Earnings Havoc Unleashed By Tax Act

Originally published on Forbes.com

The man bites dog story of the hour is the large negative effect that the Tax Cuts And Jobs Act (TCJA) will have on the reported earnings of many companies.  We have Reuters reporting “Goldman warns of $5-billion earnings hit from US tax law” and “Barclay expects $1.3 billion writedown from US tax reform” Bloomberg has BofA Says Tax Act Forces $3 Billion Fourth-Quarter Earnings Cut and earlier in the month there was Citigroup CFO Sees $20 Billion Hit If Senate Tax Bill Signed.  Are you surprised?  Well, Citigroup certainly wasn’t.  Less than a week after the election in Seeking Alpha there was Is Citigroup’s $45 Billion DTA At Risk Under President Trump?

Management of other companies not as attuned to the intersection between financial accounting and tax may be surprised.  I expect similar news from Ford and General Motors.  Other companies will have large windfalls.  Bloomberg came out with a list earlier this week, which puts Berkshire Hathaway at the top. It is actually hard to identify which companies will be ahead on net, which I will explain a little later, after I finish bragging.  What do I have to brag about?  Well, I broke this story three months ahead of Bloomberg and Reuters.  How do you like them apples?

Saw It Coming

On September 30, I posted Trump Corporate Tax Rate Cut Will Wreak Havoc With Reported Earnings.  I identified Berkshire Hathaway as the biggest winner and Citgroup as the biggest loser.  Frankly, anybody who passed the CPA exam should have been able to see this coming, but it also required a little bit of reflection.  The provision for income taxes under Generally Accepted Accounting Principles (GAAP) has only a vague relationship to what companies pay – I explain that here. The GAAP rules about income taxes were changed in the early nineties.

One of the biggest changes was about how changes in “enacted rate” are accounted for.  A significant part of the computation of the provision for income taxes concerns deferred tax assets and liabilities.  Very simply if you write something off or recognize income at a different point in time in figuring your reported earnings than you do in figuring your taxable income,  you will end up setting up an asset or liability to recognize tax benefits that you will be taking later or took sooner – deferred tax assets (DTA) or deferred tax liablities (DTL).  As timing difference reverse DTA are amortized making for higher income tax expense in later years compared to what is on the return and DTL are relieved making for lower income tax expense.

Under the old rules DTA and DTL would be layered based on the rate in effect when they were created.  So a rate change would be reflected over time as the layers were eroded.  Under the newer rules, DTA and DTL are adjusted when there is a change in enacted rate. Since those rules went into effect nearly thirty years ago there has never been a change to speak of in the top federal rate.  Changes in foreign and state rates were accounted for under that method if they were material, but there was never anything like what is happening this quarter.

For my post, I spoke with Professor Tracy Noga of Bentley University and Professor Jana Raedy of the University of North Carolina.  Bentley is probably the most prestigious accounting program in my neck of the woods (New England).  It was Professor Noga that remarked that the bill would “wreak havoc” with earnings. Professor Raedy sent me a link to an article she had coauthored in 2011 contemplating a more modest change in the top federal rate.

I went a little further and confirmed with FASB that the earnings effect was immediate. I collaborated with Professor Noga and Professor Kristi Minnick to get a rough idea of the magnitude of the effect.  We came up with S&P 100 companies having an aggregate net income pickup of $120 billion.  Companies with positive effect totaled $200 billion and those with negative effect $80 billion.  We were only considering timing differences, though, and there is more.

As bill passage became more certain, I checked back in with FASB and also contacted a few of the companies I saw as big losers.  Mostly I drew the telephonic equivalent of blank looks, but the Citigroup guy said “Oh you are talking about the DTA”. He referred me to some statements by the CFO which led me to realize Citigroup was up to speed on the issue.

Finally Just before Christmas, I tracked down a couple of experts who are now coping with the issue Blake Crow of EideBailly and Robert Hilbert of CohnReznick.  Mr. Crow who mainly audits banks told me that his C corporation clients were hoping that the President would wait until after year end to sign which would have pushed the “enacted rate” change into next year.  As it worked out it was me that broke the news to Mr. Hilbert that the President had signed.  He gave me a pretty spirited defense of GAAP that restored my lagging faith in my profession.

