This story originally appeared in the January 2015 digital edition of CFO magazine.
At CFO we know how hard it is to make predictions, especially about the future. That’s why we enlisted the help of five experts in preparing our annual CFO Outlook feature.
Leading off in The Economy, Patrick O’Keefe of CohnReznick sizes up the U.S. economy and delivers a very favorable diagnosis. Next, in Tax, KPMG’s Jeffrey LeSage weighs the prospects for corporate tax reform and advises what to expect from domestic and international tax authorities. In Deals, Martyn Curragh of PricewaterhouseCoopers explains why the boom in mergers and acquisitions activity is far from over, while in Accounting and Financial Reporting, Ernst & Young’s Neri Bukspan looks at the crowded agendas of the Financial Accounting Standards Board and the Securities and Exchange Commission. Finally, in Insurance, Eric Joost of Willis North America assesses the insurance marketplace and identifies some of the risks that should be on CFOs’ radar screens in 2015.
THE ECONOMY: Ready for Takeoff
For the U.S. economy, 2014 began with a whimper and ended with a bang. From a decline of 2.1% in the first quarter, real gross domestic product rebounded to 4.6% annualized growth in the second quarter and a stunning 5% in the third. “That is just an eye-popping number,” says Patrick O’Keefe, director of economic research at accounting and consulting firm CohnReznick.
Robust growth wasn’t the only good economic news at year-end. The unemployment rate for December fell to 5.6%, its lowest level since June 2008. The Thomson Reuters/University of Michigan’s consumer sentiment index for the month came in at 93.6, the highest level since January 2007. And the National Federation of Independent Business’s Small Business Optimism Index rose to 100.4, the highest reading since October 2006.
“Across the board, the data indicate that the U.S. economy finished 2014 in the best shape, and with the strongest forward momentum, of any time since before the early hints of the twin meltdowns in 2007 and 2008,” says O’Keefe. “We’re seeing a pace of growth that we haven’t seen in more than a decade.”
Consensus estimates for 2015, made in November, peg GDP growth at 3%, a welcome lift from the lethargic 2.3% average growth (through Q2 2014) since the recession ended in 2009. Meanwhile, core inflation, which excludes food and energy prices, will average 2% in 2015, forecasters predict.
In short, the economy in 2015 should record its best performance in 10 years, says O’Keefe.
The Jobs Deficit
But growth isn’t the only measure of an economy’s health. Despite the encouraging unemployment rate, two other job metrics — the employment rate and the labor force participation rate — reveal the extent of the U.S. “jobs deficit,” says O’Keefe.
The employment rate, the percentage of civilian adults who have jobs, was a seasonally adjusted 59.2% in November. By contrast, the average employment rate for 2007 was 63%. Had November’s employment rate been 63%, “9.4 million more people would have been at work,” says O’Keefe, raising total employment from about 147 million to nearly 157 million. “They would be earning money, buying goods and services more robustly, paying taxes.”
Similarly, the civilian labor force participation rate — the sum of job holders and those actively looking for a job, divided by the adult population — is significantly lower than it was before the recession. November’s rate was 62.8%, compared with 66.0% at year-end 2007. Had November’s labor force participation rate been the same as in December 2007, the unemployment rate for the month would have been a staggering 10.3% instead of 5.8%.
What could dampen the economy’s momentum in 2015? O’Keefe names three factors: slumping economies abroad, geopolitical risks, and the end of the Federal Reserve’s exceptionally accommodative monetary policy.
Globally, the economy is nowhere near as robust as in the United States, says O’Keefe. The eurozone threatens to slide back into recession; in November the European Commission forecast 2015 growth of 1.3% for the 28-country bloc. Many emerging markets, which have been an important engine of growth for the past decade, “have slipped into an elongated stall, or are actually contracting,” says O’Keefe.
