Originally published on Forbes.com.
There is no historical precedent for the sharp corporate tax rate cut that is proposed in the Unified Framework that is supposed to be guiding Congressional tax writers in what is supposed to be “tax reform”. The proposal is to drop the rate from 35% to 20%. The history of the corporate rate is one of increase during the first half of the twentieth century reaching a peak of 52% in 1952. It started a mostly downward trend in 1964, but nothing dramatic, bringing it to 46% in 1986 and then there were two six point drops. The 1988 34% rate creeped up to 35% in 1993 and that is where it has been for over two decades. There has never been a fifteen point drop.
Immediate And Dramatic Effect On Earnings
What intrigues me about a drop like that is the immediate and dramatic effect it will have on corporate reported earnings. There are many items that that are expenses under Generally Accepted Accounting Principles that are also deductible in computing taxable income where the timing is very different. The same is true of income. Corporations are required to establish liabilities when items decrease taxable income more than book income and set up assets when items decrease book income more than taxable income, if the differences will reverse in the future. The rate used to establish the liabilities and assets is whatever the “enacted rate” is for the period in which the reversal will happen. If the “enacted rate’ changes, the liabilities and assets are reset with the change running through the current years income tax provision.
Authority
When I considered how big those numbers would be (more on that later), I had a hard time accepting that it just flowed through income as a current period item. That is why I confirmed it with two accounting professors – Professor Jana Raedy of the University of North Carolina and Professor Tracy Noga of Bentley University. Professor Noga collaborated with Professor Kristi Minnick, also of Bentley, to give a rough idea of the magnitude of the effect on various companies in the S&P 100. Their computations show that companies for which the earnings effect will be positive will be picking up over $200 billion. Companies with a negative effect will take a hit in the aggregate of over $80 billion. Despite all those professors agreeing, I thought I should get further confirmation on the effect being immediate.
That is why I called up FASB. FASB is the Financial Accounting Standards Board. The term “generally accepted” makes GAAP sound like it is some sort of wisdom of the crowd. That’s kind of what it was back in the day when the definition of a public accountant was an out of work bookkeeper who drinks too much. Nowadays, to oversimplify, an accounting principle is generally accepted, because that is what FASB says. Here is a bit of an explanation:
The FASB is recognized by the Securities and Exchange Commission as the designated accounting standard setter for public companies. FASB standards are recognized as authoritative by many other organizations, including state Boards of Accountancy and the American Institute of CPAs (AICPA). The FASB develops and issues financial accounting standards through a transparent and inclusive process intended to promote financial reporting that provides useful information to investors and others who use financial reports.
It is all rather fascinating to me, but maybe not to you, So here is what important to this discussion. FASB media relations gave me a statement that I can attribute to Russell G. Golden, FASB Chairman:
Deferred tax liabilities and assets must be adjusted when there are changes in tax rates or tax laws. The effect of the adjustment is included in income from continuing operations in the period of enactment.
So when and if, President Trump signs the, I don’t know, maybe the Tax Reform Act of 2017 or maybe The Make America Even Greater Act, with a fifteen point drop in the corporate income tax rate there will be an immediate and dramatic effect on current year earnings. And the like of it has never been seen, because back when we had those six point drops in 1986 and 1987, the accounting rules were different. I’ll spare you the history on that. I have been trying to find out how this might be absorbed by analysts, but have not had any luck yet. At any rate here are the big winners and losers in accordance with Professors Noga and Minnick’s computations.
Positive Income Adjustments Over $10 Billion
Berkshire Hathaway has the largest positive adjustment – $33 billion. That is more than Berkshire’s net income of $27 billion in 2016. Next is AT&T with a $25 billion positive adjustment. That is even more dramatic than Berkshire when you consider AT&T’s $13 billion net income in 2016. The positive effect on Verizon is $20 billion compared to net income of $13 billion in 2016. Comcast’s earnings rise by $15 billion, Pfizer and Exxon Mobil have $13 billion positive adjustments.
Negative Income Adjustments Over $5 Billion
The biggest loser is Citigroup with a $20 billion negative adjustment followed by $15 billion for General Motors $9 billion for AIG and $8 billion for Bank of America.
Rough Numbers
If you really pay attention to my blog, you will note that I came up with a lower adjustment for Citigroup than the professors did. They drew their raw data from Compustat. I characterized my initial pass at this as “back of the envelope”. That might have been generous. Digging in and parsing what part of a company’s deferred taxes are from timing differences can be tricky and disclosures don’t necessarily have the required detail. And on the asset side there are reserves. What is certain is that there will be very dramatic effects on earnings. The numbers are wild enough that I think there will have to be an “*” put next to 2017 earnings in the future. Of course, this is assuming that Congress actually passes something consistent with the framework.
Another Complication
Mike Novogradac tweeted me about another complication. There is talk that some of the tax decreases might expire in ten years. If it works that way and the corporate rate is scheduled by law to go back to 35% in ten years, it gets much more complicated. Companies will have to predict when their timing differences will reverse and provide for them at 35% if they will reverse outside the ten-year window. This will make the effect of the change somewhat less dramatic, but it will also make for rather odd tax provisions for the next ten years. Part of the reason for strict rules about deferred taxes is to prevent companies from using the tax provision to game their earnings. Well, if the bill passes with a built-in ten-year reversion to the old rate, we can let the games begin.
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