An Example

I considered spending the weekend plowing through 10-Ks to come up with a revised list of winners and losers, but I found the task too daunting so I will just share with you what to look for and you can probe whatever companies you fancy.  First lets consider DTA and DTL.  We’ll use General Motors as an example.  Here is the GM 10-K.  The income tax note starts on page 78 (numbers are in millions) and it includes:

Deferred Income Tax Assets and Liabilities  Deferred income tax assets and liabilities at  December 31, 2016  and  2015  reflect the effect of temporary differences between amounts of assets, liabilities and equity for financial reporting purposes and the bases of such assets, liabilities and equity as measured based on tax laws, as well as tax loss and tax credit carryforwards. The following table summarizes the components of temporary differences and carryforwards that give rise to deferred tax assets and liabilities:

The key number is the net deferred tax assets at 12/31/2016 – $34,588M, but we should probe the details a little bit before we estimate the adjustment. The items listed are mostly timing differences, but I would kick out the $5,621M in Non-US operating losses and tax credit carryforwards and, just to be sporting the $1,950M in miscellaneous.  Also for computational purposes let’s add back the valuation allowance.  So we will compute our adjustment using $31,611M.  We will now introduce quite a bit of imprecision and say that there must be $90,317M in timing differences (We divided by .35) which will now be worth $18,967M.  Add back the numbers we kicked out and get $26,538M  proportionately adjusting the valuation allowance that will net to $23,572M.   (See note)

That’s a $10 billion adjustment, but there’s more and this is why it will be hard to come up with a net number for a lot of companies.  GM has $2.1 billion of foreign earnings indefinitely invested.  That amount will be taxed at either 15.5% or 8% depending on how liquid it is.  The tax will be reduced by foreign tax credits, which will be adjusted. Clearly that is not that big a deal for GM.  Amazon on the other hand had $109.8 billion indefinitely invested at September 30, 2016.  Much of that was taxed at 12.5% by Ireland which will mitigate the deemed repatriation charge.

Bottom line I don’t see how I could get a handle on the deemed repatriation tax, so it is hard to say where the earnings adjustments will end up netting overall.

There is another wrinkle that will be a positive adjustment for companies that spend a lot on capital assets. Unlimited expensing was made retroactive to September 17, 2017.  So property placed in service in the fourth quarter can be expensed yielding a 35% deduction, while the associated DTL will be set up at 21%.

What Does It All Mean?

It seems to me that the lower corporate rates increase the intrinsic value of all companies across the board.  The companies with DTL probably get a slightly bigger boost than the ones with DTA, but both of those are pretty transitory.  Matt Levine noting what was in store back in April wrote.

Next time someone complains that companies that report non-GAAP earnings are using “fantasy numbers,” let’s all remember that GAAP would require Citigroup and Bank of America to report billions of dollars of losses solely because they will pay lower taxes in the future. Under this tax plan, Citi and BofA would have the same amount of money now, and more money in the future, but under U.S. generally accepted accounting principles they would have to report a huge loss anyway. Presumably shareholders would also be interested in the pro forma non-GAAP numbers excluding that loss.

I think when earnings we are looked at historically 2017 will need a big *.

Things are confusing enough that the SEC is giving companies slack in the timing of their reports on the effect of the rate change.  Companies should report what they can reasonably figure out and might have further adjustments down the road.  I have never worked in the big leagues, but what I am thinking is that they will have a good handle on the timing differences such as fixed assets.  You have to maintain your depreciation records to get your returns and financial statements done every year.  The foreign stuff is a different story.

Glad I Am Playing In The Minors

Before I spent some time working at national firm, in the twilight of my career as the managing partner who was twenty years my junior called it, I would have thought that all the ducks would be in a row.  But I bet those foreign tax credits are going to be a bear.  A lot of people probably figured that they would never matter so as jobs migrated from one firm to another or even from one system to another, tracking them would become less and less of a priority. Somewhere in a corporate tax department, a tax manager who is 35 years old is working with senior and staff accountants to reconstruct foreign tax credits that nobody ever thought would matter.  The credits go back to 1987.  Some of them are older than the staff accountants who are trying to reconstruct them.

I once had to compute the earnings and profits of a company that was founded in 1919.  As it happened their office had not moved and they never threw anything away and they had generations of meticulous bookkeepers and the corporate minute books were well maintained.  As we used to say at Joseph B Cohan and Associates, it is better to be lucky than good.  I ‘m wondering if aged tax managers and principals, the ones who didn’t have what it took to be partners, but actually did most of the work will be called out of retirement as happened with the Cobol programmers during the Y2K crisis. It would probably good for them and good for the young people to hear from the old timers who did everything with thirteen column green paper and pencils .  It will be their last hurrah.

Note-Correction

In an earlier version I computed an adjustment of $18 billion for GM from timing differences.  The error, I made, if you must know, was failing to add back items that were either not US or not timing for purposes of the first computation. Had I used the handy shortcut method of an adjustment of 40% of DTA or DTL, I would not have been off by as much. I will be waiting with bated breath for GM’s actual adjustment.

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