expenses this period, regardless of when those taxes are paid. Simple example: assume for the year we have BDE of $100 (expense that reflects the expectation of future losses because of

uncollectibles) and net income before tax is $200 with a tax rate of 40% Estimate of NI before tax for IRS = $200 + $100 BDE = $300 (BDE not considered an expense for IRS purposes and is not taken out from revenues) Tax expense in financial statement = $200 x .4 = $80 Tax payment to IRS = $300 x .4 = $120 $80 (tax exp) = $120 (tax payable) - $40 (tax saved in the future) deferred tax assets

IRS tax accounting is still accrual accounting!

GAAP (pre-tax) income vs. IRS (taxable) income

! The difference between book and taxable income are of two types: Temporary differences - Items recognized in both tax and GAAP reporting, but the amounts differ due to timing. "! For example, book income may use straight line depreciation while taxable income will use an accelerated depreciation method. Over time, both will depreciate the same amount but at different times. "! Other examples include: Bad debt expense and warranty expense. "! Over the life of the firm, the amount of cash paid to the IRS must be equal to the tax expense recorded for financial reporting purposes. => These differences give rise to deferred tax assets or liabilities. Permanent differences are differences caused by items that either enter book income but never taxable income or vice versa. "! Some GAAP revenues are not taxable and some GAAP expenses are not tax deductible. "! Examples include: Municipal bonds yield book income but not taxable income; fines are not tax deductible. => These differences never reverse and therefore do not give rise to deferred tax assets/liabilities.

only recognize BDE when they happen

Examples of book-tax timing differences

Item
Accounts Receivable Depreciable Assets Warranty Claims Restructuring charges

Tax Method
Direct charge-off method for uncollectible accounts Accelerated high amt of exp at beg,
low amt at end

GAAP Method
Allowance method Straight-line

Accrue liability to match revenue Losses are deducted as incurred Losses are expensed when management adopts plan and losses are estimable Capitalization Interest on some self-constructed Interest is capitalized of interest costs assets is deducted when incurred Long-term Percentage of completion method Contractor may use completed contracts contract method in some cases Pensions Deducts cash contribution to Recognize expense when pension trust fund but limits employees render services deductions when fund is overfunded

Deduct actual expenditures

Simplified Formulas
! Income Taxes Payable (the amount the firm must pay to the IRS) = Taxable Income * Tax Rate
(according to IRS)

! Income Tax Expense (recorded on the firms Income Statement) = (Pre-Tax Income Permanent Differences) * differences that are never the same for Tax Rate IRS and books ! The difference between the two affects either a Deferred Tax Asset or a Deferred Tax Liability
Income Tax Expense = Income Taxes Payable +/- Deferred Tax Assets/Liabilities

! Over time, the amount of cash paid to the IRS must be equal to the tax expense recorded for financial reporting purposes. Deferred tax assets and liabilities simply affect the timing of the expense.

DTL: Depreciation expense for IRS is higher because of accelerated depreciation liability taxes payable < taxes expense

Deferred Tax Assets and Liabilities

from income statement Deferred Tax Liabilities !! From temporary differences that will result in future taxable income (i.e. book tax today > IRS tax today). Example: Book Income = $250; IRS Income = $225 we pay MORE taxes in the Dr. Income tax expense based on tax for book purposes 100 = 250 x .4 depreciation: $25 for book purposes, $50 future related to this Cr. Deferred tax liability 10 for IRS, hence the difference because in the Cr. Income taxes payable (or cash) 90 discrepancy in future accelerated

depreciation will be slower

book and IRS income

DTL of $10 equals ($250 - $225) * 40% tax rate !

