On April 26, 2017, Treasury Secretary Steven Mnuchin announced the basics of the Trump Administration’s desired corporate tax reform. In that briefing he stated, in part, “Right now, we have a 35% corporate rate on worldwide income and deferral. It is perhaps the most complicated and uncompetitive business rate in the world. […] We will lower the business rate to 15%.”

The U.S. corporate income tax came into existence in 1909 at just 1% of taxable income over $5,000. In 1968, it hit its zenith of 52.8% of taxable income over $25,000. Now, more than 100 years after its inception, the marginal corporate income tax rate sits at 35%, a level unchanged since 1993.

As with almost every proposed tax rate change, however, there are arguments pro and con. The one thing that is unarguable, however, is that a corporate tax rate cut will, because of current financial reporting regulations create a one-time, significant, immediate effect on reported corporate earnings from deferred tax account revaluations. This is in addition to simply a lower tax bill. Financial Accounting Standards Board Standard No. 109 (referred to now as ASC 740), is the applicable standard pertaining to the reporting of balance sheet deferred taxes.

Recall that deferred taxes arise when there is a temporary difference between the balance sheet amounts for assets and liabilities as reported in annual reports versus the tax basis amounts for those same assets and liabilities reported for the IRS. Per FASB’s guidance, deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are to be valued “using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”

Thus, if a law was passed in 2017 stipulating a reduced corporate tax rate effective in 2017 and beyond, the remaining 2016 DTA (or DTL) balance would need to be revalued at that lower rate for purposes of 2017 balance sheet presentation (along with any additional DTA or DTL amounts arising during 2017). The amount by which a DTA (or DTL) balance is revalued is also the amount by which 2017 earnings would need to be adjusted.

Nearly six years ago we provided estimates in CFO of the financial statement effects an Obama Administration proposed corporate tax rate reduction of 25% would have had on 2010 corporate financial statements. At that time, the U.S. economy was in the beginnings of an economic recovery, and the proposed tax rate cut was smaller and ultimately it did not happen. We reprise that analysis today using data for 2016 corporate financial positions, and with a deeper proposed tax rate cut. With both houses of Congress in GOP control, the likelihood of a legislated corporate tax rate cut is certainly greater than it was six years ago.

An Example

In light of a tax rate cut, companies with a DTA position on their balance sheets will have to decrease that asset account and simultaneously record a decrease to that period’s earnings for the same amount. Alternatively, companies with a DTL balance sheet position, will reduce that liability account and the earnings effect will be an increase. In both instances, the earnings effects are a one-time event in the year of the legislative change. And, the larger the rate cut, the larger that year’s earnings effect and similarly, the larger the balance sheet asset (or liability) adjustment, and the larger the impact on numerous financial performance metrics.

A simple illustration estimating the impact of a tax rate cut on a firm’s reported net deferred tax balance sheet amount is helpful. Assume a firm has a 2016 net DTL balance sheet amount of $21 million. If Congress passes a law reducing the corporate tax rate to 15%, effective for 2017 and beyond, that 2016 net DTL amount would need to be lowered for 2017 balance sheet presentation purposes because the future U.S. tax obligation has just been reduced.

The estimated reduction in the net DTL on the 2017 balance sheet would be by 57.1% [(.35 ‒ .15)/ .35], or $12 million. We assume the statutory tax rate of 35% as the baseline for reported DTA and DTL valuations. For companies using an effective tax rate that is different (e.g., 28%), the adjustment process used here would simply be modified to reflect that different rate (e.g., [(.28 − .15)/.28]).

In tandem, there would be a one-time boost to earnings on the 2017 income statement by the same $12 million. Throughout the remainder of our analysis we apply this straightforward approach to recalibrate various popular performance metrics applicable to most firms.

Many Companies will be Affected

Two illustrative samples are used in this study. One is the S&P 500 and the other is all publicly-traded firms available in the COMPUSTAT database. In the S&P sample, 451 firms (90%) reported either a net DTA or net DTL amount. (Through the date of this study, firms may report up to four types of deferred taxes — a current DTA, a non-current DTA, a current DTL, and a non-current DTL. In our study, and for each company, we netted all such accounts a company might have on its balance sheet into a single deferred tax position — either a net DTA or a net DTL.)

