New Tax Cut Law Is Complicating Fourth Quarter Earnings Data

The Tax Cut & Jobs Act law (TCJA) passed in a rush late last year is complicating how companies release their fourth quarter earnings data. The sweeping changes will significantly affect most large companies, and many of them took different approaches on how to explain the impact.

These varying approaches makes it difficult for analysts to separate the one-time impact of the tax cut on earnings versus other unusual adjustments that may affect business operations. Unusual tax gains and losses (such as changes in valuation allowance discussed below) could arguably be seen as red flags in financial reporting.

Major changes in the law include implementing a transitional tax of 15.5% of reinvested earnings held as liquid assets (cash and cash equivalents) and 8% on reinvested earnings held as illiquid assets (property plant and equipment) held overseas. This is a new tax, and it has a cash impact, although the payment can be spread over the course of next eight years. Prior to the new law, companies did not pay taxes on these types of overseas assets if the earnings were held overseas indefinitely.

Secondly, TCJA reduces the corporate tax rate to 21% from 35%. For some companies, the impact of this provision caused multi-billion losses in Q4 of 2017. Unlike the transitional tax, this provision is non-cash in nature. The impact of TCJA will be positive or negative depending on whether companies have tax assets (which are losses companies can use to offset future earnings) or tax liabilities (which are taxes not yet due), as they need to be remeasured. With tax rates now at 21%, those deferred tax assets lost value and those deferred tax liabilities were reduced and need to be remeasured since these will now be redeemed or paid at the 21% rate.

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Although the Securities and Exchange Commission (SEC) issued guidance on how companies should explain TCJA’s impact in their fourth quarter earnings releases, the SEC said companies can use “reasonable estimates” to report charges or benefits now and update those figures later. From a practical perspective, it means that the numbers may change throughout the year and that we would not understand the full impact of the tax reform until the end of 2018. While the Commission provided a general guideline, certain nuances of the disclosure such as presentation in the non-GAAP section, are out of the scope of the guidance.

In the past few years, aggressive non-GAAP adjustments were criticized more than once for masking significant expenses. Yet, in this case, companies almost have to exclude the one-time tax reform impact from the non-GAAP EPS data during earnings calls to give investors a more-accurate picture of company’s earnings.

S&P 500 companies adjusting GAAP EPS

80% of S&P 500 companies adjusted their GAAP EPS for the impact of the TCJA. Of those, 72% present the TCJA adjustment as a separate line item. The other 28% combined the TCJA adjustment with other tax related items.

Many of the S&P 500 companies that did not present TCJA impact in the non-GAAP section are REITs, for which TCJA impact is not expected to be material. To be sure, a one-time TCJA adjustment is not a red flag because it affects everyone, but it is important to differentiate between one-time TCJA impact and other tax-related non-standard adjustments.

For companies that breakout the impact, here some potential red flags to watch for:

Valuation allowances: Companies can carry-forward deferred tax asset to offset future earnings if they can’t use tax benefit of those losses when losses are incurred. When a company records a valuation allowance, it indicates that the company does not believe it will be able to generate future earnings to use their deferred tax asset against. This can indicate that a company is having problems.

For example, in Q3 2017 Fitbit [FIT] recorded a one-time valuation allowance change of $86 million[1]. This was a clear indication that the company did not expect to realize all tax assets because of the future decline in profitability. In Q4 2017, Fitbit reported loss of 2 cents per share and revenue of $571 million versus $589 revenue expected by analysts. The stock lost more than 10% in one day.

Adjusted EPS presentations not excluding TCJA impact: The implementation of the tax law creates a large one-time item for most companies. Because of these large one-time items, it can be difficult to compare the earnings trends for these companies from the prior period to the current period if they do not reconcile the tax law item. For companies with a large tax benefit from the tax law, earnings would be unduly inflated. For companies with large tax expenses from the tax law, earnings would be unduly depressed.

For example, Time Warner reported “adjusted EPS of $2.66 versus $1.25 for the prior year quarter.” Current quarter EPS and adjusted EPS included a tax benefit of $1.06 related to the U.S. tax reform. Excluding the impact of the Tax Reform, Time Warner would have non-GAAP EPS of $1.60. As we discussed above, 93% of the companies reporting adjusted EPS excluded impact of the tax reform, so Time Warner disclosure really stands out.

Combining tax items in the reconciliation: Companies separate line items for the reconciliation of GAAP to non-GAAP metrics so that users can evaluate the items that are being removed from earnings. When items are combined it can obfuscate the reason for the item and confuse investors. For instance, if a company combines a valuation allowance with a tax law benefit as a single tax adjustment, users of the earnings report would be missing important information for evaluating the company.

While the SEC in its guidance said companies can use “reasonable estimates” to report charges or benefits now and update those figures later, its questionable whether or not companies will adjust their EPS later this year to more accurately reflect the impacts of TCJA.

Because companies may want to roll even non-TCJA adjustments into one line item, analysts need to be mindful of what to look for, especially if they like to do their own adjustments versus the previous fourth quarter. Even if companies blend together all the tax-related adjustments, analysts can look at the total dollar impact of TCJA and manually separate the total by taking the dollar impact of TCJA, and dividing it by the number of shares to separate out TCJA’s impact compared to the disclosures on the one line item.

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