225 x .4

Deferred Tax Assets !! From temporary differences that will result in future tax deductions (i.e. book tax today < IRS tax today). Example: Book Income = $500; IRS Income = $600 500 x .4 = 200 Dr. Income tax expense were going to SAVE taxes Dr. Deferred tax asset 40 some time in the future Cr. Income taxes payable (or cash) 240 = 600 x .4 because finally IRS will
account for the deferred tax income

Everything that is an expense for IRS today but I havent accounted for today creates DTL

DTA of $40 equals ($600 - $500) * 40% tax rate

Deferred Tax Liability Example

($120,000 machine w/3-year useful life; 40% tax rate)
Straight Yr. 1 2 3 EBITDA 100 100 100 Depr. Exp. 40 40 40 120 EBIT 60 60 60 Line Tax Exp. 24 24 24 72 (books) Acm. Depr. 40 80 120 Depr. Exp. 49 53 18 120 Accel. EBIT 51 47 82 (tax) Tax Pyble 20 19 33 72 Acm. Depr. 49 102 120

Journal Entry Year 1 Income tax expense 24 Deferred tax liab. Deferred tax liab. 4 Income tax payable 20

Year 2 24 5 19

Year 3 24 9 33

differences between tax expense and tax payable

KEY: Note that DTL balance = [AD(tax) AD(book)] * tax rate DTL balance 4 4 = (49-40)*.4 9 9=(102-80)*.4 0 0=(120-120)*.4
b/c youve fully depreciated an asset for financial AND tax purposes so the balance evens out

Assume we have a $120,000 machine with a 3 year useful life; 40% tax rate Book purposes: straight line depreciation (so $40 depreciation each year), as a result tax expense is constant every year Tax purposes: accelerated depreciation (so decreased depreciation expense each year), as a result tax payable decreases every year Shortcut to find DTL balance: (accumulated dep for tax purposes - accumulated dep for book purposes) x Tax Rate

Deferred Tax Footnotes

! Components of Income before Tax !! Domestic vs. Foreign ! Components of Income Tax Expense !! Currently payable vs. Deferred ! Reconciliation from Statutory to Effective Income Tax Rates ! Components of Deferred Tax Assets and Liabilities ! Note: Deferred tax assets and liabilities are not discounted to present value, but are based on future expected tax rates ! If < 50% chance of recognizing the benefit from a deferred tax asset, then set up valuation allowance for deferred tax assets contra-asset account that reduces value of the deferred tax asset.

Income (loss) before taxes consisted of: Years Ended December 31 2008 $ 5,086.20 4,721.60 9,807.80 $ 2007 (2,647.2 ) 6,017.90 3,370.70 $ 2006 2,124.40 4,097.00 6,221.40

Merck & Co: Deferred Tax Footnotes

Tax payables

Domestic Foreign

$ Taxes on income consisted of: Years Ended December 31 Current provision Federal Foreign State

2008

2007

2006

1,053.60 292.4 123.3 1,469.30

988.1 687 202.2 1,877.30 (1,671.5 ) 157.2 (267.7 ) (1,782.0 )

1,618.40 458.3 241.1 2,317.80 (374.1 ) (130.3 ) (25.8 ) (530.2 )

! Deferred tax

Deferred provision Federal Foreign State

419 55.8 55.3 530.1 $ 1,999.40 $

95.3

1,787.60

Dr. Income tax expense (RE) Cr. Income tax payable (L) /cash Cr. Deferred tax liability

1,999 1,469 530

Merck & Co: Footnote on effective tax rate

"!

Effective tax rate = Income Tax Expense / Pretax Book Income = 1,999.4 / 9,807.8 = 20.39% (< 35% U.S. statutory rate).
2008 Amount Tax rate 2007 Amount Tax rate 2006 Amount Tax rate

U.S. statutory rate applied to income before taxes Differential arising from: Foreign earnings Foreign tax credit utilization State tax settlements Tax exemption for Puerto Rico operations State taxes Acquired research Other (1)

$ 3,432.70

35 %

$ 1,179.80

35 %

$ 2,177.50

35 %

(1,155.2 ) (11.7 ) (192.0 ) (191.6 ) 310.9 (205.4 ) $ 1,999.40 (2.0 ) (2.0 ) 3.2 (2.1 ) 20.4 % $

(1,196.0 ) (35.5 ) 11.6 113.8 (13.9 ) 95.3 0.3 3.4 (0.4 ) 2.8 %

(1,024.1 ) (16.5 ) (87.6 ) 129.6 266.9 325.3 $ 1,787.60 (1.4 ) 2.1 4.3 5.2 28.7 %