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Trump's tax cuts will play havoc with reported earnings

17 April 2018 by John Stittle

Trump's tax cuts will play havoc with reported earnings - Read more

US deferred tax reforms could lower firms’ reported profits in the short term, but will raise them over time

In December, president Donald Trump pushed through a $1.5 trillion programme of tax cuts for the US.

Whether they encourage corporate growth, stimulate investment or create jobs is a matter for economists, politicians and voters. But they will affect most individuals and companies regardless.
In the short term, cutting tax rates has important but unintended consequences.

The good news for companies is that the reduction in corporate tax rates will feed through to increased profits in future years. The bad news is that Trump’s tax rate cuts will perversely cause many companies to report lower earnings in the immediate term. How does this seemingly paradoxical situation arise?

The answer is deferred tax. It is a topic that is often baffling, unloved and widely misunderstood by investors and other users of financial statements.

Now, with the enactment of the recent Tax Cuts and Jobs Act, the impact of deferred tax is hitting the reported earnings of many US companies, as well as those based abroad.

Accounting flow

Deferred tax implications on financial statements are a key feature of corporate reporting on both sides of the Atlantic and are regulated by international accounting rules – such as ‘IAS12 Income Taxes’.

When Trump announced that key tax reforms would result in corporate tax cuts, he was largely correct. Most companies would pay less overall US tax – termed corporate income taxes – from their business activities.

“Deferred tax is a topic that is often baffling, unloved and misunderstood”

This means in cash flow terms, many companies will hand less cash to the US Treasury in future years as a result of the tax cuts.

But there are also more immediate accounting adjustments not related to cash flow. These bookkeeping adjustments arising from the tax cuts can then affect the reported net earnings of companies – quite severely in some instance.

Defining deferral

Deferred tax is a common feature under US generally accepted accounting principles (GAAP), for UK companies, and for any other countries that have adopted international financial reporting standards. Counter-intuitively, it is usually neither deferred nor tax.

In some ways, deferred tax is little more than a smoothing mechanism to iron out volatility in a company’s net earnings. Both US GAAP and IFRS adopted similar basic principles in the reporting of deferred tax liabilities and assets.

Deferred tax is an accounting area related to, but different from, the tax paid by companies on their profits. It often arises out of differences between the bookkeeping treatment adopted in financial statements and the actual payment of cash to tax authorities.

For example, a company may decide to depreciate its assets at a fixed annual rate of 10% on cost as a charge each year to its income statement. In the UK, HMRC may grant capital allowances, a tax relief, on 100% of the cost of acquiring new assets in the first year of purchase.

As a result, there will be a mismatch between the 10% bookkeeping aspect of the depreciation charge shown in financial statements and the tax actually paid on earnings to HMRC after receiving 100% tax relief from acquiring the asset.

Essentially, in the first financial year that the company purchased the asset it will pay relatively less tax because it can offset the 100% tax allowances against revenue – so will report much higher post-tax earnings.

In the next years the company will incur higher tax charges, and lower profits, because there are no capital allowances left to use.

These differences are termed timing difference, because over time they will reverse and normally even out.

Deferred tax issues can also arise when a company incurs large losses in previous financial years, which can normally be carried forward to future years to offset against future taxable earnings, termed ‘tax credits’ in the US.

“Goldman Sachs faces a $5 billion tax charge to earnings”

Likewise, a revaluation of an asset, such as property, can give rise to an increase in the property value in the balance sheet – but tax will not be paid until the property gain is realised. In other words, deferred tax is really tax accrual, just a bookkeeping adjustment ‘normalising’ or ‘smoothing out’ earnings.

It has no impact in cash flow terms on tax paid to the HMRC, but in accounting terms, the annual reported earnings can fluctuate, often significantly, if deferred tax is not included.

Trump effect

Trump’s tax cuts for companies are substantial. US federal corporate income taxes are being generally slashed from 35% to 21%, effective 1 January 2018.

Just how extensively these tax cuts affect reported earnings because of deferred tax is illustrated by the US financial services firm Citigroup. The deferred tax implications of the tax cuts led Citigroup to announce a massive charge to its income statement of $22 billion.

Most of this impact was because of the reduced value of its tax credits, resulting from the past losses being carried forward and affecting its deferred tax balance.

Publishing the firm’s fourth quarter results in January, Citigroup’s chief executive Michael Corbat said these accounting losses were only a result of a ‘significant non-cash charge due to tax reform’.

Other banks and financial institutions are also exposed to changes in the amount of their deferred tax assets. Many of these businesses have large accumulated deferred tax asset balances because of the amount of trading losses incurred through debt write-offs after the banking crisis.

Like Citigroup, these losses were then carried forward and offset against future taxable profits. Barclays Bank has pointed out that its US operational activities will suffer a £1 billion hit to earnings. The bank even said it might consider shelving dividend increases this year.

But Barclay’s earnings hit is surpassed by the impact of Trump’s changes on Goldman Sachs. The financial services group faces a $5 billion tax charge to earnings – although part of this charge is due to Trump’s repatriation tax, introduced to discourage companies from leaving investment deposits overseas.

It is not just banks affected. The energy group BP initially estimated a single $1.5 billion accounting net charge to its deferred tax balances. To reassure investors, BP said that the lowering of tax rates in the longer term would mean that ‘future after-tax earnings would be positively impacted.’

Another energy company, Shell, expects Trump’s reforms will cause an immediate hit of $2 billion to $2.5 billion against its deferred tax asset balances.

Playing the long game

Despite these short-term charges, US analysts are more optimistic about future benefits for companies.

Going forward, some analysts estimate that the reduction in tax actually paid by companies will eventually mean that net average company earnings could increase around 10% – and in some cases it could be much higher.

“The earnings per share is frequently regarded as a signalling mechanism”

Although deferred tax is merely a bookkeeping entry and does not affect cash flows, it can affect reported profits. In particular, the earnings per share performance indicator is affected by deferred tax, and frequently attracts headline publicity.

Taken at face value, the earnings per share is frequently regarded as a signalling mechanism to capital markets about a company’s performance.

In practice, analysts normally look beyond the earnings headline figures and dig deeper to investigate the actual cash flow implications, which may provide a more useful performance indicator than the earnings per share.

Some accountants would prefer moving away from the current ‘full provision’ method of using deferred tax – which is required by reporting regulations – because it often gives rise to large deferred tax balances. There is some support for switching back to the previous ‘partial provisioning’ method for deferred tax.

Under this method, deferred tax balances are often much reduced, because only deferred tax expected to crystallise is included. A few accountants would even prefer to use the ‘nil provision’ method, where deferred tax is ignored. But this comes at the cost of more volatile reported earnings.

Overall, it is probably safe to say that Trump, and indeed most investors, are not too concerned with the effects of this tax rate charges on corporate deferred tax balances.

US-based companies will be subject to a short term hit to their reported profits, but in the longer term the tax cuts will improve net earnings. Since deferred tax is a non-cash item then the economic base of a company remains unchanged.

If accounting policies were more aligned with tax rules in both the UK and US then deferred tax would be far less of a problem. And it might be better to rename deferred tax and call it what it is – an earnings ‘equalisation’ charge.

John Stittle is a senior lecturer at the University of Essex

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