For the all-public sample, we excluded firms with total assets of less than $10 million and any without positive net revenue, resulting in a sample of 6,430 firms. Of these, 73% (4,677) had either a net DTA or a net DTL amount.

Table 1 summarizes the industries with the five largest median net DTL (Panel A) and net DTA balances (Panel B), as a percent of total assets. The table presents the mean and median DTL (Group A) and DTA (Group B) as a percent of assets for the five industries with the highest medians, respectively. A minimum of 20 industry members is necessary for inclusion.

Table 1

Industries with Five Largest Net Deferred Tax Liability (DTL) and Net Deferred Tax Asset (DTA) Positions on Corporate Balance Sheets (total n= 6,430)

 

Panel A: Industries with Five Largest Relative DTL Amounts

 

 

 

Industry

 

Number of Companies

DTL as Percent of Total Assets

(mean)

DTL as Percent of Total Assets

(median)

     
     Utilities 234 13.9% 15.2%
     Telecommunications 83 8.3% 6.7%
     Transportation 111 7.7% 5.5%
     Restaurants, hotels, motels 52 6.3% 5.2%
     Precious metals and mining 143 6.0% 4.9%

 

Panel B: Industries with Five Largest Relative DTA Amounts

 

 

 

Industry

 

Number of Companies

DTA as Percent of Total Assets

–mean

DTA as Percent of Total Assets

–median

     
     Restaurants, hotels, motels 37 7.6% 4.6%
     Petroleum and natural gas 60 6.8% 4.3%
     Construction and construction materials 64 5.0% 3.5%
     Recreation 33 8.2% 3.5%
     Steel works 21 3.7% 3.1%

 

A selective review of a subsample of firms from each of the net DTL and net DTA panels reveals common themes. Large net DTL balances tend to be driven by differences in the tax treatment of depreciation on fixed assets (i.e., accelerated depreciation on the tax books).

Not surprisingly, the industries in Panel A are all capital intensive. Large net DTA balances predominantly were found to relate to firms with either substantial net operating loss (NOL) carryforwards and/or large employee benefit obligations. Interestingly, the “restaurants, hotels, motels” industry is represented with some firms in a net DTL position and some in a net DTA position.

This seeming contradiction is explained by the wide variations in prior year cumulative financial performance across this industry. There are many firms carrying forward prior year’s NOL losses that swamp what would have been a more typical net DTL position (e.g., Yum! Brands, Inc.), while at the same time many other firms in the industry do not possess such characteristics (e.g., Panera Bread Company).

Performance Measure Effects

As in our prior study, we focus on seven popular financial performance measures — return on sales (ROS), asset turnover (ATO), return on assets (ROA), financial leverage (LEV), return on equity (ROE), earnings per share (EPS), and net income (NI) growth.

If a lowered corporate income tax rate were to be passed and to take effect for 2017 and beyond, the 2016 balance sheet deferred tax accounts would need to be revalued. (If a rate reduction was passed in 2017 and did not take effect until 2018, only the 2016 non-current DTA and DTL amounts would be affected.)

The effects of a corporate tax cut that took effect this year would be felt in: (a) either the total asset or total liability amounts; (b) the owners’ equity section of the balance sheet, and (c) to net income on the income statement.

Using firms’ actual 2016 reported amounts, Table 2 provides the baseline median amounts for these seven performance measures. Then, for successive 5% rate reductions, the effects on the seven metrics are estimated.

For instance, for the S&P 500 firms with a net DTL position (Group A), the median ROS would increase to 14.91% and ROE would almost double to 20.93% if the tax rate were cut to 15%. For those with a net DTA positon (Group B), ROS would decline from 9.74% to just under 7% and ROE would go from 17.16% to 12.50%. In both instances, the effects are substantial.

