Originally published on Forbes.com.
When President Trump signed the tax bill yesterday, there was an immediate effect on the reported earnings of every US company that reports using Generally Accepted Accounting Principles. There will be some companies with very large income pickups and others, believe it or not, with very large charges. I don’t know what the net will be and suspect nobody else does either. President Trump could have kicked the effect into next year, but chose not to, since he wanted to give us the tax cut as a Christmas present.
Why The Signature Is So Important?
The measurement of income tax expense under GAAP is based on the law as enacted and the President’s signature is the final step in enactment. Blake Crow, a tax partner in the Financial Institutions Services Group of EideBailly, tweeted me that many of his C corporation clients had been hoping that the President would hold off on signing until January. I’ll explain that further in.
The immediate effect of the enactment on GAAP earnings can be broken into three components one of which is positive. The other two are negative. Let’s go with dessert first.
Deferred Tax Liabilities
If you write something off faster for tax purposes than for book purposes, you create a liability. Say your company has a machine it bought for $100,000. Thanks to Section 179 you can treat that as an expense for income tax purposes, which under previous law might save you $35,000 on your corporate tax return. You think the actual useful life of the machine is 20 years and you placed it in service near the end of the year so for GAAP purposes you take negligible expense.
That means that you got all the tax benefit of an asset that will be around for twenty years on day one. For the next twenty years there will be book deductions that have no tax benefit. Recording the liability for deferred taxes recognizes that reality. For the next twenty years your income tax expenses will be a little lower than what you have to pay and that liability will gradually be reduced. It is easier to understand if you can think in double entry.
The significance of the President’s signature is that the deferred tax liability is computed at “enacted rates”. When the rates are reduced the liability is reduced. So in this simple example President Trump’s signature drops $14,000 to your bottom line. Be sure to thank him. Ingratitude really upsets him. You can read about that in Think Big: Make It Happen in Business and Life when he discusses Martha Stewart and The Apprentice.
What I am really most upset with Martha about, though, is her ingratitude. I was her single biggest promoter. I promoted her on every show, and I said what a wonderful woman she is, and I still believe that. Never once did she thank me. Never once did she call and say, “Donald, thank you very much.”
Deferred Tax Assets
Sometimes you have to write something off for book purposes before you get a tax deduction. Although there are other examples, it is something that happens to banks with their reserves for bad loans. That creates an asset, because you will have that tax write-off in the future. Like the liability the asset is set up at “enacted rates”.
Another example of a deferred tax asset is a net operating loss carryover. Say your company lost $100 million for both book and tax purpose. When things fall apart the difference between book and tax can narrow as assets are disposed of. Somehow you survive without bankruptcy and thanks to refinancing and some other tricks, the prospects for the future are bright. When your tax returns go in, there will be, in this simplified example, no tax due. Personnel at the IRS will weep at your plight and consider taking up a collection for you (That’s a joke).
Then your tax department will give you the good news. You have a net operating loss that you can carry forward for twenty years or until it has sheltered $100 million of income. The accountants charged with computing the GAAP provision for income taxes after due deliberation, tell you that in the previous hellish year, you “only” lost $65 million and that there is now a $35 million asset on your books. Back in the day, you might be tempted to go for a bird in the hand and sell the stock for maybe $20 million to a consistently profitable company, but there are rules that make that hard to do. It’s called “trafficking”, one of those edgy terms that makes tax work sound more like organized crime than it actually is.
Citigroup is the company that, at least publicly, most cherishes its deferred tax assets (DTA) and is sensitive to the of lower “enacted rates”. CFO John Gerspach warned investors that Citigroup might have a $20 billion earnings charge.
The hit to earnings because of the revaluation of DTAs is why Blake Crow’s C corporation clients would have preferred that the President sign after the ball drops in Times Square. The lower rate on current income would have mitigated the DTA revaluation charge.
Deemed Repatriation
Then there is all that money that is going to come back to America and make us great again. Under the tax law in effect last week, companies could defer taxation by not repatriating income earned abroad. What happens in Liechtenstein, stays in Liechtenstein. Under now current law, income earned abroad will generally not be taxed and can be repatriated tax free. It’s that tax free repatriation that will open up all those closed factories on the blighted dystopian landscape that the President described in his inaugural speech.
There is a cost though. There is a one time charge on everything that has been deferred since 1986. Here is how that will be computed. Well, never mind. Just go to page 477 of the Joint Explanatory Statement of The Committee Of Conference, where they explain it better than I can. My executive summary is that it is what we call “a number”. According to the Joint Committee scoring, the provision will raise $338.8 billion.
Even though that $338.8 billion can be paid over eight years, it hits this years tax provisions. Not every company has been stashing money overseas. Blake Crow’s banks in South Dakota that loan the farmers in the dell the money to buy their new tractors, don’t have to worry about it. Citigroup and Apple and Facebook probably do.
This is a big hit to accounting income. Take a company with a vast treasure trove in Guernsey, on which it paid no tax at all thanks to a Double Irish with a Dutch Sandwich (Can’t make this stuff up). If the plan was to bring that money home someday, the company would have had to record a deferred tax liability and will now have an income pickup. On the other hand, if the company went to its auditors and pinky swore that the money was over there indefinitely, it did not have to set up a deferred tax liability. From looking at quite a few tax provisions in 10-Ks, I can tell you that there are quite a few pinky swearers out there.
