While many CFOs may be celebrating the Tax Cuts and Jobs Act, the big tax-rate decreases their companies are enjoying are spawning an accounting mismatch that will be at best a compliance headache and at worst a loss of flexibility in deploying capital.
The mismatch boils down to a discrepancy created by the law between how much tax is reported on a company’s income statement and how much is registered on its balance sheet. In one of the new law’s most widely publicized provisions, Congress slashed corporate income tax rates from to a standard rate of 21% from a maximum 35%. The widespread benefits (along with losses for some companies) will be reflected in a company’s bottom line.
At the same time, the framers of the law seemed to have overlooked that the deferred tax assets and liabilities reported on a company’s balance sheet as other comprehensive income (OCI) would still reflect the old 35% maximum rate. Only when a deferred tax gain or loss is realized can it be reported as earnings on the income statement and reflect the 21% rate.
The dollar differences between the deferred taxes reflecting the old 35% maximum rate and the new 21% rate when taxes hit the bottom line are referred to as “stranded assets.” The implication is that those taxes are marooned in a kind of accounting limbo, creating a situation that’s confusing to investors and problematic to companies.
Enter the Financial Accounting Standards Board. On January 18, FASB proposed an accounting standards update aimed at rescuing those stranded assets by requiring companies to reclassify them from OCI to retained earnings on their balance sheets.
The reclassification would apply for each period in which the effect of the new rate cut is recorded. In classifying the difference between the old and new tax rates under retained earnings rather than under OCI, FASB hopes to align balance sheet and income statement reporting under the new 21% rate.
Shifting the difference between dollars taxed at the old rates to retained earnings would cancel out the stranded assets. That’s because retained earnings represent company profits that have already been taxed. Ultimately, then, the deferred taxes classified under OCI would reflect the 21% rate.
In unsolicited comment letters, various stakeholders had told FASB that the impact of the tax act “may be confusing to financial statement users” under existing accounting standards, according to the proposed update. Among the tax assets and liabilities that could be stranded are those associated with gains and losses in foreign currency translation, pensions, available-for-sale securities, and cash-flow hedges.
Banks were particularly vocal about the need for a change, complaining that under existing accounting, their regulatory capital could be negatively affected by the tax cuts. The implication was that they would have to hold more capital on their books, thus tying it up and preventing it from more productive uses.
Currently, OCI isn’t included in a bank’s regulatory capital, while retained earnings is included as permanent capital.
Overall, what would the FASB update mean for CFOs? “A headache of sorts,” says Georgia Tech accounting professor Charles Mulford, although he feels the changes reflected in the update are absolutely needed.
Under the proposal, finance and accounting executives would have to unearth the original tax rates on the deferred assets or liabilities, determine what the effects of the new law would be, and then make the required calculations, he added.
The proposed FASB update would be effective for all companies for fiscal years beginning after December 15 and for interim periods within those fiscal years. Companies wanting to be able to adopt the new rules in time for an earlier reporting period could apply for early adoption.
The update has an unusually short comment period, with letters due to FASB by February 2, 2018.