Table 2

Median Restated Performance 2016 Ratios from Lowered Income Tax Rates for S&P 500 Firms

Group A: S&P 500 Firms with Net Deferred Tax Liability (DTL) Positions (n=272)

Tax Rate ROS ATO ROA LEV ROE EPS NI Growth
At actual 8.57% 0.427x 3.84% 2.95x 11.91% $ 2.81 ‒0.10%
a30% 10.47% 0.427x 5.18% 2.82x 15.10% $ 3.66 13.22%
25% 12.35% 0.427x 6.40% 2.79x 17.08% $ 4.44 23.29%
20% 13.59% 0.427x 7.48% 2.69x 19.01% $ 4.96 34.19%
15% 14.91% 0.427x 8.20% 2.58x 20.93% $ 5.52 45.17%

 

 

Group B: S&P 500 Firms with Net Deferred Tax Asset (DTA) Positions (n=179)

 

Tax Rate ROS ATO ROA LEV ROE EPS NI Growth
At actual 9.74% 0.668x 6.58% 2.77x 17.16% $ 2.76 4.18%
30% 9.36% 0.669x 6.08% 2.79x 15.62% $ 2.59 ‒2.20%
25% 8.64% 0.669x 5.66% 2.82x 14.59% $ 2.41 ‒7.01%
20% 7.79% 0.670x 5.24% 2.85x 13.28% $ 2.26 ‒13.93%
15% 6.97% 0.672x 5.03% 2.90x 12.50% $ 2.13 ‒19.80%

For each successively lower tax rate, the firms’ reported net DTL (or net DTA) balance was adjusted by the proportionality of the rate change against a 35 percent baseline. So, for the 30% row, the net DTL was decreased by 14.3% [(.35 ‒ .30)/ .35] and all other component parts in the performance metric’s definition were also appropriately adjusted.

Estimating the Potential Effect for Your Firm

Of course, the specific performance measure effects of a tax rate reduction on any one firm are dependent on that firm’s unique financial situation. Nevertheless, as an example and as an aid to CFOs with an eye towards anticipating just the effect on ROE, Table 3 provides “multiples” that can be applied to make that determination assuming the corporate tax rate was cut to 15%.

In the table there are two axes for specific firm positioning prior to any deferred tax adjustment effects—(1) a firm’s initial ROE level (the horizontal axis), and (2) a firm’s initial net DTA or net DTL position as a percent of total assets (the vertical axis). As an example of using these multiples, if a firm had, prior to any deferred tax related adjustments, an ROE of 10% and a net DTL position of 6% of total assets, then that firm’s current ROE of 10% would become an estimated 16.4% (10% × 1.64) after recognition of the deferred tax related adjustments.

Table 3

ROE Multiples Reflecting Change in ROE when Tax Rate is Lowered to 15%, Tabulated by Levels of Current ROE and by Levels of Net Deferred Tax Position

(negative headings denote a net DTL position) (total n= 6,430)

 

Net Deferred Tax over Total Assets
Initial

ROE Level

 

< ‒.08

 

‒.08 to < ‒.04

 

‒.04 to <.00

 

=.00

 

>.00 to <.04

 

04 to <.08

 

>.08

  .00 to .04 7.77 4.58 1.77 1.00   ‒0.15   ‒1.15     ‒11.20
  >.04 to .08 3.48 2.12 1.26 1.00 0.68   ‒0.11      ‒1.73
  >.08 to .12 3.09 1.64 1.13 1.00 0.81 0.38      ‒0.54
  >.12 to .16 2.37 1.47 1.08 1.00 0.88 0.54 0.17
  >.16 to .20 1.79 1.36 1.07 1.00 0.91 0.74      ‒0.28
  > .20 1.45 1.21 1.04 1.00 0.96 0.86 0.72

 

Table presents the median observable multiple by level of current ROE and level of net deferred tax position. The multiple, when multiplied by current ROE, reflects the restated ROE under the denoted new statutory tax rate. Firms with a negative ROE were excluded from the preparation and presentation of this table. Firms with no net DTA or DTL position are represented in the .00 column.

Heads Up

A corporate tax rate reduction is likely and the one-time, immediate effects on firms’ financial benchmarks will be noteworthy. For those firms with a net DTA positon, financial performance will appear to have deteriorated after the required adjustments and vice versa for those with a net DTL position. For a number of reasons, not the least of which is a potential corporate tax rate reduction, CFOs are wise to stay tuned to Congressional tax reform actions.

We assume the statutory tax rate of 35% as the baseline for reported DTA and DTL valuations. For companies using an effective tax rate that is different (e.g., 28%), the adjustment process used here would simply be modified to reflect that different rate (e.g., [(.28 − .15)/.28].

Mark E. Haskins is a professor and Paul J. Simko an associate professor at the Darden Graduate School of Business at the University of Virginia.

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