China (“to the extent we can rely on its data”) is decelerating far more rapidly than its policymakers or external analysts had expected, he says, while a recent rise in sales taxes “has taken some wind out of Japan’s sails.” The OPEC countries, too, are in a weakened condition, thanks to the pricing pressure on oil.
“Big as the U.S. economy is, it can’t singlehandedly counterbalance the declines across the board,” says O’Keefe. Still, the problems of trading partners shouldn’t severely affect growth, he adds. Of the 5% GDP growth in the last quarter, “most was domestically generated. But over time, [external pressures] could erode that momentum.”
As for geopolitical risks, it’s an increasingly tense world. “Pax Americana is far back in the rearview mirror,” says O’Keefe. Turmoil in Ukraine, sanctions on Russia by the West, increasing terrorism (domestically and internationally), the rise of cyber-attacks, as seen in the massive information breach at Sony Entertainment Pictures — these and myriad other geopolitical risks could put a damper on U.S. growth in 2015.
Finally, normalizing monetary policy involves the potential for missteps, says O’Keefe. Based on the statements of Federal Reserve Chair Janet Yellen, the Fed should raise the federal funds rate (currently locked at zero) by midyear, “to signal that it is comfortable that the economic recovery has reached a self-sustaining momentum, and therefore it can begin to normalize the relationship of interest rates both to the economy and to one another.”
But such normalization could be fraught with risks. “We are in areas where we’ve never been,” says O’Keefe, citing the unprecedented size of the Federal Reserve’s balance sheet, whose assets have swelled from $800 billion before the financial crisis to about $4.3 trillion, or 25% of GDP. The eventual unwinding of that massive position could have unforeseen effects on the financial markets and the economy, he says.
Even the most sophisticated econometric models can peer only so far into the “murky waters” of how monetary policy changes ripple through the economy and markets, says O’Keefe.
TAX: Rumblings of Reform
The prospect of federal tax reform will command the attention of CFOs and tax managers in 2015, but there are also significant state and international tax issues that shouldn’t be overlooked, says Jeffrey LeSage, U.S. vice chairman of KPMG’s tax practice.
The Republican takeover of Congress has given renewed hope to those who have been campaigning for comprehensive business tax reform, including a lower corporate income tax rate. “The view of many is that the corporate tax rate is regressive in relation to other major countries,” says LeSage. Among the 34 nations in the Organisation for Economic Co-Operation and Development (OECD), the United States has the highest top marginal corporate income tax rate, at 39.1%, according to the Tax Foundation.
While both domestic and multinational companies have priorities in tax reform, the purely domestic companies will probably lobby harder for a reduced tax rate than multinationals, since the latter have the ability to lower their effective tax rates through tax arbitrage, says LeSage. “A lot of reform proposals cite a 25% rate.”
There is also general agreement on Capitol Hill that the number of tax preferences should be reduced, says LeSage, but far less agreement on which ones. As for corporate inversions, which generated much controversy in 2014, LeSage says he believes it is unlikely that Congress would pass any legislation concerning them unless it is part of a comprehensive tax reform package.
Ultimately, the ball will be in President Obama’s court, says LeSage: “Does he really want to get something done around tax reform? Is it a priority for his administration?” The likelihood of bipartisan reform will fade after July, when Congress goes on summer recess and Presidential campaigns gear up for the fall.
The push for lower business taxes will also be seen at the state level in 2015, in the wake of Republican success in the midterm elections. Some states, like New York and Connecticut, are also creating or expanding tax incentives to attract companies to their state, says LeSage — offering a 5- or 10-year exemption on certain amounts of income tax, property tax, or sales and use taxes, for example.
Other states, such as Texas and Florida, “have made a concerted public push to attract more businesses,” notes LeSage. Through advertising they are actively promoting themselves as having no personal income tax or no corporate income tax.
Multinational companies should keep a weather eye on the OECD’s base erosion and profit shifting (BEPS) initiative in 2015. The initiative stems from the perception that multinationals may not be paying their fair share of tax in the countries where they operate, as evidenced by the outcry in the United Kingdom several years ago over the disclosure that companies like Starbucks, Amazon, and Google were paying little or no taxes in that country.
