Consider this: if Japan reduces its corporate tax rate as planned, the United States will have the dubious honor of having the highest statutory corporate rate in the world. While the topic of taxes is always top-of-mind for CFOs, in recent months it has climbed higher on the national agenda as well. As the sluggish recovery drags on and as issues of debt reduction and job creation dominate the national discussion, pressure is clearly building for Congress to lower the corporate rate.
Proponents of such a change have argued that it will create a more globally competitive business environment for U.S. firms and stimulate economic growth. President Obama’s deficit-reduction commission recommended a rate between 23% and 29%. At least one U.S. senator, Mike Johanns (R–Nebr.), has called for the rate to be lowered to 20%, while others have even suggested a drop to 10%. No matter the final rate, most indications point to a reduction coming — and soon.
A Significant Earnings Effect
While the news of a rate reduction will likely be warmly received among finance executives, they will have work to do to address the change. With the enactment of any prospective corporate-income-tax rate change, current U.S. financial-reporting requirements will cause a financial statement effect in the year the legislation is passed. According to Financial Accounting Standards Board pronouncement ASC 740 (formerly FASB No. 109), if the rate is lowered, finance executives at companies with a net deferred tax liability (DTL) position will need to make an immediate, one-time adjustment to decrease that balance-sheet account while making a commensurate increase in the company’s earnings through the provision for taxes account. Conversely, a company with a net deferred tax asset (DTA) position on its balance sheet will need to decrease that account and decrease earnings. Either of these one-time effects are potentially material and will alter a number of key financial-performance ratios.
In our research, we focus on seven important ratios: earnings per share (EPS), percentage change in earnings, and the five DuPont ratios (return on sales [ROS], asset turnover [ATO], return on assets [ROA], financial leverage [LEV], and return on equity [ROE]). With an assumed tax-rate reduction to 25%, our research indicates that for the 239 S&P 500 firms with net DTL positions, fiscal 2010 EPS would have increased by 40%, simply due to the one-time required adjustment. For the 226 S&P 500 firms with net DTA positions, the opposite would occur: earnings would have fallen, but by a smaller amount. (See Table 1 for details.)
Looking Forward, Looking Back
There are two significant financial-reporting issues associated with deferred taxes. Determining the deferred tax amount to be reported in accordance with GAAP requires both a balance-sheet focus and a future statutory-income-tax-rate focus. For our purposes, we have used the currently enacted U.S. statutory corporate income-tax rate of 35%. In practice, however, per ASC 740, DTAs and DTLs are to be measured “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.” If Congress were to pass legislation during 2011 that would lower the rate beginning in 2012, however, the deferred tax amount to be reported on the 2011 ending balance sheet must reflect the effects of that lower rate.
CFOs could easily overlook the required adjustment (see formula, below).
If a company currently has a net DTL position of $14 million and in 2011 Congress lowers the corporate tax rate to 25% beginning in 2012, the DTL account must be reduced as of the year-end 2011 balance sheet by $4 million — (.10/.35) x $14 million — and 2011 earnings would also be increased by $4 million.
Many CFOs would see the impact of a corporate-rate tax change on their financial statements, as deferred tax amounts on corporate balance sheets are both prevalent and substantial. Within the S&P 500, 93% of companies report either a net DTA or a net DTL, as do 71% of all publicly traded companies. There are roughly an equal number of companies with deferred tax assets as with deferred tax liabilities, but the relative size of the net DTL position is larger than that of the net DTA position.
In general, large DTL account balances are most likely to occur in capital-intensive industries like utilities, petroleum and natural gas, and transportation, primarily due to differences in Internal Revenue Service and financial-statement depreciation schedules (see Table 2). Conversely, sizable DTA account balances often exist for companies in industries with large balance-sheet liabilities that have not yet been recognized for tax purposes — contingent liabilities, for example — and at companies with operating losses where the tax law permits carryforward and carryback offsets. Apparel, heavy equipment, and recreation-related businesses lead the list.
The effect of a change in corporate tax rates on a particular company’s earnings and balance sheet, and the performance metrics drawn from those two financial statements, is, of course, dependent on both the company’s deferred tax-balance position, the starting point of the financial ratio of interest, and the assumed reduction in tax rates. Pro-forma effects for a specific company should be evaluated individually, but reasonable projections can also be applied using a “multiples” approach as a shortcut. (See Table 3 for an example.)
There is little doubt that Congress will change the corporate income-tax rate. It could be this year, or it could be next. No matter when, CFOs will need to make immediate adjustments to their income statements and balance sheets. The resultant effect on key financial-performance metrics will be experienced by many, and in rather significant ways.
Mark E. Haskins is a professor of business administration and Paul J. Simko is an associate professor of business administration at the Darden Graduate School of Business at the University of Virginia.