If President Trump signs a bill consistent with the recently released Unified Framework, there will be an immediate one time dramatic effect on corporate earnings. Few large companies will be unaffected and for some the effect will be extreme.
I have been going through the S&P 100 doing a kind of back of the envelope computation of the immediate GAAP income effect of President Trump’s signature on the hypothetical bill. I’ll just give you two examples, but besides being dramatic they illustrate the principles at work. The companies I picked are Citigroup(C) and Berkshire Hathaway (BRK.B). (I am, I think, obligated to mention that a disproportionate amount of my unimpressive net worth consists of Berkshire Hathaway shares).
A Big Boost For Berkshire Hathaway
My rough computation is that President Trump’s signature on the Tax Reform Act of 2017 (or whatever it is they will call it) will translate into an increase in the reported earnings of Berkshire Hathaway in the amount of $33 billion. As we used to say at Carlin Charron & Rosen – That’s a number. Berkshire’s net income for 2016 was $24.4 billion. I have to tell you. It makes me want the change to pass just so I can hear what Warren Buffett will have to say on how that accounting change affects intrinsic value. Compared to Berkshire’s $621 billion in shareholder’s equity, the $33 billion is a little less dramatic, but it is still a number.
Not So Good For Citigroup
Maybe they will not be popping champagne corks at Citigroup, when the President signs the bill. By my even rougher computation, Citigroup takes an earnings hit of $14.8 billion before the ink dries on President Trump’s signature. Citigroup’s net profit in 2016 was $14.9 billion. Even compared to shareholder’s equity of $225 billion, $14.8 billion is still a number.
The Boring Part
It all has to do with deferred taxes (which produce both assets and liabilities). You will often see commentaries on what major corporations pay in taxes as compared to their earnings. Those analyses are in my view pretty much always wrong. The number that they use for what corporations pay is the “provision for income taxes” on the income statement. As I explained here, that number is only vaguely related to what companies actually pay.
Here comes the part that will make normal people want to stop reading and accounting nerds will consider a gross oversimplification. In computing GAAP (Generally Accepted Accounting Principles) and taxable income (Internal Revenue Code), there are items that produce deductions and income that though moving in the same direction and in total the same over a long period differ sharply on a year to year basis. Depreciation is an example of something that generally goes faster for income tax computation purposes. Loss reserves are an example of something where the earnings hit is taken up front under GAAP but delayed for tax purposes.
If you write something off more quickly for tax purposes, you will have to pay the piper in the future. GAAP requires you to set up a liability for that. On the other hand, if the write-off comes early for GAAP purposes, the piper will be paying you in the future. GAAP gives you an asset for that. The offset to the liability is a charge against income included in the provision for income taxes and the offset to the asset is a credit to income included as a reduction in the provision for income taxes. Here is the thing. The asset and the liability are computed based on “enacted rates”. When new rates are enacted, the assets and liabilities are recomputed and the change runs through current earnings.
If you skip to a bit before the 12:00 mark on this video clip, you will get a more detailed explanation. It is a lecture by Professor Brian Bushee at Wharton
Some Experts
I had a sense that this dramatic earnings effect might be coming. I am after all a CPA. It has, however, been a long time since I have concerned myself with computing deferred taxes. The Tax Reform Act of 1986 shifted most of the businesses that a large local or regional accounting firm would concern itself with to flow-through. My first managing partner, Herb Cohan, was of the view that specialization was for insects and at Joseph B. Cohan and Associates, you had to be prepared to be the leading expert on just about anything if you happened to be in the hallway when Herb was pitching somebody. As I matured, or got older anyway, the firm evolved, if you can call it that, until I was a partner in a large regional that went so far as to specialize even within the tax department keeping me entirely out of “provision work”. The point of all this nostalgia is to explain why I sought some help to confirm my conclusions.
I spoke with Professor Tracy Noga, Associate Professor of Accountancy at Bentley University. She confirmed for me that the boost or hit to reported earnings is immediate and that it is at the currently enacted rate. She also told me that she expects that the adjustment will wreak havoc with earnings. What neither one of us can figure out to any satisfaction is how analysts will take this into account. Will they recognize that 2017 earnings reports will be radically distorted by this tax change? Maybe they are all focused on EBITDA and they won’t even notice.
I also spoke with Professor Jana Raedy, Associate Professor of Accounting at the University of North Carolina. Professor Raedy confirmed my conclusion that enactment of the corporate tax rate will have an immediate and, in many cases, dramatic effect on reported earnings. She also sent me a copy of an article she had coauthored Tax Reform, Deferred Taxes, and the Impact on Book Profits in 2011. Back then, the talk was about moving the corporate rate down to 30%. It was still dramatic.
Using hand-collected data from the tax footnotes of the Fortune 50, we estimate that a reduction in the corporate tax rate from 35% to 30% would substantially affect the accounting earnings, capital, and effective tax rate of many companies. For the 18 publicly-traded Fortune 50 companies with a net deferred tax asset position, the total drop in accounting earnings would be $12 billion, with the banking industry experiencing some of the largest earnings decreases. For the 31 publicly-traded Fortune 50 companies with a net deferred tax liability position, the total jump in accounting earnings would be $28 billion, with the energy industry enjoying many of the largest increases. Although these large, one-time adjustments to the deferred tax accounts do not affect cash taxes paid, users of the financial statements should be aware that the deferred tax accounts may be significantly altered if and when tax rates change and that these effects will be reflected in net income.
And Another Hit To Everybody’s Earnings
Besides the corporate rate cut, the Framework has another provision that will likely have a major effect on deferred taxes.
….. the framework treats foreign earnings that have accumulated overseas under the old system as repatriated. Accumulated foreign earnings held in illiquid assets will be subject to a lower tax rate than foreign earnings held in cash or cash equivalents. Payment of the tax liability will be spread out over several years.
For the most part, companies treat earnings accumulated abroad as not subject to U.S. income tax ever, thereby avoiding book deferred taxes for them I think enactment of the above will change that, but given that there are no rates discussed, I can’t do much with that right now.
Accounting Nerd Challenge
I’d like to challenge my brother and sister CPAs who do provision work and all the bright young lads and lasses who are preparing for the CPA exam to start digging in the 10-Ks to identify the biggest winners and losers when it comes to 2017 earnings if the corporate rate changes as promised. Contact me (Figuring out how to do that is part of the challenge. It is not hard.) with your candidates and be sure to show your work. I will find a way to recognize the best answers.