The BEPS project is addressing such legal shifting of corporate profits from high-tax jurisdictions by developing recommendations for OECD members to adopt new rules regarding the taxation of digital goods and services, transfer pricing documentation, tax treaties, and so on. “Some countries have already proposed changes to their laws in response to the project,” says LeSage, such as Ireland and Switzerland. It’s unlikely that the U.S. will follow suit anytime soon, but tax planners will have to monitor changes made in foreign regulations. CFOs, meanwhile, should be mindful of the reputational risk associated with tax avoidance.
Also in 2015, multinationals, particularly financial services companies, will be ensuring that their systems for complying with the Foreign Account Tax Compliance Act will also accommodate the OECD’s Common Reporting Standard, which is based on FATCA. Early-adopting countries are expected to implement the CRS by the end of the year, notes LeSage.
Finally, LeSage observes that companies in general will come under increasing pressure from shareholders and boards to divest noncore assets, as in the recent cases of eBay’s spin-off of PayPal and Procter & Gamble’s sale of its Duracell battery unit. To make sure that such transactions are as tax-efficient as possible, CFOs should be ready when the call from the CEO to divest comes, he advises.
DEALS: Another Big Year
When it comes to mergers and acquisitions, 2014 will be a tough year to beat. Through November, aggregate disclosed deal value in the United States was $1.9 trillion, the highest annual deal value since 2007’s total of $1.67 trillion, according to an analysis by PricewaterhouseCoopers.
Nevertheless, 2015 has the potential to be even better. Companies’ renewed appetite for growth, the improving economy, the continuing low-interest-rate environment, the strong equity market, large corporate cash reserves, and low oil prices will combine to spur M&A activity this year, according to PwC.
No less important, increased CEO confidence will continue to drive the deals market in 2015. “I’m a big believer in bellwether deals,” commented Martyn Curragh, principal and U.S. deals practice leader at PwC, during a December webcast. “When large corporations do the transformational deals that we’ve seen in the last six months, I think that confidence is infectious.”
Transformational deals — the result of businesses’ strategic efforts to grow by, say, expanding (or refining) their footprints, acquiring new technologies, or changing their business models — drove much corporate M&A activity in 2014, according to PwC, ranging from the smallest deals to multibillion-dollar mergers. All things held equal, the surge in transformational deals should continue in 2015, according to Curragh.
Compared with 2014, when the top 10 deals in size drove nearly a third of total deal value, the year ahead should see a more balanced mix of large and middle-market (under $1 billion) deals, according to Curragh, as companies continue to focus on strategic transactions.
Sectors that look especially ripe for deals in 2015 are technology, health care, energy, and retail and consumer, says PwC.
Not surprisingly, corporate deals will continue to account for the lion’s share of deal volume and value; last year, corporate-led transactions drove 82% and 89% of volume and value, respectively, compared with 18% and 11% for private-equity transactions. For large targets, PE firms will be hard pressed to compete with strategic buyers, given the synergies available to the latter and their ability to use their own stock as acquisition currency.
But don’t feel sorry for private equity. Like 2014, 2015 will be a seller’s market, and many PE firms will only be too happy to reduce the overhang of unsold companies in their portfolios. Meanwhile, PE firms have plenty of dry powder and will be active buyers in the middle-market space (if they can stomach the frequently high valuations). “We’re seeing lots of buy-and-build activity,” said Curragh. Middle-market deal activity has risen moderately but steadily since 2009, according to PwC, reaching $419 billion for the 12 months ended in November.
Corporate divestitures should continue to be a strong driver of M&A activity, according to Curragh. Not only are market conditions favorable for divestitures, but “we’ve seen a big difference in the last three or four years in the way that corporates look at the businesses they own,” said Curragh. Management teams and boards are evaluating their portfolios on a regular basis, asking whether their businesses still fit with their strategies. No doubt, the rise in shareholder activism has helped concentrate companies’ attention on this task.
