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 changes to the law will significantly affect earnings for most large companies, and companies took different approaches on reporting the impact.
Because it affects everyone, a one-time TCJA adjustment is not a red flag in itself, so analysts must distinguish between the effects of the TCJA and other tax-related non-standard adjustments. Apart from the changes to the law, unusual tax gains and losses are often as red flags in financial reporting.
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. The varying approaches will make 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.
Effects of the Tax Cut
We can identify two significant impacts from the Tax Cut & Jobs Act.
First, the TCJA implements a transitional tax of 15.5% of reinvested earnings held as liquid assets and 8% on reinvested earnings held as illiquid assets 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.
Second, the 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. With tax rates now at 21%, deferred tax assets lost value and deferred tax liabilities were reduced. These items will need to be remeasured since these will now be redeemed or paid at the 21% rate.
Potential Red Flags
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. 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.