An Expert
I spoke with Robert Hilbert of CohnReznick . Depending on which ranking service you look at CohnReznick is a top ten firm or maybe eleven. Mr. Hilbert is the Managing Partner – Assurance. If you are not awe struck by that title, you don’t understand public accounting. There are over 600,000 licensed CPAs in the United States and we do all sorts of things. For example, the head of the high net worth practice at CCR, would go to the house of an eighty year old client and help him install software.
There is actually only one thing thing that we can do that nobody else is allowed to do, which is to provide assurance on certain things. Most commonly it is to provide assurance that financial statements are fairly stated in accordance with Generally Accepted Accounting Principles. You do that without a CPA license and you are breaking the law.
One of the themes of my blog is to mock the ways in which CPAs dramatize their work. Assurance really is a big deal. If a company can’t get a clean audit opinion, it can have dire consequences. One of the things I always hated contemplating was a going concern qualification. It seemed to be like kicking somebody when they were down. On the other hand issuing an unqualified opinion to a house of cards supported by smoke and mirrors, just once, can bring a venerable CPA firm to the brink of extinction and beyond. Remember Arthur Andersen and Enron. Mr. Hilbert has to guide his firm between that Scylla and Charybdis, while also figuring out how to make a profit.
We went over the details of the accounting rules which I have been brushing up on since September and he knows inside out. We’ve already covered that, but Mr. Hilbert helped me with a couple of mysteries that I have been trying to explore.
Are The Tax Departments Ready For This?
One of the things that struck me when I started looking into the large effect that the tax changes will have on earnings is that it is unprecedented. The rules on the computation of deferred taxes changed in the early nineties. Under the old rules the earnings effect of a rate change would be recognized as the timing difference reversed. In our first simple example, it would be over whatever was left of the machine’s twenty year life. Since the accounting rule change that requires “enacted rate” changes to be immediately recognized, there have not been any changes in the top federal rate.
As it happens, the people who do tax provisions will still have practical experience with the computations. There have been shifts in states and foreign rates that required changes. Still, the magnitude of the coming change is only starting to sink in in some circles. He pointed me to a guide that EY recently issued. If your really want to dive into this topic check out the EY Technical Line piece Accounting for the effects of the Tax Cuts and Jobs Act issued on December 19. You can get it here after you go through a registration process. That’s a pain, but at least the price is right.
Mr. Hilbert sums up the challenge facing accounting departments this way:
In the period of enactment, the Act will create a significant amount of work for accountants and the financial reporting departments of reporting entities, and may result in a significant amount of volatility in income tax expense as deferred tax assets and liabilities are reduced to the new 21 percent corporate tax rate.
The future effects on financial reporting of moving from a worldwide tax system to a territorial system have not been fully explored and could result in more volatility in earnings , especially when there are changes in the mix of income from different foreign countries.
The changes resulting from the Act are significant and could take tax departments and financial reporting groups for reporting entities months to measure the full effects of the Act on an entity’s tax situation and reporting.
Does Anybody Care?
I am still mystified by what the reaction of analysts might be. According to Wochit Business, Citigroup’s stock fell 1.48% in reaction to John Gerspach’s warning that the accounting hit might be greater than previously expected.
Mr. Hilbert then enlightened me on the subject of Regulation G. Publicly traded companies are required to issue GAAP financial statements. And Regulation G prohibits them from indicating that GAAP does not matter in the propaganda section in the front part of the 10-K. Nonetheless, they do it anyway. Financial companies not so much, but bricks and mortar and especially technology companies emphasize other measures like EBITDA. Don’t got talking about no stinking EBITDA if you want to sell your company to Berkshire Hathaway. Here is what Warren Buffett has to say about EBITDA:
People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.
Mr. Hilbert advised me to go hunting not in the S&P 100, but in the next tier to find companies that use other measures besides GAAP. I found that Boston Scientific (Number 163 by market cap) had GAAP income of $177 million in 2016. Under their superior way of figuring it the real income was $1.751 billion. That GAAP loss of $650 million in 2015, was really a profit of $1.396 billion when you look at it the right way.
Those companies will likely be arguing that the whole think is just some accounting hocus pocus. Of course, if there is a big income pickup, which is likely to happen with a bricks and mortar company that has not been stashing its profits in the Cayman Islands and recording a lot of deferred compensation, they might be all ebullient about their record year and start loving GAAP, at least for a little while.
Should It Matter?
When people talk about GAAP not being important, it is really discouraging. Even though many if not most of my 600,000 brothers and sisters no longer concern ourselves with GAAP, it was at the core of our basic training and a big part of the dramatic process of passing the CPA exam, a long struggle for some. As it happens I passed the whole thing on the first try and have a certificate on my wall to prove it. Not bragging. Just saying. Well, actually bragging, but so what?
Mr. Hilbert gave me some comfort on why deferred taxes are real and should be taken seriously. They represent “future tax consequences of things that have already happened.”
So I’ll hang onto my certificate and await developments.
Merry Christmas.