The good news is that current deal activity has some way to go to reach its prerecession peak, said Curragh. At recent count there were some 12,000 deals in 2014, according to PwC, compared with 14,000 in 2007, a 15% difference. “It doesn’t feel like we’ve created a bubble, where volumes have spiked to an historical peak,” said Curragh. “There is plenty of runway left for growth in M&A.”
Finally, when it comes to initial public offerings, 2014 may be even harder to top: as of December 4, 288 companies went public last year, up from 238 IPOs in 2013 and the highest volume since 2000, when more than 400 companies went public, according to PwC. “You’d be hard pressed to say you’ll beat , but ultimately the indicators are still pretty positive” for the IPO market in 2015, Curragh tells CFO—in particular, a robust stock market and a healthy IPO pipeline.
ACCOUNTING & FINANCIAL REPORTING: Crowded Agendas
Finance chiefs will have plenty of new proposals, rules, and recommendations on accounting and financial reporting to digest in the New Year, courtesy of the Financial Accounting Standards Board and the Securities and Exchange Commission. At the same time, they will have their hands full adopting recently issued rules and standards, even though their deadlines for compliance may extend beyond 2015.
One of the latter is the converged standard from FASB and the International Accounting Standards Board on revenue recognition, Revenue from Contracts with Customers. Issued in May 2014, the standard is effective for U.S. public companies for reporting periods beginning after December 15, 2016, although FASB is currently considering delaying the effective date to allow companies more time to implement the rule.
Implementing the new standard will be “quite difficult on many fronts,” says Neri Bukspan, a partner in Ernst & Young’s Financial Accounting Advisory Services practice. Companies will have to change not only their accounting but also their managerial processes, says Bukspan, in order to collect the information necessary for making judgments and estimates about recognizing revenue. That won’t be easy for, say, a large multinational company with contracts in 50 countries, he says.
What’s more, a change in a company’s top line could be significant: “It may change your communication with the Street, change your bottom line,” says Bukspan.
Even if FASB does delay the effective date, “the sooner you start [implementing the standard], the better off you are,” he says, given the daunting nature of the task. Also, many companies will be entering into contracts today that will be affected when the standard goes into effect, Bukspan points out: “Is there anything you can do in your contractual arrangement to make your accounting simpler?” The sooner you start thinking about such matters, the better.
Other FASB standards and projects to keep abreast of, says Bukspan, include:
• The disclosure framework project. FASB wants to help companies cut through the clutter and optimize disclosures in the notes to the financial statements, says Bukspan. (See “Tackling Disclosure Overload,” CFO, December 2014.)
• Leases. “I would be remiss if I didn’t mention that,” says Bukspan. FASB and the International Accounting Standards Board are continuing to clarify and simplify their 2013 joint proposal to put most leases on the balance sheet, while retaining their separate allegiances to a single approach (the IASB) or a dual approach (FASB). A finished standard by one or both boards may be issued in 2015.
• The simplification initiative. FASB has embarked on various short-term simplification projects, narrow in scope, such as the measurement of inventory and accounting for income taxes. “In theory, simplifying should make your life easier,” says Bukspan. But even simplification is a change, one that has to be explained, adopted, and embedded within an organization, he says.
• Financial instruments, including the classification and impairment of financial instruments. FASB is likely to “crystallize” some of its proposals during 2015. says Bukspan.
• Insurance accounting. Originally a joint project of FASB and the IASB, at this point it’s more of an improvement and maintenance project for FASB, says Bukspan.
The SEC’s Interests
At the annual conference of the American Institute of Certified Public Accountants in December, SEC officials spoke about accounting and reporting issues that the commission is currently taking an interest in. Three of those issues were:
• The increasing number of restatements tied to the statement of cash flows. Professional accounting fellow Kirk Crews suggested that companies review their processes and controls when preparing the statement.
• The use of international financial reporting standards in the United States by domestic registrants. Chief accountant James Schnurr, who joined the commission in October, said that SEC Chair Mary Jo White has asked him “to make a recommendation to her as to the path forward” on IFRS, one he hopes to make in the near future.
• Segment reporting. Saying that the SEC “will be taking a refreshed approach when reviewing operating segment disclosures,” deputy chief accountant Dan Murdock focused on challenges that corporate accountants face in identifying and aggregating operating segments.
Last but far from least, like FASB, the SEC is seeking to make financial disclosure more effective, particularly in the Management’s Discussion and Analysis, says Bukspan. SEC staff recommend, among other things, that the MD&A evolve over time, shun boilerplate, summarize the most important aspects of the business, disclose key performance indicators, and avoid repeating discussion from other sections of the filing.
INSURANCE: Stability and Risk
Unlike in years past, one insurance story you won’t see in 2015 is the return of the hard market. That’s because the insurance industry has so much capacity today that even multibillion-dollar disasters like Hurricanes Katrina or Sandy are quickly absorbed. “$100 billion [in losses] isn’t what it used to be in today’s massive global insurance environment,” declares a recent report from insurance broker Willis North America, musing that we may be seeing the end of traditional market cycles.
“The balance sheet of the industry has improved a lot over the last 15 years,” agrees Eric Joost, chief operating officer of Willis North America. Even the 2005 Atlantic hurricane season, which featured a record-setting four Category 5 storms (including Katrina) and four Category 4 storms, didn’t have a significant impact on property insurance pricing beyond wind-exposed risks, he says, or have knock-on effects in other categories. At the same time, the insurance industry “has gotten better at helping mitigate or manage some risks,” says Joost.
Thanks to the industry’s abundant capacity, the Willis report (Marketplace Realities 2015) predicts “stability and generally softening conditions” in the 2015 insurance marketplace. That’s not to say, of course, that companies can relax: risk prevention is still better than the insurance cure. Moreover, significant new risks are emerging.
Cyber risk, in particular, is a major concern. “I spend a lot of time on this issue,” says Joost. “It is a systemic problem.” Major data breaches occurred over the past year or so at JPMorgan Chase, Home Depot, and Target, for example. But Joost says that “the more difficult piece [of cyber-attacks] isn’t loss of data—although that’s very difficult, very irritating—but loss of control.”
In December, for example, the German government revealed in its annual IT security report that a domestic steel factory had suffered significant damage after hackers obtained control of a blast furnace. In the United States, hackers have attacked the computers of water treatment plants, causing damage in at least one plant several years ago.
While carriers offer cyber-risk insurance, “risk management is the issue here,” says Joost. “You can’t avoid the problem. I’ve talked to some of the most sophisticated leaders in technology, and the first thing they say is: if you think you’re going to secure yourself and not have this problem, you’re naïve.”
Instead of “functionalizing” the management of cyber risk — delegating the problem to IT or the risk manager — companies should “institutionalize” it, says Joost. The CEO and board should ensure that awareness and ownership of cyber-risk management are shared by managers and employees throughout the company, he explains.
Big Risks Ahead
What can CFOs expect of premium prices in 2015? In property, rates have been falling for several quarters, according to the Willis report, “and we do not see an end to this trend.” In casualty, “many buyers will see rates softening fractionally,” while directors’ and officers’ insurance for public companies “should see stable pricing.”
Even rates for cyber policies will be “competitive,” predicts Willis, although point-of-sale retailers may see sizable increases, thanks to the recent data breaches in retail.
Finally, what are some of the top risks U.S. businesses will face in 2015? Joost names five, in no particular order:
- Health care cost inflation
- Cyber risk
- Political instability and terrorism
- The threat of a global economic downturn
- The prospect of permanently high rates of youth unemployment abroad.
Edward Teach is editor-in-chief of CFO.